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Elasticity in the airline industry

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Introduction

One aspect economics most concern with is the aspect of production and consumption. Demand and supply analysis, helps us to understand the concept of production and consumption in relation human behaviour. Firms, producers or businesses cannot just assume that if they increase their prices their sales will fall or if income increase their sales will increase, the obvious question they need to answer is by how much? They need economics tool to help them to understand by how much sales with increase or decrease in relation to the above assumption, this tool that helps them to understand how responsive their sales is to a number of factors is known as Elasticity. The concept of elasticity and the factors that determines it is what this essay will examine in airline industry. For Airline industry to remain afloat in the market they need to know the impact of price changes in the market and the responses of the market to the change. In order to measure this accurately they use the concept of elasticity.

Development

This essay aims to explore the term elasticity and examine its determinants in relation to the airline industry; however this cannot be done appropriately without looking at demand and supply. Demand is the quantity of goods and services consumers wish to purchase at a given price, while Supply is the quantity of goods and services producers wish to produce at a given price (M.Ghanei 2010). Air travel is one of the lots of services consumers are willing to purchase at a given price; likewise there are suppliers who are willing to supply this service at a given price.

It will be useful to define what elasticity means, Elasticity is define as "the quality something has being able to stretch and return to its original size and shape" (Oxford advanced learners dictionary 6th edition). In Physics, elasticity is defined as "the property of a substance that enables it to change its length, volume, or shape in direct response to a force effecting such a change and to recover its original form upon the removal of the force." (dictionaryreference.com).

This can be explained further in the contest of an employee who was allowed to do some extra hours outside of the contracted hours for extra pay. At the end of the month, the amount of extra money he will earn will depend on how much more extra hours he is able to work. Then how responsive the employee is to this offer can be seen as elasticity. Elasticity can then be calculated as:

Em = percentage of extra money you earn/percentage of extra hours worked.

Where Em is the elasticity of money the employee earn at the end of the month.

Browning and Zupan (2006) explain that elasticity measures the degree of responsiveness of any variable, such as demand and supply to a change in particular determinants. Elasticity measures the degree of responsiveness of any variable to extra stimulus.

Elasticity is measure in percentage because it allows a clear comparison of change in qualitatively different things which are measured in two different units (sloman and Wride 2009). It is the only sensible way of deciding how big a change in price or quantity. Thus elasticity is a unit free measures as the ratio of the percentage of the two variables are number without units. (Parkin 2006).

The law of demand states that when the price of goods increases the quantity demanded decreases, thus either of the number will be negative which after division will end up in a negative result, due to this fact we always ignore the sign and just concentrate on the absolute value, ignoring the sign to tell us how elastic demand is. (Parkin 2006).

Elastic demand occurs when quantity demanded changes by bigger percentage than price (Sloman and Wride 2009). Here customer has lot of other alternative goods to choose from. The value is always higher than 1, the change in quantity has a bigger effect on total consumer spending than in price. For example a reduction in the price of a branded bottle of washing up liquid say from £1.00 to 50p will prompt people buy more, which means they end up spending more on that product than they will do on a normal day, this will increase total consumer spending which is calculated as

Total consumer expenditure (TE) = Price x Quantity.

This is illustrated in the graph below:

Elastic demand curve between two points, sloping to the downward, as price rises from P1 to P2, Quantity demanded decrease from q2 to q1

Figure1

Inelastic demand occurs when price change is proportionately more than quantity demanded; elasticity here is less than 1. Example consumer who is diabetic will always buy insulin no matter how much it cost to be able to stay alive. When quantity demanded is unchanged when price changes, that is quantity demand does not respond to changes in price this is known as unit elastic (lipsey & christal 2007). Hence figure (ii)

Figure (ii)

http://t0.gstatic.com/images?q=tbn:tFtMriahtetqvM:http://i597.photobucket.com/albums/tt52/Economiste/BoardsD1.png&t=1

Unit elastic demand occurs where quantity demanded changes by the same percentage as price, which means the value will be 1 (sloman and wride 2009).

η = -1 price elasticity of demand is 1.

η=%ΔQ÷%∆p

Where η is the Greek letter eta and it stands for elasticity, Δ is a Greek letter that means change in, Q is Quantity and P is price.

