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Econ2166-Lecture4-Chapter3.pdf

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Economics 2166F-001

Lecture 4

Chapter 3

• Supply and Demand:

– Analysis in the Airline Industry

* Assume that airline industry is perfectly competitive.

Imperfectly competitive market structures will be studied

in Chapter 8 and Chapter 9.

Part I: Basics of Demand

• Law of demand

– Demand curve

– Derived demand vs. Direct demand

– Demand function

• Determinants of demand for air transportation

• Inverse demand function

• Other demand functions

• Characteristics of demand for air transportation

Demand function

• A demand function (demand schedule):

the quantity of a good all consumers in the market are

willing to buy is a function of various factors.

QDNY-LA = Function (PX, PZ, Y, ANY-LA, PANY-LA, H)

– QDNY-LA is the quantity of tickets demanded between JFK-LAX

– PX is the own ticket price;

– PZ is the competition’s ticket price;

– Y is the annual income or state of the economy;

– ANY-LA is the availability of other mode of transportation between

JFK–LAX;

– PANY-LA is the price of other mode of transportation between JFK–

LAX;

– H is a composition of other factors such as service, customer

loyalty, safety, cabin amenities, and random factors.

Demand function: an example

Demand curve

• The Demand Curve is a graphical description of the

demand function [demand schedule], and it plots the

quantities of a good that customers are willing to buy

at alternative prices in a given period of time,

ceteris paribus [all other things being equal].

• Linear demand curve: QDNY-LA = 15000 – 2P

• Inverse demand curve: P = 15,000 – 75Q

Law of demand

• The law of demand states that, ceteris paribus, as price

increases, the quantity demanded decreases.

Other demand curves

• Log-linear demand curve: LnQD = βo + β1LnP

• General log-linear demand function:

LnQD = βo + β1LnPX + β2LnPZ + β3LnY

Derived demand vs. direct demand

• Derived Demand

– The part of demand for a good that is derived from the

production and sale of other goods.

• Direct Demand

– The part of demand for a good that comes from the

desire of buyers to directly consume the good itself.

Characteristics of demand

for air transportation

• The demand for air travel also has many unique

characteristics that present problems for the airline

industry.

 fluctuations

 cyclicality

 seasonality and peaking

 directional flow

 perishability

Cyclicality of demand

for air transportation

Seasonality of demand

for air transportation

Part 2: Basics of Supply

• Factors affecting supply of airline services

• Characteristic of supply for airline services

– rigidity

Supply

• Supply refers to a firm’s willingness and ability to provide

a specific number of seats at a given price, time period,

and market. In the airline industry, supply is the capacity

of an airline to transport passengers, a function of

offered routes and available aircraft.

• Supply is usually expressed in available seat miles (ASM

s) or available ton miles (ATMs). An ASM is simply one

seat carried through the air for one mile, regardless of

whether it contains a passenger or not. The presence of

a revenue passenger in the seat is the key difference

between RPMs (demand) and ASMs (supply).

Load factor

• Dividing RPMs by ASM gives us a key performance

indicator for airlines, the load factor.

• This is defined as the percentage of capacity that has

been matched with demand.

• Similarly, for cargo or freight transportation, the

equivalent unit to RPMs is RTM, which may be matched

up with ATMs to yield a cargo load factor. Load factors

are critical to airline performance, since they determine

aircraft utilization, drive the profitability of a given route,

and indicate the useful utilization of capacity.

Factors affecting

supply of airline services

• The implicit supply function for the airline industry can be

written as:

QS = f{P, PRES, Tech, Comp, Rand, GOV} where

– P is the ticket price; •

– PRES is the price of resources; •

– Tech represents technological improvements; •

– Comp is the behavior of the competition; •

– Rand represents random factors; •

– GOV is government regulation.

Rigidity of supply for airline services

• An airline’s supply is fairly rigid as it can be difficult for

airlines to reduce and/or increase supply dramatically.

Since an airline creates a schedule at least six months

out, and accepts bookings up to a year out, the airline

must adhere to the schedule or face re-accommodation

fees.

• Fixed costs, such as investment in infrastructure at hub

airports, aircraft leases, and labor contracts have to be

paid regardless of the schedule, making it impractical for

airlines to reduce capacity on short-term notice.

• This rigidity in supply limits the airlines’ ability to adjust

supply to fluctuating demand effectively.

Part III: Market equilibrium

• Market equilibrium is the setting of a price such that the

quantity demanded and the quantity supplied of a good

are exactly equal.

Market Equilibrium Analysis

• Identify market equilibrium

• Analyze changes in equilibrium

– comparative statics

• Examine welfare properties of equilibrium

– Invisible Hand (Adam Smith)

– consumer surplus and producer surplus

• Examine effects of price control policies

– price ceiling and price floor

• Disequilibrium

Equilibrium analysis

consumer surplus and

producer surplus

• Consumer surplus is the benefit accrued by consumers

whose willingness to pay exceeds the market equilibrium

price.

• Producer surplus is defined as the benefit that accrues to

producers whose willingness-to-supply lies below the

market equilibrium price.

Price control and shortage

Price Controls on Landing Fees in Airports

Airport under Bad Weather

Part IV: Elasticity

• The elasticity is the percentage change in the dependent

variable (quantity demanded) resulting from a one

percent change in an independent variable (factor of

demand).

• Informally, elasticity measures the responsiveness of

one variable to changes in another.

– price elasticity of demand

– cross-price elasticity of demand

– income elasticity of demand

Price elastic of demand

• Price elasticity of demand is the percentage change in

the quantity demanded resulting from a one percent

change in price.

Price elasticity of demand

Cross-price elasticity of demand

• Cross-price elasticity of demand measures the

responsiveness of demand for one product or a service

following a change in the price of another product or

service.

o EX,Y > 0 Substitute

o EX,Y < 0 Complement

o EX,Y = 0 Independent

Cross-price elasticity of demand

Income elasticity

• Income elasticity determines the sensitivity that changes

in the annual income of consumers have on the quantity

demanded for a product.

Income elasticity

• EY > 0 Normal good

• EY < 0 Inferior good

• EY > 1 Luxury good (or superior good)

• 0 < EY < 1 Necessary good

Income elasticity

Elasticity example

Pricing and elasticity application

• Revenue management

Ex) P = a – bQ

Ex) P = 500 – ½ Q

Figure 3.22

Pricing Decision Based on Elasticity

Price elasticity of supply

• The price elasticity of supply measures the sensitivity of

quantity supplied Qs to price.

• The price elasticity of supply - denoted by ϵQs,P - tells us

the percentage change in quantity supplied for each

percent change in price: