Sunday, September 13, 2009

Test your understanding of economics in the news: Is this a change in supply or a change in demand?

In the September 12, 2009 article "Airlines offer lightest fall schedules since 2001," Associated Press airlines writer David Koenig reports that the airline industry is reducing the number of flights because of "falling demand for air travel."

Can you illustrate these changes in the market for air travel using supply and demand analysis?

Do these changes include (a) an increase in the supply of air travel, (b) a decrease in the supply of air travel, (c) an increase in the demand for air travel, or (d) a decrease in the demand for air travel? What is happening to the equilibrium price of air travel as a result of these changes in the airline industry?

Read the article below and then illustrate these changes in the market for air travel with a graph that shows the initial positions of the supply and demand for air travel and the new positions of the supply and demand curves. (Hint: Do both curves shift?) There is a link at the bottom that provides the answer.
DALLAS – The U.S. airline industry is shrinking to a size not seen since the months after the 2001 terror attacks.

The airlines have been trimming flights for the past two years, matching the falling demand for air travel. Additional capacity cuts are under way at American, the nation's second-largest carrier, and at No. 3 United.

It could get worse.

Most big airlines depend heavily on a relatively small chunk of passengers who pay the highest fares, "and that's generally business travelers," says Robert Mann, an aviation consultant in Port Washington, N.Y. "If business travel doesn't rebound, we're going to see further (capacity) cuts."

Less capacity means consumers will be left with fewer flights to choose from and planes will be crowded. Fewer seats normally means higher fares but that might not happen this time unless the economy begins a true recovery and passenger traffic picks up.

Airlines measure capacity in "seat miles," the number of miles flown multiplied by the number of seats on the planes. Capacity is crucial in the airline industry in the same way that inventories matter to car dealers and retailers. Too much capacity, and airlines have to cut prices, just as a department store stuck with too many suits and dresses will hold a fire sale. Airlines cut capacity by reducing the number of flights or using smaller planes that carry fewer passengers.

The Air Transport Association, the trade group for big U.S. airlines, estimates that carriers will offer fewer than 12.5 billion seat miles in the U.S. in the fourth quarter. That's not much more than the low of 12.1 billion late in 2001, when airlines were reeling from the Sept. 11 terror attacks, and it's down 13 percent from the fourth quarter of 2000.

After such a steep decline in demand, airline executives and analysts are looking eagerly for any signs of improvement. About the best they can say is that things aren't getting much worse. Airline executives say business traffic is a bit better than it was in the spring but still far behind last year's pace.

David Swierenga, former chief economist for the Air Transport Association and now an airline consultant in Texas, said the decline in demands slows with each passing month.

"The economy has bottomed and is beginning to turn around. Carriers will sit tight and go with the (capacity) cuts they've already made," he says.

Hunter Keay, an analyst for Stifel Nicolaus & Co., also doesn't expect dramatic cuts beyond those already announced. If airlines cut more capacity, he says, it will be on international routes favored by business travelers.

Eventually the economy will recover and airlines will consider adding back service. In past recoveries, airlines added capacity quickly as they scrambled for market share. That created a glut of seats, leading to fare wars and more financial problems.

Aviation consultant Mann said that's because airlines are hooked on growth, which helps them spread out fixed costs.

"They always want to be in a growth mode," he says. "The problem is, you can be in a profitless growth mode too."

Darryl Jenkins, an airline consultant in Virginia, says this recovery will be different because the big carriers have been chastened by overly aggressive growth, high fuel prices and the recession. They've cut costs and don't want to undo those efforts by rushing to add back capacity.

This summer the airlines were busy, but weak fall bookings led them to offer deeply discounted fares to fill seats normally taken by business travelers. Southwest ran a sale with some seats as cheap as $30 each way on some routes.

Rick Seaney, the CEO of, thinks the best of the fall sales are over. With airlines cutting capacity, and having sold many fall seats during the recent promotions, planes will be crowded.

"I can't imagine we'll see anything but firm pricing," Seaney said. "There are still some $99 coast-to-coast deals occasionally, but it's much more random."

During the recession, low-fare airlines such as JetBlue, AirTran and Southwest have done better than their bigger rivals. The discounters set the prices on many routes, and the network carriers generally match them.

Even Southwest, however, is shrinking about 6 percent this year, and has announced a slightly scaled-back schedule for early 2010.

Bill Owen, Southwest's chief scheduler, says the airline has been trimming unprofitable routes, but "If it's full of full-fare business travelers, we're not about to cut that flight."

JetBlue is bucking the industrywide contraction and will add capacity in the second half of the year. The New York-based airline caters to U.S. leisure travelers and has avoided the meltdown in international business travel. It picks targets for growth carefully — it's expanding in the Caribbean while shrinking on cross-country U.S. routes.

In setting capacity, JetBlue of course studies its own traffic but also keeps an eye on what competitors are doing. Robin Hayes, JetBlue's chief commercial officer, insists that the airline doesn't try to forecast the economy.

"These are plans we put in place back in the spring," he says of the expansion now taking place. "We take a long-term view, and we don't try to guess when the recession will end."


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