AvM 112 Basics of Microeconomic Study Notes
Preliminary Lecture notes for AvM 112
(Prelim Exam Coverage)
References:
a. Microeconomics 8ed by Pindyck & Rubinfeld
b. Bijan Vasigh, Ken Fleming and Thomas Tacker; Introduction to Air Transport
Economics from Theory to Applications Second & Third Edition
c. Shaum’s outline of Microeconomics, 4ED
d. Mankiw, G (2015), Principles of Microeconomics, 7E
Chapter 1 Preliminaries
Introduction
Quote from Robert Mundell Man and Economics 1968
"Economics is the science of choice. It began with Aristotle but got mixed up with ethics in
the Middle Ages. Adam Smith separated it from ethics, and Walrus mathematized it. Alfred
Marshall tried to narrow it, and Keynes made is fashionable. Robbins widened it, and
Samuelson dynamized it, but modern science made it statistical and tried to confine it again.
But the science won't stay put. It keeps cropping up all over the place. There is an
economics of money and trade, of production and consumption, of distribution and
development. There is also an economics of welfare, manners, language, industry, music,
and art. There is an economics of war and an economics of power. There is even an
economics of love.
Economics seems to apply to every nook and cranny of human experience. It is an aspect of
all conscious action. Whenever decisions are made, the law of economy is called into play.
Whenever alternatives exist, life takes on an economic aspect. It has always been so. But
how can it be?
It can be because economics is more than just the most developed of the sciences of control.
It is a way of looking at things, an ordering principle, a complete part of everything. It is a
system of thought, a life game, an element of pure knowledge.

Economics is concerned with scarcity. If something is not scarce, there is no economic
problem.

Microeconomics => Study of behavior of individual economic units. How they react and
how they interact to form larger units.
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AvM 112 Basics of Microeconomic Study Notes

Economics uses theory to explain actions and predict future actions. For example if: the
Bulls are in the playoffs, then there will be a larger number of people wanting tickets
than if they have a poor season. If there is high unemployment, then at the university
more students enroll in business courses because their opportunity costs (pay loss due
to being in class) are less.

Theory does not work well all the time. The market test of theory is how well it does in
comparison to another theory. A theory must have the possibility to being proved wrong.
The statement "all unmarried men are bachelors" is a tautology and cannot be proved
wrong. The statement "If American Airlines lowers the ticket price to Bermuda, an
increased number of people will fly this weekend." Can be proved wrong or right.

Marginal utility theory can be used to derive the demand curve. However it will be
shown later that to get a downward sloping demand curve the only assumption needed is
that consumers buy randomly along the budget line. => a minimalist approach to
deriving an important economic concept - downward sloping demand.

Normative Economics => What should be done. "Microsoft should be allowed to
bundle the IE with Windows XP because it benefits consumers."

Positive Economics => What will happen, not what should be done. "An increase in the
property tax in the area of UIC will tend to lower the price of apartments, everything
else equal."

Many decisions involve multiple assumptions. Book example of 1985 decision of Ford
to produce the Taurus involved:
1. Consumer tastes vs demand "would they like the car?"
2. How sensitive would demand be to price changes? (elasticity),
3. What would be the production costs? (Depends on assumptions of #'s of cars
produced, union demands, inflation, how fast workers learn).
4. How would competitors react (market structure).
5. How much new capital would be needed? (interest rates, engineering).
6. How would the decision be changed if oil prices moved favorably,
unfavorably?
7. How should Ford organize the production?
8. How might anticipated Government regulation changes influence the
decision (Gas mileage requirements).
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AvM 112 Basics of Microeconomic Study Notes
Chapter 2 The Ten Principles of Economics
Introduction
The word economy comes from the Greek word oikonomos, which means “one who
manages a household.” At first, this origin might seem peculiar. But in fact, households and
economies have much in common. A household faces many decisions. It must decide which
members of the household do which tasks and what each member gets in return: Who cooks
dinner? Who does the laundry? Who gets the extra dessert at dinner? Who gets to choose
what TV show to watch? In short, the household must allocate its scarce resources among its
various members, taking into account each member’s abilities, efforts, and desires. Like a
household, a society faces many decisions. A society must find some way to decide what
jobs will be done and who will do them. It needs some people to grow food, other people to
make clothing, and still others to design computer software. Once society has allocated
people (as well as land, buildings, and machines) to various jobs, it must also allocate the
output of goods and services they produce. It must decide who will eat caviar and who will
eat potatoes. It must decide who will drive a Ferrari and who will take the bus.
HOW PEOPLE MAKE DECISIONS
PRINCIPLE 1: PEOPLE FACE TRADE-OFFS
To get one thing that we like, we usually have to give up another thing that we like.
Making decisions requires trading off one goal against another. Consider a student who
must decide how to allocate her most valuable resource—her time. She can spend all her
time studying economics, spend all of it studying psychology, or divide it between the two
fields. For every hour she studies one subject, she gives up an hour she could have used
studying the other. And for every hour she spends studying, she gives up an hour that she
could have spent napping, bike riding, watching TV, or working at her part-time job for
some extra spending money.
When people are grouped into societies, they face different kinds of trade-offs. The
classic trade-off is between “guns and butter.” The more a society spends on national
defense (guns) to protect its shores from foreign aggressors, the less it can spend on
consumer goods (butter) to raise the standard of living at home.
Another trade-off society faces is between efficiency and equality. Efficiency means
that society is getting the maximum benefits from its scarce resources. Equality means that
those benefits are distributed uniformly among society’s members. In other words,
efficiency refers to the size of the economic pie, and equality refers to how the pie is divided
into individual slices.
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AvM 112 Basics of Microeconomic Study Notes
PRINCIPLE 2: THE COST OF SOMETHING IS WHAT YOU GIVE UP TO GET
IT
Because people face trade-offs, making decisions requires comparing the costs and benefits
of alternative courses of action. In many cases, however, the cost of an action is not as
obvious as it might first appear.
The opportunity cost of an item is what you give up to get that item. When making any
decision, decision makers should be aware of the opportunity costs that accompany each
possible action. In fact, they usually are.
PRINCIPLE 3: RATIONAL PEOPLE THINK AT THE MARGIN
Economists normally assume that people are rational. Rational people systematically and
purposefully do the best they can to achieve their objectives, given the available
opportunities. As you study economics, you will encounter firms that decide how many
workers to hire and how much of their product to manufacture and sell to maximize profits.
You will also encounter individuals who decide how much time to spend working and what
goods and services to buy with the resulting income to achieve the highest possible level of
satisfaction.
Economists use the term marginal changes to describe small incremental adjustments to an
existing plan of action. Keep in mind that margin means “edge,” so marginal changes are
adjustments around the edges of what you are doing. Rational people often make decisions
by comparing marginal benefits and marginal costs.
For example, consider an airline deciding how much to charge passengers who fly standby.
Suppose that flying a 200-seat plane across the United States costs the airline $100,000. In
this case, the average cost of each seat is $100,000/200, which is $500. One might be
tempted to conclude that the airline should never sell a ticket for less than $500. In fact, a
rational airline can often find ways to raise its profits by thinking at the margin. Imagine that
a plane is about to take off with ten empty seats, and a standby passenger waiting at the gate
will pay $300 for a seat. Should the airline sell the ticket? Of course it should. If the plane
has empty seats, the cost of adding one more passenger is tiny. Although the average cost of
flying a passenger is $500, the marginal cost is merely the cost of the bag of peanuts and can
of soda that the extra passenger will consume. As long as the standby passenger pays more
than the marginal cost, selling the ticket is profitable.
PRINCIPLE 4: PEOPLE RESPOND TO INCENTIVES
An incentive is something that induces a person to act, such as the prospect of a punishment
or a reward. Because rational people make decisions by comparing costs and benefits, they
respond to incentives. You will see that incentives play a central role in the study of
economics. One economist went so far as to suggest that the entire field could be simply
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AvM 112 Basics of Microeconomic Study Notes
summarized: “People respond to incentives. The rest is commentary.” Incentives are crucial
to analyzing how markets work. For example, when the price of an apple rises, people
decide to eat fewer apples. At the same time, apple orchards decide to hire more workers
and harvest more apples. In other words, a higher price in a market provides an incentive for
buyers to consume less and an incentive for sellers to produce more. As we will see, the
influence of prices on the behavior of consumers and producers is crucial for how a market
economy allocates scarce resources.
HOW PEOPLE INTERACT
PRINCIPLE 5: TRADE CAN MAKE EVERYONE BETTER OFF
Countries as well as families benefit from the ability to trade with one another. Trade allows
countries to specialize in what they do best and to enjoy a greater variety of goods and
services. The Japanese, as well as the French and the Egyptians and the Brazilians, are as
much our partners in the world economy as they are our competitors.
PRINCIPLE 6: MARKETS ARE USUALLY A GOOD WAY TO ORGANIZE
ECONOMIC ACTIVITY
In a market economy, the market economy an economy that allocates resources through the
decentralized decisions of many firms and households as they interact in markets for goods
and services decisions of a central planner are replaced by the decisions of millions of firms
and households. Firms decide whom to hire and what to make. Households decide which
firms to work for and what to buy with their incomes. These firms and households interact
in the marketplace, where prices and self-interest guide their decisions. At first glance, the
success of market economies is puzzling. In a market economy, no one is looking out for the
economic well-being of society as a whole. Free markets contain many buyers and sellers of
numerous goods and services, and all of them are interested primarily in their own wellbeing. Yet despite decentralized decision making and self-interested decision makers,
market economies have proven remarkably successful in organizing economic activity to
promote overall economic well-being.
As you study economics, you will learn that prices are the instrument with which the
invisible hand directs economic activity. In any market, buyers look at the price when
determining how much to demand, and sellers look at the price when deciding how much to
supply. As a result of the decisions that buyers and sellers make, market prices reflect both
the value of a good to society and the cost to society of making the good. Smith’s great
insight was that prices adjust to guide these individual buyers and sellers to reach outcomes
that, in many cases, maximize the well-being of society as a whole.
PRINCIPLE 7: GOVERNMENTS CAN SOMETIMES IMPROVE MARKET
OUTCOMES
One reason we need government is that the invisible hand can work its magic only if the
government enforces the rules and maintains the institutions that are key to a market
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AvM 112 Basics of Microeconomic Study Notes
economy. Most important, market economies need institutions to enforce property rights so
individuals can own and control scarce resources. A farmer won’t grow food if he expects
his crop to be stolen; a restaurant won’t serve meals unless it is assured that customers will
pay before they leave; and a music company won’t produce CDs if too many potential
customers avoid paying by making illegal copies. We all rely on government-provided
police and courts to enforce our rights over the things we produce—and the invisible hand
counts on our ability to enforce our rights.
Consider first the goal of efficiency. Although the invisible hand usually leads markets to
allocate resources to maximize the size of the economic pie, this is not always the case.
Economists use the term market failure to refer to a situation in which the market on its own
fails to produce an efficient allocation of resources. As we will see, one possible cause of
market failure is an externality, which is the impact of one person’s actions on the wellbeing of a bystander. The classic example of an externality is pollution. Another possible
cause of market failure is market power, which refers to the ability of a single person (or
small group) to unduly influence market prices. For example, if everyone in town needs
water but there is only one well, the owner of the well is not subject to the rigorous
competition with which the invisible hand normally keeps self-interest in check. In the
presence of externalities or market power, well-designed public policy can enhance
economic efficiency.
