South-Western College Publishing - Economics  
Airlines are in for a Long Road This Summer
Subject Pricing Wars Between Airlines are Hurting Profits
Topic Supply and Demand; Elasticity; Price Discrimination
Key Words

Price, Competition, Airlines, Costs.

News Story

The airline industry as a whole is anticipating a brutal traveling season later this summer, as it faces increased fuel costs, increased operating costs, and increased competition from low-cost carriers. Delta Airlines has already announced that it will lose $387 million in the first quarter of 2004, and the industry as a whole could amass losses exceeding $1 billion for the first quarter. As a response, Delta is seeking a 30% cut in benefits and salaries from its pilots to reduce its costs. Further, jet fuel prices have been increasing significantly, and every $0.01 increase in fuel costs the industry approximately $180 million.

Competition from low-cost carriers such as SouthWest and Song Airlines, is also hitting major airlines hard. As a result, while airlines would like to raise prices to compensate for increased costs, competition is preventing them from doing so. Travelers are increasingly price-sensitive, and therefore are likely to switch to lower-priced fares even if they have to sacrifice amenities such as onboard snacks and legroom. Even business travelers, long considered a high revenue segment of the market, are moving away from frequent-flyer programs and booking flights with the cheapest fares on the route.


(Updated June, 2004)

Questions
1.

Use a graph of supply and demand to illustrate what you would expect the effects would be on the price of an airline ticket and quantity sold in the market based on information in the article.

2. Given that even business travelers are becoming more price conscious, what is happening to the relative elasticity of airline customers? Explain this phenomenon in terms of price discrimination as practiced by oligopolists.
3. Let's look at this phenomenon graphically. Delta announced that it is earning a loss in this imperfectly competitive market. Draw a graph of marginal revenue, marginal cost, demand, average variable cost, and average total cost to indicate a loss, and on the graph shade in the area of loss for the firm. Since they are continuing to operate in the short run even with a loss, what must be true about the cost of airline travel and the average variable cost of airline travel?
Source Micheline Maynard. "Airlines are Looking at a Long, Hot Summer." The New York Times. 15 April 2004.

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