Day 1

1. Concept focus:
1. Supply and Demand
Economics and Finance
for the Modern Airline 2. Elasticity
3. Consumer and Producer Surplus

Lion Air Seminar, December 5 – 9, 2016 2. Airline industry applications:

1. Terminology and Measures for Airline Economics
2. Competition and Market Share
3. Analysis of the Airline Industry

Buyers and Sellers in the Market Consumer’s reservation price:

Meredith’s Demand Schedule for
Buyers and sellers have different motivations Salmon Fillets
Buyers want to benefit from the good Salmon Fillets
Price of Salmon
Sellers want to make a profit Demanded
Higher price $20.00 0 Lower quantity
demanded
Market: buyers and sellers jointly determine outcome: $17.50 1
$15.00 2
P, Q $12.50 3
$10.00 4
$ 7.50 5
$ 5.00 6
$ 2.50 7 Higher quantity
Lower price $ 0.00 8 demanded

1
Demand Curve Market Demand
Price of Meredith’s Derek’s Market
Salmon Demand Demand Demand
$20.00 0 0 0
$17.50 1 0 1
$15.00 2 1 3
$12.50 3 1 4
$10.00
$ 7.50
4
5
+ 2
2
= 6
7
$ 5.00 6 3 9
$ 2.50 7 3 10
$0.00 8 4 12
Is the (horizontal) sum of all individual demands
Lower prices bring more buyers into the market
Lower prices cause existing buyers to buy more

From Equations to Graphs… Movement along vs. Shifts in Demand

Demand for pizza is given by: P = 16 – 2 Qd Movement along a demand curve

Draw the demand curve Caused by a change in the price of the good
Inverse relationship between price and quantity
demanded

Shift in demand
Caused by changes in non-price factors
Entire demand curve will shift to the left or right

2
Normal and Inferior Goods Substitutes and Complements in Consumption

Normal Goods Inferior Goods Complements Substitutes

Steak Canned meat, SPAM Milk and cereal Coke and Pepsi
Housing Ramen Printers and toner Butter and margarine
Name-brand Secondhand clothing Peanut butter and jelly Pizza Hut and Dominos
clothing

Determinants of Demand (shift in demand) Shift in Demand

Price of complementary goods Demand for Pizzas

If buyers are willing to buy more
P
Price of substitute goods at each price, then demand has
increased
Income: normal or inferior goods?
$2
Preferences
D'
Number of buyers in the market D
Q
8 10
Expectations about future prices (000s of pizzas/day)

Price changes never cause a shift in demand

3
 Class Exercise
Economics in The Hudsucker Proxy
How would the following affect the Demand for pizza (a
normal good)?
1. An increase in the price of soda Watch for changes in price.

2. An increase in the price of sandwiches

3. Consumers now believe that pizza is bad for them

4. Consumer income increases

5. More people move in the area

Quantity Supplied & The Individual Supply Curve From Equations to Graphs…
Quantity supplied
The amount of a good that Supply of Pizzas Supply for pizza is given by: P = 4 + 4 Qs
P
sellers offer at a given price Draw the supply curve
S
$4
Supply curve
The quantity of a good that $2
sellers offer at each price
Positive slope. Why? 8 16 Q
(000s of slices/day)

Seller’s reservation price:

the lowest price a seller is willing to accept

4
 Determinants of Supply (shift in supply) Shift in Supply
Supply of
Supply increases when sellers P Pizzas
A change in the price of an input S S'
are willing to offer more for sale at
each possible price
A change in technology $2
8 9 Q

Number of sellers in the market (000s of slices/day)

Expectation of future price changes

Price changes never cause a shift in supply

Class Exercise Market Equilibrium

How would the following affect the supply for pizza? How do we describe the
An increase in the price of cheese equilibrium?
Market for Pizzas
New energy efficient ovens Quantity supplied equals P
quantity demanded AND S
More pizza restaurants open up in the area
No tendency to change P $3
Expect the price of pizza to increase tomorrow. What or Q
happens with the supply today? D
Q
12
(000s of slices/day)

5
What if the market price is not the equilibrium price?
At $4, there is an excess supply
(surplus) of
8,000 slices
Market for Pizzas
Each firm has an incentive to P
decrease the price in order Surplus
S
to sell more
What happens with the $4
$3.50
surplus? $3 Equilibrium

D
Q
8 12 16
(000s of slices/day)

Changes in Market Equilibrium

Economics in Pawn Stars
Consumer income increases
and pizza is a normal good.
How do the equilibrium
Moving towards the equilibrium. quantity and price change?
The price of sodas
increases. How do the
equilibrium quantity and
price change?

