Supply and Demand:

Analysis in the Airline

Industry
Chapter 3

Basics of Demand
Demand: the ability and willingness to buy specific
quantities of a good or a service at alternative prices in
a given time period Ceteris Paribus conditions.
Revenue Passenger Miles (RPMs): are measures of traffic
for an airline obtained by multiplying the number of
revenue-paying passengers aboard the aircraft by the
distance traveled.
Revenue Ton Kilometers (RTK): obtained by multiplying
the weight of paid in tonnage by the total number of
kilometers it has been transported.

Quantification of Demand in the airline industry:

Number of passengers (PAX)
Revenue Passenger Miles (RPMs), which normalizes passenger
demand according to miles traveled
Revenue Passenger Kilometers (RPKs), which normalizes
passenger demand according to the number of kilometers
traveled;
Revenue ton miles (RTMs);
Revenue ton kilometers (RTKs)
Expressing demand in RPMs gives a sense of airline traffic in
terms of distance, and is the preferred metric for airline demand
analysis throughout the industry.

The law of demand

The law of demand states that, ceteris paribus, as price increases,
the quantity demanded decreases. (Quantity demanded has a
negative relationship with price)
Demand Schedule: a table showing the quantities of a goof that
customers are willing and able to buy at alternative prices in a
given time period, ceteris paribus.
The demand curve is downward sloping, confirming the negative
relationship between quantity demanded and price.
The curve is concave to the origin, suggesting that at some point,
demand increases tremendously as a result of decreasing price,
but above that point, demand is much less responsive to changes
in price.

 Demand Curve: is a graphical description of the demand schedule

and the quantities of a good that costumers are willing and able to
buy at alternative prices in a given period of time.
Derived demand: demand is derived from the demand of
consumption or utilization of another good or service. (The demand
for air transportation stems from factors other than the
transportation itself)
Direct demand: demand for goods and services meant for final
consumption.
Demand function: the functional relationship between quantity
demanded and the factors influencing demand.
- Implicit demand functions simply state general relationship between
the quantities demanded and factors affecting demand.
- Explicit demand functions are mathematical relationships between
quantity demanded and the various variables impacting demand.

 Two other types of demand functions are the semi-log

function and the log-linear function.
For the airline industry, it is usually assumed that the
typical demand function takes the log-linear shape.
In log-linear functions the slope of changes.

Determinants of demand for air

transportation
Factors that affect demand: ticket price; competitors
ticket price; passenger income; state of the economy;
availability of other modes of transportation; passenger
loyalty; in-flight amenities; frequency of service; safety;
aircraft type, location of airport; random factors, such as
volcano ash cloud, SARS, and 9/11 or threat of
terrorism.
Ticket price is the only determinant of demand that
causes movement along the demand curve; changes in
other determinants of the demand cause a shift in the
entire demand curve.
Positive changes shift the demand curve to the right,

 With the advent of the Internet and numerous price

aggregation websites like Expedia, Travelocity, and so
on, price and competitors prices have probably become
even more important as airline ticket price information
is readily available to potential customers.
The price coefficient is negative and the cross-price
coefficient is positive.
The inverse demand function is also called the price
function, and it treats price as a function of quantity
demanded.
Consumers with higher incomes are able to purchase
more goods and services; therefore, an increase in
disposable income will provide an increase in demand
for travel.
Because of this direct relationship between demand and

 Other variables that might affect the demand for air

travel include the quality of service offered, product
differentiation, and so forth. (known as quality or
hedonic indicators)
Hedonic Indicators: flight frequency; connectivity
between city-pairs; customer loyalty programs; service
levels; on-time performance; customer service.
Flight frequency is especially important for business
travelers since they are generally more time-sensitive
than leisure travelers.

Characteristics of demand for air

transportation
Fluctuations; cyclicality; seasonality and peaking; directional
flow; perishability; schedule wait time; airport access time; flight
time; hub connection time; denied boarding time.
Fluctuations because of the numerous determinants highlighted
in the preceding section, demand for individual flights is
constantly changing.
Cyclicality refers to the long-term trend of peaks and troughs of
economic activity.
Seasonality, unlike cyclicality, which is a long-term cycle, peaking
is more of a short-term event where demand spikes. (demand
increases during the summer & decreases during the winter)

 Directional flow relates to the increased demand of

passengers in one direction for a period of time.
The major problem with cyclicality, peaking, and
directional flow is that demand for air transportation is
perishable. The moment the plane leaves the gate, any
empty seats are lost as revenue-generating products.

Characteristics of supply for airline

service
Seasonality: Airlines must react to seasonal fluctuations in demand
by adjusting the supply to match the passenger demand. In order to
accommodate seasonality, airlines need to either pull capacity off
existing routes, or have idle capacity available to accommodate
additional flights (both costly).
Rigidity: airlines supply is fairly rigid as it can be difficult for airlines
to reduce and/or increase supply dramatically. Since an airline
creates a schedule at least six months out, and accepts bookings up
to a year out, the airlines must adhere to the schedule or face reaccommodation fees. Fixed costs, such as investment in
infrastructure at hub airports, aircraft leases, and labor contracts
have to be paid regardless of the schedule, making it impractical for
airlines to reduce capacity on short-term notice.