Figure (iii)

http://wpcontent.answcdn.com/wikipedia/commons/thumb/6/64/Price_elasticity_of_demand.svg/250px-Price_elasticity_of_demand.svg.png

There are unusual cases, case A is where price has no impact on quantity because it's fixed, η =0.

In case B, quantity has no effect on price, therefore η = ∞. They are both exceptional cases.

Figure A

http://img.search.com/thumb/9/99/Elasticity-inelastic.png/180px-Elasticity-inelastic.png

Figure B

http://img.search.com/thumb/8/89/Elasticity-elastic.png/180px-Elasticity-elastic.png

Types of elasticity

Price or own price Elasticity

Income elasticity

Cross elasticity

Price or own price elasticity of demand

Price or own elasticity of demand measures how much the quantity demanded of a good (airline ticket) responds to a change in price of that same good (airline ticket). (Mankiw and Taylor 2006). The law of price elasticity of demand states that the higher the prices of a commodity the less the quantity demanded provided that all other factor stay the same.

However, price elasticity of demand is not constant through the demand curve, there are two ways to measure elasticity which are: point elasticity- which measure exact elasticity at a particular price) and arc elasticity - which measures average elasticity over a range of values (vasigh et al 2008) The formula for measuring arc and point elasticity is below:

Arc = (Percentage ∆Q/ Q) ÷ (percentage ΔQ/ P)

Point = ΔQ / ΔP Ã- P/Q

Generally we use the midpoint formula which is

η = (ΔQd /average Qd) ÷ (ΔP /average P)

where Qd is quantity demanded and P is the price

Price elasticity of demand is probably the most useful one in airline industry, and it's considered to be elastic and inelastic, how elastic demand is will be relation to the purpose for the journey. Elastic demands exist for the pleasure traveller due to demand increase while prices lower. Conversely, business travellers would subscribe to an inelastic demand for this market. Lipsey and Chrystal (2007) elaborate that elasticity is said to be inelastic when quantity demanded is unchanged when price changes, when quantity demanded was not affected by a price change. The business traveller experiences an inelastic demand due to the quantity of service demanded and quantity has not decreased as prices have risen.

Demand is usually assessed in terms number of passenger revenue mile PRMs or revenue ton miles (RTMs) in airline industry. For us to examine the concept of elasticity in airline industry we have to understand demand in airline industry. For example a trip to Nigeria, how much customer is willing to pay for the journey says £250? £500? or £750?. It is a fact that some passengers will consider the price to be too expensive and will not fly as a result. Their decisions not to fly agreed with the law of demand which state the higher the price the lower will be the quantity demanded of the product. If different travellers are faced with these decisions, their responses will vary in relation to their purposes for travelling and level of income. Consumers different response help create demand schedule which is simply the table showing the quantities of goods and services that an individual is willing and able to buy at various prices over a given period of time. From the example I can have a demand schedule for flight to Nigeria

Price of tickets to Nigeria

Number of passengers (quantity demand)

£200

£300

£500

£700

£1000

1000

800

500

300

100

The above schedule will help to construct a demand curve. A demand curve is a graphical description of demand schedule showing the relationship between the price of a good and quantity demanded over a given period of time.

Income elasticity of demand

Income elasticity of demand measures the degree of sensitivity of demand to changes in buyers' income. Krugman et al (2007) stress that income elasticity of demand measures how much the demand for a good is influenced by changes in consumers' incomes. Mankiw and Taylor (2006) explain further that income elasticity of demand helps in understanding whether a good is a normal good (higher income increases quantity demanded such as food and clothing) or inferior good (higher income decreases quantity demanded such as own brand products) as well as measuring the degree of intensity the demand for the good responds to changes in income.

The formula is

η = %ΔQd ÷ %Y

Where Y represents the income, Δ is change in and Qd is the quantity demanded.

As people income rise they are willing to spend more on goods and services, which includes holidays, when income rises consumers are less likely to be sensitive to price, but when income decreases people are less willing to travel since holidays abroad is seen as a luxury goods which is why airline industries offers huge discounts during recessions.

Cross elasticity of demand

This is a measure of how responsive a consumption of one good is to a change in the price of a related good (Edgar & Zupan) either a substitute good or complementary good, (Sloman & wride)

The formula is

ηAB = %ΔQDA / %ΔPB

In a case where B is a substitute product for product A as price of A rises demand for B will increase.

For example if the price of potato rises consumer might substitute it for rice since they are both carbohydrate food.

