Price Floors: Airline Fares

In this video, we cover how price floors lead to wasteful increases in quality and a misallocation of resources. Using the real-world example of airline regulations from 1938-1978, we show how price floors can be used to restrict entry and reduce competition within an industry. When the Civil Aeronautics Board regulated airline fares, airlines couldn’t compete on price so they instead had to compete by increasing quality. This may sound like a good thing, but we’ll show how this actually created quality waste since the cost of that quality was higher than the value to the customers. Price floors also lead to the misallocation of resources by preventing competition and responsiveness to consumer demand. In this video, we’ll show you how consumers are negatively affected by price floors.

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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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