Suggested Answer to Economics 8819/01 October/November 2009 Section A Question 1 The Growth of Air Travel

(ai) Using Figure 1, summarise the trends in international air passenger growth 2000-2004; [2] International air passenger growth fluctuated between 2000 and 2004, with a negative growth rate in year 2001.

(aii) Compare these trends with the forecast trends for 2005-2009.

[2]

While international air passenger growth is fluctuate generally from 2000 to 2004, growth rate is expected to decrease gradually from 2005 to 2009.

(b) With the help of a demand and supply diagram, explain the likely impact of both global economic growth and the entry of low-cost airlines on the market for international air passenger travel. [6] Global economic growth will result in an increase in national incomes and employment rates causing the level of incomes of consumers to rise. With greater purchasing powers and ability to spend, consumers will increase their demand for air travel, which can be considered a luxury good for the average income earner. The entry of low-cost airlines increases the supply of air travel in the market. In addition, the entrance of low-cost carriers results in strong price competition among airlines as they cut prices to attract or keep customers. This fall in price of air travel will cause the quantity demanded for air travel to rise. As seen in figure 1 below, the increase in demand is represented by the rightward shift of the demand curve from D1 to D2 while supply increases from S1 to S2. The increase in supply of air travel is likely to be less significant than the increase in demand as higher fuel costs will reduce the effect of the increase in supply from the entrance of low-cost carriers. Overall, price increases from P1 to P2 while quantity increases from Q1 to Q2. (Diagram) (ci) What is meant by price elasticity of demand?

[2]

Price elasticity of demand measures the responsiveness of the quantity demanded of a good to a given change in the price of the good itself, ceteris paribus. It is derived by dividing the percentage change in quantity demanded with the percentage change in price. 1

(cii) How far does the concept of price elasticity of demand help to explain the success of low-cost airlines such as AirAsia, Virgin Blue and Tiger Airways? [6] The concept of price elasticity of demand helps to explain the success of low-cost airlines such as AirAsia, Virgin Blue and Tiger Airways to a large extent. Low-cost airlines run mostly short-haul flights. The demand for short-haul flights is fairly price elastic as money spent on air travel constitutes a large proportion of incomes and there is availability of substitutes i.e. traveling on flights by major airlines or on other transport modes such as rail, car or ship. Assuming that airline companies are profit maximizers, the success of low-cost airlines can be determined by the amount of total revenue and profits they make. Using the above concept, in order to increase their revenues and hence profits, airlines will have to charge lower prices to result in a more than proportionate increase in the quantity demanded of their services. Low-cost airlines such as AirAsia, Virgin Blue and Tiger Airways are able to price their services at lower rates compared to major airlines such as Cathay Pacific, British Airway and Singapore Airlines. They keep their cost of production low by various methods including addition of more seats in each flight, removal of middlemen such as travel agents and reducing in-flight services. This allows them to offer competitive rates for their flights compared to major airlines, therefore enhancing their profit margins, making them successful. There are however, other reasons besides low prices which have contributed to low-cost airlines success. Firstly, consumers are likely to travel on affordable flights by low-cost airlines rather than other transport modes such as rail which may cost cheaper but take longer traveling times. Secondly, some low-cost airlines offer frequencies better than major airlines. For example, easyJet offers higher frequencies than British Airways. Higher frequencies mean low-cost airlines become more attractive to consumers such as business passengers. (di) With reference to the data, explain how the existence of a negative externality can lead to market failure. [4] Market failure is the result of inefficient allocation of resources in the economy when production and consumption does not occur at the socially optimal level. The existence of a negative externality causes a divergence between the private and social costs of production or consumption and individuals or society who are not directly involved in the production or consumption of the good bear the external costs incurred. Negative externality can lead to market failure if the price mechanism does not take into account the full social costs of production and consumption. With reference to Extract 3, aviation results in negative externality in the form of carbon emissions. The society or people not directly involved in the consumption/ production of air travel have to bear external costs such as higher medical bills due to weaker health as a result of polluted air. As illustrated in figure 2, assuming that airline companies only consider their private cost while ignoring the costs imposed on third parties, they will produce output Qp where MPB=MSC, assuming MPB=MSB. However, the socially optimal level of output is at Qs where MSB=MSC. 2

Hence, there is an over production or over consumption of air travel and a net welfare loss represented by the shaded area. Price

MSC MPC MEC

Ps Pp

MPB = MSB 0 Figure 2

Qs

Qp

Output

(dii) As a consultant economist, what options would you present to the Singapore government for responding to the alleged negative externalities of air travel, and what would you recommend? Justify your answer. [8] The Singapore government can adopt policies such as taxation, implementation of tradable permits and legislation to reduce carbon emissions from airlines. Taxation Air pollution created by air travel can be internalized if the government imposes a tax on airlines that is equal to the marginal external cost. A tax charged on each unit of production has the same effect as an increase in the costs of production to the firms. If this tax accurately reflects the marginal external costs, market output will be at the socially optimal level and airline companies now effectively have to pay for the damage they cause to the environment. Taxation is a beneficial measure because it provides incentives for airline companies to reduce pollution so as to reduce their burden of taxation. In addition tax revenue collected by the government can be used to fund research into cleaner fuel and more efficient aircraft, thus helping to reduce pollution in the long run. However, there are some limitations to taxation. Firstly, MEC cannot be easily quantified and measured. In addition, it is difficult to determine the amount of carbon emissions each airline company is producing and to what extent each airline company is responsible for the pollution.

Tradable permit Tradable permit is a policy which requires firms to buy permits to pollute. The government caps the amount of pollution by fixing the number of permits. The permits are then traded on the market and the price of the permits is determined by demand and supply forces. Tradable permits encourage airline companies to use cleaner methods of production so that they can sell their excess permits in the market. Firms which are less efficient in cutting down carbon emissions must be prepared to pay for the permits, thus the external cost of pollution is internalized. The limitation of tradable permits is that it may not lower the total amount of carbon emissions but merely change its source. It is also expensive to monitor. Major airlines may shelve their measures to reduce pollution as they can always buy the permit in the market whenever they pollute excessively. Legislation The Singapore government can pass legislation to regulate behavior that incurs external costs. For example, laws enforced to restrict airline companies to using aircrafts which meet certain emissions standards and effluent levels. This forces airline companies to prioritize environmental performance by purchasing only aircraft that use less fuel per passenger. The advantage of legal restrictions is that they directly reduce the level of negative externality to the desirable level. However, the administration cost on monitoring and enforcement of rules and legislations can be high. Recommendation Despite its limitations, taxation may the most effective measure in the long run as it forces airlines to find alternative fuels to reduce pollution. With a tax on carbon emissions, the more the airline company reduces the effluent, the less tax it would have to pay. Thus with a system of taxes, there is a continuing incentive for airline companies to want to reduce pollution. It is also important to note that, flying accounts for only 1.7% of all global greenhouse gas emissions. On the other hand, power stations and other forms of transportation account for a massive 24% and 12% of global greenhouse gas emissions respectively. Thus, by reducing aircraft emissions to taxation, total pollution will still remain high. There is a need to address other causes of carbon emissions to effectively reduce pollution. For example, within Singapore, commuters can be encouraged to use public transport such as MRT and buses instead of traveling on private vehicles.