HOW THE ECONOMY AS A WHOLE WORKS
PRINCIPLE 8: A COUNTRY’S STANDARD OF LIVING DEPENDS ON ITS
ABILITY TO PRODUCE GOODS AND SERVICES
Changes in living standards over time are also large. In the United States, incomes have
historically grown about 2 percent per year (after adjusting for changes in the cost of living).
At this rate, average income doubles every 35 years. Over the past century, average income
has risen about eightfold. What explains these large differences in living standards among
countries and over time? The answer is surprisingly simple. Almost all variation in living
standards is attributable to differences in countries’ productivity—that is, the amount of
goods and services produced from each unit of labor input. In nations where workers can
produce a large quantity of goods and services per unit of time, most people enjoy a high
standard of living; in nations where workers are less productive, most people endure a more
meager existence. Similarly, the growth rate of a nation’s productivity determines the
growth rate of its average income.
The relationship between productivity and living standards also has profound implications
for public policy. When thinking about how any policy will affect living standards, the key
question is how it will affect our ability to produce goods and services. To boost living
standards, policymakers need to raise productivity by ensuring that workers are well
educated, have the tools needed to produce goods and services, and have access to the best
available technology.
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AvM 112 Basics of Microeconomic Study Notes
PRINCIPLE 9: PRICES RISE WHEN THE GOVERNMENT PRINTS TOO MUCH
MONEY
In January 1921, a daily newspaper in Germany cost 0.30 marks. Less than two years later,
in November 1922, the same newspaper cost 70,000,000 marks. All other prices in the
economy rose by similar amounts. This episode is one of history’s most spectacular
examples of inflation, an increase in the overall level of prices in the economy.
What causes inflation? In almost all cases of large or persistent inflation, the culprit is
growth in the quantity of money. When a government creates large quantities of the nation’s
money, the value of the money falls. In Germany in the early 1920s, when prices were on
average tripling every month, the quantity of money was also tripling every month.
Although less dramatic, the economic history of the United States points to a similar
conclusion: The high inflation of the 1970s was associated with rapid growth in the quantity
of money, and the low inflation of more recent experience was associated with slow growth
in the quantity of money.
PRINCIPLE 10: SOCIETY FACES A SHORT-RUN TRADE-OFF BETWEEN
INFLATION AND UNEMPLOYMENT
Although a higher level of prices is, in the long run, the primary effect of increasing the
quantity of money, the short-run story is more complex and controversial. Most economists
describe the short-run effects of monetary injections as follows:
• Increasing the amount of money in the economy stimulates the overall level of spending
and thus the demand for goods and services.
• Higher demand may over time cause firms to raise their prices, but in the meantime, It also
encourages them to hire more workers and produce a larger quantity of goods and services.
• More hiring means lower unemployment.
This line of reasoning leads to one final economy-wide trade-off: a short-run tradeoff
between inflation and unemployment.
Policymakers face this trade-off regardless of whether inflation and unemployment both
start out at high levels (as they were in the early 1980s), at low levels (as they were in the
late 1990s), or someplace in between. This short-run trade-off plays a key role in the
analysis of the business cycle—the irregular and largely unpredictable fluctuations in
economic activity, as measured by the production of goods and services or the number of
people employed.
Summary
How People Make Decisions
1: People Face Trade-offs
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AvM 112 Basics of Microeconomic Study Notes
2: T he Cost of Something Is What You Give Up to Get It
3: Rational People Think at the Margin
4: People Respond to Incentives
Terms to remember
Efficiency the property of society getting the most it can from its scarce resources
Equality the property of distributing economic prosperity uniformly among the members of
Society
Opportunity cost whatever must be given up to obtain some item
Rational people are those who systematically and purposefully do the best they can to
achieve their objectives
Marginal change a small incremental adjustment to a plan of action
Incentive something that induces a person to act
How People Interact
5: Trade Can Make Everyone Better Off
6: Markets Are Usually a Good Way to Organize Economic Activity
7: Governments Can Sometimes Improve Market Outcomes
Terms to remember
Market economy an economy that allocates resources through the decentralized
decisions of many firms and households as they interact in markets for goods and services
property rights the ability of an individual to own and exercise control over scarce
resources
market failure a situation in which a market left on its own fails to allocate resources
efficiently
externality the impact of one person’s actions on the well-being of a bystander
market power the ability of a single economic actor (or small group of actors) to have a
substantial influence on market prices
How the Economy as a Whole Works
8: A Country’s Standard of Living Depends on Its Ability to Produce
Goods and Services
9: Prices Rise When the Government Prints Too Much Money
10: Society Faces a Short-Run Trade-off between Inflation and
Unemployment
Terms to remember
Productivity the quantity of goods and services produced from
each unit of labor input
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AvM 112 Basics of Microeconomic Study Notes
Chapter 3 Market forces and basics of Supply and
Demand
Introduction
A market is the place or context in which buyers and sellers buy and sell goods, services,
and resources. We have a market for each good, service, and resource bought and sold in the
economy. A market includes more than an industry (a collection of firms that sell the same
or closely related products). Key business decision: Determining the market for the product!
A function shows the relationship between two or more variables. It indicates how the value
of one variable (the dependent variable) depends on and can be found by specifying the
value of one or more other (independent) variables.
Equilibrium refers to the market condition which once achieved, tends to persist.
Equilibrium results from the balancing of market forces.
If prices differ in two markets, arbitrage may be possible. If the price of a T-bill maturing
in period t in NY is > than the price of the same T-bill in Chicago => people will buy in
Chicago and sell on the NY market. If the price of a Big-Mac is less in Norfolk VA than
Chicago, arbitrage is NOT feasible, even with fast planes.
Markets can be competitive (wheat) or noncompetitive (electric power) due to entry costs.
In a competitive market with many producers no one producer can change the industry
price. Product differentiation => power to alter price within limits. Successful advertising
=>  in perceived product differentiation.
Extent of the market => the boundaries, both geographical and physical of a market.
Real vs Nominal Price. Economic decisions should be made on the basis of real prices.
Money illusion => consumer looks at the nominal price not the real price. Assume two
groups: debtors and creditors. Creditors and debtors set the interest rate depending on their
expectations of price movements. Unexpected price increases (decreases) favor debtors
(creditors).
A. Functions of Microeconomic Theory
Distinguish between microeconomics and macroeconomics.
Microeconomic theory or price theory deals with the economic behavior of individual
decision-making units such as consumers, resource owners, and business firms as well as
individual markets in a free-enterprise economy. This is to be contrasted with
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AvM 112 Basics of Microeconomic Study Notes
macroeconomic theory, which studies the aggregate levels of output, national income,
employment, and prices for the economy viewed as a whole
What basic underlying assumption is made in studying microeconomics?
In studying microeconomic theory, the implicit assumption is made that all economic
resources are fully employed. This does not preclude the possibility of temporary
disturbances, but monetary and fiscal policies are supposed to assure us a tendency toward
full employment without inflation. During periods of great unemployment and inflation,
microeconomics is overshadowed by the aggregate problems.
Diagram Showing The Direction Of The Flows Of Goods, Services, Resources, And Money
Between Business Firms And Households
Figure 1 Circular Flow Diagram
Explain what is a cost to households represents income for business firms, and vice versa.
The top loop in Figure 1 above shows that households purchase goods and services from
business firms. Thus, what is a cost or a consumption expenditure from the point of view of
households represents the income or the money receipts of business firms. On the other
hand, the bottom loop shows that business firms purchase the services of economic
resources from households. Thus, what is a cost of production from the point of view of
business firms represents the money income of households.
With which of the five problems faced by every society is microeconomics primarily
concerned?
Of the five problems faced by every society, microeconomics is concerned primarily with
the first three (i.e., what to produce, how to produce, and for whom to produce). The crucial
step in solving these problems is the determination of the prices of the goods, services, and
economic resources that enter the flows shown in the Figure 1 diagram above.
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AvM 112 Basics of Microeconomic Study Notes
With reference to the circular-flow diagram in Figure 1, explain how the prices of goods,
services, and resources are determined in a free-enterprise economy.
Households give rise to the demand for goods and services, while business firms respond by
supplying goods and services. The demand and the supply of each good and service
determine its price. In order to produce goods and services, business firms demand
economic resources or their services. These are supplied by households. The demand and
supply of each factor then determine its price. In microeconomics we study some of the best
available models that explain and predict the behavior of individual decision-making units
and prices.
B. MARKETS, FUNCTIONS, AND EQUILIBRIUM
THE INDIVIDUAL’S DEMAND FOR A COMMODITY
The quantity of a commodity that an individual is willing to purchase over a specific time
period is a function of or depends on the price of the commodity, the person’s money
income, the prices of other commodities, and individual tastes. By varying the price of the
commodity under consideration while keeping constant the individual’s money income and
tastes and the prices of other commodities (the assumption of ceteris paribus), we get the
individual’s demand schedule for the commodity. The graphic representation of the
individual’s demand schedule gives us that person’s demand curve.
Example:
Suppose that an individual’s demand function for commodity X is Qdx = 8 - Px ceteris
paribus. By substituting various prices of X into this demand function, we get the
individual’s demand schedule shown in Table below. The individual’s demand schedule for
commodity X shows the alternative quantities of commodity X that the person is willing to
purchase at various alternative prices for commodity X, while keeping everything else
constant.
Px($)
Qdx
8
0
7
1
6
2
5
3
Exercise:
Plot the demand curve of the this demand schedule
11
4
4
3
5
2
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AvM 112 Basics of Microeconomic Study Notes
THE LAW OF NEGATIVELY SLOPED DEMAND
Quantity demanded is the amount (no of units) of a product/services that a household
would buy in a given time period if it could buy all it wanted at current market price.
A demand schedule is a table showing how much of a given product/services a
household would be willing to buy at different prices.
law of demand the claim that, other things being equal, the quantity demanded of a
good falls when the price of the good rises
Type of goods
Normal Goods are goods for which quantity demanded goes up when income is higher and
vice versa
Inferior Goods are goods for which quantity demanded falls when income rises.
A Giffen good is a low income, non-luxury product for which demand increases as the price
increases and vice versa
Complements are goods that “go together”; a decrease in the price of one results in an
increase in quantity demanded for the other, and vice versa.
Substitutes are goods that can serve as replacements for one another; when the price of one
increases, people switch to the substitute. Perfect substitutes (rare) are almost identical
products.
Hypothetical Demand Schedule: DIANAIA
Demand curve – a graph of the relationship between the price of a good and the
quantity demanded.
Market demand – sum of all individual demand of consumers.
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AvM 112 Basics of Microeconomic Study Notes
Note: a change in the demand is not the same as the change in quantity demanded
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AvM 112 Basics of Microeconomic Study Notes
Note the difference
THE SINGLE PRODUCER’S SUPPLY OF A COMMODITY
The quantity of a commodity that a single producer is willing to sell over a specific time
period is a function of or depends on the price of the commodity and the producer’s costs of
production. In order to get a producer’s supply schedule and supply curve of a commodity,
certain factors which influence costs of production must be held constant (ceteris paribus).