Market for Pizzas Market for Pizzas

P
P S
S
P' P

P P'
D' D
D D'
Q Q' Q Q' Q Q

6
Class Exercise Class exercise:

Flour becomes cheaper. How One of the local pizzeria

Herbs used in pizza sauce are harmful AND the price
do the equilibrium quantity goes out of business. How of flour decreases
and price change? do the equilibrium quantity
and price change?

S
Market for Pizzas Market for Pizzas S'

Price ($/pizza)
P
P S P S'
S' S
P P' P'
P' P D
D'
D D
Q' Q
Q Q' Q Q' Q Q Millions of pizzas per month

Find the equilibrium P & Q
Demand for pizza is given by:
Supply for pizza is given by:
Airline Competition
Airlines compete for passengers and market share based on:
P = 16 – 2 Qd
P = 4 + 4 Qs Frequency of service & departure schedule on each route

Price charged, relative to other airlines & regulation

Quality of service and products offered: airport & in‐flight

Passengers choose combination of flight schedules, prices

and product quality that minimizes disutility of air travel

28

7
 Class Exercise Airline Terminology and Measures
Fill in the blanks for the following airline profit maximizing
strategies Traffic – Enplaned Passengers (PAX)
Intended Benefit Strategy Pitfalls
RPM = Revenue Passenger Mile
Cutting Fares/ Yields
One paying passenger transported 1 mile
Increasing Fares/ Yields

Increase Flights (ASM) Yield = Revenue per RPM

Decrease Flights (ASM) Average fare paid by passengers, per mile flown
Improve Passenger

Service Quality

Reduce Passenger

Service Quality

30

Airline Terminology Continued Airline Performance

Average Load Factor (ALF) = RPM/ASM

Airline Demand = Traffic + “Rejected Demand”
“Rejected Demand” or “Spill” = Passengers unable to find Average Leg Load Factor (ALLF) =
seats to fly ΣLF/ # of Flights
Average Network or System Load Factor (ANLF) =
Airline Supply ΣRPM/ΣASM
ASM = Available Seat Mile
One aircraft seat flown one mile Unit Revenue = Revenue/ASM (“RASM”)

Unit Cost = Operating Expense per ASM (“CASM”)

Average operating cost per unit of output

31 32

8
 Frequency Share / Market Share Class Exercise
A 200-seat aircraft flies 1000 miles, with 140 passengers:
Frequency share for airline A:
( )
RPM =
FS(A) = ⋯ ASM =
where F (i) = non-stop frequency of airline i
Assume total revenue = $16,000; total operating expense
Market share for airline i: = $15,000:
∗ ∗ Yield =
MS(A) = ∗ ( ) ∗ ( ) ∗ ( ) ∗ ⋯ Unit Cost =
where C (i) = the frequency of the last leg in a O-D trip for Unit Revenue =
airline i
Average Load Factor = RPM / ASM
ALF =

33 34

Airline Supply Terminology

Airline Markets
Flight Leg (or “flight sector” or “flight segment”)
Non‐stop operation of an aircraft between A and B The purpose of each air trip is to move from the “true”
origin to the “true” destination of the passenger.

Flight
There is typically an outbound and inbound portion of
One or more flight legs operated consecutively by a passenger air trips.
single aircraft (usually) / single flight number (usually)

Direct/ Connecting Flights

Route
Consecutive links served by single flight numbers

Passenger Paths or Itineraries

Combination of flight legs chosen by passengers in a
O‐D market to complete a journey
35 36

9
 Origin‐Destination Market Demand

Air travel demand is defined for an origin‐destination

market, not a flight leg in an airline network

Airline networks create complications for analysis of

market demand and supply

37 38

Dichotomy of Demand and Supply Airline Markets Example

Inherent inability to directly compare demand and

supply at the “market” level

Demand is generated by O‐D market, while supply is

provided as a set of flight leg departures over a network
of operations

One flight leg provides joint supply of seats to many

O‐D markets

Single O‐D market served by many competing airline

paths For this example no additional passengers are boarding at the connection

39 40

10
 Class Exercise Class Exercise – continued

Frequency Share for IAD‐BOS = For this example all flight legs are 1 mile of distance
RPM =

