Section C: Essay Question (1 double-period)1. The terrorist attack on New York on 11 September 2001 caused a

worldwide recession and an increased fear of flying, both of which severely affected the demand for travel by air. This led to the closure of some of the major airlines in the world.

a) With the aid of diagrams, explain how the recession and the closure of some of the major airlines of the world affected the market for air travel. (For H1 and H2)

b) Assess the relevance of price elasticity of demand, income elasticity of demand, cross elasticity of demand and price elasticity of supply in explaining the effects of these events on the airline industry. (For H2 only)

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(a)Approach:The answer requires an explanation of how the recession led to a fall in the world demand for air travel and how the closure of airlines led to the fall in overall world supply. The effects of the shifts in demand and supply on equilibrium price and output then need to be illustrated with diagrams.

Introduction- Applying DD and SS analysis, price and quantity sold determined by market DD and

SS.- Demand for air travel is a derived demand and is affected by the demand for

travel for leisure (holidays) and business purposes. - Impact of recession, terrorism and closure of some of the major airlines of the world

on the market for airlines will be analyzed by how these factors affect the market demand and supply of air travel.

Body Assume that price was initially at equilibrium level.

Recession Falling income → decrease ability to pay → fall in demand for tourism → fall in demand for air travel, assuming air travel is a normal goods.

Terrorism increased fear of flying → fall in preference → decrease willingness to pay → fall in demand

Impact on market of fall in demand in short-run

Fig 1Explain how fall in market demand → shortage → downward pressure on prices → fall in equilibrium price and quantity.

Qe Qe1

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Quantity / period

S

D

Pe

D1 Pe1

e

e1

While many airlines would be making subnormal profits, most airlines would still continue producing, if variable costs can be covered. There should not be any shift in the supply curve as yet.

Impact on market of fall in demand in long-run- The fall in price will cause some airlines to incur losses. In the short-run, they will

continue production if total variable costs <TR < total costs.- However, if losses continue into the long-run, some airlines will exit the industry.- When this happens, supply falls (market supply shifts to left)- As such, equilibrium quantity falls further (new equilibrium point is e2) but effect on

equilibrium price depends on whether SS falls by more or less than DD.- If SS falls by less than fall in DD, final equilibrium price Pe2 will be lower that the original

equilibrium price of Pe.

Fig 2

(b)Approach:For each elasticity concept – very briefly define and explain the meaning of signs and coefficient magnitudes before applying it Introduction:- Elasticity of demand is a measure of the degree of responsiveness of quantity

demanded to a change in one of its determinants (e.g price or income) whilst holding other factors constant.

- Price elasticity of supply is a measure of the degree of responsiveness of quantity supplied to a change in price, ceteris paribus.

- To assess whether these concepts are relevant in explaining the effects of the events on airline market, we need to consider whether they are relevant in explaining how the events impact on the direction of change and extent of change in demand and supply and whether they are relevant in explaining the extent of the change in price when either demand or supply changes.

Body: Income elasticity of demand (Ey)

- Define Ey.- Ey determines 1) the direction of change in demand 2) the extent of the fall in demand

when income falls during a recession.- If air travel is a normal good with Ey >0, then demand will fall when income falls. This, as

seen in part (a), causes price to fall.- However, does price fall sharply or not? This is partly determined by the Ey, whether it is

<1 or > 1.- For business travelers, demand for air travel is derived from the aggregate demand for

final goods which in turn is tied to the income level of the economy. I would expect their demand to be very responsive to falling income, i.e. Ey>1.

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Quantity / period

S

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D1 Pe1 Pe2

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- For households who use air travel mainly for overseas holidays, air travel is probably a luxury (Ey>1).

- This means I would expect market DD to fall more than proportionately to a fall in income and this in turn would contribute to a large fall in price. Output and revenue of the airline industry will likewise fall.

