Any change in these determinants that make consumers willing to fly more for a given price will trigger an increase in demand.
Market Supply – The supply for any good is based on the production cost. Supply in airlines refers to, airlines capability to provide a specific number of seats at different price in a given period of time. In air transportation supply is expressed in terms of available seat miles. Airline industry supply more seats with the increase in ticket prices.
Determinants of Supply:
- price of the good or the service
- Prices of Resources (aircraft, fuel, maintenance, labor, landing fees)
- Technology (Civil aviation rules for the safest modes of transportation).
- Government Regulation
Price Elasticity- Price elasticity in airlines can be categorized into three groups based on its numerical value and its impact on demand.
If the demand for the product is inelastic then the company increases the price, similarly if the demand is elastic, the price is reduced and finally if it’s unitary the price remains unchanged.
|E|>1 Elastic demand
|E|<1 Inelastic demand
|E|=1 Unitary demand
Below graph shows the revenue maximization in airline industry.
Figure 1: Pricing decision based on elasticity
(Source: Vasigh B, Tacker T and Fleming K, Introduction to air transport economics)
When supply and demand both increases, the equilibrium quantity will increase, but the equilibrium price may be unchanged, increase or decrease.
Figure 2: Increase in Supply and Demand where Price decreases
Figure 3: Increase in Supply and Demand where Price increase
In Figure 2 and Figure 3, an increase in supply is represented by a shift of the supply curve to the right and increase in demand is represented by a shift of the demand curve to the right.
Equilibrium Price in the airlines is achieved when the supply and demand intersect or when they are set to zero. Since demand and supply are equal to each other at equilibrium price, either demand or supply function can be used to determine the market equilibrium quantity.
Why is their variation in airline prices?
In the airline industry, price discrimination is used by firms to distinguish between relatively price-inelastic business travelers and relatively price-elastic leisure travelers.
The third degree price discrimination in airlines is a basis of fare differentiation. This discrimination involves airlines dividing their markets into travel segments, then bundling their services with limitations and selling them to each segment at different fares. Another is that they are ways for firms facing competitive pressures and having high fixed costs to maintain their survival (Baumol and Swanson, 2003). The impact of this price discrimination is that on any given flight there are many travelers paying different fares.
By offering a flexible ticket, the airlines allow the customers to reschedule the flight at any time and even cancel the flight without any costs attached to it. The airlines offer restrictive ticket with several restrictions on it. For example, Saturday night stay-over, advance purchase and no flexibility regarding rescheduling of the flight. The main reason for damaging the product here is to make it less attractive for the consumer with the high willingness to pay. This is obviously the driving force in the airline industry when they introduce a particular restrictive ticket. Airlines try to figure out passengers whose demand for airline tickets is highly elastic and whose demand is highly inelastic.
Price discrimination in the airline industry is affected by competition. Stavins, 2001, says that “as more carriers operate on a given route, the carriers’ competition for consumers with higher price elasticity of demand increases, while fares charged to consumers with inelastic demand stay high”.
Another source of fare differentiation is rationing where airlines use fares to distribute their supply of limited seats among travelers. This rationing is efficient because it equalizes the marginal cost of providing an additional seat and the marginal benefit to the consumer and transfers consumer surplus to airlines thereby increasing their profit.
Most airlines offer fully refundable tickets at relatively high prices, while offering non-refundable tickets at much lower prices. For passengers with high price elasticity, the airlines will provide low airfares which will attract many customers and hence secure high revenues for the airlines.
Conclusion:
Price discrimination should increase with market concentration. Even on more competitive routes, each carrier’s distinctive market position (route schedule, airport dominance, regular flier plan) enables it to maintain market power with respect to its business (inelastic) consumers, but not tourist (elastic) consumers. Travelers buying unrestricted tickets tend to choose a particular airline. Therefore, airlines on competitive routes are forced to lower the fares, but they will be able to maintain high markups on their business fares. Even when carriers face competition on a route, they effectively compete only for the price-elastic segment of the market, while retaining their market power in the other market segment. As a result, the more competitive routes the more price discrimination can be witnessed. Changing crude oil prices is also a factor for differentiation of airline fares.
Reference:
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