economic essay 8 pages due in 48 hours

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Economics 2166F-001

Lecture 3

Chapter 2 • Principles of economics with applications

in aviation

Economics • Economics is the science that deals with

the allocation of limited resources to satisfy unlimited human wants. – Economics is the study of how society manages its

scarce resources (Mankiw, 2001, p. 4). – [Economics is the] social science that studies the

choices that individuals, businesses, governments, and entire societies make as they cope with scarcity (Bade and Parkin, 2002, p. 5).

– “Economics is what economists do.”

Two branches of economics • Microeconomics studies the economic behavior

of individual economic decision makers, such as a consumer, a worker, a firm, or a manager.

• Macroeconomics analyzes how an entire national economy performs – GDP, inflation, unemployment,, and business cycles in a national economy.

Macroeconomics A business cycle is defined as the movement of

economic activities such as unemployment, inflation, and economic growth.

Economic Model: Basic Assumptions

• Decision makers are rational. • They pursue their own interest.

– Consumers maximize utility (satisfaction). – Producers maximize profit. – Government maximizes social welfare.

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Microeconomics: Study of constrained choices

• Variables that have values taken as given in the analysis are exogenous variables – constraints.

• Variables that have values determined as a result of the model’s workings are endogenous variables – choice.

Ex) A consumer wants to allocate 24 hours in eating, sleeping, studying, and playing.

Airline’s decision making • Choice

• Constrains

Choice and opportunity cost • Choosing to utilize a resource has an implicit

cost referred to as opportunity cost.

• Opportunity cost is defined as the value of a resource in its best alternative use, that is, the benefits that would accrue if the resource were being utilized in its next best allocation.

Definition: The marginal effect of any activity is the effect of doing the activity just a little bit more.

(e.g., marginal revenue, marginal cost)

Definition: The marginal principle states that any a ctivity should be carried out as long as the marginal benefit exceeds the marginal cost.

Marginal reasoning

Budget = $1m to allocate between TV ( T ) and radio ( R )

Problem: Max B(T,R) (T,R)

subject to: pTT + pRR < $1m

where: B is "barrels“ and pT, pR are the prices of TV and radio advertising, respectively.

Total Spent New Beer Sales Generated

TV Radio

$ 0 0 0

$100,000 4,750 950

$200,000 9,000 1,800

$300,000 12,750 2,550

$400,000 16,000 3,200

$500,000 18,750 3,750

$600,000 21,000 4,200

$700,000 22,750 4,550

$800,000 24,000 4,800

$900,000 24,750 4,950

$1,000,000 25,000 5,000

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Economic systems: Different role of government control

• Market economy (pure capitalism) – laissez-faire

• Command economy – central planning

• Mixed economy – policy and regulation (creating incentives)

Incentives • An economic incentive is best described as

a force or circumstance that encourages an individual to engage in a particular activity.

Incentives • Incentives are a powerful tool for analyzing

public policy (and understanding consequences of policy and regulations).

Ex. The threat of litigation has incentivized the Federal Aviation Administration (FAA) to institute ever more stringent tests for aircraft certification, which has in turn dis-incentivized many general aviation manufacturers from major or frequent innovation.

Government and aviation • Throughout the world, aviation has always been deeply

intertwined with government. Since the beginning of com mercial aviation in the 1920s and 1930s, governments supported and subsidized the fledgling industry, encouraging innovation through lucrative mail contracts, and later through military contracts. – In Europe, this took the form of direct government subsidies to

aviation. – The American and British governments took the route of indirect

subsidies through mail contracts. – Airbus is arguable subsidized more directly, while others argue

that Boeing receives an indirect cross-subsidization through its defense contracts.

US aviation history • Air Commerce Act of 1926 (with Airmail Act of 1925)

authorized the Post Office to contract with airlines to transport mail.

• By the mid-1930s, the four major domestic airlines that do minated commercial travel for most of the 20th century beg an operations: United, American, Eastern, and TWA.

• Civil Aeronautics Board (CAB) created in 1940 • Federal Aviation Administration (FAA) created in 1958 • Airline Deregulation in 1978 • Transportation Security Administration (TSA) created in

2001

Before deregulation • These airlines were regulated by the CAB in terms of routes and

fares, and new entrants had to apply for permission to carry out air transportation, which could be contested by the existing carriers.

• Every aspect of airline operations was regulated, right down to new aircraft acquisitions, the type and disposition of freight carried, whether carriers could issue refundable tickets, whether a carrier certificated to operate a one-stop segment could change to non-stop service, whether the flight attendants of two financially affiliated airlines could wear similar uniforms, and so forth.

• Every operational detail of air transportation was under scrutiny and required approval—and while on one hand, no carrier ever went bankrupt under such regulation, neither did they have the flexibility to conduct any business on their own terms without extensive approval processes.

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After regulation • Airline deregulation introduced the practice of revenue

management, which was a byproduct of competition engendered by the emergence of LCCs.

• Revenue management increases revenue by charging each consumer what he/she is willing to pay, as opposed to a blanket single fare across consumer characteristics.

• Furthermore, the fall in ticket prices and the increase in route choices points to a distinct benefit. On the other side, airlines, especially legacy carriers, had to operate in an environment of much more heated competition.

Market failure • Market failure occurs when the market does not allocate

resources to their most efficient use. • Two main categories of market failures are externalities

and a lack of competition. • Imperfect / asymmetric information is another source of

market failure.

Externality • Externalities are hidden costs and benefits associated

with the production of a good or service that are not fully experienced by the individual producing or consuming it, but exist as a byproduct of such production or consumption.

Government failure • Government failure occurs when a government

attempts regulation, but does so inefficiently and the resulting allocation of resources is inferior to that achieved by the free market. – Ex. Airline regulation

Scheduled departures within US Hub dominance