Teaching oligopoly pricing and came across a useful video about airline pricing and which class of passenger makes the airline money. It also mentions price discrimination, predatory pricing and the price elasticity of demand for a leisure and business traveler. Excellent economics in action.
The global airline industry has been one of those that has been hardest by Covid-19. In the US passenger volume is down 96 %, whilst globally losses have topped US$314bn worldwide. Based on booking patterns Air New Zealand will lose over NZ$5bn in revenue per year and a loss of 3.500 jobs. What makes it even worse is that the latest Oxford Economics forecast shows that the loss in global output could be double that of the GFC. This has implications on the speed of the recovery in air travel in the second half of 2020. The table shows that Asia-Pacific takes a big hit financially and is second behind Middle East/Africa (51%) with a 50% loss in RPK.
RPK = Revenue Passenger Kilometres is an airline industry metric that shows the number of kilometres traveled by paying passengers
IATA estimate that RPKs will decline by 48% in year-on year terms and passenger revenues will be US$314 billion lower this year compared to 2019- see table below. IATA note that a typical airline has cash to cover around two months of revenue loss.
Below is a short video from PBS Newshour with Paul Solman looking at the airline industry.
Another great graphic from The Economist showing the change in the price of an economy class ticket for both short-haul and long-haul flights. Routes longer than 5,000km have generally seen price drops of 30% and 50% on some transatlantic routes.
Reasons for the drop in fares:
- Fuel costs have come down – 2014 = US$0.81 / litre – 2016 = US$0.22 / litre
- Increasing long-haul competition from low-cost carriers
- More fuel efficient planes = lower costs
- Subsidies to state owned e.g. China
- Major airline deregulation
- Airlines have become much better at making more efficient use of their planes – i.e. having them full
Airlines and dynamic pricing
To the average buyer, airline ticket prices appear to fluctuate without reason. But behind the process is actually the science of dynamic pricing, which has less to do with cost and more to do with artificial intelligence. See video below from Tom Chitty of CNBC
Price discrimination involves charging different prices to different sets of consumers for the same good or service. So when you are on your next flight there are going to be different fares for the same class of seat whether it be in economy, business class or first class. What variables at work to bring about price discrimination in airline routes?
- What day of the week you fly – Monday and Friday are usually peak times for business so you should find that fares are expensive. Also because it is usually for business purposes it is assumed that firms will be paying for the flights and therefore are prepared to pay more.
- Times of the day – morning and evening tend to be more expensive as this is peak time.
- How competitive the route is – if there is a lot of competition fares will be cheaper to the extent that there maybe predatory pricing. There is a good piece in the video showing the fares for flights from Montreal to St Johns Newfoundland. Once low cost carriers entered the market Air Canada dropped their price below cost.
- Reputation of each airline – better reputation = higher fare
The video below is a very good especially the fare structure on the New York to Los Angeles route.
What a difference a year makes for Indian low cost airline Spicejet. On the verge of shutting down in December 2014 with $300m of debt with suppliers refusing to refuel planes unless paid upfront and staff not been paid their monthly salaries, the airline has made a remarkable recovery. Today it is filling 93% of available seats and has made a profit in the last 4 quarters.
What has been the cause of the turnaround?
- Aircraft fuel expenses dropped nearly 35 percent
- Demand has increased – compared to the previous year Indian airlines carried 20% more passengers in 2015.
- Negotiated better terms with aircraft-leasing firms
- Cut jobs and managers pay
- Scrapped unprofitable routes
Measures to reduce inefficiencies of Spicejet
- Reducing the time to second-tier cities and thereby making it possible to fit in an extra flight a day.
- Steel brakes on wheels of Boeing 737 were replaced with lighter carbon brakes
- In-flight magazines reduced – less weight
- Meals served in cardboard boxes instead of plastic trays – reducing fuel consumption
- Planes were filled with just enough fuel within safety margin
- Landing gear was deployed 8km from touchdown instead of 14km – reduce drag
- Taxi on the runway using just one engine – more fuel efficient
- Stocks of spares parts are now more readily available so planes spend less time on the ground
Although the airline still has a long way to go to reduce its debt its recent performance has enabled it to think about long-term expansion.
I came across a useful blog post by Ben Cahill (Senior College) on the Tutor2u site. It involves the price of airfares. The New Zealand Herald found that flights originating in London were significantly cheaper than NZ deals on equivalent trips leaving Auckland.
Fares for Departing April and returning May:
London – Auckland return – booked in UK = NZ$1,620 equivalent
Auckland – London return – booked in NZ = $3,189 (difference of $1569)
Flights out of NZ can’t be booked on Air NZ’s UK website – discrimination by location (third degree discrimination). In the UK the cost of a one-way fare is similar to that of a return.
Reasons for differences:
Greater demand for flights out of Auckland to London.
Exchange rate – 2003 difference would have been $616 instead of $1569
However airline pricing is based on many considerations and is ideal for price discrimination for the following reasons:
* Airlines has some control on the price,
* Buyers have different price elasticities of demand – business travelers vs. vacation travelers (see graph below)
* Each ticket can be sold at a different price, depending on when you book, how you book, the day you book, and so on.
* Software programmes can constantly calculate the empty seats remaining and price them while maximising returns. Yet, competition eats away all those margins. Hence, the tendency to raise revenues from wherever possible.
To maximize profit, the firm sets a price for each group by equating marginal revenue and marginal cost.
29 cover fuel
20 cover salaries of airlines
16 cover ownership costs
14 cover Government fees taxes
11 cover Maintenance
9 cover other costs – catering etc
1 = Profit
But airline operating costs are off the charts compared with other industries. In a business where much of the work is done outside, routine storms can eat into margins. And there are many moving parts to flying people through the air, and many safety costs required by regulation.
While ticket revenue pays the bulk of these costs, “ancillary revenue” supplements the flight by another $18 per person on a 100-passenger flight. That includes fees for checked baggage, seat assignments, ticket penalties and revenue from cargo.
To go to the full article, graphic and video – click link below:
Robert Nutter wrote an informative piece in the Sept edition of econoMAX (online Economics magazine of Tutor2u) on the airline production duopoly. Duopoly is a form of oligopoly and exists in a market when two companies control nearly all the market share of a product or service. The $1.6 trillion market for passenger aircraft has been dominated by Airbus and Boeing for over 20 years with Airbus accounting for 47% of the market in 2009 and Boeing 43%. Thus whenever we fly with airlines such as Air New Zealand or JetSar the chances are we are being carried in one of a range of planes produced by these two firms such as the Airbus 320 or the Boeing 737.
These two aircraft manufacturers use non price competition as they battle for market share in the short haul and long haul passenger aircraft market. While price is obviously a factor for airlines purchasing their airliners they also look for increased fuel efficiency, lower emissions, low maintenance costs, reliability and design as key selling points. The high research and development and marketing costs would seem to suggest this is not a contestable market that will remain a duopoly. However there are increasing threats to the dominance of Airbus and Boeing, particularly in the area of the market dominated by the Airbus 320 and the Boeing 737. Embraer, the Brazilian manufacturer, the Russian aircraft manufacturers United Aircraft Company and Sukhoi as well as China’s Comac and Bombardier from Canada will probably challenge the big two in the year’s ahead forcing them to spend more on R&D than they previously planned.