Price elasticity of supply (Es)- It determines the extent of the fall in price when DD falls.- Es varies with production time periods- In the short-run, when airlines are not able to vary at least 1 factor, airlines are not able

to vary at least they are less able to react to a fall in price, the fall in price due to a fall in demand will be quite sharp. Es for airlines is likely to be low in the short-run as many of the flights have been scheduled months in advance. Hence the planes will still have to fly even if demand drops.

- In the long run (LR) when airlines are able to exit the industry, market supply becomes even more elastic and the fall in price from the fall in DD will be even lesser.

- Output and revenue in the industry will fall due to the fall in DD.

Fig 3

Price elasticity of demand (Ep)- Ep determines the extent of the fall in price when there is a surplus. DD fell. Refer to fig

3. If DD is price inelastic, a similar extent of fall in DD would have led to a sharper fall in price.

- Output and revenue falls.

Cross price elasticity of demand (Eab)- Define Eab.- Fall in price of a substitute will cause fall in demand for air travel (Eab is

+ve.)- Fall in price of a complement will cause a rise in demand for air travel (Eab

is –ve)- This concept appears to be not relevant because the factors which have

changed (mentioned in the quote) do not include changes in the price of a related good like a substitute or a complement of air travel.

- The lack of substitutes for long haul flights also reduces the relevance of cross price elasticity.

- However, in the aftermath of 9/11, the likely result is that hotels would cut room rates to attract more customers. Some people will decide that they should now travel because of the fall in hotel room rates.

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Quantity / period

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D

Pe

D1

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SLR

- Eab determines the extent of the demand curve shift for airline seats when there is cut in hotel room rates, given that air travel and hotel accommodations were in joint demand.

- This means the extent of the fall in demand for air travel (due to falling income) is therefore less severe.

Limitation Application of the Eab concept here might be limited as the assumptions of ceteris paribus do

not hold. When hotels are cutting room rates, incomes are also falling. Other limitations The falling demand was also largely affected by the fear of flying due to possible terrorist

attacks on airplanes following the 911 incident. Such ‘changes in tastes’ cannot be quantified. Hence elasticity concepts may not be able to capture all factors affecting the market.

The market for air travel is in reality not perfectly competitive. Analysing using a perfectly competitive industry model may at best be only useful in explaining the direction of change. To have an accurate estimation of magnitude, the elasticities for individual airlines and flight routes would be required. However, gathering sufficient data to accomplish such an exercise would likely be unfeasible.

ConclusionThe elasticity concepts should be applied with reservation. Nonetheless, income elasticity is likely to be the most relevant in view of the significance of the worldwide recession on the demand for air travel.

Teaching point: Answering skill - Length of analysis of each elasticity concept should be proportionate to the degree of significance of the elasticity concept to the question.

(a)L1 1-3 Able to identify effects on DD side of market and effect on price / qty sold but

no explanation of links.OrBrief explanation of price determination via DD&SS with no ref. to context of Q.

L2 4-6 Able to explain effects of the 2 factors on the DD-side of the market and able to explain impact on price and qty sold with aid of mkt diagram but some gaps in explanation.

L3 7-10 More analytical. No gaps in explanation Considers both SR and LR (exit of firms) with 1 diagram for each case.

(b)L1 1-4 Merely able to define Ep, Ey, Eab and Es and identify the values. (Knowledge

only)L2 5-7 Shows understanding of Ep, Ey, Eab, Es and their values and provides

generic application to market analysis (like in lecture notes) that is relevant to this particular essay Q with no ref. to context of Q.

L3 8-9 Able to apply at least 3 elasticity concepts in analyzing the effect on the airline market based on the context of the Q.

10-11 Able to apply all 4 elasticity concepts to the contextE1 +

1 to 2)Provides only generic limitations (regurgitate lecture notes)

E2 + Provides limitations with ref. to context of Q + judgment of relative

(3 to 4)

relevance (which is the least relevant concept) + overall judgment in conclusion.