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- [Alex] In our final video 
on price floors,

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we'll look at the last two effects,

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and we'll take a close look 
at the example of airline regulation

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in the United States.

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We've shown using 
the minimum wage

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how price floors create surpluses 
and also lost gains from trade.

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We now want to look
at wasteful increases in quality

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and a misallocation of resources, 
and for that we're going to turn

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to a different example: the regulation
by the Civil Aeronautics Board

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of airline fares.

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From 1938 to 1978, 
the Civil Aeronautics Board

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regulated airlines.

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CAB regulations restricted entry --

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they prevented new competitors 
from entering the industry --

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and they kept airfares 
well above market levels.

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There's some interesting evidence,
by the way, on how high

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the CAB kept fares
above market rates.

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Within state air routes were not 
controlled by the CAB;

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they were unregulated by the CAB.

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Therefore, the price of flights 
between cities within a state,

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such as between L.A. 
and San Francisco,

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was not regulated by the CAB.

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And looking at these prices 
of these flights,

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economists found 
that they were half the price

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of equal distance flights,

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which were between 
two different states,

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and, thus, which were regulated 
by the CAB.

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So it looked like 
the CAB was keeping

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the prices of airline flights
twice as high as market rates.

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Now you might wonder 
why they were doing this.

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And in fact, the CAB is 
a classic example

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of a regulatory agency, 
which many people argue

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was captured by the industry 
that it was meant to regulate.

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Instead of regulating airlines, 
it was regulated by the airlines.

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It was controlled by the airlines.

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In any case, the result 
of preventing competition

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by price was that airlines competed 
for customers on the basis

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of quality rather than of price.

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Now to see how this worked 
and why this is actually

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a bad thing, why you can 
have too much quality,

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let's take a look at our model.

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Okay, here's our model: 
along the horizontal axis

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we have the quantity of flights; 
along the vertical axis we have

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the price, demand, supply 
and market equilibrium.

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And here is the price floor,
the CAB-regulated fare.

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This was the price
below which it was illegal

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for the airlines to sell tickets.

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Now, at this price we could read 
the quantity demanded

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off the demand curve, which is 
given by this amount here.

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This is the size of the industry

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or the quantity of flights demanded.

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It's also the quantity supplied

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because the CAB regulated entry.
They kept entry just to that level

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which was necessary to satisfy 
the quantity demanded

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at the regulated fare.

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Now here's the key point: 
at the quantity demanded,

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the sellers -- their willingness to...,
the price at which they're willing to sell --

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is much below the regulated fare, 


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the price which demanders are paying.

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This meant that being 
in the airline industry was

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extremely profitable
because they were selling

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a good when their cost 
was down here,

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and the price that they were 
selling it at was up here.

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So this entire rectangle 
here, okay, was profit,

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a very profitable industry 
because the price was kept

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well above the cost.

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But now, each airline really wanted 
more customers

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and this, in fact, was 
the genesis of the undoing

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of the plan. Because each airline
was trying to compete

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to get more of these profitable 
customers. But, they couldn't

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compete by lowering the price.

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So how do you get more customers 
if you can't compete

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by lowering the price?

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Well, by increasing quality.

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And indeed, at this time 
it was wonderful if you could

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afford it to be on an airplane

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because the seats were wide, 
the stewardesses were nice

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and kind, and you got 
lots of free food.

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You got good quality food, 
sometimes served on bone china.

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You got to fly direct.

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Even some airplanes --
believe it or not --

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had piano bars on them in order 
to attract more customers.

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But all of this competition 
in terms of quality was raising

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the costs to the airline.

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In addition, these profits
attracted the unions.

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The unions said,
"Well, we want a chunk of this."

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So wages would start to go up.

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So what happened was that 
the airlines gave up this profit

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or producer surplus by competing 
in terms of better meals,

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more frequent service, and so forth.

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And they did so...you might say, 
"Well, what's wrong with quality?"

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But what's wrong is that the airlines 
were producing quality

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even when the value of that quality
was less than the cost to, excuse me,

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even when the cost of that quality 
was higher than the value

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to the customers.

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So this was a form of quality waste.

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It was too much quality: 
it was quality for which the cost

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was greater than the value 
to the customers.

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Okay, we can also show 
the deadweight loss

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which you've seen before, 
so we have the quality waste

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and the deadweight loss.

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In the 1970s, there was
deregulation of the airlines,

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and the Civil Aeronautics Board, 
in fact, was eliminated,

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highly unusual for bureaucracy 
to be eliminated.

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The result was that fares went 
down dramatically,

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the quantity of air
flights went up,

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quality waste disappeared.

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This meant, of course, 
that rich people found

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that it wasn't so pleasant 
to travel on the airlines

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as it used to be, 
but fares were a lot lower

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and overall customers appreciated 
lower fares more than

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they were upset 
by the reduced quality.

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Remember, an airline can 
always offer quality

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if the customers want to pay for it.

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But, the customers decided 
they would prefer to have

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the lower fares.

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That's another way 
of seeing that there was

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quality waste: the fact that 
after deregulation fares went down

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and quality went down 
indicates that the quality

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really wasn't worth what the
people had been paying for it.

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This also is the genesis 
of a lot of problems

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in the airline industry
since the older airlines had

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trouble funding union benefits.

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They promised all of their
employees these big benefits

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when those profits were high 
because of regulation

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and restrictions of competition, 
and they had trouble supplying

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those benefits 
once regulation ended.

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Price floors and regulations, 
such as that provided

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by the Civil Aeronautics Board, 
created misallocation of resources.

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In particular, 
it prevented competition.

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So in 1938 -- believe it or not --
there were 16 major airlines.

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In 1974, just before deregulation, 
there were 10 airlines,

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fewer than in 1938, 
despite many requests

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to enter the industry.

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Indeed, restrictions on entry 
misallocated resources --

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it meant that low-cost airlines,
such as Southwest,

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now one of the world's
largest airlines,

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were kept out of the industry, 
raising costs overall.

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Okay, that's it for price floors: 
price floors create surpluses,

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lost gains in trade, 
wasteful increases in quality,

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and misallocation of resources.

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We'll have one more lecture 
on price ceilings

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and price floors, talk a little bit 
about the politics,

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and then we'll be moving on.

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We'll have covered this chapter.

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This is a tough chapter,
lots and lots of material

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but lots of depth to it, 
lots of meat to this chapter.

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So, pay attention. Okay, thanks.

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- [Narrator] If you want to test 
yourself, click "Practice Questions."

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Or, if you're ready to move on,
just click "Next Video."

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♪ [music] ♪