These are technology, the prices of the inputs necessary to produce the commodity, and for
agricultural commodities, climate and weather conditions. By keeping all of the above
factors constant while varying the price of the commodity, we get the individual producer’s
supply schedule and supply curve.
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AvM 112 Basics of Microeconomic Study Notes
EXAMPLE 7. Suppose that a single producer’s supply function for commodity X is Qsx= 40 +20P cet. par.
By substituting various “relevant” prices of X into this supply function, we get the
producer’s supply schedule shown in Table 2.4 below
Plotting each pair of values from the supply schedule in Table 2.4 on a graph and joining the
resulting points, we get the producer’s supply curve (see Figure beside table 2.4. As in the
case of demand, the points on the supply curve represent alternatives as seen by the producer
at a particular point in time.
THE SHAPE OF THE SUPPLY CURVE
In the supply schedule of Table 2.4, we see that the lower the price of X, the smaller the
quantity of X offered by the supplier. The reverse is, of course, also true. This direct
relationship between price and quantity is reflected in the positive slope of the supply curve
in Figure beside table 2.4. However, while in the case of the demand curve we can talk
about “the law of negatively sloped demand,” in the case of the supply curve we cannot talk
of “the law of positively sloped supply.” Even though the supply curve is usually positively
sloped, it could also have a zero, infinite, or even negative slope, and no generalizations are
possible.
SHIFTS IN THE SINGLE PRODUCER’S SUPPLY CURVE
When the factors that we kept constant in defining a supply schedule and a supply curve (the
ceteris paribus condition) change, the entire supply curve shifts. This is referred to as a
change or shift in supply and must be clearly distinguished from a change in the quantity
supplied (which is a movement along the same supply curve).
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Market Equilibrium - Supply and Demand
The basic model postulates that Supply responds positively to price and Demand
responds negatively to price. Qs = Qs(P) and Qd = Qd(P). At equilibrium P (P0) = Q (Q0)
and the market clears. Qs(P) > Qd(P) implies excess supply while Qs(P) < Qd(P) implies
excess demand. This is shown below
S
P
P1
P0
P2
D
Q
Points where price is above P0 represent excess supply, while points below P0 represent
excess demand. The laws of motion of Walrus state "If there is excess demand, price will
rise." The laws of motion Marshall state "If there is excess demand, quantity will rise." P0
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AvM 112 Basics of Microeconomic Study Notes
is the "market clearing price." Here supply = demand. Assume that somehow the price goes
to P1. Now demand < supply. According to Marshall adjustment will proceed by a reduction
in supply, while according to Walrus price will fall. Similar arguments can be made for P2.
In a market for Old Master Paintings clearly Walrus adjustment is the only legal adjustment
mechanism. In 1969 the first man walked on the moon. The New York times printed the
edition showing this historic moment for three days until everyone got a copy. This was
Marshall adjustment.
In the above diagram it does not matter which adjustment model you use, price will go to P0.
Assume that supply now is negatively sloped or that economics of scale exist. The producer
can increase his production and lower his price. Two Models are possible.
P
D
P
S
D
S
Q
Q
The left graph is stable according to Marshall and unstable according to Walrus. The right
graph is stable according to Walrus and unstable according to Marshall. Why?
There is a shift in supply if one of the variables held constant (not on the axis) changes and
that in turn changes the amount supplied. Assume the supply of wheat is a function of P and
R where R = rainfall.
Qs = a
+
1 P
+
2 R
(3)
where 1 > 0 and 2 > 0. An increase in R would, everything else equal move the supply
curve right and lower the price for wheat assuming the demand curve is not flat. Assume the
demand for wheat is a function of price and income.
Qd = a'
+
3P
+
4Y
(4)
Where 3 < 0 and 4 > 0. An increase in Y moves the demand curve right and results in an
increase in price assuming that the supply curve is not flat and that Y => quantity
demanded .
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AvM 112 Basics of Microeconomic Study Notes
Demand and supply curves hold tastes, prices of all other good, incomes and technology etc
constant. Over time supply and demand usually shift right. An exception would be the
demand for buggy whips! Why?
Key Concept:
Given a demand curve, it can be said that there is a change in demand or shift in
the demand curve if the price of another good changes, income changes or tastes
change. If the price of the good itself changes, then there is a change in the
quantity demanded or a movement along the demand curve. In the above
example will cause a change in demand while will cause a change in the quantity
demanded.
For supply, price of the good causes a change in the quantity supplied while factors
other than the price itself causes a change in supply. It is always important to
understand the difference with what moves a curve and what causes a movement
along the curve.
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AvM 112 Basics of Microeconomic Study Notes
Chapter 4
Supply and Demand: Analysis in the Airline Industry
Introduction
Airline demand and supply analysis is concerned with understanding passenger behavior,
measuring and characterizing the airline response to a change in ticket prices or incomes,
and deriving the demand-side information necessary to make sound supplyside business
decisions. In this chapter, we present supply and demand analysis in the context of airlines,
airports, and aircraft manufacturers. We examine the characteristics of supply and demand
such as price and income elasticities and we outline the factors that determine and shift the
two market forces. We present market equilibrium analysis and analyze market
disequilibrium in the context of supply or demand disruptions in aviation.
We present examples of the efficiency of market allocation of resources, contrasting with a
regulated allocation, using general aviation user fees and airport landing slot allocation as
examples. We conclude by stressing the importance of a thorough understanding of the
factors influencing supply and demand for an aviation manager.
================================================
Basics of Demand
I.
Law of demand
a. Demand curve
b. Derived demand
c. Direct demand
d. Demand function
II. Determinants of demand for air transportation
III. Inverse demand function
IV. Other demand functions
V. Characteristics of demand for air transportation
Basics of Supply
I.
Factors affecting supply of airline services
II. Characteristics of supply for airline services
Market Equilibrium
I.
Changes in equilibrium
II. Equilibrium price maximizes consumer well-being
III. Price controls
Consumer and Producer Surplus
I.
Airport landing fees and airport congestion
II. Price floors
III. Price ceiling
Disequilibrium
Elasticity
I.
Price elasticity
II. Cross-price elasticity
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AvM 112 Basics of Microeconomic Study Notes
III. Income elasticity
IV. Pricing and elasticity application
Summary
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Basics of Demand
Demand may be defined as the ability and willingness to buy specific quantities of a good or
a service at alternative prices in a given time period under ceteris paribus conditions.
Ceteris paribus is a Greek term for all else being equal or for everything other than the
variable of interest being held constant.
Understanding demand theory and the demand function is one of the more important aspects
for any business, since the characteristics of demand will dictate the patterns and
characteristics of sales. For example, if an airline were to drop ticket prices, would the
resulting increase in passenger demand cause an increase or decrease in passenger revenue?
At what point would the increased sales generated by low ticket prices start to hurt
passenger yield? What are the macroeconomic variables that could positively or negatively
affect air transport demand? Demand analysis will shed light on these and other businesscritical decisions.
Revenue passenger miles (RPMs) are measures of traffic for an airline obtained by
multiplying the number of revenue-paying passengers aboard the aircraft by the distance
traveled.
Airlines determine revenue ton kilometers (RTK) by multiplying the weight of paid in
tonnage by the total number of kilometers it has been transported.
The quantification of demand varies from industry to industry. For instance in the airline
industry, demand is usually expressed in terms of:
•
•
•
•
•
the number of passengers (PAX);
revenue passenger miles (RPMs), which normalizes passenger demand according to
the number of miles traveled;
revenue passenger kilometers (RPKs), which normalizes passenger demand
according to the number of kilometers traveled;
revenue ton miles (RTMs);
revenue ton kilometers (RTKs).
The rationale behind normalizing by miles is that raw passenger numbers are only partially
informative—a passenger traveling on a 100-mile route from New York, NY to New
Haven, CT is not worth the same to an airline as the passenger who travels close to 9,500
miles from New York to Singapore. Therefore, expressing demand in RPMs gives a sense
of airline traffic in terms of distance, and is the preferred metric for airline demand analysis
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AvM 112 Basics of Microeconomic Study Notes
throughout the industry. For aircraft manufacturers, demand would be represented as the
number of aircraft sold. While demand varies from industry to industry, its characteristics
remain similar, and its importance to business is always high. Therefore, it is critical to fully
understand the nature of demand.
I. The Law of Demand
The law of demand states that, ceteris paribus, as price increases, the quantity demanded
decreases. In other words, quantity demanded has a negative relationship with price. In order
to understand the law of demand’s practicality, consider a transcontinental flight from New
York to Los Angeles. For this round-trip flight, what would be the maximum a passenger
would be willing to pay? $500? $1,000? $5,000? The fact is that at some price the passenger
would consider it too expensive to fly and not take the trip. This decision to not fly is the
law of demand in practice; that is, at some price the quantity demanded for the individual
will decrease. The amount by which the quantity demanded decreases with ticket prices will
vary by consumer characteristics and preferences—this responsiveness of quantity
demanded to price is termed demand elasticity, since it is the basis of airline pricing and
revenue maximization. No matter what the extent of the response of demand, the law of
demand states that the quantity demanded will fall with an increase in price.
When this decision is presented to all possible travelers, there will be different responses
because people have different incomes and purposes for travel. These different responses
help create a demand schedule, which is simply a table showing the quantities of a good that
customers are willing and able to buy at alternative prices in a given time period, ceteris
paribus. Such a table outlines the number of customers who would purchase a product or
service at the given price. It is important to remember that demand is cumulative; that is, a
consumer who is willing to pay $1,000 for the flight would certainly also be willing to pay
$500 for the same flight.
Table 3.1 provides a hypothetical demand schedule for the New York to Los Angeles flight.
It highlights the law of demand since the quantity demanded (number of passengers) for the
$200 airfare is significantly more than the quantity demanded for the expensive $5,000
airfare. At an airfare of $5,000, very few people are willing and able to pay for the ticket—
perhaps only a few extremely wealthy and/or time-sensitive passengers.
Table 3.2 presents data from the BTS O&D Database on ticket prices of the four carriers
along that route: American Airlines, US Airways, Delta Airlines, and Virgin America. The
various observed fares were divided into 29 bins of $150 width. Fares lower than $100 were
omitted from the dataset because of non-revenue passengers or airline-subsidized passengers
like crewmembers or family who generally pay artificially low prices. Graphically, the
above data yields the demand curve shown in Figure 3.1:
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AvM 112 Basics of Microeconomic Study Notes
Table 3.1 Hypothetical Demand Schedule: JFK–LAX
Table 3.2 Observed Average Fares for Route JFK–LAX, 2009 Quarter 2
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AvM 112 Basics of Microeconomic Study Notes
Figure 3.1 Observed Demand Curve for JFK–LAX Route
Source: Compiled by the authors using Back Aviation O&D data
As can be observed, the empirical demand curve is downward sloping, confirming the law
of demand presented above, and demonstrating a negative relationship between quantity
demanded and price. The curve is concave to the origin, suggesting that at some point,
demand increases tremendously as a result of decreasing price, but above that point, demand
is much less responsive to changes in price. For the JFK–LAX route, the abrupt change in
demand elasticity occurs somewhere around $350.
