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Economics for Business

Microeconomics Principles and Strategies.

Economics for Business


Prepared by: Asiya Kamboo
Table of Contents Page No.
1 Introduction .2
2. Economic analysis of Indian airlines..2
2.1 Overview ...................................................................................2
2.2 Fall in demand and rise of substitute prices..3
2.3 Airlines Short Run Decision to shut down..4
2.4 Competitive Firms are Price Takers4
2.5 Impact of economics on Indian airlines.5
3. Yield management models in the airline industry
3.1 What is Yield Management?. 6
3.2 Strategies used in yield management6
3.3 Price management8
3.4 Demand Forecasting8
4. Supply curve changes in the airline industry
4.1 Increase in wages paid to airline crew8
4.2 Increase in the price of airline seats9
4.3 An increase in the number of airlines operating in the region9
5. Changes in market Structure and its influence on yield management......................10
6. Conclusion.12
7. References..13

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1. Introduction
Microeconomics is the study of economic tendencies, or what is likely to
happen when individuals make certain choices or when the factors of production
change. Microeconomics helps us to understand how buyers, sellers and
business owners interact with the supply and demand for resources, using
money and interest rates as a pricing mechanism for coordination. To make it
simple, economics studies human behavior and how human make choices when
resources are scarce. In this report I have made an attempt to analyze the
economics of the airline industry and how it helps airlines to maximize revenue
and maintain sustainability in the airlines industry.

There are numerous equipment and facilities involved in air transportation,


which makes it easy to ignore the fact that this is, fundamentally, a service
industry. Airlines perform a service for their customers - transporting them and
their belongings (or their products, in the case of cargo customers) from one
point to another for an agreed price. In that sense, the airline business is similar
to other service businesses like banks, insurance companies or even
barbershops.

2. Economic Analysis of Indian Airlines

2.1 Overview

Airline industry supply and demand is largely dependent on fuel prices. Indian
airlines industries went through a critical phase in 2008 when aviation turbine
fuel (ATF) prices reached a record high (Rs. 71,028.26 per kiloliter) in the month
of August 2008 (Fig 1).

Fig. 1 Reduction in air traffic due to price rise of ATF [Source: The Economic
Times, 14 January 2009, Page 7]

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This resulted in big decline in load factors and the situation gets worse with the
rupee hitting a record low of Rs.51.92 per dollar on March 2009.It is estimated
that 30% of an airlines operational expenses, excluding the cost of jet fuel are
denominated in dollars. Therefore most Indian domestic carriers were aiming to
reach their breakeven targets in the next fiscal.

2.2 Fall in demand and rise of substitute prices.

As airlines started increasing airfares in 2008, following the law of economics


the demand automatically started to decline. In this case, the substitution
phenomena between airline and train were quite predominant when passengers
started to travel more by train.

Comparison of the number of passengers travelled by air and trains (AC classes)
in 2007-08 and 2008-09 , it was observed that when air traffic during April-
November, 2008 declined nearly 4% , number of passengers travelling in air
conditioned bogies of trains increased by 18.33%.

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2.3 Airlines Short Run Decision to shutdown

When cost of operation was high compared to revenue earn, a few airlines
particularly budget carrier, found it difficult to continue operation. A decision of
shutdown can be taken when the price in the market is less than the average
variable cost(AVC) .In economics term shutdown occurs if P < AVC , where P=
Price and AVC = Average Variable Cost

2.4 Competitive Firms are Price Takers

Indian airline industries can be treated as differentiated oligopoly market. When


the price of aviation turbine fuel is reduced eventually by 57% (Rs. 30,457 per
kiloliter in January 2009 from Rs. 71,028.26 in August 2008), airlines started
slashing the air fares. As the number of sellers in an oligopoly grows larger,
oligopolistic market looks more and more like a competitive market. In
Economics it is known that in competitive market firms are price takers. When

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one airline slashed the fare, others had to do so to stay in the market. Fig. 8
corroborates that idea. It is learnt that after announcing a fare reduction of up
to 82% a few days back, national carrier Air India has announced that it will cut
basic fares anywhere between 45% and 60% in February following a drop in ATF
prices. Jet Airways has cut fare up to 40%, Kingfisher by 21 to 65%. Indigo and
Spice jet are offering Rs.1 to Rs. 99 base fare [Ref. 4]. Fig. 8 Price competitions
in domestic airlines after drop of ATF price [Source: The Economic Times, 7
January 2009, Page 18]5

2.5 Impact of economics on Indian airlines

Analyzing the above phenomena, the following conclusions can be drawn.

i) When price rises, demand falls (load factor declines due to rise of
airfare)
ii) When price of one service rises, demand of substitute services rises
(airline and AC train are substitute services)
iii) In short run, when price is less than average variable cost (AVC), firms
take shut down decision (Some airline stopped their operation in
certain short route in 2008).
iv) In competitive market, firms are price taker (one airline slashed fare,
others slashed too).

