For example, if the PED of a good is 1.5, a 10% increase in the price of the good will result in a 15% fall in quantity demanded.
Secondly, income elasticity of demand (YED) is the measure of the responsiveness of a change in quantity demanded of a good to a change in the real income of the consumers, ceteris paribus. The formula for income elasticity of demand is:
The value of YED can be positive or negative. If YED is negative, the good is an inferior good. An increase in real income will cause a fall in quantity demanded for the good and vice versa. When YED is positive, the good is a normal good. Increase in real income will cause an increase in quantity demanded of the good and vice versa.
Normal goods can be further subdivided into necessities and luxury goods. If YED is greater than zero but less than 1, the good is a necessity. An increase in real income will cause a proportionally smaller increase in quantity demanded of the good. If YED is greater than 1, the good is a luxury good. An increase in real income will cause a proportionally larger increase in the quantity demanded of the good.
For example, black and white television sets are usually considered as an inferior good; staple food like rice, bread and potatoes are necessities; and jewelry are considered as luxury goods.
Finally, cross elasticity of demand is the measure of the responsiveness of a change in quantity demanded of good X with respect to changes in the price of a related good Y, ceteris paribus. The formula for cross elasticity of demand is:
Cross elasticity of demand can be positive or negative. If the value of CED is negative, it would indicate that the related good is a complementary good and the goods are used together. A rise in the price of good Y will cause a fall in the demand of good X, causing the demand curve of good X to shift to the left. If the value of CED is positive, the related good is a substitute. A rise in the price of good Y will cause an increase in the demand of good X, causing the demand curve of good X to shift to the right.
The magnitude for CED will indicate how closely related the goods are. A larger magnitude would indicate a stronger relationship between the complements or substitutes, while a smaller magnitude would indicate a weaker relationship.
For example, hotels and airline tickets are complementary goods while buses and trains are substitutes.
Part (b)
The airline industry in Europe is an oligopoly. It is dominated by a few large international airlines like, British Airways, Lufthansa and KLM. Very often, these airlines would form alliances to share resources as well as to keep out other competitors. For example, a few airlines would join together to offer a common air miles program as well as offer code-sharing to facilitate ease of transfer. They would sometimes form a cartel to control airfares as well. There are also other barriers to entry as the cost of operating an airline is very high and landing rights are sometimes difficult to secure at some international airports. For a small regional airline to survive in this very competitive industry, it needs to carefully consider the different elasticities of demand and its strategy as to how they would price their tickets and which segment of the market it wants to attract.
In terms of price elasticity of demand, different customers have different price elasticity of demand. This has resulted in the airlines practicing price discrimination, offering tickets at different price and level of service to different segments of the market. People who travel in first class and business class tend to have more inelastic demand. However, tourist and budget travellers who travel by economy class tend to have elastic demand. A fall in the price of airline tickets in this segment of the market will result in a greater than proportionate increase in the sales of its tickets and an increase in total revenue.
It appears that this airline is trying to capture the bottom segment of the market where demand is price elastic. By lowering its price, the demand for the airline’s tickets will rise by a more than proportionate amount. The airline will then be able to capture a larger segment of this market. It can afford to offer very cheap tickets by keeping their costs low. Since most European flights tend to be relatively short, the airline can reduce cost by not serving meals on board. It also avoids paying commission to travel agents by allowing direct bookings only. The service is also infrequent, implying that the airline may choose to fly only if there are sufficient bookings to make the flight profitable.
The airline faces competition not only from other airlines, but also from other forms of transports, such as trains and buses. An increase in the price of other airlines’ tickets would greatly reduce the demand for this airline’s tickets as they are close substitutes. Hence the cross elasticity of demand between be positive and its magnitude would be very high. However, trains and buses are not such close substitutes, hence changes in the prices of train and bus fares will have a lesser effect on the demand for airline tickets.
As most travellers would require accommodation when they arrive at their destination, hotel accommodation and airline tickets would then be complementary goods. If the airline can persuade hotels to lower its price by offering special discounts to its passengers, the demand for the airline tickets would then increase. As a result, airlines and hotels very often have joint promotions and offer cheap travel packages where the airline provide the return air ticket and the hotel would several nights of accommodation.
Knowing the income elasticity of demand would enable the airline to predict changes in demand as the consumers’ income changes. However, in this case, the airline appears to be in a position to benefit whether consumers’ income rises or falls.
Since the airline offers very basic services, it may be considered as an inferior good. If the income of consumers falls, passengers who were previously travelling by first class and business class may downgrade to economy class and the demand will rise. This can be seen during a recession when many companies try to cut down on their expenses by forcing their executives to travel by economy instead of first or business class for shorter regional trips.
On the other hand, if the economy improves, budget travellers and backpackers who previously used to travel by bus or train may consider upgrading and travel by airplane instead.
It seems that this airline has considered all three elasticities carefully in the pricing of its fares as well as the type of services it is offering. By undercutting its competitors, it gained a significant amount of the market. However, it needs to constantly monitor its competitors’ prices as well the growth of the economy to prepare itself for changes in demand in the future. It also needs to work with other service providers like hotels and car rental firms in order to increase its market share.