In the same way in airline industry if the price of an airline is too high people will substitute it for a cheaper one especially European airline industry where there is rapid expansion of low-cost airlines, This has pose major challenge to the well-established national air carriers, who must now adjust their business and pricing strategies to cope with the increased competition.

Determinants of Elasticity

The willingness to buy a particular product is influenced by so many factors among which is

Price

Random factors

Consumers' income

Tastes

Preferences,

Price of substitute and complementary goods

Price expectations

Time (Begg and Damian 2007)

Elasticity in airline industry like in any other industry is determines by the above factors, and more which depends upon current market conditions which make the industry unstable. Price of oil which has been increasing throughout the whole year has a significant effect in the demand for airline ticket. Likewise inflation and terrorist attacks have greatly influence demand in airline industry. Competition consistently affects the price of tickets as it gives the customers other options. Substitutes that are in existence such as travelling by car, bus, train or avoiding travel whenever possible also affect demand in airline industry. Currently, the economy is very gloomy and fragile. Many people are out of work and a lot of people are earning less than they used to earn and as a result of that a large percentage of airline customers who normally fly on business class have resulted to flying on economy class to conserve spending and safe money.

One more important factor that greatly influenced demand in airline industry is the customers' purpose for travel, in a situation where by customer is compelled by situations to travel, the customer has no choice but to buy a ticket no matter how much it cost, in this case to such customer demand it is inelastic.

Elasticity of supply in airline industry

Demand is relatively fixed and constantly fluctuating in airline industry. There is also lack of flexibility in supply function which makes it very difficult to manage capacity effectively. All these are some of the reasons why airline industries face financial difficulty and have profit margins well below other industry.

Supply in airline industry is the ability and willingness to provide a specific numbers of seats at a given price in a given time period in a given market. In the air transportation industry supply is expressed in available seat miles (ASMs) or available ton miles (ATMs). ASM simply mean a seat carried through for one mile regardless of whether it contains passenger or not. The presence of revenue passenger in the seat is the key difference between RPMs (demand) and ASMs (supply), RPMs only measures the seat which has passengers in them. Similar expression can be made between ATMs (supply) and RTMs (demand).

The supply function is written as follows:

Qs= f (P, Pres T, C, R, G)

Where P = price of tickets

Pres = price of resources including air craft costs, labour cost, maintenance cost, fuel e.t.c

T = technological improvement

G = government regulation

C = behaviour of the competition

R = random factors

Ticket price is the main determinant of goods and services just like demand, thus the theory of supply that the quantity supply of product in a given time increases as it price increases, in a situation where all else is held constant. This means that the airlines are willing to supply more seats as the price increases.

In relation to the law of supply, the supply curve slopes upward so that any chance in price is simply movement along the supply curve. Another major determinant of supply in airline industry is the price of production resources which include but are not limited to maintenance, fuel, aircraft, labour and landing fees. All these and many more impact on supply because they influence cost of productions.

In the airline industry, the higher the cost of production, the higher the total cost which causes a leftward shift in the supply curve. Equally, an increase in cost of production may pressurise the airline to cut some flights that would no longer viable and profitable, this move will cause a leftward shift in supply curve, which is seats are offered at the same ticket price. Conversely, if ticket price decreases the supply curve shift to the right which means more seat are offered at the same ticket price.

Other factors determining supply of air transportation are technology and competition. Airlines have history of aggressive competition over market share as a result competition from other airlines has had a considerable impact on price. Airlines regularly adjust to capacity and supply in markets in response to competition and changing market forces Vasigh et al (2008). Example of this is the low cost or budget airlines which usually compete aggressively in the market.

Conclusion

The measurement of elasticity of demand is the tool economists use to understand the level of customers sensitivity when price of a product change over a period. It is very useful in predicting consumers' behaviour and in forecasting major events like recession or recovery. As consumers, our decisions are measured by economists on a daily basis. If the prices of a necessary good increase where we have little or no substitute such as food, water, medicine or gasoline, we will still buy them this is known as inelastic demand, whereas if the price of luxurious goods increase we either cut back, switch to substitute goods or leave the market altogether, this is called elastic demand.

This concept of elasticity is critical in understanding pricing policy in any industry, especially in air transportation industry, and as earlier discussion has shown, elasticity can be used to determine the optimum price level where total revenue is maximized ultimately revenue management has its foundation in this concept since elasticity can be used to help manage both pricing and capacity.


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