Omitting the lowest four fare classes, and just graphing the demand curve at prices above
the point of changing elasticity, the following graph shown in Figure 3.2 occurs:
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AvM 112 Basics of Microeconomic Study Notes
Figure 3.2 Observed Demand Curve for JFK–LAX Route: Omitting Four Lowest Fare
Classes
Here too, a negative relationship between price and quantity emerges, but the
responsiveness of quantity demanded to changes in price is much lower. This clearly
demonstrates the relative inelasticity of demand at lower ticket prices and is the basis for
revenue management strategies in airlines.
Demand curve
From the demand schedules, a demand curve can be constructed. A demand curve is a
graphical description of the demand schedule, and the quantities of a good that customers
are willing and able to buy at alternative prices in a given period of time. The law of demand
can then be derived from this schedule and it shows that the demand curve will always be
downward sloping. It should be noted that the demand curve does not portray actual
purchases, but only what consumers would be willing and able to purchase. Figure 3.3
provides the demand curve for the New York to Los Angeles trip. In this example, the
demand curve is a linear negative sloping line. The demand curve in this example is linear
and downward-sloping. Both vertical and horizontal intercepts have an economic
interpretation—the vertical intercept is called a “choke price,” which is defined as the price
at which demand shrinks to zero. In other words, this price is above what every consumer in
the market would be willing to pay for the trip between JFK–LAX. The horizontal intercept
is the limit of demand even if the travel were offered free of charge. This could represent the
entire size of the market, since, as discussed below, the demand for air transportation is a
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AvM 112 Basics of Microeconomic Study Notes
derived demand. The demand for air transportation is based on people’s willingness to
travel, which is itself contingent on their reasons for travel. Even if the trip between JFK and
LAX were to be offered free of charge, demand might increase slightly due to an increase in
vacationers and other leisure travelers, but would not increase greatly, as the underlying
factors affecting the desire for travel have not changed.
Derived Demand
An important aspect of air transportation demand analysis is the fact that the demand is
derived, meaning that it is derived from the demand of consumption or utilization of another
good or service. In other words, the demand for air transportation stems from factors other
than the transportation itself. Individuals do not directly demand travel—their demand stems
from the reason they desire to undertake the travel. Once they have decided to travel, they
choose between different modes of transportation, and later, between different airlines.
However, their core demand stems from their reasons to travel. A managerial implication of
this analysis is that an absolute drop in prices might not necessarily cause an increase in
travel if all the competing airlines on a particular route simultaneously drop their prices as
well. In a derived-demand market, only relative price decreases matter, since the overall
quantity demanded cannot necessarily be increased by a drop in prices. If every airline were
to cut its prices for the JFK–LAX route by $100 tomorrow, travel might increase slightly
due to the leisure segment, but overall, not many more people would necessarily want to go
to JFK–LAX merely because it is cheaper to do so. However, if Virgin America alone were
to cut its fares by $100, while American Airlines, Delta, and US Airways kept their prices
unchanged, Virgin America could take customers from the other three airlines, thus
increasing the demand for its product. However, derived demand markets tend to present
zero-sum games in terms of decision- making equilibrium. One player gains at the expense
of another, and this lends itself to price matching and price wars. The demand for that travel
route is derived, and ceteris paribus, consumers will switch over to the competitor at the
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AvM 112 Basics of Microeconomic Study Notes
expense of the airline they are currently flying if the rival airline lowers its price. The
derived nature of demand in the air transportation industry might also account for the slim
operating and net profit margins in the industry; that is, zero-sum game markets tend to lend
themselves to competition where each player earns zero economic returns.
Direct Demand
In contrast to derived demand, direct demand refers to demand for goods and services meant
for final consumption. For example, if you fly general aviation aircraft to enjoy flight, then
your demand for aircraft is a direct demand. For commercial airlines, each aircraft has a
unique cost/revenue analysis that makes it suitable for certain airlines. The pricing
implication of this is that a drop in the price of aircraft will lead to an increased demand for
aircraft in terms of market growth — airlines that had previously been unable to afford a
certain type of aircraft due to fixed cost constraints will now be able to do so. Itineraries that
were previously deemed uneconomical might suddenly become profitable, and the size of
the market could grow. Therefore, a managerial implication is that for the manufacturer,
demand and market size can be directly influenced by decisions about types of aircraft, and
competition is not necessarily a zero-sum game. Add to this large degrees of technological
differentiation and one gets a scenario where Boeing can create and capture an entirely
different segment of the market than Airbus. Although both companies compete for the
same set of customers, high levels of product differentiation and a direct demand for aircraft
make them both able to segment the market and benefit from increasing numbers of
customers.
Demand Function
Using information from the demand schedule and/or the demand curve, a demand function
can be constructed. A demand function is simply the functional relationship between the
quantity demanded and factors influencing demand. There are numerous factors that
influence the demand for air travel, for example, in the New York to Los Angeles market,
and therefore price is not the sole determinant of demand. (However, when the other
determinants are held constant, the relationship between price and quantity demanded is
always negative.) If, however, some of those other characteristics are varied, the quantity
demanded can change accordingly. For instance, if a drop in the price of airline tickets
occurs in conjunction with a global influenza pandemic, the quantity of airline tickets might
decrease, even though prices of tickets dropped simultaneously.
Demand functions may be classified into two categories based on their composition: implicit
or explicit. Implicit demand functions simply state a general relationship between the
quantities demanded and the factors affecting demand. Explicit demand functions are
mathematical relationships between the quantity demanded and the various variables
impacting demand. Implicit functions do not have the actual mathematical relationships but
rather a more generalized statement of the factors affecting demand. For example, the
implicit demand function for the New York to Los Angeles flight could be:
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AvM 112 Basics of Microeconomic Study Notes
The implicit demand function simply states that a relationship exists between dependent
variable and the independent variables, but it does not state the extent to which the variables
are related. The numerical relationship that displays the degree of influence that each factor
has on the quantity demanded is the explicit demand function. Using the information
obtained from the demand schedule and the demand curve, an explicit demand function for
the New York to Los Angeles flight could be written as:
Based on this linear demand function, two statements can be made about the nature of
demand for a round-trip New York to Los Angeles flight. First, when the price of the ticket
is $7,500, then demand for this trip drops to zero. In other words, demand for any product or
service is always limited by the extent of the market demand (in this case any price above
$7,500). The other statement concerning the linear demand curve is that the negative price
coefficient (or slope) is -2, which means that for every dollar increase in the ticket price, the
demand drops by two passengers. This change in demand occurs for all price points,
creating a constant negative slope.
While the linear demand function is simplistic and clear to understand, the fact remains that
the demand schedule rarely has a perfect linear form. This makes intuitive sense as
passenger demand does not drop off evenly with price increases, but instead drops off in
steps. Frequently, there is a major inflection point where demand decreases dramatically. As
demonstrated in Figure 3.1, for the JFK–LAX route, this point of inflection occurs around
$350. Above this point, demand is much less responsive to changes in price. Below that
point, demand increases rapidly. In other words, in our example, a $300 decrease in price
from $1,800 to $1,500 will only increase demand by 1,010, whereas a $300 decrease
in price from $600 to $300 will increase demand by 44,800.
Two other types of demand functions are the semi-log function and the log-linear
function. The general forms for the two functions are:
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AvM 112 Basics of Microeconomic Study Notes
For the airline industry, it is usually assumed that the typical demand function takes the loglinear shape. The general shape of a log-linear function is contained in Figure 3.4.
Unlike a linear demand function where the slope of the function is constant throughout, the
slope of a log-linear demand function changes. In Figure 3.4, the initial slope of the function
is fairly steep, indicating that a unit drop in the ticket price does not generate a similar
increase in the quantity demanded. This is partly a result of the fact that the ticket price is
still considered expensive by the majority of potential customers. Eventually, as the price
decreases, the quantity demanded for the product or service becomes greater and greater to
the point where a small drop in the price generates a large increase in the quantity
demanded. Once again, referring to Figure 3.1, the demand curve for the JFK– LAX route
can be best approximated by a log-linear function, both before and after the demand
inflection point.
II. Determinants of Demand for Air Transportation
Some of the factors that affect this demand are:
• ticket price;
• competitor’s ticket price;
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AvM 112 Basics of Microeconomic Study Notes
• passenger income;
• state of the economy;
• availability of other modes of transportation;
• passenger loyalty;
• in-flight amenities;
• frequency of service;
• safety;
• aircraft type, location of airport;
• random factors, such as volcano ash cloud, SARS, and 9/11 or threat of terrorism.
To illustrate the impact that these factors might have on the demand curve, consider the
previously used demand schedule for the New York to Los Angeles flight. Table 3.3
provides an updated version of that demand schedule. In order to highlight the effect of the
ticket price on the demand curve, refer to Figure 3.5. As we said earlier, a change in the
ticket price is always defined as a ceteris paribus movement along the demand curve. For
example, if the current ticket price for the flight was set at $3,000 and then lowered to
$2,000 (all other things remaining constant), the only effect this change would have would
be on the quantity demanded. This is reflected in the demand schedule from Table 3.3 in
column two where the quantity demanded moves from 315 to 465. This movement is
displayed graphically in Figure 3.5, where the quantity demanded moves from point A to
point B along the demand curve. Ticket price is the only determinant of demand that causes
a movement along the demand curve; changes in the other determinants of the demand
cause a shift in the entire demand curve. Continuing with the New York to Los Angeles
example, suppose that a competitive airline decreases air fares. This will cause demand for
this airline’s flight to increase as some consumers switch to this airline. This increase in
demand is reflected in Table 3.3’s third column, where the quantity demanded at each price
level increases by 210 passengers from column two. The increase in the quantity demanded
across all price levels creates a rightward shift in the demand curve from D1 to D2, as
depicted in Figure 3.6. For every price level, the quantity demanded has increased by 210.
For instance, at the price of $3,000, 525 passengers would be willing to travel from Los
Angeles to New York instead of 315. This is represented by a shift in the demand curve
from A to B. Conversely, a negative impact on demand would create a leftward shift in the
demand curve. Finally, an increase in demand also causes an increase in the choke price of a
market from D to C. In other words, the absolute maximum price beyond which a consumer
would not be willing to purchase air travel will increase, since the quantity demanded has
increased at every price level.
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AvM 112 Basics of Microeconomic Study Notes
The demand for a single flight is affected by multiple factors but for many, especially pricesensitive leisure travelers, the price of the flight and the price of competing flights are
probably the most important variables. With the advent of the Internet and numerous price
aggregation websites like Expedia, Travelocity, and so on, price and competitors’ prices
have probably become even more important as airline ticket price information is readily
available to potential customers. However, these price variables affect different segments of
the population in different ways. For time-sensitive travelers, ticket price versus a
competitor’s ticket price may not be as important as for price-sensitive travelers. For the
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AvM 112 Basics of Microeconomic Study Notes
competitor’s price variable, the coefficient would be expected to be positive, since an
increase in the competitor’s price would make the competition’s product less competitive,
and ultimately increase demand for the company’s product. Consider airlines A and B who
both have flights on the same route and both have introductory fares of $400. If airline B
were to increase its airfare to $450, this would make it less competitive and ultimately
increase demand for airline A. Conversely, if airline B were to drop its airfare to $350, this
would make it more competitive, which would decrease demand for airline A and increase
demand for airline B. Regardless of the viewpoint, the price coefficient would be negative
and the cross-price coefficient would be positive.
