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Explain price elasticity of demand, income elasticity of demand and cross elasticity of demand.

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Introduction

a) Explain price elasticity of demand, income elasticity of demand and cross elasticity of demand. (12) b) In 1998 an airline offered very cheap flights from UK to other parts of Europe. However, the service was not very frequent, tickets could not be booked at agencies but directly with the airline, and no meals were offered on the flights. Discuss whether the different elasticity concepts could be useful in explaining this airline's pricing policy for its flights. (13) Part (a) The concepts of price elasticity of demand, income elasticity of demand and cross elasticity of demand are three of the most important economic concepts for a firm in making their pricing decisions. This will be illustrated in the second part of the essay when we examine how these concepts are used to help an airline in its pricing policy. Firstly, price elasticity of demand (PED) is the measure of the responsiveness of a change in quantity demanded of a good to a change in its price, ceteris paribus. The formula for price elasticity of demand is: Price Elasticity of Demand = % change in quantity demanded % change in price of good The value of PED is usually negative to indicate the inverse relationship between price and quantity demanded. ...read more.

Middle

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. ...read more.

Conclusion

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. ...read more.

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