Chapter 2

Principles of Economics with Applications in Aviation

Basic Economics
• Economics may be defined as the science of decision –making
and resource allocation under scarcity.
• Example
The construct a 1.28Billion dollar fifth runway at Atlanta’s
Hartsfield- Jackson airport (ATL) to increase the operational
capacity of the airport. Broadly speaking, every resource is
scarce, and the allocation of resources under a variety of
incentives and decision-making parameters forms the core of
economic analysis.
 Opportunity Cost.
• people understand and can act in their own best interest,
• For instance, individuals will engage in a search process to find the lowest ticket price for
a given itinerary and set of requirements like flexibility, refundability, and service level.
• This implicit cost of resources is known as opportunity cost, and is yet another
fundamental concept in economics. the next best use of the resource is the economic
cost of using it in the current allocation.
• For instance, in the above example, the opportunity cost of the time spent in searching
for the best ticket price is the next best use of that time, perhaps in running the
company, generating greater sales, or spending time with one’s family.
• For an airline, the opportunity costs of acquiring a new aircraft could be an alternative
use of that money, perhaps in acquiring another type of aircraft, opening a new route, or
restructuring
• To continue with the example above, as long as the opportunity costs of time
do not exceed the potential cost savings that can be achieved, the individual
will continue the search. When the opportunity cost of time exceeds the
potential cost savings, the individual will cease the search and take the best
price that can be found.
• How can we reduce opportunity cost?
Continuing the example, travel aggregators like Expedia.com and Travelocity
have massively reduced the search costs associated with booking airline tickets.
By aggregating the various ticket prices into a convenient form, time spent in
searching for the best fare is reduced, and the opportunity costs of travel
arrangements are reduced. Effectively, travel has been made cheaper due to
information provided by a knowledgeable middleman.
 Price
• Fundamental of economic thinking is the concept of prices.
• Prices constitute the central allocating mechanism of economics, and are
the decision-making parameters by which individuals organize their
actions. For example, consider the price of oil; literally millions of people
use the price of oil to make decisions affecting both business and
personal consumer interests. Large corporate firms use the price of oil to
make important corporate decisions regarding their own pricing
(consider the airlines for example), exploration and development
activities depend upon the present price of oil, numerous transportation
decisions are related to the price of oil, and of course, consumers alter
their behavior based directly on the price of gasoline and oil.
Scope of Economics
• First, there is the notion of scarcity and second, the idea of unlimited
wants.
• So we can define economics as the art or science of using limited
productive resources such as land, capital, labor, and technology to
produce different goods and services to satisfy unlimited human wants.
• choices and tradeoffs
• choices matter because resources are limited while human wants are
unlimited. The economic method of thinking centers on analyzing the
decisions of individuals and the movements of markets in light of
incentives and choices
Micro Economics
• Microeconomics deals with the behavior of individual households
and businesses (decision-making units).
• It depends heavily on the concepts of supply and demand; that is,
the way in which the market determines the price of goods and
services and the level of production.
 Example in Airline Industry

• Capacity (quantity) management is a good example of

microeconomic decisions. Some cases follow: during the Gulf
War airlines experienced a significant decline in traffic so they
reduced their capacity (supply) by 10 percent over a period of
about one year. In India, the low-cost carrier (LCC) Jet Lite
Airways, a subsidiary of Jet Airways, slashed fares on all sectors
by up to 40 percent to increase quantity demand.
Example 2
• Airline revenue management is another good example of a
microeconomic decision-making. Airbus and Boeing are two tough
rivals in the aircraft industry; they compete with each other to
capture a bigger market share by introducing more efficient aircraft.
Pricing Decisions

• Based on pricing, businesses can forecast what a consumer

may buy, and how many units of that product or service will be
sold.
• the basic concept is that airlines price seats differently
according to several variables including service level, time
before flight, and day of the week. The idea is to charge each
consumer the maximum he/she is willing to pay based on
his/her personal characteristics.
How can Airline Charges different prices by
using people choices?
• The business traveler with little flexibility and last-minute travel
needs would intuitively be willing to pay a great deal more than
the casual vacationer who is much more price sensitive.
• Airlines separate the aircraft into cabins (economy, business, and
first in the typical three-class system) that are further separated
into classes, each with its own price point and often slightly
different ticket characteristics like flexibility and refundability.
• Purchasing of new air craft, fleet selection, route planning and
identifying the enough market on this route to support the new air
craft is the example of microeconomic decision making
Output Decisions
• Output decisions for an airline often come in the form of capacity
decisions, aircraft size, aircraft type, and schedule selection
• In April of 2008, Emirates Airline started New York service with a
double-deck aircraft, but pulled it two months later and replaced it
with the smaller Boeing 777.
Example 2

