A Levels Economics Model Essays RESOURCE ALLOCATION IN COMPETITIVE MARKETS

March5, 2018
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A Levels Economics Model Essays
RESOURCE ALLOCATION IN COMPETITIVE MARKETS
(DEMAND, SUPPLY AND ELASTICITY CONCEPTS)

Adapted from A Levels Economics N2004 Question

(a) Explain how a global economic downturn and the bankruptcy of some major airlines can affect the market for air travel. (10)

(b) Assess the relevance of elasticity concepts in explaining how the above events would affect the market for air travel. (15)

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This question specifies the product market to consider (i.e. airlines market) as well as the relevant factors affecting demand and supply (fall in income, change in taste and preferences and closure of airlines).

Part (a) only requires us to explain the impact of the recession and closure of airlines on the market for air travel. Since part (b) explicitly requires students to consider the relevance of elasticity concepts, it can be inferred that elasticity is not required to be discussed under part (a).

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(a)       The combination of a worldwide recession and an increased fear of flying would lead to a fall in the demand for air travel, while the closure of airlines would lead to a fall in the supply of airlines.  The overall impact on equilibrium price and quantity depends on the extents of shift in demand compared to the shift in supply, as well as the nature of the airlines market.

 

A worldwide recession results in a fall in global income. Given that air travel is a complementary good to overseas holidays, with the latter being a normal good, the fall in global income will lead to a drop in the demand for overseas holidays. Hence, the demand for air travel will fall as well. Furthermore, the increased fear of flying may lead consumers to switch to rail travel, or even video conferencing for business travellers. This would further cause a fall in demand for air travel.  Overall, demand for air travel falls from D1 to D2 as shown in Fig.1, leading to decrease in price and quantity demanded from P1 to P2 and Q1 to Q2 respectively.

 

 

The closure of major airlines reduces the number of producers of air travel, leading to a fall in supply from S1 to S2, as shown in Fig.2. The closure of these airlines could have been triggered by the higher cost of production arising from the increased cost of airline security to safeguard passenger safety (e.g. more stringent checks on passengers’ belongings and deployment of airline marshals), as well as producers’ expectations of a prolonged slowdown in the airline industry. The fall in supply results in a rise in price from P1 to P2 and a fall in quantity exchanged from Q1 to Q2.

 

Overall, the fall in demand could be more than the fall in supply of air travel, given that many national carriers still remained in operation throughout the trying period.

 

As seen from Fig.3, at the original price of P1, quantity supplied (Qss) exceeds quantity demanded (Qdd), leading to a surplus. The surplus puts downward pressure on prices.  As prices falls, quantity demanded rises along D2 while quantity supplied falls along S2.  This happens until the new equilibrium is reached at b, where there is no tendency for further change. Overall, equilibrium price falls from P1 to P2 while equilibrium quantity falls from Q1 to Q2.

 

However, the nature of the air travel in question also influences the impact on the market. For example, in the case of budget airlines, the fall in income could result in a rise in demand instead. This is because budget airlines are regarded as inferior goods, having minimal amenities on board. Hence, consumers with lower income may prefer to travel on budget airlines than to take conventional flights. With a rise in demand coupled with a fall in supply, the equilibrium price would rise overall, while the overall impact on equilibrium quantity depends on the extent of change in demand compared to supply.

 

Overall, the combination of a recession and increased fear of flying would lead to a decline in price and quantity consumed in the conventional airline market, while this could provide a boost to demand in the budget airline market instead.

 

(b)       As mentioned under (a), the combination of a worldwide recession and increased fear of flying leads to a fall in demand and supply for air travel (normal good).  Price elasticity of demand (PED) is useful in assessing the extent of fall in quantity exchanged compared to the rise in price when supply falls, and hence affects the impact on total revenue. Similarly, price elasticity of supply (PES) influences the extent of fall in quantity exchanged compared to the fall in price when demand falls. Income elasticity of demand (YED) helps in determining whether an increase in income leads to a rise or fall in demand, as well as the extent of the change.  While cross-elasticity of demand (XED) is not directly applicable, the degree of substitutability between air travel and other modes of travel/communication such as rail travel and video conferencing could in turn affect the PED for air travel.

