Price Floors: Airline Fares
-
0:10 - 0:14- In our final video on price floors,
we'll look at the last two effects, and -
0:14 - 0:19we'll take a close look at the example of
airline regulation in the United States. -
0:24 - 0:28We've shown using the minimum wage how
price floors create surpluses and also -
0:28 - 0:33lost gains from trade. We now want to look
at wasteful increases in quality and a -
0:33 - 0:36misallocation of resources, and for that
we're going to turn to a different -
0:37 - 0:42example: the regulation by the Civil
Aeronautics Board of airline fares. From -
0:43 - 0:491938 to 1978, the Civil Aeronautics Board
regulated airlines. CAB regulations -
0:49 - 0:53restricted entry, they prevented new
competitors from entering the industry, and -
0:53 - 0:57they kept air fares well above market
levels. There's some interesting evidence -
0:58 - 1:04by the way on how high the CAB kept fares
above market rates. Within-state air -
1:04 - 1:10routes were not controlled by the CAB;
they were unregulated by the CAB. -
1:10 - 1:14Therefore, the price of flights between
cities within a state, such as between LA -
1:14 - 1:20and San Francisco, was not regulated by the
CAB. Looking at the prices of these -
1:20 - 1:25flights, economists found out that they
were half the price of equal-distance -
1:25 - 1:29flights which were between two different
states and thus which were regulated by -
1:29 - 1:35the CAB. So it looked like the CAB was
keeping the prices of airline flights -
1:35 - 1:40twice as high as market rates. Now you
might wonder why they were doing this. In -
1:41 - 1:46fact the CAB is a classic example of a
regulatory agency which many people argue -
1:46 - 1:52was captured by the industry that it was
meant to regulate. Instead of regulating -
1:53 - 1:58airlines, it was regulated by the airlines.
It was controlled by the airlines. In any -
1:59 - 2:05case, the result of preventing competition
by price was that airlines competed for -
2:05 - 2:09customers on the basis of quality rather
than of price. -
2:09 - 2:14Now to see how this worked and why this
was actually a bad thing, why you can have -
2:14 - 2:19too much quality, let's take a look at our
model. OK, here's our model: along the -
2:20 - 2:23horizontal axis we have the quality of
flights; along the vertical axis we have -
2:23 - 2:28the price, demand, supply and market
equilibrium. And here is the price floor, -
2:28 - 2:33the CAB-regulated fare. This was the price
below which it was illegal for the -
2:33 - 2:39airline to sell its tickets. At this
price we could read the quantity demanded -
2:40 - 2:43off the demand curve which is given by
this amount here. This is the size of the -
2:44 - 2:48industry or the quantity of flights
demanded. It's also the quantity supplied. -
2:48 - 2:53Because the CAB regulated entry, they kept
entry just to that level which was -
2:53 - 2:58necessary to satisfy the quantity demanded
at the regulated fare. Here's the key -
2:59 - 3:06point: at the quantity demanded, the
sellers, the price at which they're -
3:06 - 3:12willing to sell, is much below the
regulated fare, the price which demanders -
3:12 - 3:18are paying. This meant that being in the
airline industry was extremely profitable -
3:18 - 3:22because they were selling a good when
their cost was down here and the price -
3:22 - 3:29that they were selling it at was up here.
So this entire rectangle here was profit, -
3:30 - 3:35a very profitable industry because the price
was kept well above the cost. But now each -
3:36 - 3:41airline really wanted more customers and
this in fact was the genesis of the -
3:42 - 3:47undoing of the plan because each airline
was trying to compete to get more of these -
3:47 - 3:52profitable customers but they couldn't
compete by lowering the price. So how do -
3:52 - 3:56you get more customers if you can't
compete by lowering the price? -
3:56 - 3:59Well, by increasing quality.