III. Inverse Demand Function
In the airline industry, revenue managers are mostly interested in knowing their pricing
power and the factors influencing passengers’ behavior in response to variation in ticket
prices. The inverse demand function is also called the price function, and it treats price as a
function of quantity demanded. The inverse demand function is given by P(Q) = a + b(Q),
where a is the intercept and b is a number always less than zero. To compute the inverse
demand function, simply solve for P in the demand function. For example, if the demand
function is Q = 350 – 0.50P then the inverse demand function would be P = 700 – Q.
Suppose the inverse demand function for an airline flying from London Heathrow (LHR) to
Beijing China (PEK) is given by: P = 15,000 – 75Q According to the above equation, the
maximum the airline can charge to sell 160 seats is $3,000 per seat.
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AvM 112 Basics of Microeconomic Study Notes
IV. Other Demand Functions
V.
The general form of a log-linear demand function can be expanded to explicitly include the
competition’s price:
While own price, substitute price, and income are the three major determinants of demand
for air transportation, there are other factors that affect demand. An important one of these is
the availability of substitutes. For air travel, this includes other modes of transportation. In
the US, driving is a reasonable substitute for many short flights, while in Europe highspeed
rail can greatly impact the demand for select air services. For example, the highspeed
Brussels to Paris rail line has created a situation where there is little demand for Brussels to
Paris air transportation. However, in situations where there is a lack of other modes of
transportation, for example, air services to a remote Caribbean island, demand for air travel
can be expected to increase. Based on this discussion, the expected coefficient for the
availability of substitutes could be either positive or negative.
Other variables that might affect the demand for air travel include the quality of service
offered, product differentiation, and so forth. These are typically known as ‘quality’ or
‘hedonic’ price determinants, and can play an important role in the demand for a good or
product. Some of the hedonic indicators for airline demand are:
• flight frequency;
• connectivity between city-pairs;
• customer loyalty programs;
• service levels;
• on-time performance;
• customer service.
VI. Characteristics of Demand for Air Transportation
The demand for air travel also has many unique characteristics that present problems for the
airline industry. While all of the following characteristics shape the demand for air
transportation, only the first five will be examined in detail.
• fluctuations
• cyclicality
• seasonality and peaking
• directional flow
• perishability
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AvM 112 Basics of Microeconomic Study Notes
• schedule wait time
• airport access time
• flight time
• hub connection time
• denied boarding time.
The first major characteristic of demand for air transportation is that, unlike the demand for
many products, it is constantly fluctuating. Because of the numerous determinants
highlighted in the preceding section, demand for individual flights is constantly changing.
Moreover, no two routes exhibit the same properties of demand, making every route unique
in its demand characteristics.
Basics of Supply
I.
Factors Affecting Supply of Airline Services
Following the previous definition of demand, supply refers to a firm’s willingness and
ability to provide a specific number of seats at a given price, time period, and market. In the
airline industry, supply is the capacity of an airline to transport passengers, a function of
offered routes and available aircraft. Supply is usually expressed in available seat miles
(ASMs) or available ton miles (ATMs). An ASM is simply one seat carried through the air
for one mile, regardless of whether it contains a passenger or not. The presence of a revenue
passenger in the seat is the key difference between RPMs (demand) and ASMs (supply), as
RPMs only measure seats that have a revenue passenger in them. Dividing RPMs by ASM
gives us a key performance indicator for airlines, the load factor. This is defined as the
percentage of capacity that has been matched with demand. Similarly, for cargo or freight
transportation, the equivalent unit to RPMs is RTM, which may be matched up with ATMs
to yield a cargo load factor. Load factors are critical to airline performance, since they
determine aircraft utilization, drive the profitability of a given route, and indicate the useful
utilization of capacity.
Some of the factors affecting supply are:
• ticket price;
• price of resource inputs:
− fuel prices
− labor costs
− landing fees
− aircraft costs
− maintenance costs
• navigation charges;
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AvM 112 Basics of Microeconomic Study Notes
• technology;
• availability of other mode of transportation;
• government regulation;
• stochastic factors:
− weather condition
− strikes.
The implicit supply function for the airline industry can be written as:
The major determinant of supply, just like demand, is the ticket price of the good or service.
This relates to the law of supply in that the quantity of a good supplied in a given time
period increases as its price increases, assuming all else is held constant. In the airline
industry this simply means that airlines are willing to supply more seats as ticket prices
increase. Based on the law of supply, the supply curve slopes upward up so that any change
in price is simply a movement along the supply curve and this is referred to as an increase in
the quantity supplied. Table 3.4 provides a hypothetical supply schedule for the New York
to Los Angeles flight. The next major determinant of supply is the price of resources. For
the air transportation industry, production resources include, but are not limited to, aircraft,
fuel, maintenance, labor, and landing fees. All these factors, and many more, impact supply
because they affect the cost of production. If the cost of production increases, then the
airline’s total costs increase, causing a leftward shift in the supply curve. In the airline
industry, an increase in the costs of production may force the airline to cut some flights that
would no longer be profitable. This reduction in flights is a leftward shift of the supply curve
(that is, fewer seats are offered at the same ticket price). Conversely, if the price of resources
decreases, then the supply curve shifts to the right. (That is, more seats are offered at the
same ticket price.)
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AvM 112 Basics of Microeconomic Study Notes
Figure 3.9 exhibits a linear supply curve. As ticket price goes up, so does the number of
seats offered. At a price of $3000 per ticket, an airline would be willing and able to supply
4,520 seats. The degree of responsiveness of quantity supplied to a change is price is called
the price elasticity of supply. The next major factor that determines supply for air
transportation is technology. The impact of technology on the supply of air transportation
has been vast. Technology has advanced civil aviation to the point where it is one of the
safest modes of transportation. The introduction of the Boeing 747 in 1970 created a
rightward shift in the supply curve as the jumbo-jet was able to carry more passengers on a
flight than any other aircraft (Boeing, 2007). Similarly, the 787-8 Dreamliner use 20 percent
less fuel for comparable trips than today’s similarly sized airplane (Boeing, 2010). The new
Airbus 380 has also caused a shift in the supply curve of airlines that received the aircraft.
However, perhaps one of the best examples of technology’s impact on air transportation
supply is the introduction of ultra-long-range aircraft. Prior to ultra-long-range aircraft such
as the Boeing 777-200LR and the Airbus A340-500, non-stop routes such as Singapore to
Los Angeles and New York to Dubai could not be operated. Finally, the introduction of
Extended Twin-Engine Operations (ETOPS) enabled a greater supply of air transportation
over the Atlantic and Pacific oceans through the use of smaller twin-engine aircraft.
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AvM 112 Basics of Microeconomic Study Notes
Competitive factors are another important determinant of supply for air transportation. Since
airlines have historically aggressively competed over market share, competition from other
airlines has impacted supply considerably. Airlines regularly adjust capacity and supply in
markets in response to competition and changing market forces; however, there have been
cases where airlines have taken this to an extreme.
Deregulation and liberalization of air transport have also significantly affected the supply
curve. Since regulation generally prohibits market forces from determining supply, there is
usually an artificial cap set on supply. Therefore, when air transport deregulation occurred,
the artificial cap on supply was withdrawn and supply subsequently increased.
The final factor impacting air transportation supply is government regulation. Despite the
fact that aviation industry has gone through massive privatization and financial deregulation,
almost all aspects of safety and operations remain highly regulated. In the US, the federal
government completely controls all US airspace, and airlines are totally dependent on the
Federal Aviation Administration (FAA) to operate that airspace in a safe, efficient, and
affordable manner. On January 20, 2005, the FAA mandated that the vertical separation
between aircraft above the US at altitudes from 29,000 to 41,000 feet be reduced from 2,000
feet to 1,000.9 The Domestic Reduced Vertical Separation Minimum (DRVSM) rule was
designed to increase airspace capacity. This action has allowed more available routes for
airlines and has had the effect of shifting the supply function to the right (Figure 3.10).
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AvM 112 Basics of Microeconomic Study Notes
II.
Characteristics of Supply for Airline Services
Two major characteristics of supply that help shape the air transportation industry are
seasonality and rigidity. Both these characteristics make it difficult for airlines to match
supply and demand.
One of the major characteristics of air transportation demand is that demand constantly
fluctuates. Because of this, airlines must react to this fluctuation by adjusting the supply to
match the passenger demand. In order to accommodate seasonality, airlines need to either
pull capacity off existing routes, or have idle capacity available to accommodate additional
flights. Both of these options have imbedded costs, and airlines typically use a mix of both
options. While the increased costs of a seasonal schedule can be offset by increased
revenues, airlines have greater difficulty adjusting supply on a short-term basis due to the
second major characteristic of airline supply, rigidity. An airline’s supply is fairly rigid as it
can be difficult for airlines to reduce and/or increase supply dramatically. Since an airline
creates a schedule at least six months out, and accepts bookings up to a year out, the airline
must adhere to the schedule or face re-accommodation fees. Fixed costs, such as investment
in infrastructure at hub airports, aircraft leases, and labor contracts have to be paid regardless
of the schedule, making it impractical for airlines to reduce capacity on short-term notice.
This is particularly a problem for those major US carriers that operate in a hub-and-spoke
network and is one reason why a non-hub carrier such as Southwest Airlines has greater
flexibility with supply. Ultimately, this rigidity in supply limits the airlines’ ability to match
supply and demand effectively.
Market Equilibrium
So far, we have analyzed supply and demand separately, considering the characteristics of
both. Matching supply and demand occurs when both parties agree on a price that
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AvM 112 Basics of Microeconomic Study Notes
determines the allocation of the resource. At any given price, there will be a quantity
demanded, and a quantity supplied. At one price, however, quantity demanded will exactly
equal quantity supplied, and this point is known as equilibrium. In other words, market
equilibrium is the setting of a price such that the quantity demanded and the quantity
supplied of a good are exactly equal. It is the point where both supply and demand curves
intersect, and the price is known as the market clearing price. Figure 3.11 presents a supply
and a demand curve on the same set of axes, with price on the y-axis and quantity demanded
on the x-axis. We find equilibrium price at P* where supply and demand intersect. At P*
buyers want to buy exactly the same amount that sellers want to sell. Although we tend to
think of businesses as being in control of prices, it is fair to say that consumers “set” prices
just as well as producers. Airlines always want high ticket prices and passenger consumers
always desire low prices; P* is a compromise that forces both sides to take into account the
other’s needs. Producers must receive a high enough price to cover costs and motivate
production; consumers must receive a price consistent with their budget. P* is achieved
through a process of trial and error. The firm estimates demand and plans a level of output
and charges a price based on that estimate. Suppose an airline underestimates demand and
therefore charges too low a ticket price, P1 and offers too little output, Qs 1, as in Figure
3.11. At this low price the amount demanded by passengers
is much greater than the
output supplied. Airlines, or any other business in this situation, will see that tickets are sold
at unusually high rates; that is, the aircraft will begin to fill up its seats much faster than
normal. In fact, if airlines don’t respond there will be a shortage; they will soon be sold out
and turn away numerous customers. However, airlines typically respond fairly quickly.
