Price Floors: Airline Fares

Course Outline

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.

Teacher Resources


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 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.



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