Externalities and Elasticity in the Airline Industry

The airline industry and the surrounding forces that control its success in the economy, make up this segment of the industries economic profile. Key issues surrounding shifts in price elasticity of supply and demand, and externalities, help to determine how the economy affects the success of this industry. In addition, a thorough evaluation of these issues can help determine how economic influences affect the industry in a negative way.

Elasticity

In the airline industry, price elasticity of demand is separated into two segments of consumers and is considered to be both elastic and inelastic. A good example of how elastic demand is related to the airline industry is in relation to travel for pleasure. Pleasure travelers will be affected by the amount of travel they do based on the demand increase or decrease, affected by prices that lower with high demand or prices that rise with low demand; directly attributed to competition in this market (Gerardi & Shapiro, 2007). Inversely, the business traveler would apply to an inelastic demand for this market. This has shown by demand increases or decreases, as well as the price distribution attributed, which has little effect on the buying power of the business person (Gerardi & Shapiro, 2007). Furthermore, Voorhees and Coppett (1981) explain that elastic demands exist for the pleasure traveler due to demand increase rising while prices lower and vise versa. The business traveler experiences an inelastic demand due to the quantity of service demanded and quantity has not decreased as prices have risen. In other words, this travel is seen as a necessary business tool, not affected by price changes in the demand curve.

There are substitutes available to the airline industry. These substitutes include commuting to destinations by passenger trains, passenger bus lines, cars, private charter flights, and taking advantage of the advancements in telecommunication. An external competitive force, telecommunications, has become a substitute to the airline industry in its ability to bring video conferencing, webinars, and other services (Voorhees & Coppett, 1981). This questions the need for substantial business travel when air fares are high.

The airline industry can be viewed both as a luxury or necessity. The need for quick travel to different locations for business people, law enforcement, medical personnel, and diplomats is very important for each of these professions and would be considered a necessity. However, the pleasure traveler takes advantage of the opportunity given by air carriers to speed travel to desired destinations. This luxury advantage allows the traveler to move great distances quickly without the need to drive personal or rented vehicles and offers an advantage to traveling by bus or train.

The price elasticity of supply for the airline industry has proven to be elastic. As defined by Mankiw (2004), the elasticity is measured by how much the quantity supplied of a good responds to a change in price of that good. The supply of seats (fares) in the airline industry responds substantially to changes in the price of the fares, deeming this industry as elastic. Additionally, elastic supply can be seen in price wars initiated by competitors in the industry. As the supply of seats is great or small, drastic changes in price accompany the movement in supply.

Externalities

There continues to be externalities that exist between the buyer and seller transactions that impact third parties in the airline industry. Externalities exist when the seller sells seats at a fare to the buyer and the buyer uses the seat to travel to a destination. During this process, planes take off and land at an airport, creating noise, which affects homeowners in the surrounding areas. The noise created by the take off and landing of these planes impacts the homeowners in the surrounding the area which had nothing to do with the transaction. The noise disturbances caused by the airlines have stirred reactions from communities surrounding airports.

This noise pollution issue has proven to be a negative externality for the airline industry. Homeowners continue to complain to agencies and representatives to place regulations and policies on the airline industry to force the airlines to minimize noise levels. These complaints can affect market performance or the institution of taxes or restrictions on the airline industry.

This negative externality has caused losses in the billions for the airline industry and no analyst has shown if the benefits exceed the cost of such regulations. Morrison and Winston (1998) show that 5 billion dollars in benefits for the regulations fall short of the 10 billion in cost. Policy and regulations should consider a noise tax plan that could optimally cut noise and still benefit the homeowners; but to a much smaller extent. Substantial pressures from externalities have caused a poorly devised regulation that impacts society with little justification of efficiency to justify any level of government intervention (Morrison & Winston).

The airline industry is a private good. Mankiw (2004), states that private goods are excludable and rival goods. One needs to see through the anti-trust laws and regulations that tempt some to call the industry a natural monopoly; airlines still reserve the right to administer price and destination. The airline industry shows that it is an excludable good by having the power to place prices on fares and having the ability to refuse service to any person for whatever the reason. The airline industry also shows that it is a rival good because when someone purchases fare for a seat, it diminishes the ability for another person to get a seat on the plane. Because the airline industry is a private good, in a competitive market place, prices, supply, and demand are very sensitive to new policies or tax incidences placed on them.

This noise externality impacts the economy in many different ways. Government agencies place restrictions on the agencies to quiet the noise down by regulating types of planes that can fly in and out of airfields. This externality causes a loss to the airline industry, raising prices and causing demand to fall. This creates new market equilibrium and like a tax incidence, causes buyers, sellers, and revenues of the airline industry to share the burden.

As we have seen, the airline industry is extremely price elastic. Small shifts in prices have dramatic effects on the consumer base. Externalities, such as noise ordinances, can cause negative effects, driving cost upward and threatening loss in demand due to a price sensitive customer base. Since deregulation, competition in the economy have kept prices in the industry low and have caused airlines to force cuts in areas such as wages; contributing to a growing concern of wage inequality.

Refrences:

Gerardi, K., & Shapiro, A. (2007, April). The Effects of Competition on Price Dispersion in the Airline Industry: A Panel Analysis. Working Paper Series (Federal Reserve Bank of Boston), 7(7), 1-46. Retrieved April 30, 2008, from Business Source Complete database.

Mankiw, N. G. (2004). Principles of economics (3rd ed.). Chicago, IL: Thomson South-Western.

Morrison, S., Watson, T., & Winston, C. (1998). Fundamental Flaws of Social Regulation: The Case of Airplane Noise. Retrieved May 8, 2008, from http://www.brookings.edu/~/media/Files/rc/papers/1998/09_airplane_winston/09_airplane_winston.pdf

Voorhees, R., & Coppett, J. (1981, Summer). New Competition for the Airlines. Transportation Journal, 20(4), 78-85. Retrieved April 30, 2008, from Academic Search Premier database.