In 1978, under the Airline Deregulation Act, the United States deregulated its domestic airline industry. The main purpose of deregulation was to remove government control and open the air transport industry to market forces. Prior to the Act, the Civil Aeronautics Board regulated all domestic air transport, controlling fares and setting routes. In this regulated market, airlines competed more through advertising and onboard services than through fares. Similar to other highly regulated industries, the airline industry was heavily unionized with a highly trained and stable workforce. In the years since deregulation, many studies, including ours, have found that fares measured in real terms have fallen since 1978. For example, in 1999, we reported that overall airfares had fallen 21 percent in constant dollars between 1990 and the second quarter of 1998. However, while deregulation led to lower fares, it did not bring about the full measure of competition envisioned by its creators. Legacy airlines created unique hub- and-spoke networks that increased service for consumers but kept local market fares high at their dominated hubs. Generally, the legacy airlines earned a premium for operating their hub and acted in a highly competitive fashion (e.g. substantially increasing scheduled service and aggressive pricing) against intruders, including low cost new entrant airlines. In many ways, however, these legacy airlines continue to compete based on service rather than fares. The U.S. commercial airline industry is capital-intensive, labor-intensive, and has high fixed costs with revenues and profits closely tied to the nation’s business cycle. Fixed costs, including labor union contracts that are in effect for several years at a time, comprise a large portion of airline expenses and airlines must anticipate their capacity needs several years in advance. As a result, airlines tend to place orders for aircraft during profitable years, but deliveries tend to occur during down years. This has contributed to the cyclic nature of industry profitability. For example, in the 1990s, the industry recorded historically high profits of $47.4 billion from 1993 through 1999, during which time several airlines signed new agreements with their contract work force and ordered new aircraft. However, the industry has also experienced downturns at the beginning of each decade since deregulation. The airline industry reported losses of $2.5 billion from 1980 through 1982, $7.7 billion from 1990 through 1992, and $23 billion from 2001 through 2003. It is during these lean times that legacy airlines such as Braniff and Eastern failed, and others—such as US Airways and United more recently—filed for bankruptcy protection. It is also during these lean times that new entrant low cost airlines emerged. In the past, many of those new airlines quickly disappeared. In response to the latest downturn, the Congress provided several forms of financial relief, including direct grants and a 4-month security fee holiday, and it set up the Air Transportation Stabilization Board to provide up to $10 billion in loan guarantees. The U.S. airline industry is principally composed of legacy, low cost, and regional airlines; and while it is free of economic regulation, it remains regulated in other respects, most notably safety and operating standards. Legacy airlines are essentially those airlines that were in operation before deregulation and whose goal is to provide service from “anywhere to everywhere.” To meet this goal, these airlines support large, complex hub- and-spoke operations with thousands of employees and hundreds of aircraft (of various types) with service to domestic communities of all sizes as well as international points at numerous fare levels. To enhance revenues without expending capital, legacy airlines have entered into domestic (and international) alliances that give them access to some portion of each other’s network. Legacy airlines contract with or separately operate regional airlines to provide service to smaller communities; regional airlines typically operate turboprop or regional jet aircraft with up to 100 seats. Low cost airlines entered the marketplace after deregulation and primarily operate point-to-point service from “focus cities” using fewer types of aircraft. These airlines typically offer a simplified fare structure that was originally aimed at leisure passengers, but is increasingly attractive to business passengers because they do not have restrictive ticketing rules that make it significantly more expensive to purchase tickets within 2 weeks of the flight or make changes to an existing itinerary. Low cost airlines do not yet offer service outside Canada, Central America, and the Caribbean. DOT oversees industry competition and safety, including the air traffic control system. The Department of Homeland Security’s Transportation Security Administration (TSA), which was formed after the September 11, 2001, terrorist attacks and was originally part of DOT, oversees industry security, including passenger and baggage screening. Although the airline industry was deregulated 26 years ago, during the last several years, airlines have been presented with a sweeping set of challenges. These challenges stem from the internal restructuring of the airline industry and from external factors affecting the demand for air travel. Internally, the