 

Generally, the more price-elastic the demand for air travel, the greater the fall in quantity exchanged when supply falls, and vice-versa.  PED measures the degree of responsiveness of quantity demanded when price changes. Price-elastic demand is given by PED>1, while price-inelastic demand is denoted by PED<1

 

We can see from Fig.4 that the same fall in supply leads to a rise in equilibrium price from P1 to P2e, and a more than proportionate fall in quantity consumed from Q1 to Q2e (where PED>1); while it leads to a rise in equilibrium price from P1 to P2i, and a less than proportionate fall in sales volume from Q1 to Q2i (where PED<1). The PED for air travel could depend on the nature of the consumer.  For example, if the passenger is a business traveller who needs to travel for overseas meetings, demand could be price-inelastic. In this case, total revenue rises from OQ1aP1 to OQ2ibP2i with a fall in supply. On the other hand, a holiday-seeker tends to have a more price-elastic demand, given that the holiday plans can be deferred until the airline industry picks up.  Hence, the same fall in supply results in a fall in total revenue from OQ1aP1 to OQ2ecP2e.

 

On the other hand, a fall in demand due to the global recession would lead to a decrease in total revenue, regardless of the price-elasticity of supply (PES) of the good.  PES is defined as the degree of responsiveness of quantity supplied to a change in the price of the good.  Price-elastic supply is given by PES>1, while price-inelastic supply is denoted by PES<1.

 

Based on Fig. 5, in the case of price-elastic supply, e.g. when considering production period in the long-run (since producers can be more responsive to any change in price), the decrease in demand leads to a decrease in price from P1 to P2e and a more than proportionate fall in quantity sold from Q1 to Q2e. However, in the shorter term, supply tends to be more price-inelastic. For example, some airlines could have already placed orders for new airplanes. Hence, the decrease in demand leads to a decrease in price from P1 to P2i and a less than proportionate fall in quantity sold from Q1 to Q2i.  In both cases, total revenue rises from OQ1aP1 to OQ2ecP2e (price-elastic supply) and OQ2ibP2i (price-inelastic supply).

 

As mentioned in part (a), a decrease in income would reduce the demand for normal goods while increasing the demand for inferior goods. YED measures the degree of responsiveness of demand to a change in income.  Hence, YED is positive for a normal good while it is negative for an inferior good.  Income-elastic demand is given by YED>1, while income-inelastic demand is denoted by YED<1.

 

In the case of a normal good such as non-budget air travel, the extent of the decrease in demand when income falls depends on the size of YED (i.e. whether good is a luxury good or necessity). YED could be greater than 1 in the case of first-class air travel, while YED could be smaller than 1 in the case of economy-class travel, especially if it serves a route dedicated to business flights e.g. flights to Chennai in India.  In the former, which is a luxury good, demand falls significantly from D1 to Dl; while in the latter, demand falls to a smaller extent from D1 to Dn given the degree of necessity of the good.  As shown in Fig. 6, total revenue falls by a larger extent from OP1aQ1 to OPlcQl in the case of luxury air travel, compared to inferior goods (OP1aQ1 to OPnbQn).

 

While the combination of a global recession and heightened fear of flying do not involve XED directly, the degree of substitutability between air travel and other alternative modes of travel/communication influences the PED of air-travel, and hence has an impact on price, quantity and total revenue.  For example, if the travel location is served by rail transport other than air travel, with little difference in travelling time, PED could be higher. Similarly, a firm which is IT-savvy may be prepared to switch to video-conferencing as a substitute to air-travel when conducting cross-border meetings.  This will also result in a more price-elastic demand for air travel.

 

Overall, PED, YED and XED (through PED) affect the proportion of change in quantity demanded compared to the change in price, and hence influence total revenue in the market for air travel.  While PES also has an impact on change in quantity exchanged when demand changes; given that price and quantity exchanged change in the same direction, there is no direct impact on the total revenue. However, when assessing the application of each elasticity concept, we note that additional information may be required. For example, PED is affected by a number of factors, including the proportion of income spent on the air ticket. The relevance of XED also depends on the substitutability between air travel and other means of communication not just in terms of ease of communication, but also in terms of their costing. An understanding of such information is necessary to fully appreciate the relevance of each elasticity concepts.

 

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