Airlines will raise the price and, since the higher price can cover the higher associated per
unit costs, will increase output. Suppose that airlines raise output to
and increase
average fare to
so that quantity demanded falls to
This is a step in the right
direction but there is still excess quantity demanded; the price is still too low so that seats
continue to fill overly fast. So, price and output will be raised again and will not settle into
equilibrium until P* is reached, at which point
are equal, at least approximately,
at Q*. Once the average fare reaches P* seat inventories behave normally and quantity
supplied is brought into balance with quantity demanded as well as is feasible under the
given conditions.
39
AvM 112 Basics of Microeconomic Study Notes
There is a dynamic process for reaching P*, equilibrium price, if airlines initially
overestimate demand. In that case, the average fare is too high and very few bookings are
received. If this persists there will be a surplus of available seats and aircraft will depart with
many more empty seats than normal. Of course, airlines want to avoid this and will therefore
bring price down, and reduce capacity until equilibrium is reached at P*. Once equilibrium
is achieved then price and quantity will remain at P* and Q* as long as both supply and
demand remain constant. In practice, supply and demand for air travel tend to shift often so
we see almost constant changes in price and quantities (Mankiw, 2007). The same concept
is presented in a mathematical fashion below. Suppose that the demand and supply functions
for DirectJet’s flights from New York to Seattle are the following:
40
AvM 112 Basics of Microeconomic Study Notes
Based on this calculation, the market equilibrium price for DirectJet’s flight between New
York and Seattle is $125. At this price point, the quantity demanded equals the quantity
supplied. Since the supply and demand curves are equal to each other at the equilibrium
price, either the demand or supply function can be used to determine the market equilibrium
quantity. Both functions are used below to illustrate this point.
41
AvM 112 Basics of Microeconomic Study Notes
I. Changes in Equilibrium
Analyzing changes in equilibrium is straightforward as long as one proceeds by first
deducing which curve is shifting in which direction. Suppose, for instance, that the air travel
market is in equilibrium initially and then changed when a new event causes passengers to
more fully realize how safe commercial flying is compared to other modes of travel. Though
the airlines are very pleased with this development this does not change production costs;
therefore we know that the supply curve doesn’t move. It stands to reason that a more
realistic assessment of airline safety will result in a greater general willingness to fly—for a
given price people want to fly more than before. This causes an increase in demand; the
demand curve shifts right as we see in Figure 3.13. Now, we simply read the graph, based
on where the new demand curve,
intersects supply to see that equilibrium price
rises and equilibrium quantity also rises. Supply doesn’t change since the supply curve is not
shifting but quantity supplied increases as we move along the existing supply curve.
42
AvM 112 Basics of Microeconomic Study Notes
II. Equilibrium Price Maximizes Consumer Well-being
The equilibrium price is generally the best possible price for consumers given the reality of
producer costs. Consumers would love for air travel to be provided for free but most have
enough sense to realize that a law requiring airlines to give their product away would simply
result in airlines shutting down. Price must be high enough to motivate sellers to provide
their product at appropriate quality. Sometimes price may seem higher than necessary to
motivate needed production—but things are not always as they seem. It is generally optimal
for consumers to let price move wherever supply and demand may send it.
It is useful to initially illustrate this point outside of the air travel market; then we can apply
a similar logic to a more complex aviation example. Let us first analyze the widely
misunderstood case of pricing crucial consumer goods in the aftermath of a natural disaster.
Suppose a severe hurricane knocks out electrical power in an area with drastic consequences
for, say, the ice market. Most of the ice in the area will have melted while simultaneously
the demand for ice surges way above normal level. The drastic reduction in supply
combined with huge demand will raise equilibrium price far above the norm, as depicted in
Figure 3.15 where we see equilibrium price at $20 for a bag of ice that would normally sell
for less than $2.
43
AvM 112 Basics of Microeconomic Study Notes
The natural, emotional reaction to this is to feel that sellers are engaged in “outrageous price
gouging” but economic logic leads to a very different conclusion. In this case the high price
actually helps consumers to better deal with the emergency—the problem here is the
hurricane; the high price helps people cope far better than a “normal, fair price” would. The
harsh reality is that the hurricane leaves the city with an ocean of demand for ice but only a
few drops of ice available. It is impossible to get the product to all who want it; so it is
important to guide this crucial resource to those that have the most urgent needs. Everyone
is thirsty for something cold to drink but a few people have life-saving medicines that will
spoil unless they are preserved with ice. The $20 price will convince most of those who are
merely thirsty to leave the ice alone while those who face a literal life or death need for ice
will not hesitate to pay the exorbitant price. Thus, the high price rations the good to those
who need it most urgently. Of course, to truly minimize human suffering we need more than
just a high price, we need some charity as well to buy the ice for those who have urgent
health needs but are too poor to afford to buy the ice themselves. The high price maximizes
their chance to find and purchase ice in time to save lives. In fact, any philanthropist rushing
in with ice would do more good to sell it for the $20 than they would by giving it away
randomly—ice selling at $20 is mainly going to those with urgent needs while ice randomly
given away is mainly going to thirsty people. Naturally, it would be ideal to give the ice only
to those with urgent needs but it is difficult to quickly identify those with greatest need
under such chaotic conditions. This seemingly unfair, outrageous price also motivates
extreme measures to bring in more supplies. In such situations, young pilots have rented
aircraft and flown in ice by helicopter and sea plane, a mode of transport normally
unaffordable for most young pilots. But with a bag of ice going for $20, pilots of modest
means could afford to rent the aircraft and bring in the life-saving supplies. It would be nice
if private charities or, perhaps, government officials were able to miraculously bring in
enough ice to solve all problems. But this is inherently not the case— no consumer would
pay $20 for something they could readily receive as a free handout from the Salvation Army
44
AvM 112 Basics of Microeconomic Study Notes
or a Government Relief agency. The high price is conclusive evidence that charities and
governments are overwhelmed and an urgent response is needed by anyone capable of
bringing ice in quickly. It may be that some people bringing in the ice do so out of purely
selfish motivation, unconcerned about saving lives and minimizing human misery, they are
simply rushing in to “make a fast buck.” We might fret about the soul of such a person, but
if the ice they bring saves the life of a sick child by preserving her antibiotics then that child
is no less alive because she was saved by a selfish money grubber rather than a generous
philanthropist. When generous people can’t do enough it’s nice to have a high price to get
everyone else motivated to help as well.
III. Price Controls
It has been argued that the primary objective of price control is to prevent extreme, runaway
inflation and all the evils that go with it, but some other negative consequences may happen
as well. For example, in the early 1970s, the US President Richard Nixon imposed price
controls on August 15, 1971 to contain inflation. A controlled price will allocate resources,
but not in accordance with supply and demand. Suppose government decrees that the price
of ice must be reduced from $20 to $2. The siren call of low prices is appealing to
consumers anxious to get a bargain but the result is tragic. As Figure 3.16 illustrates, the low
price will drastically reduce quantity supplied, from
Renting helicopters or
driving refrigerated trucks from far away is no longer so affordable or appealing with price
an artificially low $2. So the flow of ice slows to a trickle, suffering and even death become
more likely because there is so little ice. At the same time quantity demanded surges now to
because price is depressed—most anyone is thirsty enough to pay $2 to ice down some
drinks. So what little ice is available is now mostly snapped up for casual use. Perhaps the
greatest irony is that the government price control results in consumers typically “paying”
more for ice then the market rate of $20. This follows from the fact that there is more to life
than cash; time, in a manner of speaking, is money, too. Figure 3.16 shows that the amount
of ice available,
could be sold for
which is obviously well above the $20 market
rate. If is, say, $32, then we know consumers would pay that price to buy up all the ice.
Normally consumers compete for scarce products through the price but in this case errant
government regulation precludes that. So, consumers instead compete by getting to limited
supplies ahead of the crowd; that is, they arrive early and wait in line. Since the cash price is
artificially limited to $2, consumers are willing to use up an additional $30 worth in time. If
the average ice consumer values their time at $10 per hour than the average wait in line will
be three hours. Of course, the chaotic uncertainty of the situation will result in some people
waiting much longer or giving up altogether, others may luckily stumble into an unexpected
delivery and face little waiting. But the average price paid will be $30 worth in time plus $2
cash. One way or another, massive demand in the face of miniscule supplies will bid up
price. In the absence of regulation, people pay $20 for ice; with the price control there is
much less ice and people pay a higher “price” for it—only now the greatest cost is time with
a much smaller cash cost. But it’s that total cost that counts and renders the price control a
sort of “fool’s gold.”
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AvM 112 Basics of Microeconomic Study Notes
Consumer and Producer Surplus
Consumer surplus is the benefit accrued by consumers whose willingness to pay exceeds the
market equilibrium price. The lower the equilibrium price, the higher the consumer surplus.
Referring to Figure 3.17 below, region C marks the area of consumer surplus— these are the
consumers that “benefit” from the market equilibrium price of $125. Consumer surplus is
defined as the difference between the total amount that consumers are willing and able to
pay for a good or service and the total amount that they actually do pay. Similarly, producer
surplus is defined as the benefit that accrues to producers whose willingness-to-supply lies
below the market equilibrium price. In other words, if airlines were willing to supply the
market with seats at prices below the $125 per seat market equilibrium shown in Figure
3.17, then these airlines are able to sell their seats at the higher price and therefore reap the
benefits of the higher price. This is depicted as section D in Figure 3.17 below. Now,
consumer surplus results only because some consumers in the market have a willingness to
pay that lies above the equilibrium price. Supposing an airline could identify these
customers and charge them each what they would be willing to pay—it could derive the
benefit of charging some consumers higher prices, while leaving them no worse off because
they are still paying the price at or below their expressed willingness to pay. Further, with a
multi-tiered pricing strategy (known as price discrimination), the airline could maximize its
producer surplus, since total producer surplus would now equal areas C + D.
46
AvM 112 Basics of Microeconomic Study Notes
I.
Airport Landing Fees and Airport Congestion
Following the logic of the preceding discussion, excessive and persistent airport congestion
may be a function of a price that is not in equilibrium; that is, the landing fee is kept too low
by government. (Most of the world outside the US is moving toward privatizing airports but
major private airports, such as Heathrow, typically have landing fees mandated by
government.) Other factors, of course, may contribute to airport congestion—stringent
environmental regulation that prevents airport expansion or dated technology that forces
aircraft to maintain wider separation, and so on. But regardless of other factors, the correct
price can eliminate excessive congestion. The situation is illustrated in Figure 3.18. The
supply curve is represented as vertical, because in the short run (and usually in the long run
as well) airport supply is fixed. Adding runways or ramp capacity takes time and
investment, and is not a decision that can be undertaken at short notice. Sometimes
expansion may be impossible due to nearby development. Therefore, airport supply is fixed
no matter what the price for its services. Airport demand, on the other hand, is downward
sloping as airlines can choose to fly into an airport or stop flying into an airport depending
on the prices charged for use of airport resources. Market equilibrium landing fee for airline
traffic is P*. This fee eliminates excessive congestion at the airport, since the price is set
such that the number of planes landing at the airport closely matches its capacity. However,
most airports face government regulation on the fees that they can charge landing traffic.
