NARRATOR: In any free market economy, the pricesk of goods ...



Principles of Economics

by N Gregory Mankiw

The Video Series script

Principle #6 Markets are Usually a Good Way to Organize Economic Activity

In any free market economy, the prices of goods and services are determined by the laws of supply and demand.

The prices and quantity sold of goods and services reach equilibrium by responding to the behavior of buyers and sellers. The force that moves price and quantity to equilibrium is called “The Invisible Hand,” a phrase coined by Adam Smith in the 1700s.

In a marketplace that is heavily regulated by the government, this invisible hand can no longer work, because prices reflect political policy rather than the consumer’s choice.

Before 1978, America’s airline industry was a regulated marketplace where prices were determined by the government. Consumers had little choice in terms of fare, airline, or quality of service.

After five decades of regulation, prices could not adjust naturally to free market forces. Because fares were set by planning committees, airlines had no incentive to compete for customers or to run efficiently.

Airlines had become so inefficient and polluting that the problem came to the attention of the U.S. Congress.

Congress reasoned that by setting market forces loose in the airline industry, airlines would soon compete with one another for passengers.

In 1978 Congress passed the Airline Deregulation Act with the support of President Carter. They speculated that the invisible hand of a free market was still a good way to organize the economic activity.

By opening more routes to competition, more suppliers entered the market. They hoped that this would lead to lower airfares, better efficiency, technological advances, and greater choices for travelers.

In the years following deregulation, the invisible hand of the marketplace has benefited all kinds of travelers.

Take Amy, for example, who wants to fly our to visit her boyfriend for the weekend.

In a regulated market, she would have the choice of one or two carriers and a fare that is fixed by the government. But in a free market, she can choose from a range of fares and companies. All that is required is a call to her travel agent, who can compare the prices of all the major airlines.

If she can travel with one airline at an off-peak time, for example, she can save hundreds of dollars off the full fare of another. A regulated marketplace would probably now allow this kind of flexibility.

Deregulation has forced airlines to become innovative in competing with one another.

This graph demonstrates the hub and spoke system developed by the airlines as a outgrowth of deregulation. As small regional airports, or spokes, feed into larger hubs in a major city, passengers are routed to their destination from the hub. Large airlines can control the terminals at their hub airports and charge other airlines to use them.

United Airlines, for instance, often routes passenger traffic through their Chicago hub. They then service smaller airports with economical propeller planes and save large jets for longer routes that have more passengers. For this reason, Amy might make a stop at a large airport before continuing on to her destination.

Southwest Airlines is a good example of a company that has benefited by deregulation. It began as a small commuter airline which served markets ignored by larger companies.

Flying short and low-maintenance routes enabled Southwest to quickly establish itself as a price leader.

Since shorter routes require less maintenance and smaller crews, Southwest streamlined operations. They have developed passenger routing and baggage loading techniques that allow them to turn a plane around in thirty minutes. They save time and money, the keys to survival in the airline business.

This efficiency translates into savings on fuel, labor, insurance and other expenses that get passed on to the consumer.

Efficiency is the outstanding advantage that Southwest uses over its competitors. To fill an undersold flight, Southwest can add passengers for literally the price of peanuts.

Other airlines have tried to mimic Southwest’s success. As they enter the market the increased competition keeps prices in check. This prevents any one airline from monopolizing the market.

Some airlines, however, were not able to survive after deregulation. Giants of the past like Pan Am and Eastern airlines folded in 1991 because they were unable to streamline operations and match the lower fares of their competitors. Instead, expenses took there toll as labor unions resisted wage cuts.

Other airlines were forced to make trade-offs in their quest for efficiency. Compromises in safety have been uncovered as airline cut expenses to stay competitive. Or some airline are forced to fly an aging fleet longer in an effort to avoid expenditures and keep air fares down.

Yet overall, deregulation of the airline industry has been a windfall to the consumer. The US General Accounting Office reports that on average, air fares are down almost 10 percent at small, medium, and large airports since deregulation.

The increased number of flights, savings in travel time, and overall efficiency of the hub-and-spoke system has saved US consumers 10.3 billion dollars a year. Deregulation has also spurred overall advances in safely. The accident rate per one hundred thousand departures has dropped 90%.

By removing barriers to free competition, the government has allowed the airline industry to demonstrate one of the basic principles of economics: that markets are a good way to organize economic activity.

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