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1. Concept focus:
1. Supply and Demand
Economics and Finance
for the Modern Airline 2. Elasticity
3. Consumer and Producer Surplus
1
Demand Curve Market Demand
Price of Meredith’s Derek’s Market
Salmon Demand Demand Demand
$20.00 0 0 0
$17.50 1 0 1
$15.00 2 1 3
$12.50 3 1 4
$10.00
$ 7.50
4
5
+ 2
2
= 6
7
$ 5.00 6 3 9
$ 2.50 7 3 10
$0.00 8 4 12
Is the (horizontal) sum of all individual demands
Lower prices bring more buyers into the market
Lower prices cause existing buyers to buy more
Shift in demand
Caused by changes in non-price factors
Entire demand curve will shift to the left or right
2
Normal and Inferior Goods Substitutes and Complements in Consumption
Steak Canned meat, SPAM Milk and cereal Coke and Pepsi
Housing Ramen Printers and toner Butter and margarine
Name-brand Secondhand clothing Peanut butter and jelly Pizza Hut and Dominos
clothing
3
Class Exercise
Economics in The Hudsucker Proxy
How would the following affect the Demand for pizza (a
normal good)?
1. An increase in the price of soda Watch for changes in price.
Quantity Supplied & The Individual Supply Curve From Equations to Graphs…
Quantity supplied
The amount of a good that Supply of Pizzas Supply for pizza is given by: P = 4 + 4 Qs
P
sellers offer at a given price Draw the supply curve
S
$4
Supply curve
The quantity of a good that $2
sellers offer at each price
Positive slope. Why? 8 16 Q
(000s of slices/day)
4
Determinants of Supply (shift in supply) Shift in Supply
Supply of
Supply increases when sellers P Pizzas
A change in the price of an input S S'
are willing to offer more for sale at
each possible price
A change in technology $2
8 9 Q
5
What if the market price is not the equilibrium price?
At $4, there is an excess supply
(surplus) of
8,000 slices
Market for Pizzas
Each firm has an incentive to P
decrease the price in order Surplus
S
to sell more
What happens with the $4
$3.50
surplus? $3 Equilibrium
D
Q
8 12 16
(000s of slices/day)
P P'
D' D
D D'
Q Q' Q Q' Q Q
6
Class Exercise Class exercise:
S
Market for Pizzas Market for Pizzas S'
Price ($/pizza)
P
P S P S'
S' S
P P' P'
P' P D
D'
D D
Q' Q
Q Q' Q Q' Q Q Millions of pizzas per month
Airline Competition
Find the equilibrium P & Q
Airlines compete for passengers and market share based on:
Demand for pizza is given by: P = 16 – 2 Qd
Supply for pizza is given by: P = 4 + 4 Qs Frequency of service & departure schedule on each route
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7
Class Exercise Airline Terminology and Measures
Fill in the blanks for the following airline profit maximizing
strategies Traffic – Enplaned Passengers (PAX)
Intended Benefit Strategy Pitfalls
RPM = Revenue Passenger Mile
Cutting Fares/ Yields
One paying passenger transported 1 mile
Increasing Fares/ Yields
Service Quality
Reduce Passenger
Service Quality
30
31 32
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Frequency Share / Market Share Class Exercise
A 200-seat aircraft flies 1000 miles, with 140 passengers:
Frequency share for airline A:
( )
RPM =
FS(A) = ⋯ ASM =
where F (i) = non-stop frequency of airline i
Assume total revenue = $16,000; total operating expense
Market share for airline i: = $15,000:
∗ ∗ Yield =
MS(A) = ∗ ( ) ∗ ( ) ∗ ( ) ∗ ⋯ Unit Cost =
where C (i) = the frequency of the last leg in a O-D trip for Unit Revenue =
airline i
Average Load Factor = RPM / ASM
ALF =
33 34
Flight
There is typically an outbound and inbound portion of
One or more flight legs operated consecutively by a passenger air trips.
single aircraft (usually) / single flight number (usually)
9
Origin‐Destination Market Demand
37 38
39 40
10
Class Exercise Class Exercise – continued
Frequency Share for IAD‐BOS = For this example all flight legs are 1 mile of distance
RPM =
41 42
Demand Models
Demand models are mathematical representations of the
relationship between demand and explanatory variables:
Based on our assumptions of what affects air travel
demand
43 44
11
Demand for Air Travel in General Airline Demand
Next to price of air travel, most important factor affecting Demand for carrier flight f of carrier i in O-D market j is a
demand for airline services: function of:
Access and egress times to/from airports at origin and Characteristics of flight f
destination
Characteristics of carrier i
Pre‐departure and post‐arrival processing times at each
airport Market characteristics
Actual flight times plus connecting times between flights Characteristics (including price) of all rival products:
Schedule displacement or wait times due to inadequate Competing markets’ products (other airports serving
frequency city‐pair in j, other transport modes, etc.)
