## Project Description:

activity: airline elasticity

the purpose of this exercise is to do some calculations and then see how the principles of economics contribute to decision making. you are not expected to do research on the airline industry. you can answer the questions from the information provided at the link below plus a little of your own experience as an airline passenger.

this task is in three parts. it will likely take you less space to address the task than it does to present it here. don’t panic.

part 1
1.as the midwest regional manager for american airlines, you have recently undertaken a survey of economy-class load factors (the percentage of economy-class seats that are filled with paying customers) on the chicago-columbus route that you service. the survey was conducted over 5 successive months. the survey results appear in the table below. assume that all other factors have remained constant over the 5-month period:

month

american’s
price

united’s
price

monthly per
capita income

american’s

united’s

1

\$110

\$112

\$1,900

65

60

2

110

110

1,900

62

63

3

110

110

2,100

70

66

4

109

110

1,900

70

61

5

108

110

1,900

72

59

2.based on the data you have collected, how responsive is your company’s load factor on the chicago-columbus route to your own price, income levels, and united’s price? select appropriate months and compute elasticity values to complete the following table.

elasticity (arc)

value

(1) own-price elasticity of demand for american’s
economy-class seats

(2) income elasticity of demand for american’s
economy-class seats

(3) cross-price elasticity of demand for american’s economy-class seats with respect to united’s price on the same route

hint: elasticity here is based on ceteris paribus conditions – all other things unchanged. in fact, there should be only one pair of consecutive months that meet the “all other things unchanged” criterion for each elasticity coefficient to be calculated, and it is a different pair of months for each one. arc or midpoint elasticity formula appears in your text. the formula is the same for all three calculations. the quantity is always the change in american’s load factor. the “price” is the price of american’s tickets (own-price elasticity), or the income (income elasticity), or the price of united’s tickets (cross-price elasticity).

questions:
a.are economy-class tickets a normal or inferior good in the chicago-columbus market? explain.
b.how close a competitor/substitute does united appear to be in the chicago-columbus market? explain.
c.based on the survey you have undertaken, to increase your profits, should you raise your price, lower it, leave it unchanged, or is it impossible to tell without more information? (hint: consider what will happen to total revenues (tr) and total costs (tc) if you change your price.)
d.if you had conducted your survey over a period of 5 successive years, rather than over 5 successive months, would the own-price elasticity of demand for your product be larger or smaller than your estimate here? explain.
e.now, assume that american’s own price elasticity of demand that you calculated holds true for even lower prices (in other words, assume elasticity is linear). the plane used on these flights has 310 seats. a load factor of 70 means 70% of the seats are filled. a load factor of 72 means 72% of the seats are filled. what price would it take to fill all seats? (as you do your calculations, differentiate between percent and percentage points.)

part 2

use same assumptions and figures calculated above. the plane used on these flights has 310 seats. a load factor of 70 means 70% of the seats are filled. a load factor of 72 means 72% of the seats are filled.
fixed costs per flight between the two cities are \$20,000 per flight.
average variable costs for a flight with 70% load factor are \$10 per passenger. (note: while fuel consumption with one passenger is infinitesimally more than for none, it does take more fuel to fly with half a load than with none, and more fuel for a full load than with half.) marginal costs for adding passengers between 70% load factor and 100% load factor are \$11 for each passenger.

2. questions:

to increase profits, what should american do? use the same pair of observations you used to calculate own-price elasticity of demand for your price and load-factor data.
a.what would be american’s profit if the price were reduced to fill the plane as you calculated in part f above?
b.how much can prices fall before american should either not cut them any more or not fly? (i can think of four answers to this question, one of which was contributed by students.)
c.what if putting price at the level you calculated in part f above causes sufficient demand that another flight could go, but about half full? what would you do with pricing then?
d.ok, now you get to consider what united would do. what would they do? how would that affect your decisions?

part 3

now, apply some of these lessons to your own firm or industry. you may be able to make good guesses from your current experience. if not, this is a great time to meet some of the accounting people and learn more about the organization, the products, and the challenges and opportunities. this portion does not require hard numbers.

questions:
1.in the airline industry example, fixed costs per seat were a large portion of total costs, while variable costs per seat were a small portion of total costs. what is the situation in your enterprise or industry? are fixed costs or variable costs the biggest portion of total costs? why do you think that is the case?
2.if, in your enterprise, fixed costs are also the largest portion of total costs, what impact does that have on your enterprise’s ability or willingness to reduce prices to sell more / fill capacity? or, if your fixed costs are a small portion of total costs – meaning that variable costs are the larger portion of total costs – what impact does that have on your enterprise’s ability or willingness to reduce prices to sell more/fill capacity?
3.what kinds of regulations apply to your company or industry? do the regulations result from a market failure? describe some of the activities, people, and incurred costs involved to meet regulatory requirements.
4.how important is innovation in your industry? is there much spending on research and development? how does that impact total costs?
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