Market Share for IAD‐BOS =

ASM =

“Market” O‐D Traffic for IAD‐BOS =

ALLF for IAD‐BOS =

“Segment” or “Leg” O‐D Supply for IAD‐BOS =

ALF for this network = RPM/ASM =

41 42

Demand Models
Demand models are mathematical representations of the
relationship between demand and explanatory variables:
Based on our assumptions of what affects air travel
demand

Can be linear (additive) models or non‐linear

(multiplicative)

Model specification reflects expectations of demand

behavior (e.g., when prices rise, demand should decrease)

Properly estimated demands allow accuracy in forecasting

43 44

11
 Demand for Air Travel in General Airline Demand

Next to price of air travel, most important factor affecting Demand for carrier flight f of carrier i in O-D market j is a
demand for airline services: function of:
Access and egress times to/from airports at origin and Characteristics of flight f
destination
Characteristics of carrier i
Pre‐departure and post‐arrival processing times at each
airport Market characteristics

Actual flight times plus connecting times between flights Characteristics (including price) of all rival products:

Schedule displacement or wait times due to inadequate Competing markets’ products (other airports serving
frequency city‐pair in j, other transport modes, etc.)
45 46

Total Trip Time and Frequency Total Trip Time Example

T = t(fixed) + t(flight) + t(schedule displacement) With Uniform Passenger Demand

Flight times highlighted in Yellow
Fixed time elements include:
access and egress, airport processing

Flight time includes:

aircraft “block” times plus connecting times

Schedule displacement = (K hours / frequency), meaning

it decreases with increases in frequency of departures

47 48

12
Simple Market Demand Function Multiple Demand Segments
Multiplicative model of demand for travel O‐D per period:
D = M x Pa x Tb

where:
M = market sizing parameter (constant) that represents
underlying population and interaction between cities

P = average price of air travel

T = total trip time, reflecting changes in frequency

a, b = price and time elasticities of demand

49 50

Michael Porter’s “Five Forces of Competition” Forces Driving Industry Competition

SUPPLIERS
Ideally, firms in an industry would like to capture
most or all of the economic value that they create. 4. Bargaining power
of suppliers
However, competitive forces operate to push that 3. Threat of
value “forward” to customers (in the form of lower new entrants MARKET
COMPETITORS
prices), or in some cases, “backward” to suppliers. POTENTIAL
SUBSTITUTES
ENTRANTS
2. Rivalry among
5. Threat of substitute
existing firms
products or services

1. Bargaining power
of customers

BUYERS

Source: Porter (1980)

13
 Class Exercise
Describe the 5 Forces driving competition in the Airline
Industry (special focus on Southeast Asia).
2. Elasticity
1. Define price elasticity of demand
2. Calculate price elasticity of demand
3. Understand how changes in price affect total revenue

53 54

Price Elasticity of Demand Price Elasticity of Demand

Price elasticity of demand is a measure of Demand is elastic (“sensitive” or “responsive”) if

responsiveness of quantity demanded to changes in price Quantity demanded changes significantly as the result
of the price change
Recall the law of demand
P↑ → Q↓
gives us the direction

Demand is inelastic (“insensitive” or “unresponsive”) if

Price elasticity of demand Quantity demanded changes a small amount as the
measures the amount of change result of the price change
give us the sensitivity

14
Price Elasticity of Demand Elastic Demand

Notation: Quantity demanded is responsive to price

%ΔQd > %ΔP
Percentage change in quantity demanded ε>1
ε=
Percentage change in price
Inelastic Demand
Quantity demanded is not very responsive to price
%ΔQd ΔQd / Qd %ΔQd < %ΔP
ε= = ε<1
%ΔP ΔP / P

Unit Elastic Demand

For small percentage changes in price
Price and quantity change by the same percentage
ε=1
Price elasticity of demand is always negative 58

57

Example: Demand for Pizza Price Elasticity: Graphical View

P 1
Old New % Change ε = x
Price $1.00 $0.97 3% Q slope

Price
Quantity 400 404 1%
At point A A
ΔQd / Qd P=8 P=8
%ΔQd
ε= = ΔP
ΔP / P Q=3
%ΔP P=4
Slope = (8 – 4) / (3 – 4) = 4 ΔQ
D

1% 8 1
ε= = 0.33 Demand is inelastic ε= x = 0.67 Q=3 Q=4
3% 3 4
Quantity
Demand is inelastic
59 60

15
 Class Exercise Price Elasticity Pattern
Find the price elasticity of demand at points A, B, C, E and F Price elasticity changes systematically as price goes down
(*division by 0 is undefined. Approximate it by ∞) Slope is the same for the demand curve
P/Q decreases as price goes down and quantity goes up

Price
A
At high P and low Q,
20
B Demand is elastic
15
C a ε >1
10 At the midpoint ε =1
E

Price
5
F demand is unit elastic a/2
ε <1
0 10 20 30 40
Quantity
At low P and high Q,
b/2 b
Demand is inelastic Quantity

61 62

Two Special Cases Price Elasticity and Slope

Perfectly Inelastic Demand
Zero price elasticity of
demand
Perfectly Elastic Demand
Find the price elasticity for each of the two demand curves
Infinite price elasticity of
demand
at the point where the two demand curves cross. Which
one is more elastic?

