(2018) A Level H2 Econs Paper 2 Essay Q2

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2. Competition amongst airlines within the air passenger market is high and demand is rising but many airports are at or near capacity. Both variable and fixed costs of production of passenger airlines continue to change over time. For example, airline jet fuel prices fell by 20.4% over the year ended 22 July 2016 while the price of passenger jet aircraft increased by around 1.1% between 2015 and 2016.

Source: International Air Transport Association, accessed 3 August 2016

(a) Using economic analysis, discuss how airlines would likely respond to these changes. [10]

Explain the objective of firms 

1. In general, we assume that firms have ‘profit-maximising’ as an objective 

2. Airlines operate within an oligopolistic market structure 

Explain the impact that events stated in the preamble would have on profits 

1. Increased competition amongst airlines can indicate demand for individual airlines to either fall or become more price elastic à reflected by a leftward shift of both AR & MR 

2. Jet fuel is a significant factor input in the production of flights à thus a fall in jet fuel prices can lead to a fall in AC à reflected by both a downward shift in AC & MC 

3. The bulk of costs of flights are fixed in nature à this includes prices of passenger jet aircraft à which can significantly raise COP à shifting AC and MC upwards  

4. Given the counteracting forces on costs – there will unlikely be a significant fall in AC, if any 

5. Assuming the best case scenario where demand for flights for individual airlines falls and become more price elastic while costs only inches down marginally à profitability is likely to decrease in the short term, at least. 

Likely response 1: Merger 

1. Given the uncertainty and very thin margins, it will be beneficial for airlines to look for ways to reduce costs that will be possible to maintain over the long term 

2. Mergers offers airlines a way to do that via reaping of substantial economies of scale (e.g. increased technical economies of scale through the use of more efficient and larger aircraft or managerial economies of scale) 

3. Mergers can also allow airlines to carry out rationalization and operation from smaller leaner teams achieving a reduction in overall costs 

4. Airlines in the U.S. have carried out mergers over the years. 

5. COVID-19 is likely to result in the airline industry undergoing further consolidation via mergers 

6.  

Likely response 2: Increase certainty of costs 

1. Airlines can also find ways to increase the certainty of costs – for example fuel hedging will allow airlines to lock in future prices of fuel considered to be reasonable 

2. However, in times where fuel prices fall drastically – fuel hedging may be detrimental (e.g. how fuel prices in recent times have turned negative, causing airlines to lose significantly on ‘agreeing’ to pay higher prices for future contracts. 

3. In the long-term, airlines should perhaps look into how to reduce fuel as a key component of their costs so that the dependence on fuel as a factor input is less. 

4. It can take a long while and a significant amount of research and development by aircraft manufacturers to move away from depending heavily on jet fuel given that has been the default for decades. 

Likely response 3: Optimisation of routes based on profitability 

1. Airlines can choose to cut back on routes which are less ‘profitable’ or less likely to turn a regular profit and focus on flying routes which are always ‘optimised’ or flying close to full capacity 

2. This will include flying routes where there is little competition or where the fuel economies make sense to do so. 

3. This is already being done by existing firms – for example, Singapore Airlines have frequently revised routes it flies to, depending on whether fuel economies are favourable. E.g. non-stop flight to New York City (Newark Airport) has been put ‘on and off’ it’s offerings. 

Likely response 4: Product innovation & differentiation 

1. Improve cabin products – e.g. quality of seats, food (full-sized bed on Singapore Airlines Business class) 

2. Improve quality of service – luggage allowance, in-flight service by cabin crew 

3. Improving products & service quality can differentiate airlines’ product from others, this can allow airlines to compete without cutting prices, therefore maintain profitability 

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