45 46
47 48
12
Simple Market Demand Function Multiple Demand Segments
Multiplicative model of demand for travel O‐D per period:
D = M x Pa x Tb
where:
M = market sizing parameter (constant) that represents
underlying population and interaction between cities
SUPPLIERS
Ideally, firms in an industry would like to capture
most or all of the economic value that they create. 4. Bargaining power
of suppliers
However, competitive forces operate to push that 3. Threat of
value “forward” to customers (in the form of lower new entrants MARKET
COMPETITORS
prices), or in some cases, “backward” to suppliers. POTENTIAL
SUBSTITUTES
ENTRANTS
2. Rivalry among
5. Threat of substitute
existing firms
products or services
1. Bargaining power
of customers
BUYERS
13
Class Exercise 2. Elasticity
Describe the 5 Forces driving competition in the Airline
Industry (special focus on Southeast Asia). 1. Define price elasticity of demand
2. Calculate price elasticity of demand
3. Understand how changes in price affect total revenue
53 54
14
Price Elasticity of Demand Elastic Demand
57
P 1
Old New % Change ε = x
Price $1.00 $0.97 3% Q slope
Price
Quantity 400 404 1%
At point A A
ΔQd / Qd P=8 P=8
%ΔQd
ε= = ΔP
ΔP / P Q=3
%ΔP P=4
Slope = (8 – 4) / (3 – 4) = 4 ΔQ
D
1% 8 1
ε= = 0.33 Demand is inelastic ε= x = 0.67 Q=3 Q=4
3% 3 4
Quantity
Demand is inelastic
59 60
15
Class Exercise Price Elasticity Pattern
Find the price elasticity of demand at points A, B, C, E and F Price elasticity changes systematically as price goes down
(*division by 0 is undefined. Approximate it by ∞) Slope is the same for the demand curve
P/Q decreases as price goes down and quantity goes up
Price
A
At high P and low Q,
20
B Demand is elastic
15
C a ε >1
10 At the midpoint ε =1
E
Price
5
F demand is unit elastic a/2
ε <1
0 10 20 30 40
Quantity
At low P and high Q,
b/2 b
Demand is inelastic Quantity
61 62
Price Price
12
D
D1
Less Elastic
D 6
At the common More Elastic
Price
point demand 4
D2
is less price elastic
for the steeper
Quantity Quantity curve 4 6 12
Quantity
63 64
16
Examples Implications for Airline Pricing
Elasticity Ed coefficient Interpretation Example Inelastic (‐0.8) business demand for air travel means:
a 10% price increase leads to
Perfectly price does not saving your
Ed = 0 Total revenue for the airline will
Inelastic matter pet
Perfectly Ed = -∞
price is everything $10 bill
Elastic (undefined)
66
Definition: Percent change in total O‐D demand that occurs How would you describe the typical passenger for each
with a 1% increase in total trip time. of the following cases:
67 68
17
Total Revenue Trade-offs Total Revenue Trade-offs
Price ($/ticket)
8
6 1,000
1 2 3 4 5 6 2 6 10
Quantity (00s of tickets/day) Price ($/ticket)