Price Price
12
D
D1
Less Elastic
D 6
At the common More Elastic

Price
point demand 4
D2
is less price elastic
for the steeper
Quantity Quantity curve 4 6 12
Quantity
63 64

16
Examples Implications for Airline Pricing
Elasticity Ed coefficient Interpretation Example Inelastic (‐0.8) business demand for air travel means:
a 10% price increase leads to
Perfectly price does not saving your
Ed = 0 Total revenue for the airline will
Inelastic matter pet

Relatively price is less

0 > Ed > -1 electricity
Inelastic important than Qd Elastic (‐1.6) leisure demand for air travel means:
Unitary Ed = -1
price and Qd are a 10% price increase leads to
equally important
Total revenue for the airline will
Relatively price is more
-1 > Ed > -∞ An apple
Elastic important than Qd

Perfectly Ed = -∞
price is everything $10 bill
Elastic (undefined)

66

Time Elasticity of Demand Different Types of Passengers

Definition: Percent change in total O‐D demand that occurs How would you describe the typical passenger for each
with a 1% increase in total trip time. of the following cases:

Implications of Time Elasticity • Type 1 – Time sensitive and insensitive to Price

Which one is more responsive: Business demand or
Leisure demand? Why? • Type 2 – Time sensitive and Price sensitive

• Type 3 – Price sensitive and insensitive to Time

There is a “saturation frequency” in each market (a point
at which additional frequency does not increase demand) • Type 4 – Insensitive to both Time and Price

67 68

17
Total Revenue Trade-offs Total Revenue Trade-offs

Total Revenue Trade-offs

Price Changes and Total Revenue Changes
Price $12 $10 $8 $6 $4 $2 $0
Quantity 0 100 200 300 400 500 600
Revenue $0 $1,000 $1,600 $1,800 $1,600 $1,000 $0

Total Revenue ($/day)

12 1,800
10 1,600

Price ($/ticket)
8

6 1,000

1 2 3 4 5 6 2 6 10
Quantity (00s of tickets/day) Price ($/ticket)

72

18
Elasticity, Price Change, and Revenue Determinants of Price Elasticity of Demand

• the more necessary a good is, the lower

If demand is .. A price increase will Necessity the elasticity
• HIV drugs vs. sports car
Elastic (ε >1) reduce Q reduce PxQ
Inelastic (ε <1) reduce Q increase PxQ
Substitution • More options, more elastic
Options • Pepsi vs. electricity

If demand is .. A price decrease will Budget • Large share, more elastic

Share • New car vs. Salt
Elastic (ε >1) increase Q increase PxQ
Inelastic (ε <1) increase Q reduce PxQ
• Long time to adjust, more elastic
Time • Gasoline

73 74

Economics in Just Go With It

3. Consumer and Producer Surplus

1. Consumer and producer surplus Adam Sandler must negotiate with a young girl to
2. Efficiency vs. equity convince her to pretend to be his daughter.
3. Government policies and market efficiency

75

19
Measuring consumer surplus with the demand curve Market demand and consumer surplus
Market Price P = 10
Market Price = $70
Price
Consumer's surplus is the Price of Consumer surplus from the
difference between: Albums first album ($30)
the buyer's reservation 20
Total consumer
price and the market price $100 Consumer surplus surplus ($100)
from second ($10)
80 Consumer
70 surplus
P=10
Consumer surplus
from third ($0)
50
Total consumer
surplus ($40) Demand

Demand
0 Q=20 Quantity
0 1 2 3 4
Quantity of Albums

77 78

Measuring producer surplus with the supply curve Market supply and producer surplus
Price = $800 Producer surplus at price P= 10
Price of Price
House Supply Supply
Painting
Total producer Total producer
surplus ($500) surplus ($250)
$900
Producer's surplus is the 800
difference between: Producer surplus
from the third house ($0)
the market price and the 600 P=10
seller's reservation price 500 Producer surplus Producer
from the second house ($200) surplus