Indeed, in the US, most general aviation traffic at medium or small airports cannot be
charged a landing fee at all, effectively subsidizing the use of airport facilities. However,
assume the landing fee for the airport is set at P’, below P*. This implies that L’ takeoffs and
landings will take place at the airport, which is higher than the optimal market quantity L*.
The difference between L’ and L* is airport congestion— airport operations in excess of
capacity capabilities. Of course, if the government were to set the landing fee at the optimal
quantity of P*, it would naturally eliminate most congestion. However, P* is usually
unobserved, and reached by a process of trial and error by buyer and seller. It is usually
extremely challenging to estimate P* in absence of market data and mispricing is generally
47
AvM 112 Basics of Microeconomic Study Notes
the outcome of price controls, leading to congestion. Thus, the theoretical optimal landing
fee for the airport is P*, determined by the supply and demand for the airport resources. Of
course, it must be noted that L* does not imply zero congestion, merely optimal congestion.
It may be optimal for an airport to have some degree of congestion, if only because that
represents the efficient use of its resources. For instance, while having many fewer landings
per day at Atlanta might indeed mean zero congestion, it also represents a suboptimal use of
the resources at the airport. Both airlines and passengers are willing to accept some degree
of congestion for the benefit of using that particular airport. An airline might conclude that
having a takeoff clearance wait time of ten minutes might be acceptable given the
convenience of using that airport. Therefore, L* merely represents the optimal level of
congestion at the airport. In the absence of government regulation, if the airport initially set
its landing fees too low, and congestion exceeded L*, airlines would eventually stop using
that airport due to the unacceptably high costs of delays, which would return the level of
congestion to L*.
II. Price floors
A price floor is a minimum price, generally above the equilibrium price, set by the
government on a product or service. Since the price is set above the equilibrium price, a
surplus develops because more is being produced than consumers are willing to purchase at
that price. When the market price hits the floor, it can fall no lower and the market price
equals the floor price. There is no effect on the price or quantity if the price floor is below
the equilibrium. A government may impose a price floor to protect a favored industry and
are particularly common in agricultural price supports. A good example of a price floor in
the US is the minimum wage. This is the lowest wage that an employer is allowed to pay a
worker. Suppose the market demand and demand functions given by:
48
AvM 112 Basics of Microeconomic Study Notes
III. Price Ceiling
Opposite to a price floor is a price ceiling where a maximum price is set by the government
for particular goods and services. The government may perceive the current price is too high
and potentially harm consumers and the general economy. In order to be effective, price
ceilings must be set below the natural equilibrium price. If a price ceiling were imposed
above the equilibrium price, it would have no impact on the market. Generally, price
ceilings lead to shortages. A possible consequence of the shortage created is the generation
of a black market where the good is sold illegally above the price ceiling. An example of a
price ceiling could be in the 1970s the government controlled the prices of gasoline. In
1971, President Nixon imposed wage and price controls. The wage and price controls were
mostly abandoned by April, 1974. Rent control is another example of a price ceiling and
exists in many countries around the world. In the US, New York State has had the longest
history of rent controls, since 1943 (Baar, 1983). Now, suppose that, the government
imposes price ceiling of $1 as shown in Figure 3.19.
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AvM 112 Basics of Microeconomic Study Notes
Disequilibrium
While markets tend toward equilibrium the process is not always smooth or automatic.
Indeed, there can exist extended periods of disequilibrium, where price does not allocate the
quantity demanded and the quantity supplied, even in the absence of government control. Of
course, when one adds regulatory pressures to the analysis, the effects of disequilibrium can
potentially be extended far longer than they would in a free market.
Disequilibria can occur as a result of both microeconomic and macroeconomic shocks. An
example of a macroeconomic shock was the terrorist attacks of 9/11 in 2001. Immediately
following the attacks, all aircraft were grounded in the Continental US. This had the effect
of reducing the supply of air transportation to zero within the space of a few hours. There
was no equilibrium price, because the market lacked any means of supply. The market was
in disequilibrium with no means of clearing it until supply was allowed to resume. We are
all familiar with the effects of such a disruption, with passengers and aircraft stranded at
various locations all over the country, and passengers who were forced to seek alternative
modes of transportation since air traffic was suspended until further notice. Recovery from
this disequilibrium was a long process, with passengers requiring reimbursement, airlines
receiving aid from the Federal Government as compensation for service disruptions, and so
forth.
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AvM 112 Basics of Microeconomic Study Notes
An example of a microeconomic shock may be bad weather at airports. This has the effect
of shifting the supply curve to the left. In normal days, traffic can be sequenced out of
airports under Visual Flight Rules (VFR). This helps to reduce the burden of maintaining
aircraft separation for the controllers, since aircraft are essentially asked to watch out for
each other. A less stringent set of air traffic regulations apply, most importantly in terms of
wait times between takeoffs and landings, and when an aircraft is deemed “clear” of the
airspace. Air traffic controllers also face less extensive vectoring responsibilities. In contrast,
when an airport is encountering bad weather, it restricts the supply of the airport. Bad
weather may not always imply full airport closure. More often than not, Instrument Flight
Rules apply and aircraft may still leave the airport, but under a much more stringent set of
rules, specifically involving longer separation times between aircraft, close and extensive
vectoring by air traffic control, and reduced airspace capacity around the airport. Therefore,
the supply curve shifts to the left during periods of bad weather, a phenomenon which might
be resolved by an increase in the landing price or a change in technology. Demand outstrips
supply, and congestion results. Figure 3.20 illustrates this. When the airport encounters bad
weather, the number of aircraft that can be allowed to conduct operations in the airspace
falls. This is represented by shifting the airport’s supply curve to the left from S to S1. If the
weather was to worsen, the supply curve would shift all the way to S2, causing the market to
go into disequilibrium until the weather clears.
As a broader point, it must be noted that the state of disequilibrium may last a few hours, as
in the case of bad weather, or a few days, or a few years, as with airport landing fees and
price controls.
Elasticity
An important economic principle that can aid airline or airport managers in their economic
decision-making process is elasticity. The formal definition of elasticity is the percentage
change in the dependent variable (quantity demanded) resulting from a one percent change
in an independent variable (factor of demand). Informally, elasticity measures the
responsiveness of one variable to changes in another. The basic formula for elasticity is:
51
AvM 112 Basics of Microeconomic Study Notes
In measuring elasticity, there are two types of variables: endogenous and exogenous.
Endogenous variables are variables that the airline can directly control while exogenous
variables are variables that are out of the airline’s control. In the airline industry, both price
and service would be endogenous variables, while factors such as consumer income,
competitor’s price, and price of complementary goods are exogenous variables. It is useful
to know the effects of these exogenous variables on demand, since this information allows
the airline to manage capacity and demand more efficiently. The three major elasticities that
will be explored in greater detail are:
• price elasticity;
• cross-price elasticity;
• income elasticity.
I.
Price Elasticity
While there are numerous types of elasticity, the price elasticity of demand is probably one
of the most useful elasticities for airline managers. Using the general definition of elasticity,
price elasticity is the percentage change in the quantity demanded resulting from a one
percent change in price. Therefore, price elasticity enables managers to perform “what-if”
scenarios to see the effects on the quantity demanded that a change in price would have.
Since elasticity is not generally constant throughout the entire demand curve, there are two
ways to measure elasticity. Point elasticity measures the elasticity of the function at a
specific value, while arc elasticity measures the elasticity of the function over a range of
values. Thus, arc elasticity is an average of the elasticities over a specified range of values,
while point elasticity is the exact level of responsiveness at the specific price. The basic
formulae for point price elasticity and arc price elasticity are:
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AvM 112 Basics of Microeconomic Study Notes
To illustrate the difference between the two, consider Figure 3.21, which reproduces the
demand curve for the route JFK–LAX.
Note the negative sign, which implies that the price of the product is negatively related to
the quantity demanded, which is given by the law of demand. In this case, if the airline
decides to raise the ticket price by 1 percent it will find that quantity drops by 0.96 percent.
Elasticity can range from zero to infinity. An elasticity = 0 would indicate no change in
demand no matter what the change in price. An infinite elasticity means any price increase
will drop demand from an infinitely large amount to zero. In order to calculate price
elasticity, the derivative of the demand function needs to be calculated.11 As a numerical
53
AvM 112 Basics of Microeconomic Study Notes
example, consider the following explicit short-run demand function for a flight, where we
assume that the competitor’s ticket price is $120 and that the average annual income in the
market is $40,000.
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AvM 112 Basics of Microeconomic Study Notes
Price elasticity with an absolute value of less than one is termed inelastic. Inelastic demand
occurs when a one percent increase in price results in a less than a one percent decrease in
demand. (In the above example, since the absolute value of elasticity was calculated as less
than one, the price elasticity would be inelastic). In these situations, the consumers have a
strong desire to purchase the good or service and therefore price is not a central concern. In
price-inelastic situations, firms can increase the price to increase total revenue as the price
effect dominates the quantity effect. However, since point elasticity is not constant
throughout a linear demand curve (in fact, as will be discussed later, every linear demand
curve has both an elastic and inelastic region) this practice can only continue up to a certain
price when the demand becomes less inelastic (or more elastic). A good example of a priceinelastic product includes the demand for air travel in the short run. In the few days leading
up to the day of departure, the majority of travelers who need to take the flight are willing to
pay for an expensive ticket, since they are likely to have an important reason to travel and
the convenience of the flight is more important than price to them.12
At the opposite end of the spectrum is elastic demand. Elastic demand occurs when the
coefficient of elasticity has absolute values greater than one. With elastic demand,
consumers are more sensitive to changes in price, so that a 1 percent decrease in price will
be offset by a greater than 1 percent increase in the quantity demanded, and total revenue
increases with price cuts. However, as above, the benefits of price cuts will be exhausted at
some point as the firm will eventually reach a portion of the demand curve where demand
becomes inelastic. Longer-term demand for air travel is more price-elastic than short-term
demand as many passengers (especially leisure travelers) will choose to take a flight based
solely on price.
The final category of elasticity is unitary elastic demand, which has an absolute value equal
to one. Under unitary elastic demand, the quantity and price effects are equal, creating a
situation where a 1 percent increase in price is directly offset by a 1 percent decrease in the
quantity demanded.
II. Cross-Price Elasticity
Another type of elasticity is cross-price elasticity of demand; this elasticity measures the
responsiveness of demand for one product or a service following a change in the price of
another product or service. Cross-price elasticity of demand helps determine if the related
firm is either a substitute (competitor) or a complement. The basic formulae for both point
and arc cross-price elasticity is:
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AvM 112 Basics of Microeconomic Study Notes
As the following formula indicates, the arc elasticity computes the percentage change
between two points in relation to the average of the two prices and the average of the two
quantities. This provides the average elasticity between the two points.
Using the above formulae and the preceding example, the point cross-price elasticity of
demand can be found assuming that the ticket price of the firm’s flight is $100, the
competitor’s ticket price is $120, and the annual income is $40,000.