impact of the Internet on how tickets are sold and how consumers can search for fares, the emergence of low cost airlines as a powerful market force, and the growth of regional airlines have had a major impact on the airline industry. Coincidently, a series of largely unforeseen events—among them the September 11, 2001, terrorist attacks, war in Iraq, and associated security concerns; the SARS crisis; economic downturn; and a steep decline in business travel have seriously disrupted the demand for air travel. Since 1998, the U.S. airline industry has faced internal changes that have fundamentally altered the domestic airline industry. Among the most significant factors affecting this change are the emergence of the Internet and a new breed of low cost airlines, and the growth of regional airlines have spurred the industry to reevaluate how it conducts business. Since the mid-1990s, partly in response to increasing costs of global distribution systems, airlines have increasingly sold and processed tickets through Internet-based applications, such as airline Web sites, Orbitz, and other internet-based travel agencies. Through various incentives, airlines have encouraged some passengers to book a growing portion of tickets this way (see fig. 1). This distribution method is less expensive to airlines than traditional travel agencies, but it has also increased the ability of consumers to compare airline ticket pricing and scheduling and often gives consumers access to special low fares available only on the Internet. This increased price transparency has been a significant factor in the downward pressure on airfares, creating a real decline in airline passenger revenues at the same time that airlines are incurring cost savings. Another major factor in the internal restructuring of the U.S. commercial aviation industry is the growth of low cost airlines. Low cost airlines have increased their share of available seat miles (ASM)—an industry measure of supply—from 10.8 percent in 1998 to 17.5 percent in 2003 (see fig. 2). Low cost airlines typically rely upon fewer types of aircraft and offer simpler fare structures than legacy airlines. Unlike earlier low cost airlines, many of which quickly disappeared, these airlines are well-capitalized and offer a good overall product. As relative newcomers in the industry, these airlines do not yet suffer from what is commonly know as “legacy costs,” costs that older airlines incur simply due to their longevity. These include the labor costs of a more senior workforce as well as retirees, aircraft costs from maintaining several fleet types as well as older aircraft, and the costs of maintaining networks. During this period of turmoil for the legacy airlines, their regional affiliates have increased capacity and maintained profitability. Regional airlines, which operate in affiliation with one or more legacy airlines, may be wholly or partially owned by the partner airline or completely independent. Regional airlines primarily serve smaller communities with regional jet or turboprop aircraft through contractual arrangements with legacy carriers. Many of these contracts are risk free for the regional airline because the legacy partner pays a fee for the regional airline’s service. From 1998 through 2003, the 16 largest regional airlines included in our study earned an operating profit of $3.3 billion. At the same time, regional airlines increased seat capacity 140.6 percent between 1998 and 2003 (see fig. 3). This growth and profitability of the regional airlines came about because legacy airlines transferred routes to them. Recently, two low cost carriers—AirTran and Frontier—also partnered with regional airlines for regional jet service. In contrast, JetBlue plans to introduce 100-seat Embraer 190 regional jets into its own fleet for service in late 2005. However, changes are looming for regional airlines. Legacy airlines are seeking less expensive contracts with their regional partners. In the case of one of United Airline’s former regional partners, Atlantic Coast Airlines decided to reinvent itself as a low cost carrier, Independence Air, instead of operating under a new contract with United or another airline. This may be the first of several shake-ups in the legacy-regional airline partnerships, as Delta Air Lines contemplates a bankruptcy filing and US Airways struggles to avoid a second bankruptcy. (App. III contains additional financial information on the regional airlines.) Demand for air travel began weakening in 2000 due to a number of external changes in the aviation environment. An economic downturn that began in 2000 precipitated a decrease in demand for air travel, while the terrorist attacks of September 11, the Iraq War, and the outbreak of SARS have compounded this trend. These events have accelerated the structural changes in the demand for air travel that is likely to suppress revenue for the foreseeable future, including the inability of airlines to charge premium business fares. Airlines’ financial problems of the past 4 years began with an economic downturn in 2000. As illustrated in figure 4 below, industry experts have long recognized a relationship between the nation’s economic performance and the demand for air travel. The growth in the nation’s gross domestic product (GDP) most recently peaked in 1999 before falling to 0.5 percent in 2001, and then rebounding in 2002.