Effect of Fuel Prices on the Cost of Airline Tickets

Introduction

This report will focus on why prices of airline tickets are expected to rise. As stated in the news article by Benjamin Zhang, the possible cause of a price increase to airline tickets is the expected future increase of jet fuel. IATA’a latest projections is stating the price of jet fuel is yet to increase as high as $US84 a barrel. Fuel represents approximately 25% of the airline overall operating expenses and the airlines are expected to pass this cost onto the consumer

Q1 (a)

When a resource of a good increases in price this will affect the supply of that good. The reason is that the resource and inputs prices influence the cost of production. The more it costs to produce a good, the smaller is the quantity supplied of that good at each price. (Parkin and Bade, 2016, pg 96)

Demand and Supply determine market equilibrium (Parkin and Bade, 2016, pg 115)  A decrease in supply is caused by the change in a supply determinant, in this case, it is the expected increase in price for Jet fuel and this will then result in a decrease in the equilibrium quantity and an increase in the equilibrium price

A decrease in the quantity supply of jet fuel will shift the supply curve leftwards and this will then create a shortage.  To maintain equilibrium the airline ticket price will rise and the quantity demanded decreases, the supply of airline tickets will decrease which will affect the supply curve. This will then create a shortage in sales of tickets as you can see on the supply schedule below

1 (b)

A rise in the expected future price of a good increases the current demand for that good. (Parkin and Bade, 2016, pg 88)

The rise in the expected future price of jet fuel will cause a future increase in the cost of airline tickets.  So that consumers can avoid the future price rise of airline tickets they will be motivated to purchase the tickets prior to the increase in the current market instead of the future.

If consumers purchase the tickets in the current market this will increase the current Demand for the airline tickets and the demand curve will shift rightwards.

So in summary price increases in the future for airline tickets will increase current demand, increase the quantity and increase the price of the airline tickets

Q2 (a)

7

        =  Percentage change in quantity demanded

  Percentage change in price

Elasticity

Price Elasticity of Demand- is a units-free measure of the responsiveness of the quantity

demanded of a good to a change in its price when all other influences on buyers’ plans remain the

same.The price of elasticity of demand is a measure of the responsiveness of the quantity demanded of a good to change in its price when all other influences on buyer’s plans remain the same.

To determine if a good is elastic or inelastic is influenced by the ability to find a substitute for a good. The good can be a luxury or a necessity, how narrowly the good is defined and the amount of time is available to find the substitute. (Parkin and Bade, 2016, pg 120)

If there was a variety of substitutes then air travel could be defined as elastic and the same goes if there were not many substitutes then air travel would be inelastic. So depending on the type of travel this would determine if it was elastic or inelastic.

When you are using air travel for work, it then becomes a Necessity which then makes this a poor substitute and is inelastic, (Parkin and Bade, 2016, pg 122)

When looking at airline travel for holidays it then becomes a Luxury which has lots of substitutes and is elastic. (Parkin and Bade, 2016, pg 122)

If you have plenty of time to plan and select the travel then it is elastic and when you have little time to find an airline to travel with, it then it becomes inelastic, as you have little time to respond (Parkin and Bade, 2016, pg 122)

So to summarise I think that air travel is elastic as there are many substitutes available. Air travel is a luxury, and there are many available choices of which airline to use. Usually you are looking to book airline ticket in advance so time is available to locate the right airline.

In my opinion air travel is elastic as there are plenty of airlines competing in a competitive market which gives consumers a choice of which airline to use

Q2 (b)

Total revenue can change depending on the price elasticity of demand.

Total revenue equal price multiplied by quantity. (Parkin and Bade, 2016, pg 126)

We have seen that when jet fuel increases in price, the price of airline tickets will increase and the demand decreases. When these factors are illustrated into a graph as below the total revenue can be seen.

• Prior to jet fuel increases, price of airfares was 300 and the quantity demanded was at 350 so total revenue was at 105,000.
• When the jet fuel rose in price the price of airline tickets also rose to 400 which decrease the quantity demand to 250. This would then decrease the total revenue to 100,000.

In summary the price of the airline tickets have increased and the total revenue of the future airline tickets has decreased.  As the price and the total revenue have changed in opposite directions the airline tickets are shown to be elastic.

Q3.

When a good is taxed there are two prices, a price that excludes the tax and a price that includes the tax. Buyers respond to the price that includes the tax as this is the price that they pay and sellers respond to the price that excludes the tax because this is the price they receive. A tax places a wedge between the (Marginal benefit) buyer’s price and the (marginal cost) seller’s price (Parkin and Bade, 2016, pg 203)

Efficiency is always achieved when marginal benefit equals marginal cost and they meet at the equilibrium point. When marginal benefit exceeds marginal cost consumer surplus and producer surplus shrinks.

Producer surplus is the excess of the price of a good over the marginal cost of producing it summed over the quantity produced. (Parkin and Bade, 2016, pg 158) This is the triangle below the market equilibrium price

Consumer surplus is the excess of marginal benefit from a good over the price paid for it, summed over the quantity consumed (Parkin and Bade, 2016, pg 155) this is always the triangle area above the market price

The more inelastic the demand for the good the larger share of the tax is paid by the buyer and the more inelastic the supply of the good the larger the share of the tax is paid by the seller. (Parkin and Bade, 2016, pg 205)

Inefficiency arises because a tax reduces the total amount of consumer surplus and producer surplus. The difference between the efficient market equilibrium and the government receives the tax revenue and a deadweight loss occurs.

Tax is shared between the buyer and seller and when the demand is elastic the majority of the tax burden is on the seller as shown in the diagram below is also shown that there is a negative effect on consumer surplus as the area is smaller than the Producer surplus area

Reference

• Parkin, M. and Bade, R. (2016). Microeconomics. 3rd ed. Melbourne: Pearson Australia.