3. Yield management models in the airline


industry

3.1 What is Yield Management?

Yield management is a technique which helps big companies or small and


medium enterprises to achieve highest profits by correctly identifying the

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customer groups that the company caters to, establishing the right (quantity of)
products and services as well as setting up the optimal prices to be offered to
these customers. Yield management is also known as revenue management and
it traditionally originated in the airline industry .In airline industry, often tickets
for the same flight may be sold at many different prices. This depends on product
restrictions as well as the remaining time until departure and the number of sold
seats. The use of such strategies has transformed the transportation and
hospitality industries and has become increasingly important in retail,
telecommunications, entertainment, financial services, health care, hotels, car
firms and manufacturing. Therefore yield management has various definition.
There are a few statements made about revenue management such as:

Yield Management is an approach to maximizing profit by carefully monitoring


and managing pricing, inventory availability and sales. It means managing the
trade-off between filling all available capacity and charging the highest unit price,
and ensuring that those customers most willing to pay for a product or service
can do so [Andersen, A. (1997)].

Revenue Management is the art and science of predicting real-time customer


demand at the micro market and optimizing the price and availability of
products [Cross, R.G. (1997)]

Yield Management is a method which can help a firm to sell the right inventory
unit to the right type customer, at the right time and for the right price [Ingold,
A. (2000)].

3.2 Strategies used in yield management

There are a number of strategies used in yield management to get the best result
for the company like

Segmentation

Price management

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Demand Forecasting

Availability

Product Differentiation

Booking classes

Reservation negotiation

In this report I would like to discuss briefly on two important aspects of yield
management which is price management and demand forecasting

3.3 Price management

Price discrimination is commonly observed to increase revenue which involves


application of different prices for similar products to different customer groups.
By offering multiple rates to different customer groups, firms hope to diversify
and increase their revenue or retain their current revenue level. Furthermore,
price management has been seen as systematic offering different prices to
different customer groups in response to changes in demand and its
characteristics [Ingold, A. (2000)].

For Example, quality-oriented passengers, can influence the demand for the
certain company product by their personal choices and willingness to pay as well
as they their price elasticity. The price elasticity gives the percentage change in
quantity demanded in response to a one percent change in price, by holding
constant all the other determinants of demand. This result can be used to
estimate or a price change leads to an increase in sales or just a revenue decline.
Leisure travelers may be very price elastic, and the business traveler may be
more time sensitive and less price elastic. Other examples of using price
management are early booking discounts for those customers who are booking
early at the company as well as offering the supplements for travelers in the on
weekend. By doing so, the company can cover some major costs and can
concentrate on more expensive offers (charging higher price) to receive more

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revenue. By doing so, it is important that a company realizes which products (or
services) it can offer at profitable price for each specific customer segment.
Hence, price management plays an important role for the Revenue Management
systems [Phillips, R.L. (2005)].

3.4 Demand Forecasting

The accurate demand forecasts is an essential characteristics of Revenue


Management system. For example, in the airline industry, the widespread
information on demand and booking patterns are necessary for the future
revenue forecasting. If the company knows what was the demand for the certain
destinations in the previous years, it can estimate the demand for the coming
year(s) for the similar products/services, taking into account the market
situation and the economic situation in the country or in the world. Further, a
company can use obtained demand information to classify its customers and
assign the concrete price for each specific customer class in the most optimal
way that increases the company revenue. Each industry, however, faces specific
difficulties in the forecasting of demand. For instance, in the airline industry it
is important to take into account the period of seasonal peaks and off-peaks in
demand for flights. The tour operators and travel agencies have sales peaks
around holiday periods. The restaurants and theatres have higher sales in the
weekends. 20 In the certain industries the price for the products or services may
influence the demand. Therefore, it is essential for all companies and
establishments to adjust to these seasonal periods or price changes in order to
be able to correctly predict the demand for their products or services and gain
the maximum feasible revenue [Cross, R.G. (1997)].

4. Supply curve changes in the airline industry

4.1 Increase in wages paid to airline crew

The price paid by consumers to buy air ticket will rise with the increase in wages
paid to airline crew as airlines will try to cover the extra costs for paying their

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employees. As the price increases there would be a decrease in the no. of seats
sold per month which will cause supply curve to shift upwards or to its left

Price
$ S1

400
S
350

300

250

200

150

100 5 10 15 20 25 30 35

Quantity (no. of seats in thousands)

4.2 Increase in the price of airline seats

In this scenario as well the supply curve will shift to left as there would be
decrease in the quantity of seats sold per month

4.3 An increase in the number of airlines operating in the region

With more airlines providing flights, the supply of seats will rise. This will create
a surplus of flights / seats at the existing equilibrium price. As a result, the
airlines will reduce their prices in order to fill the excess seats. With cheaper
seats available, the quantity of seats demanded will rise as consumers grab
cheap deals. As a result, the price of seats will fall and more seats will be supplied
and demanded.

