Model essay (b): how useful is elasticity to an airline?

What this lesson teaches

• I can use price, income and cross elasticities to judge how large those changes will be.

  Syllabus 9570, 2.1.2(g). Demand and Supply Analysis and its Applications: These outcomes can be affected by price elasticities of demand and supply, income and cross elasticities of demand

Make a guess

A budget airline finds that demand from leisure travellers is price elastic. Should it cut fares on every route?

1. Not necessarily: profit depends on costs, rivals and capacity too.
2. Yes. With elastic demand, a fare cut raises revenue, so profit rises too.
3. No. With elastic demand, a fare cut lowers the airline's revenue.

The answer to part (b)

Introduction

Price elasticity of demand (PED) measures how much the quantity demanded responds to a change in price. Income elasticity of demand (YED) measures how much demand responds to a change in income. A budget airline can use PED to set fares and YED to plan where and how fast to grow. This essay argues that both are useful guides, PED especially for setting fares. But their usefulness depends on how accurate the estimates are and how stable conditions stay.

Paragraph 2: PED helps set fares

Different passengers have different PEDs. Leisure travellers can choose another date, another airline or no trip at all, so their demand is price elastic. In Figure 2, cutting the fare from P0 to P1 for them raises passengers from Q0 to Q1. The revenue gained from extra passengers is larger than the revenue lost on those who would have paid P0, so total revenue rises. This is why budget airlines run fare sales. Business travellers who book late must travel and their firms often pay, so their demand is price inelastic. Charging them more raises revenue. Knowing PED lets the airline charge each group the fare that earns the most.

Paragraph 3: YED helps plan growth

Air travel is income elastic: when incomes rise, spending on flights rises by a larger proportion. As incomes grow across Southeast Asia, India and China, many more people can afford to fly for holidays. A high YED tells the airline that demand on routes to these fast-growing markets will grow quickly. So it is worth buying more planes and opening new routes there. YED also warns of the risk. In a recession demand falls sharply, so the airline should keep enough cash and flexible leases to cut capacity quickly.

Paragraph 4: estimates are uncertain and change

However, elasticity is hard to measure. The airline must estimate PED from past sales. But many things change at once, such as rivals' fares, fuel surcharges and holidays, so the estimate may be wrong. PED also changes over time. A new rival on a route gives passengers a close substitute, making demand more elastic. A fare cut may then start a fare war: if rivals match the cut, the airline gains few extra passengers. Elasticity assumes other things stay the same, which rarely holds in a competitive market.

Paragraph 5: revenue is not the whole decision

PED tells the airline about revenue, not profit. Carrying more passengers may need extra flights, crew and fuel, so higher revenue can still mean lower profit. Capacity limits matter too: a plane has a fixed number of seats, so a fare cut cannot add passengers once flights are full. Growth plans depend on more than YED, including landing slots, aircraft delivery times, fuel prices and government rules. YED based on the past may also miss new shocks, as the COVID-19 travel collapse showed.

Paragraph 6: evaluation

How useful the concepts are depends first on the decision. For fares, which change daily, the airline has large amounts of booking data, so its PED estimates are good and can be updated quickly. This is how pricing systems set fares by date and demand. For long-term growth, YED is a useful guide to where demand is heading, but over many years incomes, rivals and shocks are hard to predict. It depends second on market conditions. Where rivals react quickly, PED must be combined with knowledge of their likely response.

Conclusion

Price and income elasticity of demand are useful to a budget airline. PED is very useful for setting fares, because the airline can estimate it well and act on it quickly. YED is a useful but rougher guide to growth plans. Neither is enough on its own: the airline must also weigh costs, capacity and rivals' reactions.

Margin notes: how each paragraph scores

Introduction

Defines both concepts, links each to a decision, and states a stand with two criteria.

Paragraph 2

Uses PED for two groups and shows the revenue effect on Figure 2 with its areas. Price discrimination by booking time is real airline practice, which gives context.

Paragraph 3

Applies YED to a real growth decision (new routes, more planes) and to the recession risk. Using the sign and size of YED is L3 precision.

Paragraph 4

A limit tied to the airline market: estimation problems, changing PED and rivals' reactions. It explains why each limit matters.

Paragraph 5

A second limit: revenue against profit, and capacity. This shows the student knows what elasticity can and cannot tell a firm.

Paragraph 6

E3: two well-explained judgements (the type of decision, market conditions), each weighing usefulness against the limits.

Conclusion

Answers 'whether ... useful' with a clear degree: very useful for fares, rougher for growth.

Overall: L3 and E3, 13 to 15 marks

Both concepts applied with a diagram and real context, and both limits explained. An answer covering PED only would be capped at L2.

Worked example: A 4-minute plan

Fix the stand and criteria, then give each concept its use and its limits.

1. Stand: useful as a guide, more for fares than for long-term growth. Criteria: quality of the estimate, stability of conditions.
2. PED: leisure elastic, business inelastic; fare sales, charging by booking time (Figure 2).
3. YED: air travel income elastic; expand routes to fast-growing markets; plan for recessions.
4. Limits: estimates uncertain and change; rivals react; costs and capacity; revenue is not profit.
5. Judge: very useful for short-run fares with good data; less reliable for long-run plans.

Watch out for this

If demand is price elastic, cutting fares always raises the airline's profit.

Elastic demand means total revenue rises. Profit also depends on costs: extra passengers may need extra flights, fuel and crew, and rivals may match the cut.

Check your understanding

Why do airlines charge business travellers who book late more than leisure travellers who book early?

1. Late business demand is price inelastic, so a higher fare raises the airline's revenue from them.
2. Late bookings cost the airline much more to supply than early ones.
3. Business travellers have lower incomes, so their demand is more price elastic than others'.