72
18
Elasticity, Price Change, and Revenue Determinants of Price Elasticity of Demand
73 74
1. Consumer and producer surplus Adam Sandler must negotiate with a young girl to
2. Efficiency vs. equity convince her to pretend to be his daughter.
3. Government policies and market efficiency
75
19
Measuring consumer surplus with the demand curve Market demand and consumer surplus
Market Price P = 10
Market Price = $70
Price
Consumer's surplus is the Price of Consumer surplus from the
difference between: Albums first album ($30)
the buyer's reservation 20
Total consumer
price and the market price $100 Consumer surplus surplus ($100)
from second ($10)
80 Consumer
70 surplus
P=10
Consumer surplus
from third ($0)
50
Total consumer
surplus ($40) Demand
Demand
0 Q=20 Quantity
0 1 2 3 4
Quantity of Albums
77 78
Measuring producer surplus with the supply curve Market supply and producer surplus
Price = $800 Producer surplus at price P= 10
Price of Price
House Supply Supply
Painting
Total producer Total producer
surplus ($500) surplus ($250)
$900
Producer's surplus is the 800
difference between: Producer surplus
from the third house ($0)
the market price and the 600 P=10
seller's reservation price 500 Producer surplus Producer
from the second house ($200) surplus
Producer surplus
from the first house ($300)
5
0 Q=100 Quantity
0 1 2 3 4
Quantity of Houses Painted
79 80
20
Market Efficiency Consumer and producer surplus in the market
equilibrium
Adam Smith: markets are automatically channeling
self-interest toward socially desirable ends (the most Price
efficient allocation of resource – the invisible hand). Supply
Consumer
Economic well-being of a society (welfare) Equilibrium
surplus
Total surplus = consumer + producer surplus price
Producer
surplus
2.00
1.80
S 2.00 Consumer surplus = $900/ day
1.80 S
1.60 Consumer surplus = $900/day
1.60
1.40
Price ($/gallon)
Price ($/gallon)
Producer surplus = $900/day 1.40 Lost surplus = $800/ day
1.20
1.20
1.00
1.00
.80
0.80 Producer surplus = $100/ day
D
D
1 2 3 4 5 8
Quantity (1,000s of gallons/day) 1 2 3 4 5 8
Quantity (1,000s of gallons/day)
83 84
21
Thought Experiment: $0.50 Price Ceiling on Bread Policy experiment 2: Taxes on Sellers
Question Explanation In pictures
Will there be Consumers want to purchase more, but
more or less producers will manufacture less. Empty shelves
Tax program
bread for sale? Shortage! Seller reports sales in units to government
Will the size of Seller pays a fixed dollar amount per unit sold
Manufacturers will try to maintain profits No more giant
a typical loaf
by reducing the size of each loaf. loaves
change?
Will the quality Expensive brands will no longer be Focaccia bread
change? profitable to produce. would disappear
A tax on the seller shifts the supply curve up by the
Will the amount of the tax (for each level of output, seller
Opportunity cost of finding bread will
opportunity Bread lines would
cost of finding
rise. Resources spent looking for bread in
become the norm charges his marginal cost PLUS the tax)
different stores and waiting in line.
bread change?
Black market
Would you buy
Since bread is hard to find, and people bread dealers
illegal bread if
still need it, a black market will develop. reduce the
you could?
shortage
86
Total surplus = $9 M
4 D
3.50
3 0 P
3 Q S + tax
2.50 6
2 After Tax
1 Consumer surplus = $3.125 M
3.50
0
D Producer surplus = $3.125 M
1 2 3 4 5 Total surplus = $6.25 M
2.5 1 D
Quantity (millions of pounds/month) Consumer&Producer Loss = $2.75 M
2.5 Q
Tax revenue = $2.50 M
Net benefit = - $0.25 M
87 88
22
Tax on Avocado Sellers and Total Surplus
Taxes and Price Elasticity of Demand
S + tax
Total surplus
Total surplus
before tax
after tax S
6 Tax
Price ($/pound) 5 revenue Avocado tax was shared equally
4
Buyers paid $0.50 more
3.50 Deadweight Sellers received $0.50 less
3
2.50
Loss
2
1
D The amount of the tax paid (the burden) by buyers and
1 2 3 4 5 sellers depends on the price elasticity of demand
2.5
Quantity (millions of pounds/month)
More Elastic Demand Less Elastic Demand More Elastic Demand Less Elastic Demand
P P P Deadweight loss P Deadweight loss
S+T S+T S+T S+T
2.40 S 2.60 2.40 2.60
2.00 S S S
2.00 2.00 2.00
1.40 1.60 1.60
1.40
D1 D1
D2 D2
19 24 Q 21 24 19 24 21 24
Q Q Q
Consumers pay a smaller share of the tax when demand is more elastic
Deadweight loss is larger when demand is relatively elastic
91 92
23