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 air fares
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 LA

and San Francisco, was not regulated by the
CAB. Looking at the prices of these

flights, economists found out 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. 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
was actually a bad thing, why you can have

too much quality, let's take a look at our
model. OK, here's our model: along the

horizontal axis we have the quality 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

airline to sell its tickets. 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. Here's the key

point: at the quantity demanded, the
sellers, 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 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.

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

a lot 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 cost 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 is
that the airlines gave up this profit or

producer surplus by competing in terms of
better meals, more frequent service and so

forth. You might say "well what's wrong
with quality?" But what's wrong is the

airlines were producing quality even when
the cost of that quality was higher than

the value to the customers. 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. We can also show the deadweight
loss which you've seen before, so

you have the quality waste and the dead
weight loss. In the 1970's 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
rather 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 indicated that the quality

really wasn't worth what people had been
paying for it. This also is the genesis of

a lot of problems in the airline industry
as the older airlines had trouble funding

union benefits. They promised all of their
employees these big benefits when profits

were high because of regulation and
restrictions of competition, and they had

trouble supplying these 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. 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 of entry and misallocated
resources meant that low-cost airlines

such as Southwest, now one of the world's
largest airlines, were kept out of the

industry, raising cost overall. OK, that's
it for price floor: 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. Pay attention. Okay, thanks.

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