• Ryanair announced a capacity cut by grounding 80 aircraft in the

winter schedules between November 2011 and April 2012 due to
the high cost of fuel and continuing weak economic conditions.
Ryanair clearly focused on a strategy that is low in cost structure,
which allowed them to charge low fares.
Choice and opportunity cost
• Choosing to utilize a resource has an implicit cost referred to as
opportunity cost. As mentioned, opportunity cost can be defined as
the true cost of using a resource, which is the benefits that could
accrue if the resources were not being utilized in the current
allocation.
• In other words, the next best use of the resource is the true cost of
using it. This is why it may be efficient for executives to outsource their
travel arrangements to their executive assistant. The opportunity costs
of the assistant’s time are less than the executive’s—the latter could
be better employed in running the company and generating profits.
Macroeconomics
• Macroeconomics studies the decision-making process for the entire
economy. Movements in gross domestic product (GDP), interest
rates, inflation rates, exchange rates, balance of trades, and their
interrelationships are all considered macroeconomics.
• For instance, movements in GDP and economic activity have
implications for travel—the microeconomic decisions made by
individuals are impacted by the overall economy, and the airline or
airport manager has to take into account these circumstances while
making decisions.
• In a slow economic climate for instance, introducing discounted
fares or sales promotions might be more effective strategies at
generating demand than introducing a new luxury class.
• Airport and airline managers have to deal with seasonality as well
—travel is typically slow in the winter months, but picks up during
the holiday season, and prices may have to be altered to account
for the effects.
Macroeconomics Variables

• Similarly, the impact of taxes and passenger fees on airline

tickets is a macroeconomic variable the airlines have to
contend with.
• Manufacturing the air line crafts are also the macroeconomics
variable.
Inflation

• Inflation can be simply defined as the rise in prices of goods and

services in an economy over time.
• The Bureau of Labor Statistics (BLS) and consumer price index (CPI)
• CPI measures the cost of goods and services to a typical consumer,
based on the costs of the same goods and services at a base period.
The CPI is published monthly by BLS.
• The Producer Price Indexes (PPIs). PPIs are a family of indexes
formerly called Wholesale Price Indexes that represent the change
in the selling prices received by manufacturers of goods and services
Unemployment

• a person is considered unemployed if they not have a job, have

actively looked for work in the prior four weeks, and are currently
available for work.
• Persons who were not working and were waiting to be recalled to a
job from which they had been temporarily laid off are also included
as unemployed.
How can we calculate the unemployment
• Assume 2,000 people are unemployed in a small city with a
population of 60,000 people, 48,000 people in the labor force, and
46,000 people are employed. Hence, the unemployment rate is
calculated as follows:
 Types of Unemployment According to
Aviation industry.
• Natural unemployment
The natural rate of unemployment is the inherent rate that will occur
in an economy, separate from unemployment occurring due to
business cycles. The natural rate is determined by the rate at which
jobs are simultaneously created and destroyed, the rate of turnover in
particular jobs, and how quickly unemployed workers are matched
with vacant positions. The Congressional Budget Office forecasts the
natural unemployment rate of the US to be 5.0 percent through to
2017.
Cyclical unemployment
• Cyclical unemployment is another class of unemployment, and
refers to the unemployment that occurs as a result of business
cycles. As businesses go through their cycles, cyclical
unemployment occurs; when the business cycle is at its peak
(maximum economic output), cyclical employment is low. Cyclical
unemployment occurs when consumer expenditure is low and
there is not enough demand for employers to hire everybody
who wants a job
Frictional unemployment

