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1. Introduction
Microeconomics is the study of economic tendencies, or what is likely to
happen when individuals make certain choices or when the factors of production
change. Microeconomics helps us to understand how buyers, sellers and
business owners interact with the supply and demand for resources, using
money and interest rates as a pricing mechanism for coordination. To make it
simple, economics studies human behavior and how human make choices when
resources are scarce. In this report I have made an attempt to analyze the
economics of the airline industry and how it helps airlines to maximize revenue
and maintain sustainability in the airlines industry.
2.1 Overview
Airline industry supply and demand is largely dependent on fuel prices. Indian
airlines industries went through a critical phase in 2008 when aviation turbine
fuel (ATF) prices reached a record high (Rs. 71,028.26 per kiloliter) in the month
of August 2008 (Fig 1).
Fig. 1 Reduction in air traffic due to price rise of ATF [Source: The Economic
Times, 14 January 2009, Page 7]
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This resulted in big decline in load factors and the situation gets worse with the
rupee hitting a record low of Rs.51.92 per dollar on March 2009.It is estimated
that 30% of an airlines operational expenses, excluding the cost of jet fuel are
denominated in dollars. Therefore most Indian domestic carriers were aiming to
reach their breakeven targets in the next fiscal.
Comparison of the number of passengers travelled by air and trains (AC classes)
in 2007-08 and 2008-09 , it was observed that when air traffic during April-
November, 2008 declined nearly 4% , number of passengers travelling in air
conditioned bogies of trains increased by 18.33%.
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2.3 Airlines Short Run Decision to shutdown
When cost of operation was high compared to revenue earn, a few airlines
particularly budget carrier, found it difficult to continue operation. A decision of
shutdown can be taken when the price in the market is less than the average
variable cost(AVC) .In economics term shutdown occurs if P < AVC , where P=
Price and AVC = Average Variable Cost
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one airline slashed the fare, others had to do so to stay in the market. Fig. 8
corroborates that idea. It is learnt that after announcing a fare reduction of up
to 82% a few days back, national carrier Air India has announced that it will cut
basic fares anywhere between 45% and 60% in February following a drop in ATF
prices. Jet Airways has cut fare up to 40%, Kingfisher by 21 to 65%. Indigo and
Spice jet are offering Rs.1 to Rs. 99 base fare [Ref. 4]. Fig. 8 Price competitions
in domestic airlines after drop of ATF price [Source: The Economic Times, 7
January 2009, Page 18]5
i) When price rises, demand falls (load factor declines due to rise of
airfare)
ii) When price of one service rises, demand of substitute services rises
(airline and AC train are substitute services)
iii) In short run, when price is less than average variable cost (AVC), firms
take shut down decision (Some airline stopped their operation in
certain short route in 2008).
iv) In competitive market, firms are price taker (one airline slashed fare,
others slashed too).
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customer groups that the company caters to, establishing the right (quantity of)
products and services as well as setting up the optimal prices to be offered to
these customers. Yield management is also known as revenue management and
it traditionally originated in the airline industry .In airline industry, often tickets
for the same flight may be sold at many different prices. This depends on product
restrictions as well as the remaining time until departure and the number of sold
seats. The use of such strategies has transformed the transportation and
hospitality industries and has become increasingly important in retail,
telecommunications, entertainment, financial services, health care, hotels, car
firms and manufacturing. Therefore yield management has various definition.
There are a few statements made about revenue management such as:
Yield Management is a method which can help a firm to sell the right inventory
unit to the right type customer, at the right time and for the right price [Ingold,
A. (2000)].
There are a number of strategies used in yield management to get the best result
for the company like
Segmentation
Price management
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Demand Forecasting
Availability
Product Differentiation
Booking classes
Reservation negotiation
In this report I would like to discuss briefly on two important aspects of yield
management which is price management and demand forecasting
For Example, quality-oriented passengers, can influence the demand for the
certain company product by their personal choices and willingness to pay as well
as they their price elasticity. The price elasticity gives the percentage change in
quantity demanded in response to a one percent change in price, by holding
constant all the other determinants of demand. This result can be used to
estimate or a price change leads to an increase in sales or just a revenue decline.
Leisure travelers may be very price elastic, and the business traveler may be
more time sensitive and less price elastic. Other examples of using price
management are early booking discounts for those customers who are booking
early at the company as well as offering the supplements for travelers in the on
weekend. By doing so, the company can cover some major costs and can
concentrate on more expensive offers (charging higher price) to receive more
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revenue. By doing so, it is important that a company realizes which products (or
services) it can offer at profitable price for each specific customer segment.
Hence, price management plays an important role for the Revenue Management
systems [Phillips, R.L. (2005)].
The price paid by consumers to buy air ticket will rise with the increase in wages
paid to airline crew as airlines will try to cover the extra costs for paying their
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employees. As the price increases there would be a decrease in the no. of seats
sold per month which will cause supply curve to shift upwards or to its left
Price
$ S1
400
S
350
300
250
200
150
100 5 10 15 20 25 30 35
In this scenario as well the supply curve will shift to left as there would be
decrease in the quantity of seats sold per month
With more airlines providing flights, the supply of seats will rise. This will create
a surplus of flights / seats at the existing equilibrium price. As a result, the
airlines will reduce their prices in order to fill the excess seats. With cheaper
seats available, the quantity of seats demanded will rise as consumers grab
cheap deals. As a result, the price of seats will fall and more seats will be supplied
and demanded.
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Price
S
$
400
350
S1
300
250
200
150
100 5 10 15 20 25 30 35
Perfect competition: Under perfect competition, firms can sell as much they
want at market price and the only constraint limiting its output are their own
capacity constraints or costs of productions. Hence the market price is equal to
the marginal cost of production for each firm supplying the market. In this case
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the firms decision is supply driven based only on their technology and costs of
productions rather than demand consideration. Therefore, under perfect
competition it would seem there is little scope for the sorts of demand decisions
that lies at the heart of revenue management. However adding some small
modification to competitive model leads to interesting insights about Yield
management. If marginal costs are constant the first order profit condition
reduces in other words the market price just covers the marginal cost of
production and hence firm earns zero profit. This leads to the so called zero profit
equilibrium in which a zero profit condition for all firms is assumed as essentially
the definition of competitive market.
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the demand of its competitors. This creates a strategic interaction among the
firms decision. Oligopoly is arguably the most interesting market condition for
studying yield management because it is the prevailing competitive situation in
many industries.
6. Conclusion
Understanding of micro economics is crucial for the success of any firm. While
Researching for this report and analyzing the information I got I have gained an
in depth knowledge of micro-economic principles and its application in real life.
In this report I have tried to explain the principles and its applications in the
airline industry .This research has also helped me to understand the importance
of yield management and how it has been used in the airline industry and the
hotel industry.
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References
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