Effect of Price Elasticity of Demand on Indian Airline Industries

Asokendu Samanta
SMSID 104118, PGCBM 15, XLRI, Center: Powai, Mumbai, Email: asokendu@hotmail.com March 23, 2009

Abstract Effects of excessive fuel price rise in 2008 (Fig. 1) and falling rupees (in terms of US$) (Fig. 2), created a major imbalance between supply and demand in Indian airline industries in recent years. Due to these external factors, Indian airline industries, an oligopoly market, had to increase airfares in many folds and some low cost carriers (LCC) took a short run decision to shut down the operation in a few short distance routes to avoid huge losses. Substitution effect (increase in number of the railways passengers) was observed, maintaining the law of demand of Economics. Recently, when fuel prices are reduced (by nearly 57% from August 2008 price), competition in the market returns and being price taker in the competitive market, airline industries have started slashing their airfares. These fascinating economic phenomena are delineated and explained with sufficient data wherever needed in the present report. Key Words: Breakeven point, Indian airline industries, Oligopoly market, Price elasticity of demand.

1. Overview
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]

Effect of Price Elasticity of Demand on Indian Airline Industries

This has resulted in big declines in load factors (Fig. 3). The situation becomes worse as the rupee hit a record low of Rs. 51.92 per dollar on 3 March 2009 (Fig. 2). Domestic airlines are likely to revise their breakeven targets. It is estimated that 30% of an airlines operational expenses, excluding the cost of jet fuel are denominated in dollars. Airlines, such as Air India, Jet Airways, Kingfisher airlines, SpiceJet make substantial payments in dollars towards the rentals of leased aircraft, maintenance, spare parts, foreign crew and pilots. This will push up airlines operation costs by 10% forcing carriers to revise their breakeven targets. Most Indian carriers are aiming to reach their breakeven targets in the next fiscal [Ref. 1].

Fig. 2 Falling Rupees created a great concern to airline industries [Source: Economic Times, 3 March 2009, Page 18]

Fig. 3 Indian domestic passenger numbers and passenger numbers growth: Jan-07 to Sep-08 [Source: Centre for Asia Pacific Aviation & Ministry of Civil Aviation]

2. Fall in Demand and Rises of Substitute Service

When airlines started increasing airfares in 2008, the demand of its service fell. In Economics, when rise in the price of one service increases the demand for another service, the two services

Effect of Price Elasticity of Demand on Indian Airline Industries

are called substitutes. Substitutes are often pairs of goods/services that are used in place of each other. In this case, the substitution phenomena between airline and train were quite predominant when passengers stared traveling more by train [Fig. 4].

Fig. 4 Shifting of load factor from airline to railways [Source: The Economic Times, Mumbai, 6 January 2009, Page 7]

Comparison of the number passengers traveled by air and trains (AC classes) in 2007-08 and 2008-09 are shown in Fig. 5. It indicates the drop in number of the airline passengers in 2008-09 compared to 2007-08, while increase in the number of railway passenger at that time. It was observed that when air traffic during April-November, 2008 declined nearly 4%, number of passengers traveling in air-conditioned bogies of trains increased by 18.33%.

400 350 No of Passengers (in lakhs) 300 250 200 150 100 50 0

2007-08 2008-09

First AC

Second AC

Third AC

Air Traffic

Modes of Travels

Fig. 5 Statistics of the passengers traveled by rail/air [Chart prepared by author from the data published in The Economic Times, 6 January 2009]

Effect of Price Elasticity of Demand on Indian Airline Industries

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. Airfare went up to Rs. 4500 from Rs. 1700 earlier in some short-haul rout which is evident from Fig. 6, forcing certain budget carrier to suspend their operations in some short routes. In Economics term, A shutdown refers to a short-run decision not to produce anything during a specific period of time because of current market condition [Ref. 5].

Fig. 6 Airlines decision to stop flying in shorter routes [Source: The Economic Times, Mumbai, 6 January 2009, Page 7]

A decision of shutdown can be taken when the price in the market is less than the average variable cost (AVC). In mathematics term, Shutdown if P < AVC (Fig. 7). Where, P = Price in the market, and AVC = Average Variable Cost
4.0 3.5 3.0 2.5

Price

MC
2.0 1.5 1.0 0.5 0.0 0 1 2 3 4 5 6 7 8 9 10 11 12

ATC AVC

No. of Passengers (in lakh)

Fig. 7 Relation between MC, ATC, AVC and price

In the long run, if a firms average total cost exceeds the price (P < ATC), it has to exit the market as it incurs losses. It is evident from the past history that in 1992-1994 certain airlines (East West, Modi Luft etc.) had to exit from the market.

Effect of Price Elasticity of Demand on Indian Airline Industries

4. Competitive Firms are Price Takers

Indian airline industries can be treated as differentiated oligopoly market. However a large oligopoly is essentially a group of competitive firms. When the price of aviation turbine fuel is reduced eventually by 57% (Rs. 30,457 per kiloliter in January 2009 from Rs. 71,028.26 in August 2008), airlines started slashing the air fares. As the number of sellers in an oligopoly grows larger, oligopolistic market looks more and more like a competitive market. In Economics it is known that in competitive market firms are price takers. When 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 Spicejet 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. Conclusions
Certain interesting economic phenomena in Indian airlines industries are observed recently. Analyzing the above phenomena, the following conclusions can be drawn. i) ii) iii) iv) When price rises, demand falls (load factor declines due to rise of airfare) When price of one service rises, demand of substitute services rises (airline and AC train are substitute services) 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). In competitive market, firms are price taker (one airline slashed fare, others slashed too).

Abbreviation AC AVC ATC ATF LCC MC Air Condition Average Variable Cost Average Total Cost Aviation Turbine Fuel Low Cost Carrier Marginal Cost

Effect of Price Elasticity of Demand on Indian Airline Industries

References [1] [2] [3] [4] [5] [6] The Economic Times, Mumbai, pg. 7, 14 January 2009. The Economic Times, Mumbai, pg. 18, 3 March 2009. The Economic Times, Mumbai, pg. 7, 6 January 2009. The Economic Times, Mumbai, pg. 18, 7 January 2009. Economics Principles and Applications, Mankiw, 2009. Class Note of Economics of Prof. Vishwa Ballabh, PGCBM15 Course, XLRI Jamshedpur.