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Factors That Determine Demand And Supply

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Published: Fri, 12 May 2017

Introduction

The market of our choice is the airline industry in Malaysia. The main commercial airline companies in Malaysia consist of Air Asia, Malaysia Airline System Berhad (MAS), Firefly, a subgroup of MAS, Berjaya Air as well as a few other smaller companies in East Malaysia.

Factors that determine demand and supply

Price is a major factor that plays a part in determining the demand and supply of airline services. Flying is a luxury service, which means it is a form of transportation that is costlier and is usually sought after by consumers with a greater amount of expendable income (WebFinance, 2013). Thus, the demand for this service is elastic, meaning it is very sensitive to changes in price.

Of late, we have witnessed a sudden increase in the number of low-cost carriers in the last few years such as Air Asia and Firefly. However, research has shown there is a conflicting relationship between price elasticities these days. On one hand, passengers are becoming more sensitive to price, caused by the influx of low cost travel, transparency brought on by the Internet and powerful competition from unregulated markets. On the other hand, passengers are less sensitive to changes in price as the revenue generated from ticket sales become less significant in the total cost of the journey (Smyth & Pearce, 2008). The two explanations for this are; firstly, the components of the journey can be easily replaced, such as routes, modes, airlines, etc. Therefore, the actual price elasticity of air travel may be higher than the suggested price elasticity of the overall cost of the journey. Passengers make a decision regarding their flight destination by first weighing the price of air travel and then only the other costs incurred by the journey (Smyth & Pearce, 2008).

Another factor that plays a part in determining the demand for airline services is the income of the consumers. Research has found that air travel income elasticities were consistently positive (Smyth & Pearce, 2008). This means that the demand for the good or service will increase when the income of consumers increase, suggesting that consumers are willing to allocate a greater share of their income to luxury expenses such as air travel. In addition, if the country has a developing economy, the responsiveness of the passengers is greater, showing that long-distance journeys have higher income elasticities. This suggests that lower to middle income households are more inclined to short haul routes whereas higher income households prefer long haul routes (Smyth & Pearce, 2008).

In addition, the price of related goods in the airline industry also affects the demand and supply of airplane tickets. An increase in the price of a complementary good would result in a subsequent increase in the price of airplane tickets, thus lowering the demand for it. Another related good, known as substitutes are two goods that can be used in place of each other (Mankiw, 2008). If we define the market narrowly, then there are a great number of available substitutes, thus making the demand elastic. If we define it broadly, then airplanes have little or no close substitutes.

Furthermore, the number of buyers in a market also influences the price of airplane tickets. A greater number of buyers in the market would result in an overall greater demand for airplane tickets and therefore, an increase in the quantity supplied by airline companies.

Besides, time period also plays a role in influencing demand elasticities. The longer the time period, the more elastic the demand, as consumers have a longer time to adjust their behavior to the price.

Changes in Trends of Price & How the Determinants Affect the Market Price and Quantity Traded

The price of a particular good or service is derived by the interaction between supply and demand. The market price that results is entirely dependent of these two very essential and important components of a market. When buyers and sellers alike both agree on a price, an exchange of goods or services will occur, and this agreed upon price will be called the ‘equilibrium price’.

When either demand or supply changes, the equilibrium price will change. For example, cheaper fuel prices normally increases the supply of airplane tickets, with more products being made available over a range of prices. With no increase in the quantity of product demanded, there will be movement along the demand curve to a new equilibrium price in order to clear the excess supplies off the market. Consumers will buy more but only at a lower price. This is illustrated in Figure 3.

http://futures.tradingcharts.com/learning/graphics/figure3.gif

In the case of the airline industry, the changes of trends of price of air travel tickets are determined by factors such as competition on route, seat demand, distance of route, seat supply, and fuel prices. According to the Wall Street Journal’s Market Watch, the average price of air fare for international flights went up 23 percent between 2009 and 2010. Domestic ticket prices in the US also rose 15 percent over the same period. Prices are expected to continue increasing in the foreseeable future. These fluctuations were blamed on the rising prices of fuel and the global economic crisis that started in 2008.

Fuel cost is one of the biggest determinants of price trends in the airline industry. As the gross price of crude oil rises, so does the price of flying and the airline’s costs. The general world oil crisis is a huge determinant as oil is an exhaustive material. Oil is a complement of airplanes and therefore there is a direct relationship between the oil prices and demand for airline tickets.

Likewise a shift in demand due to changing consumer preferences will also influence the market price. In recent years there has been a shift in demand for tourist airline tickets to Japan, which was due to the recent devastating earthquake. A decline in the preference for airline tickets to Japan shifts the demand curve inward, to the left, as illustrated in figure 4.

http://futures.tradingcharts.com/learning/graphics/figure5.gif

Another factor that affects airline ticket prices is the global economic slowdown. Since companies don’t make so much revenue as before, they have to cut down the costs in order to attain the same profit. However, it’s not only the cost aspect that causes a decline in air travel, but also the fact that due to an economic slowdown, there is not so much business going on anymore. This can be seen during the Asian Financial Crisis of the late 90’s, whereby it brought down the number of people travelling to and from Asian countries.

How and why the government intervenes

The government intervenes in the airline industry by controlling the destinations of the flight routes. Air Asia and Malaysia Airline Services (MAS), the most well-known airline firms in Malaysia have different flight routes as the various destinations of these firms need the support from the government to fly to a particular country. For instance, MAS with the support of the Malaysian government will approach Singapore Airlines to create a direct flight from Kuala Lumpur to Singapore as the demand is high. Hence, due to the strong diplomatic tie between the two governments, Singapore airlines will agree as it helps both countries’ economic growth as well as their tourism industry. This applies to other routes from different countries as well.

The government also implements taxes in the price of plane tickets. In general, tax is implemented to discourage a certain market activity. However, in this industry the need of flying is high. Hence, the small percentage of the tax implementation done by the government will not make much difference in demand but, consumers always think at a margin. They make decisions based on price. As this industry is elastic, consumers tend to look for other close substitutes which are relatively cheaper.

To intervene in a market where there is reason to believe that market prices are somewhat unfair to buyers and sellers, the government may choose to enforce certain policies to stabilize prices or bring them to a desired level. These policies are almost always properly planned by professional economists with the intention of creating the optimum economy.

Policies enacted by the government to control prices by creating a price ceiling would encourage more people to take advantage of today’s technological advances. An example would be rent control policies by placing price ceilings on the rent that landlords are allowed to charge. Through this policy, the anticipated goal of making housing more affordable to help the poor was achieved. However, it is often the case that policymakers do not achieve the expected goal. Introducing a price ceiling would be attractive but it does not guarantee an increase in sales.

Conclusion

The airline industry in Malaysia is a dynamic industry that is influenced by the various factors of demand and supply in different degrees. There is no hard and fast rule when it comes to analysing each factor as this industry is ever evolving and growing.


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