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- [Alex] In our final video on price floors,
we'll look at the last two effects,
and we'll take a close look at the example of airline regulation
in the United States.
We've shown using the minimum wage
how price floors create surpluses and also lost gains from trade.
We now want to look at wasteful increases in quality
and a misallocation of resources, and for that we're going to turn
to a different example: the regulation by the Civil Aeronautics Board
of airline fares.
From 1938 to 1978, the Civil Aeronautics Board
regulated airlines.
CAB regulations restricted entry --
they prevented new competitors from entering the industry --
and they kept airfares well above market levels.
There's some interesting evidence, by the way, on how high
the CAB kept fares above market rates.
Within state air routes were not controlled by the CAB;
they were unregulated by the CAB.
Therefore, the price of flights between cities within a state,
such as between L.A. and San Francisco,
was not regulated by the CAB.
And looking at these prices of these flights,
economists found that they were half the price
of equal distance flights,
which were between two different states,
and, thus, which were regulated by the CAB.
So it looked like the CAB was keeping
the prices of airline flights twice as high as market rates.
Now you might wonder why they were doing this.
And in fact, the CAB is a classic example
of a regulatory agency, which many people argue
was captured by the industry that it was meant to regulate.
Instead of regulating airlines, it was regulated by the airlines.
It was controlled by the airlines.
In any case, the result of preventing competition
by price was that airlines competed for customers on the basis
of quality rather than of price.
Now to see how this worked and why this is actually
a bad thing, why you can have too much quality,
let's take a look at our model.
Okay, here's our model: along the horizontal axis
we have the quantity of flights; along the vertical axis we have
the price, demand, supply and market equilibrium.
And here is the price floor, the CAB-regulated fare.
This was the price below which it was illegal
for the airlines to sell tickets.
Now, at this price we could read the quantity demanded
off the demand curve, which is given by this amount here.
This is the size of the industry
or the quantity of flights demanded.
It's also the quantity supplied
because the CAB regulated entry. They kept entry just to that level
which was necessary to satisfy the quantity demanded
at the regulated fare.
Now here's the key point: at the quantity demanded,
the sellers -- their willingness to..., the price at which they're willing to sell --
is much below the regulated fare,
the price which demanders are paying.
This meant that being in the airline industry was
extremely profitable because they were selling
a good when their cost was down here,
and the price that they were selling it at was up here.
So this entire rectangle here, okay, was profit,
a very profitable industry because the price was kept
well above the cost.
But now, each airline really wanted more customers
and this, in fact, was the genesis of the undoing
of the plan. Because each airline was trying to compete
to get more of these profitable customers. But, they couldn't
compete by lowering the price.
So how do you get more customers if you can't compete
by lowering the price?
Well, by increasing quality.
And indeed, at this time it was wonderful if you could
afford it to be on an airplane
because the seats were wide, the stewardesses were nice
and kind, and you got lots of free food.
You got good quality food, sometimes served on bone china.
You got to fly direct.
Even some airplanes -- believe it or not --
had piano bars on them in order to attract more customers.
But all of this competition in terms of quality was raising
the costs to the airline.
In addition, these profits attracted the unions.
The unions said, "Well, we want a chunk of this."
So wages would start to go up.
So what happened was that the airlines gave up this profit
or producer surplus by competing in terms of better meals,
more frequent service, and so forth.
And they did so...you might say, "Well, what's wrong with quality?"
But what's wrong is that the airlines were producing quality
even when the value of that quality was less than the cost to, excuse me,
even when the cost of that quality was higher than the value
to the customers.
So this was a form of quality waste.
It was too much quality: it was quality for which the cost
was greater than the value to the customers.
Okay, we can also show the deadweight loss
which you've seen before, so we have the quality waste
and the deadweight loss.
In the 1970s, there was deregulation of the airlines,
and the Civil Aeronautics Board, in fact, was eliminated,
highly unusual for bureaucracy to be eliminated.
The result was that fares went down dramatically,
the quantity of air flights went up,
quality waste disappeared.
This meant, of course, that rich people found
that it wasn't so pleasant to travel on the airlines
as it used to be, but fares were a lot lower
and overall customers appreciated lower fares more than
they were upset by the reduced quality.
Remember, an airline can always offer quality
if the customers want to pay for it.
But, the customers decided they would prefer to have
the lower fares.
That's another way of seeing that there was
quality waste: the fact that after deregulation fares went down
and quality went down indicates that the quality
really wasn't worth what the people had been paying for it.
This also is the genesis of a lot of problems
in the airline industry since the older airlines had
trouble funding union benefits.
They promised all of their employees these big benefits
when those profits were high because of regulation
and restrictions of competition, and they had trouble supplying
those benefits once regulation ended.
Price floors and regulations, such as that provided
by the Civil Aeronautics Board, created misallocation of resources.
In particular, it prevented competition.
So in 1938 -- believe it or not -- there were 16 major airlines.
In 1974, just before deregulation, there were 10 airlines,
fewer than in 1938, despite many requests
to enter the industry.
Indeed, restrictions on entry misallocated resources --
it meant that low-cost airlines, such as Southwest,
now one of the world's largest airlines,
were kept out of the industry, raising costs overall.
Okay, that's it for price floors: price floors create surpluses,
lost gains in trade, wasteful increases in quality,
and misallocation of resources.
We'll have one more lecture on price ceilings
and price floors, talk a little bit about the politics,
and then we'll be moving on.
We'll have covered this chapter.
This is a tough chapter, lots and lots of material
but lots of depth to it, lots of meat to this chapter.
So, pay attention. Okay, thanks.
- [Narrator] If you want to test yourself, click "Practice Questions."
Or, if you're ready to move on, just click "Next Video."
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