Price Floors: Waste and Misallocation of Resources

Wasteful Increases in Quality

• When a price floor is in place, firms want more customers
• How do firms compete when they can’t lower prices?
  • They have to offer higher quality
  • Ex: when airlines were regulated, they competed by offering their customers fancy meals and wide seats
  • Increase in quality comes with a price
  • An increase in quality that consumers aren’t willing to pay for is a wasteful increase in quality
  • As firms competed by offering higher quality, the initial producer surplus was wasted away in things that consumers liked, but wouldn’t be willing to pay for (the red area is labeled “Quality Waste”)

The Misallocation of Resources

• Restrictions on entry of new airlines misallocated resources because low-cost airlines were kept out of the industry
  • Increases prices and costs and reduced innovation
  • Ex: southwest airlines began as a Texas only airline because it couldn’t get a license from the CAB to operate between states
  • They were able to enter the national market only after deregulation occurred
  • this was not just a case of increasing supply
• one of the virtues of the market process is that it’s open to new ideas, innovations, and experiments
  • ex: southwest pioneered consistent use of the same aircraft to lower maintenance costs, greater use of smaller airports, and long-term hedging of fuel costs
• Deregulation improved allocation of resources by allowing low-cost, innovative firms to expand nationally