Producer surplus
from the first house ($300)
5

0 Q=100 Quantity
0 1 2 3 4
Quantity of Houses Painted

79 80

20
Market Efficiency Consumer and producer surplus in the market
equilibrium
Adam Smith: markets are automatically channeling
self-interest toward socially desirable ends (the most Price
efficient allocation of resource – the invisible hand). Supply

Consumer
Economic well-being of a society (welfare) Equilibrium
surplus
Total surplus = consumer + producer surplus price
Producer
surplus

Efficiency (Pareto efficiency) – property of a resource

allocation Demand
Maximizing the total surplus 0 Equilibrium Quantity
quantity
Total well-being—the sum of consumer and producer surplus—is the area between
Equity the supply and demand curves up to the equilibrium quantity
is the concept or idea of fairness in economics
81 82

Heating Oil Market Policy experiment 1: $1 Price Ceiling on Heating Oil

2.00
1.80
S 2.00 Consumer surplus = $900/ day
1.80 S
1.60 Consumer surplus = $900/day
1.60
1.40
Price ($/gallon)

Price ($/gallon)
Producer surplus = $900/day 1.40 Lost surplus = $800/ day
1.20
1.20
1.00
1.00
.80
0.80 Producer surplus = $100/ day

D
D
1 2 3 4 5 8
Quantity (1,000s of gallons/day) 1 2 3 4 5 8
Quantity (1,000s of gallons/day)

83 84

21
Thought Experiment: $0.50 Price Ceiling on Bread Policy experiment 2: Taxes on Sellers
Question Explanation In pictures
Will there be Consumers want to purchase more, but
more or less producers will manufacture less. Empty shelves
Tax program
bread for sale? Shortage! Seller reports sales in units to government
Will the size of Seller pays a fixed dollar amount per unit sold
Manufacturers will try to maintain profits No more giant
a typical loaf
by reducing the size of each loaf. loaves
change?
Will the quality Expensive brands will no longer be Focaccia bread
change? profitable to produce. would disappear
A tax on the seller shifts the supply curve up by the
Will the amount of the tax (for each level of output, seller
Opportunity cost of finding bread will
opportunity Bread lines would
cost of finding
rise. Resources spent looking for bread in
become the norm charges his marginal cost PLUS the tax)
different stores and waiting in line.
bread change?
Black market
Would you buy
Since bread is hard to find, and people bread dealers
illegal bread if
still need it, a black market will develop. reduce the
you could?
shortage

86

Tax on Avocado Sellers Tax on Avocado Sellers and Total Surplus

P
S + tax S Before Tax
6
Consumer surplus = $4.5 M
S
6
Producer surplus = $4.5 M
3
5
Price ($/pound)

Total surplus = $9 M
4 D
3.50
3 0 P
3 Q S + tax
2.50 6
2 After Tax
1 Consumer surplus = $3.125 M
3.50
0
D Producer surplus = $3.125 M
1 2 3 4 5 Total surplus = $6.25 M
2.5 1 D
Quantity (millions of pounds/month) Consumer&Producer Loss = $2.75 M
2.5 Q
Tax revenue = $2.50 M
Net benefit = - $0.25 M
87 88

22
 Tax on Avocado Sellers and Total Surplus
Taxes and Price Elasticity of Demand
S + tax
Total surplus
Total surplus
before tax
after tax S
6 Tax
Price ($/pound) 5 revenue Avocado tax was shared equally
4
Buyers paid $0.50 more
3.50 Deadweight Sellers received $0.50 less
3
2.50
Loss
2

1
D The amount of the tax paid (the burden) by buyers and
1 2 3 4 5 sellers depends on the price elasticity of demand
2.5
Quantity (millions of pounds/month)

Deadweight loss is the reduction in total economic surplus that

results from the adoption of a policy.
89 90

Taxes and Price Elasticity of Demand Taxes and Deadweight Loss

More Elastic Demand Less Elastic Demand More Elastic Demand Less Elastic Demand
P P P Deadweight loss P Deadweight loss
S+T S+T S+T S+T
2.40 S 2.60 2.40 2.60
2.00 S S S
2.00 2.00 2.00
1.40 1.60 1.60
1.40
D1 D1
D2 D2

19 24 Q 21 24 19 24 21 24
Q Q Q
Consumers pay a smaller share of the tax when demand is more elastic
Deadweight loss is larger when demand is relatively elastic

91 92

23