Price Elasticity of Supply and Demand Essay

In the economics of air travel, the term “elasticity” is used when describing the “price elasticity of demand.” That ratio is defined as the percent change in quantity of air travel in response to a percent change in the price of air travel. For example, in a given city pair, if a 10% increase in the price of air travel caused a 10% reduction in the number of passengers, the price elasticity of demand would be -1.0. The ratio usually vary by market segment, trip purpose, and other factors. Elasticity is also influenced by the availability of substitutes to commercial air travel – fir example videoconferencing, bus, car, train, private jet trips.

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Cross-price elasticity is very important in airline industry. Demand for flights is significantly impacted by changes in prices in competitive firms. In the case of the airline industry, the cross-price elasticity of demand for airline tickets is very high, and firms respond immediately to fare changes. If, for example, American Airlines lowers price for a ticket, United Airlines have to respond immediately and change the ticket price on the same route. If one airline such as American initiates a fare war, competitors such as United quickly follow in reducing prices to prevent a loss of market share. Since there is a high cross-price elasticity, if American lowers its fare from Boston to Washington DC, and United keeps its fares constant, consumers quickly shift consumption towards the lower priced American tickets. The resulting decrease in the demand for United Airlines tickets is large.

For example the cross-price effect occurred with the rapid expansion of low-cost airlines in the European airline industry. These usually small airlines are now a major threat to the existing and well-established national air carriers, many of whom have made necessary changes in their operation style and pricing policies in order to survive with the increased competition.

Airline industry has seasonal demand. During peak seasons prices are normally higher. However, it is not always the case for prices on non-competitive routes. Very often they are priced too high and airline companies might loose some profit.

Leisure travelers have higher price elasticity compared to business travelers. Usually airlines offer lower rates for passenger who book tickets 2 weeks in advance or stay over during Saturday night. In this way airline companies are trying to find customers with highly elastic demand for tickets and passengers whose demand is highly inelastic. For the first group airlines offer low fairs which will attract many customers and hence secure high revenues for the airlines. The passengers who do not purchase several weeks in advance and don’t stat on Saturday nights are most probably business travelers with inelastic demand for flights. They usually travel on short notices from their companies and will purchase tickets at much higher prices. The airlines therefore charge these passengers higher rates and again ensure higher revenues.

There numerous external factors that contribute to shifting demand for airline travel. Low-cost companies, such as EasyJet and Ryanair brought prices down which allowed lower-income families to fly. New technologies also made long flights cheaper and more enjoyable. Because of increasing number of international companies there is increased demand for international business air travel.

The events of 9/11 changed airline travel in many ways. These events decreased demand for air flights and increased concern for safety. The cost of travel has increased because of security issues.

Positive and negative externalities

Airline industry has potentially large externalities and for this reason it is often regulated by government. Among positive externalities is providing work to numerous employees in various industries. Airlines are a key element of the travel and tourism industry, which has revenues of $3,400 billion a year and which makes up about 10% of world GDP in employing 200 million people. In general, one of the main positive externalities of airlines is economic growth in various industries.

The main negative externality of airlines is pollution and damage to the environment. It has been calculated that a two-way flight from London to Australia produces as much carbon dioxide as 3 cars in one year. Round trip from London to Edinburgh creates 8 times as much carbon dioxide as taking the train. Since airline industry is growing, it is expected that amount of pollution will also significantly increase in the coming years.

There were numerous suggestions to impose tax on airlines for pollution. However, there are problems in calculating tax so that private cost will exactly equate with the social cost. Scientists cannot precisely value the private benefits and cost of airlines, it is even more difficult to estimate monetary value on externalities such as the cost to natural habitat, the long-term effects if resource depletion and the value of human life.

Wage inequality

Recently there is increasing rise in inter-firm wage inequality – especially for pilots. The main reason of wage inequality is increased product and service inequality. Since competition increases, companies are more sensitive to cost reductions. Airlines prefer to pay more to high skilled workers and cut wages of low skilled workers. This increases wage difference between high and low skilled workers.

Vast wage differences exist between old and new carriers. Pay for a pilot on a unionized airline is roughly twice that on a nonunionized one. The old carriers did not worry excessively about labor costs in the days of regulation because they could always pass along the higher union salaries in higher fares. But now, in an era of deregulation, an airline can set any price it wants, and the nonunionized carriers are offering inexpensive flights that are stealing business away from the unionized ones.
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