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 J anuary 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, J et Airways,
Kingfisher airlines, SpiceJ et 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: J an-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%.


0
50
100
150
200
250
300
350
400
N
o

o
f

P
a
s
s
e
n
g
e
r
s

(
i
n

l
a
k
h
s
)
First AC Second AC Third AC Air Traffic
Modes of Travels
2007-08
2008-09


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

0 1 2 3 4 5 6 7 8 9 10 11 12
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
AVC
ATC
MC
P
r
i
c
e
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 J anuary 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. J et 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 J anuary 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) When price rises, demand falls (load factor declines due to rise of airfare)
ii) When price of one service rises, demand of substitute services rises (airline and AC train
are substitute services)
iii) 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).
iv) In competitive market, firms are price taker (one airline slashed fare, others slashed too).

Abbreviation

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

Effect of Price Elasticity of Demand on Indian Airline Industries


References

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