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Price
S
$

400

350
S1
300

250

200

150

100 5 10 15 20 25 30 35

Quantity (no. of seats in thousands)

5. Changes in market Structure and its influence


on yield management.
Yield management (RM) is based on setting the right price at the right time to
maximize revenue. It has been successfully practiced in airlines and many other
industries to increase revenue .Traditional yield management models typically
assume a monopoly setting. However it is important to understand how effective
and sustainable it is in oligopoly and perfect competition.

Perfect competition: Under perfect competition, firms can sell as much they
want at market price and the only constraint limiting its output are their own
capacity constraints or costs of productions. Hence the market price is equal to
the marginal cost of production for each firm supplying the market. In this case

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the firms decision is supply driven based only on their technology and costs of
productions rather than demand consideration. Therefore, under perfect
competition it would seem there is little scope for the sorts of demand decisions
that lies at the heart of revenue management. However adding some small
modification to competitive model leads to interesting insights about Yield
management. If marginal costs are constant the first order profit condition
reduces in other words the market price just covers the marginal cost of
production and hence firm earns zero profit. This leads to the so called zero profit
equilibrium in which a zero profit condition for all firms is assumed as essentially
the definition of competitive market.

Monopoly: A monopoly happens when a single firm (monopolist) becomes the


exclusive provider of a given service or a product. A monopoly firm dominates its
market and can dictate the terms of trade like price and quantities. The extent
of monopoly power also depends on the availability and quantity of substitutes.
Thus yield management happens in a monopoly through price discrimination.
For example in traditional airlines yield management attempt to segment the
customer population and exploiting the correlations between price sensitivity
and product preferences. They are designed so that customers self-respect the
product and pay the price targeted for their segment.

Monopolistic: As discussed monopoly occurs when a single firm dominates a


market and is the only provider of a service or product. However, monopolist has
a threat of another competitor entering into the market which may reduce its
pricing power. For example, in the airlines industry if a carrier made unusually
high profits it would tempt others to enter into the market. Therefore for a
monopolist it would be better off to price less aggressively and if the threat of
competitor entry is severe they would also consider it to price as in a competitive
market. This is called contestability or monopolistic competition

Oligopoly: An oligopoly is a market in which a limited number of firms compete


to supply the same or similar good. In such market the actions of one firm affect

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the demand of its competitors. This creates a strategic interaction among the
firms decision. Oligopoly is arguably the most interesting market condition for
studying yield management because it is the prevailing competitive situation in
many industries.

6. Conclusion
Understanding of micro economics is crucial for the success of any firm. While
Researching for this report and analyzing the information I got I have gained an
in depth knowledge of micro-economic principles and its application in real life.
In this report I have tried to explain the principles and its applications in the
airline industry .This research has also helped me to understand the importance
of yield management and how it has been used in the airline industry and the
hotel industry.

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References

Airline Economics Retrieved from http://www.avjobs.com/history/airline-


economics.asp

Cederholm, T. (2014, September 03). Why economic factors support airline


industry growth. Retrieved from http://marketrealist.com/2014/09/why-
economic-factors-support-airline-industry-growth/

Samanta, A. (2011, September 13). Effect of Price Elasticity of Demand on


Indian Airline Industries. Retrieved from
http://www.slideshare.net/asokendu/indian-airline-industries

Goksen, S. (2011, July). Implementing Revenue Management. Retrieved from


https://www.few.vu.nl/nl/Images/werkstuk-goksen_tcm243-225780.pdf

Revenue Management. (n.d.). Retrieved from


http://decisioncraft.com/dmdirect/revenue_management.htm

Revenue Management. (n.d.). Retrieved from


https://en.wikipedia.org/wiki/Revenue_management#Segmentation
https://books.google.co.nz/books?id=GhdDbEM-
_5oC&pg=PA336&lpg=PA336&dq=how+does+yield+management+happens+in+p
erfect+competition&source=bl&ots=wH7SUBz0MW&sig=ITT0pBnsjBPwW74fKM

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Kr-
wsKpmE&hl=en&sa=X&ved=0ahUKEwj1nqPynLfSAhWIi1QKHYguDAAQ6AEIKj
AD#v=onepage&q&f=true

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