• Frictional unemployment is also referred to as transitional

unemployment. This form of unemployment is always present in
the economy as a result of persons transitioning between jobs
and new workers entering the labor force.
Business cycle
• From an economic point of view, a business cycle is defined
as the movement of economic activities such as
unemployment, inflation, and economic growth and it is
divided into four stages
• Expansion or recovery: Historically, the annual growth in air
travel has been about twice the annual growth in GDP, with
increased growth during periods of economic expansions.
Peak: The peak occurs at the highest point between economic
expansion and the start of economic contraction.
• Contraction or recession: Contractions (recessions) start at the
peak of a business cycle and end at the trough and are marked
by a significant decline in economic activity spread across the
economy, lasting more than a few months, normally visible in
real GDP, real income, employment, industrial production, and
wholesale–retail sales.
• Trough: The trough signals the end of a period of declining
business activity and the transition to expansion. This is the
beginning of economic recovery.
The Role of Economic System
• Broadly speaking, modern political systems can be characterized by
the perceived role of the market and the prevalence of government in
decision-making and resource allocation.
Types of Economic System
• laissez-faire capitalism
• which would be an economy driven purely by the market with very
little government involvement and where the market dictates
resource allocation.
Command economy
where resources are allocated with reference to a central authority or
a government, with no reference to a market.
Mixed economy
The mixed economy is a combination of private enterprise with a larger
government sector (usually involved with income transfer) and the
existence of freedom of ownership, pricing policy, and profit earning.
• Historically, no economies have ever achieved either extreme. The
beginnings of the post-industrial revolution US in the nineteenth
century was close to pure capitalism. although there was still some
government involvement in the economy.
• The Soviet Union’s communist economy for the better part of the
twentieth century was very close to a complete command economy,
although some market forces did exist in the form of black markets.
• Further, even within the aviation industry, there will be more or less
regulation. For instance, the airline deregulation in the 1970s brought
airlines firmly within the sphere of the free market.
• simultaneously, aircraft manufacturing and certification has grown
more highly regulated over time, due to liability concerns. Further
still, different parts of the aviation industry might be regulated
differently.
• In Europe, for instance, airports are beginning to be privatized, while
the same is not taking place to that extent in the US. Therefore
arguably, airports in the US are subject to greater regulation than in
Europe, while the opposite is true for operational restrictions due to
environmental and noise concerns.
Free Market of Aviation
• Increasingly, however, the push has been toward less government
involvement in aviation. For instance, the various open skies
agreements between the European Union(EU) and US allow any
airline in the US to fly from any point in the US to any point in Europe.
This EU–US Open Skies Agreement was first signed on April 2007 and
became effective in March 2008.
• A second phase of the agreement aimed at reducing further barriers
in the transatlantic aviation market was signed in June 2010. This
reduces the involvement of governments in the decisions of individual
carriers to offer transcontinental service, and allows for increasing
competition between airlines in different countries.
Economics Incentives
• An economic incentive is best described as a force or circumstance
that encourages an individual to engage in a particular activity.
• Similarly, the emergence of LCCs and a competitive threat incentivized
the legacy carriers like American Airlines to become more competitive
and adopt practices like revenue management, which drove ticket
prices lower.
• Raising the tax on jet fuel would necessitate higher ticket prices for
the consumer as a result of cost pass through, and give consumers a
disincentive for air travel.
Incentive and Air Line Industry
• Incentives are a powerful tool for analyzing public policy. Phrasing
things in the language of incentives has the effect of throwing light
upon the consequences of policy and regulations:
• While airline deregulation may have caused airlines’ operational
structures to become unpredictable, their revenue to fall, and their
costs to rise, it in turn incentivized competition, highly efficient
operational practices like revenue management and route profitability
analysis. As a result, airline consumers reaped the benefits of such
operations in terms of new routes, new airline options, and vastly
lower ticket prices.
Government and The Aviation
• Aviation has always been deeply intertwined with government.
• Governments subsidized the fledgling industry, encouraging
innovation through lucrative mail contracts, and later through military
contracts.
• Europe, this took the form of direct government subsidies to aviation.
• France and Germany laid the foundations for their aviation industry
with flag carriers Air France and the Deutsche Luft Reederei, which
would later become Lufthansa
• Aircraft and engine manufacturing, on the other hand, had been
receiving government subsidies through direct contracts with the
military since the First World War, with many of the developments in
aircraft design conducted by Boeing, Lockheed Martin, McDonnell
Douglas, Fokker, De Havilland, and Northrop
• first, they put commercial aviation squarely into the hands of the
private sector, but offered it massive government support and
reserved the power of regulatory oversight in the determination and
disposition of those contracts.
• Secondly, it spurred manufacturer/airlines to focus on building and
operating airplanes that could deliver the most weight with the
highest speed, leading to innovations in airplane design that poised
aircraft to take over high-speed passenger transportationin the future.
• 1930 Watres Act, championed by Congressman Walter Brown
• The Federal Airways Act of 1946 implemented key elements of
infrastructure such as navigational aids like the Instrument Landing
System (ILS).
• Arguably, it was airline deregulation that introduced the practice of
revenue management, which was a byproduct of competition
engendered by the emergence of LCCs. Revenue management, as
discussed earlier, minimizes consumer surplus by charging