Basics of Supply
The perishability of air transport services, the high fixed
costs, and the predetermined capacity in the form of
schedules that are published well in advance of the
flight, make supply relatively unresponsive since an
airline cannot shift its supply at short notice.

Factors affecting supply of airline

services
Supply refers to a firms willingness and ability to provide a
specific number of seats at a given price, time period, and market.
Supply is usually expressed in available seat miles (ASMs) or
available ton miles (ATMs).
Dividing RPMs by ASM gives us a key performance indicator for
airlines, the Load Factor.
Load Factor: the percentage of capacity that has been matched
with demand.
Load factors are critical to airline performance, since they
determine aircraft utilization, derive the profitability of a given
route, and indicate the useful utilization of capacity.

 The law of supply states that at higher prices, produces are willing
and able to produce more products. The quantity supplied increases
as price increase, and decreases as price decrease, given
everything else constant.
Factors affecting supply are: ticket price; price of resource inputs;
navigation charges; technology; availability of other mode of
transportation; government regulation; stochastic factors.
For the air transportation industry, production resources include, but
are not limited to, aircraft, fuel, maintenance, labor, and landing
fees. (affect the cost of production)
An increase in the cost of production causes a leftward shift in the
supply curve.
Deregulation and liberalization of air transport have also
significantly affected the supply curve. Since regulation generally
prohibits market forces from determining supply, there is usually an
artificial cap.

Market Equilibrium
At any given price, there will be a quantity demanded,
and a quantity supplied. At one price, however, quantity
demanded will exactly equal quantity supplied, and this
point is known as equilibrium.
It is the point (P*) where both supply and demand
curves intersect, and price is known as the market
clearing price.
P* is achieved through a process of trail and error. The
firm estimates demand and plans a level of output and
charges a price based on that estimate.
Due to the perishability of airline service, it is almost
impossible to equal Qd with Qs.

Changes in equilibrium
Analyzing changes in equilibrium is straight forward as
long as one proceeds by first deducing which curve is
shifting in which direction.

Equilibrium price maximizes

consumer well-being
The equilibrium price is the best possible price for
consumers given the reality of producer costs. It is
generally optimal for consumers to let price move
wherever supply and demand may send it.

Price Controls
It has been argued that the primary objective of price
control is to prevent extreme, runaway inflation and all
the evils that go with it, but some other negative
consequences may happen as well.
A controlled price will allocate resources but not in
accordance to supply and demand.

Consumer and Producer Surplus

Consumer surplus is the benefit accrued by consumers
whose willingness to pay exceeds the market
equilibrium price. The lower the equilibrium price, the
higher the consumer surplus.
Consumer surplus is defined as the difference between
the total amount that consumers are willing and able to
pay for a good or service and the total amount that they
actually do pay.
Similarly, producer surplus is defined as the benefit that
accrues to producers whose willingness-to-supply lies
below the market equilibrium price.

Airport landing fees and airport

congestion
Excessive and persistent airport congestion may be a
function of a price that is not in equilibrium; that is, the
landing free is kept too low by government. Other
factors, may contribute to congestion stringent
environmental regulation that prevents airport
expansion or dated technology that forces aircraft to
maintain wider separation, and so on.
In the short run airport supply is fixed and therefore
represented as a vertical straight line.

Price floors
A price floor is a minimum price, generally above the
equilibrium price, set by the government on a product
or service.

Price ceiling
Opposite to a price floor is a price ceiling where a
maximum price is set by the government for particular
goods or services.
Generally price ceilings lead to a shortage. ( Black
market as a consequence)

Disequilibrium
There can exist periods of disequilibrium, where price
does not allocate the quantity demanded and the
quantity supplied, even in the absence of government
control.
Disequilibria can occur as a result of both
microeconomic and macroeconomic shocks.
Macroeconomic: 9/11 (Aviation system shutdown)
Microeconomic: Bad weather conditions (Reduced
capacity)

Elasticity
Elasticity is a percentage change in the dependent
variable (quantity demanded) resulting from a one
percent change in an independent variable (factor of
demand).
In measuring elasticity, there are two types of variables:
endogenous and exogenous. Endogenous variables are
variables that the airline can directly control while
exogenous variables are variables that are out of the
airlines control.
Three major elasticity's: Price elasticity; cross-price
elasticity; income elasticity.

Price elasticity
Price elasticity is the percentage change in the quantity
demanded resulting from a on percent change in price.
Two ways to measure price elasticity:
- Point elasticity measures the elasticity of the function at
a specific value, while arc elasticity measures the
elasticity of the function at a range of values.
Elasticity can range from zero to infinity.