From this example, the cross-price elasticity of 0.24 indicates that the related competitor can
be considered a mild substitute to the firm, since the cross-price elasticity of demand is
greater than zero. In this situation, a 1 percent increase in the competitor’s ticket price will
cause a 0.24 percent increase in the airlines’ ticket sales. In the airline industry, where price
competition is fierce, the cross-price elasticity of demand is undoubtedly highly positive.
From the perspective of revenue management, fare transparency has forced airlines to
redouble efforts to stay competitive. With information from the Internet, passengers are now
able to view almost all the pricing options for their flights, and therefore some passengers
can be extremely price conscious (especially since there is little difference between the
product; that is, an airline seat). As a result, the cross-elasticity of demand for the airline
industry is generally very high. Therefore, because of liberalization and deregulation the
56
AvM 112 Basics of Microeconomic Study Notes
competition in the airline market is very vigorous. When several airlines compete with each
other on the same route, they must consider how one airline might react to its competitor’s
price change. Will many passengers switch? Will the other airlines match a price rise? Will
it follow a price reduction?
If the cross-price elasticity of demand is found to be less than zero, then the related firm’s
product is determined to be a complementary good. A complementary good is a good which
increases the demand for the firm’s good. Examples of complementary goods to the airline
industry are both hotels and rental cars, as the price of accommodation and transportation
directly relate to the demand for air transportation. As an example, if the cross-price
elasticity of demand was found to be -0.55, then a 1 percent increase in the complementary
good’s price would create a 0.55 percent decrease in the quantity demanded. As in the case
of own-price elasticity, cross-price elasticity can be categorized into one of three groups
based on its numerical value and its impact of a related firm’s price on demand:
For example, the cross-price elasticity of demand between Ryan Air and easyJet is expected
to be strongly positive. Likewise when there is a strong complementary relationship between
two products (hotels and airlines), the cross-price elasticity will be highly negative.
Independent or unrelated products have a zero cross elasticity.
III. Income elasticity
A third type of elasticity is income elasticity. Income elasticity determines the sensitivity
that changes in the annual income of consumers have on the quantity demanded for a
product. Disposable income, personal income, and Gross Domestic Product (GDP) are all
good measures for this variable. Disposable income is income available to spend on leisure
travel, while business income is a part of the equation since increased business activity will
likely spur an increased need for business travel. Since the income variable is comprised of
two parts for air transportation, GDP is the best proxy variable for income, since it takes into
consideration both household disposable income and business activity. The formulas for
income elasticity are similar to both the price and cross-price elasticity formulas:
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AvM 112 Basics of Microeconomic Study Notes
58
AvM 112 Basics of Microeconomic Study Notes
If the product’s income elasticity is greater than zero, then the good is categorized as a
normal good; that is, the quantity demanded of a normal good increases with any increase in
the consumer’s income. As we might expect, the vast majority of goods and services can be
classified as normal goods, as in the above example. A sub-category of normal goods are
superior goods, whose income elasticity is greater than one. Superior goods have a
proportional increase in the quantity demanded that is greater than the increase in consumer
income. Superior goods usually encompass high-end luxury products such as fancy sport
cars and business jet travel. The other goods categorized according to income elasticity are
inferior goods. Inferior goods have income elasticity values less than zero, indicating that for
any increase in income, the quantity demanded decreases. This peculiar situation occurs
when products have a price advantage over competitors but are generally not perceived as
quality goods. Therefore, when consumers’ income increases, they are more willing to
purchase the perceived better product. Examples of inferior goods might include generic
products versus brand names or, in some markets, coach travel against firstclass seats. The
concept of elasticity is critical to understanding the pricing policies of any industry,
especially the air transportation industry. And, as the 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 as elasticity can be used
to help manage both pricing and capacity.
V.
Pricing and elasticity application
Since the ultimate goal of any pricing policy is to maximize total revenue, and total revenue
is known to be maximized where price elasticity is unitary elastic, formulas can be derived
to determine the optimum price. In order to understand the formula derivation, consider the
inverse demand function with the general form of:
P = a — bQ
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AvM 112 Basics of Microeconomic Study Notes
The basic, general formula for point price elasticity can be slightly modified to reflect an
inverse demand function. The derivative of the demand function is simply the inverse of the
derivative for the inverse demand function. Since the derivative, or slope, of the inverse
demand function is (b), the price point elasticity formula can be rewritten as:
Since the goal is to determine the optimum pricing point where total revenue is maximized,
the elasticity formula needs to be set equal to -1, or where unitary elasticity is achieved.
Once the equation is set equal to negative one, the optimum quantity where total revenue is
maximized can be determined. The optimum quantity is:
While this formula provides the optimum quantity demanded for where total revenue is
maximized, it needs to be placed back into the inverse demand function to obtain the
optimum price level. Total revenue is maximized where:
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AvM 112 Basics of Microeconomic Study Notes
Therefore, the revenue maximizing price is $250, which creates a demand of 500 seats. At
this point, the point price elasticity of demand is negative one, or unitary elastic.
SUMMARY
In this chapter, we introduce the reader to supply and demand analysis in the context of
aviation. We commence by defining demand as the willingness and ability to pay for a good
or service, then outline the law of demand which postulates an inverse relationship between
quantity demanded and price. We go on to examine the determinants of demand, analyzing
the impact of own price, the price of substitutes, the price of complements and other
influences on the demand for a product. We go on to classify movements in the demand
curve as movements along a curve caused by price shifts, and shifts in the curve caused by
external factors. Peaking and cyclicality are covered as some of the unique characteristics of
airline demand. Supply is then defined as the willingness and ability of a producer to supply
a good to the market at a given price. The unique characteristics of airline supply are
examined, including the perishability of the product, a lack of inventories and a general lack
of flexibility in longer-term provision of the product. We analyze supply movements, and
some of the determinants of supply such as own price, resource prices, technology and
competitive factors. We then discuss market equilibrium as an interaction between supply
and demand, and the market clearing price as the price at which the quantity demanded
matches the quantity supplied. We point out the effects of government price controls in the
case of airport congestion pricing, and market disequilibrium is discussed with appropriate
examples. Finally, we discuss price elasticity of demand, income elasticity of demand, and
the cross elasticity of demand. We present the formulas and interpretation of elasticities, and
analyze revenue management as an application of price elasticity of demand. Supply and
demand analysis is the cornerstone of economic thought, and the concepts presented in this
chapter will be used as analytical tools throughout the book.
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AvM 112 Basics of Microeconomic Study Notes
Review Questions and Exercises for Prelim Coverage
Multiple choice:
1. The meaning of the word “economic” is most closely associated with the word
a. free,
b. scarce,
c. unlimited, or
d. unrestricted
2. In a free-enterprise economy, the problems of what, how, and for whom are solved
by
a. a planning committee,
b. the elected representatives of the people,
c. the price mechanism, or
d. none of the above.
3. Microeconomic theory studies how a free-enterprise economy determines
a. the price of goods,
b. the price of services,
c. the price of economic resources, or
d. all of the above.
4. Complete the sentence, “A market ….”
a. necessarily refers to a meeting place between buyers and sellers,
b. does not necessarily refer to a meeting place between buyers and sellers,
c. extends over the entire nation, or
d. extends over a city.
5. Complete the sentence, “A function refers to ….”
a. the demand for a commodity,
b. the supply of a commodity,
c. the demand and supply of a commodity, service, or resource, or
d. the relationship between one dependent variable and one or more
independent variables.
6. The market equilibrium for a commodity is determined by
a. the market demand for the commodity,
b. the market supply of the commodity,
c. the balancing of the forces of demand and supply for the commodity, or
d. any of the above.
7. Which of the following is incorrect?
a. Microeconomics is concerned primarily with the problem of what, how, and
for whom to produce.
b. Microeconomics is concerned primarily with the economic behavior of
individual decision-making units when at equilibrium.
c. Microeconomics is concerned primarily with the time path and process by
which one equilibrium position evolves into another.
d. Microeconomics is concerned primarily with comparative statics rather than
dynamics.
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AvM 112 Basics of Microeconomic Study Notes
8. Governments may intervene in a market economy in order to
a. protect property rights.
b. correct a market failure due to externalities.
c. achieve a more equal distribution of income.
d. All of the above.
9. If a nation has high and persistent inflation, the most likely explanation is
a. the central bank creating excessive amounts of money.
b. unions bargaining for excessively high wages.
c. the government imposing excessive levels of taxation.
d. firms using their monopoly power to enforce excessive price hikes.
10. Adam Smith’s “invisible hand” refers to
a. the subtle and often hidden methods that businesses use to profit at
consumers’ expense.
b. the ability of free markets to reach desirable outcomes, despite the selfinterest of market participants.
c. the ability of government regulation to benefit consumers, even if the
consumers are unaware of the regulations.
d. the way in which producers or consumers in unregulated markets impose
costs on innocent bystanders.
Problems and applications:
1. Distinguish between (a) economic resources and (b) noneconomic resources.
2. Why is “what to produce” a problem in every economy?
3. How does the price mechanism solve this problem.
a. in a free-enterprise economy?
b. In a mixed enterprise economy?
c. In a centralized economy?
4. Distinguish between microeconomics and macroeconomics. What basic underlying
assumption is made in studying microeconomics?
5. Draw a diagram showing the direction of the flows of goods, services, resources, and
money between business firms and households. Explain what is a cost to households
represents income for business firms, and vice versa.
6. What is a competitive market? Briefly describe a type of market that is not perfectly
competitive.
7. Does a change in consumers’ tastes lead to a movement along the demand curve or a
shift in the demand curve? Does a change in price lead to a movement along the
demand curve or a shift in the demand curve? Explain your answers.
8. Does a change in producers’ technology lead to a movement along the supply curve
or a shift in the supply curve? Does a change in price lead to a movement along the
supply curve or a shift in the supply curve?
9. Define the equilibrium of a market. Describe the forces that move a market toward
its equilibrium.
10. Describe the role of prices in market economies.
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AvM 112 Basics of Microeconomic Study Notes
Problems and applications in the Air Transport Industry
1. With changes in fuel prices what kind of effects should we see in the market for air
travel?
2. Explain direct demand and derived demand. Which of these two types of demand is
the airline industry most characterized by?
3. With the recent increase in decrease in jet fuel prices, what kind of effects should we
see in the air transport market?
4. What are the factors that influence the elasticity of demand for pilots?
5. Define the law of demand and supply using airline industry as an example. Explain
the difference between demand and quantity demanded. Show it graphically.
Problem-solving questions:
1. The market for pizza has the following demand and supply schedules:
Price
Qd
Qs
4
135
26
5
104
53
6
81
81
7
68
98
8
53
110
9
39
121
a. Graph the demand and supply curves. What is the equilibrium price and
quantity in this market?
b. If the actual price in this market were above the equilibrium price, what
would drive the market toward the equilibrium?
c. If the actual price in this market were below the equilibrium price, what
would drive the market toward the equilibrium?
2. Suppose that (keeping everything else constant) the demand function of a
commodity is given by;
Qd = 6000 – 1000P, where Qd stands for market quantity demanded and P is
the price
a. Derive the market demand schedule, at following prices,
P= 10,15,20,25,30,35,40,45
b. Draw the market demand curve
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