-
4:00 - 4:05Indeed at this time it was wonderful if
you could afford it to be on an airplane -
4:05 - 4:11because the seats were wide, the
stewardesses were nice and kind, and you got -
4:11 - 4:17a lot of free food. You got good quality
food, sometimes served on bone china. You -
4:17 - 4:23got to fly direct. Even some airplanes -
believe it or not - had piano bars on them -
4:23 - 4:28in order to attract more customers. But
all of this competition in terms of -
4:28 - 4:36quality was raising the cost to the
airline. In addition, these profits -
4:36 - 4:40attracted the unions. The unions said
"well we want a chunk of this," so wages -
4:40 - 4:46would start to go up. So what happened is
that the airlines gave up this profit or -
4:46 - 4:53producer surplus by competing in terms of
better meals, more frequent service and so -
4:53 - 4:58forth. You might say "well what's wrong
with quality?" But what's wrong is the -
4:58 - 5:10airlines were producing quality even when
the cost of that quality was higher than -
5:10 - 5:17the value to the customers. This was a
form of quality waste. It was too much -
5:17 - 5:23quality: it was quality for which the cost
was greater than the value to the -
5:23 - 5:28customers. We can also show the deadweight
loss which you've seen before, so -
5:28 - 5:33you have the quality waste and the dead
weight loss. In the 1970's there was -
5:33 - 5:38deregulation of the airlines, and the Civil
Aeronautics Board in fact was eliminated, -
5:38 - 5:43highly unusual for bureaucracy to be
eliminated. The result was that fares went -
5:43 - 5:49down dramatically, the quantity of air
flights went up, quality waste -
5:49 - 5:53disappeared. This meant of course that
rich people found that it wasn't so -
5:53 - 6:00pleasant to travel on the airlines as it
used to be, but fares were a lot lower and -
6:00 - 6:07overall customers appreciated lower fares
more than they were upset -
6:07 - 6:08by the reduced quality.
-
6:08 - 6:12Remember, an airline can always offer
quality if the customers want to pay for -
6:12 - 6:17it. But, the customers decided they would
rather have the lower fares. That's -
6:18 - 6:21another way of seeing that there was
quality waste: the fact that after -
6:22 - 6:26deregulation fares went down and quality
went down indicated that the quality -
6:26 - 6:33really wasn't worth what people had been
paying for it. This also is the genesis of -
6:33 - 6:38a lot of problems in the airline industry
as the older airlines had trouble funding -
6:39 - 6:45union benefits. They promised all of their
employees these big benefits when profits -
6:45 - 6:51were high because of regulation and
restrictions of competition, and they had -
6:51 - 6:59trouble supplying these benefits once
regulation ended. Price floors and -
6:59 - 7:03regulations such as that provided by the
Civil Aeronautics Board created -
7:04 - 7:10misallocation of resources. In particular
it prevented competition. In 1938 - believe -
7:10 - 7:16it or not - there were 16 major airlines. In
1974 just before deregulation there were -
7:16 - 7:2410 airlines, fewer than in 1938, despite
many requests to enter the industry. -
7:24 - 7:29Indeed, restrictions of entry and misallocated
resources meant that low-cost airlines -
7:29 - 7:34such as Southwest, now one of the world's
largest airlines, were kept out of the -
7:35 - 7:41industry, raising cost overall. OK, that's
it for price floor: price floors create -
7:42 - 7:46surpluses, lost gains in trade, wasteful
increases in quality, and misallocation of -
7:46 - 7:51resources. We'll have one more lecture on
price ceilings and price floors, talk a -
7:51 - 7:54little bit about the politics and then
we'll be moving on. We'll have covered -
7:54 - 7:58this chapter. This is a tough chapter,
lots and lots of material but -
7:58 - 8:03lots of depth to it, lots of meat to this
chapter. Pay attention. Okay, thanks. -
8:05 - 8:09If you want to test yourself click
Practice Questions or if you're ready to -
8:09 - 8:11move on just click Next Video.
- Title:
- Price Floors: Airline Fares
- Description:
-
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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- Video Language:
- English
- Team:
- Marginal Revolution University
- Project:
- Micro
- Duration:
- 08:17
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