The Effect of Price Elasticity of Demand in Airline Industry

The global airline industry is experiencing cold season since the terrorist attack in 2001. Though china’s airline suffered less from the 9-11 effect, price hike of fuel has also plagued the industry. Moreover, in response to the entry of the WTO, Chinese government has phased out regulations upon airline industry and encouraged competition by introducing budget airline. To maintain competitive advantage and considerable profit margin as a domestic leading airline company, China Southern Airlines Co. Ltd. (CSA) needs to design a pricing strategy in accordance with the natures of the distinct markets. The principle of price elasticity of demand will help elaborating how different pricing tactics are applied to different market segments.

What is a Price Elasticity of Demand

The demand for a particular good or service varies depending on a number of factors, including the levels of consumer income, the tastes of consumers, the expectations of future price changes, and the prices of related goods. As a general rule, when other factors on demand remain unchanged, a higher price for a product results in a lower quantity demanded. However, the price sensitivity to demand varies from one good to another and from one market to another. The price elasticity of demand measures the sensitivity of the demand for a good to changes in its price provided that other factors’ influences are omitted. It is defined as the percentage change in quantity demanded caused by a 1-percent change in price. For example, if a 1% increase in price causes a 1.3% decrease in quantity demanded, the price elasticity of demand is 1.3, indicating that the percentage fall in demand is greater than the percentage rise in price. The demand for it is deemed as “elastic”. If, on the other hand, a 1% price rise results in a smaller percentage decrease in the quantity demanded, the price elasticity will be less than one, and demand is deemed as “inelastic”. Furthermore, when demand is price inelastic, total cost (“revenue” on the supplier side) moves in the same direction as price. When demand is elastic, total cost (“revenue” on the supplier side) moves in the opposite direction from price.

Elasticity in the Context of Air Travel Demand

Using a single elasticity for all market segments is inappropriate as elasticity in airline industry is anything but unanimously identical as an aggregated market. In air travel, ideally market segment boundaries should be defined by first separating leisure and business passengers and second long-haul and short-haul flights. The reason is that we expect different behaviour in each of these markets. Given that no statistical figures as to elasticity in China airline market are available, the Canadian research data is employed as follow which works the similar way by nature.

The ranges of values shown capture the middle one-half of the estimates and encompass the median, which is represented by a black dot.

As the figures indicate, elasticity values can and do differ significantly between travel distance, type of traveller and even domestic and international routes. Long-haul international business segment represents the highest price inelasticity, which means that price variation has little effect on passenger turnout. Meanwhile, short-haul business comes second at -0.7, which is also price inelastic. Short-haul leisure segment has the greatest absolute value of price elasticity, which means that passenger turnout is heavily influenced by pricing mechanism. In general, long-haul flight is less elastic than short-haul flight, while business sector is less elastic than leisure sector. The results are not difficult to be explained by empirical evidence. Since more alternatives become available for substituting short-haul flight than long-haul flight, passengers are more likely to switch to substitutes including automobiles, trains and boats if the price of an airline ticket increases. This is more commonly found in leisure passengers, while it is unnecessarily true in applying to business customers who are solely looking for the fastest method of transportation, making the business sector price inelastic. For example, in flying to Beijing from Shanghai to close a multi-million dollar deal and sign the contact, the high air fare is low when factored into the overall value of the trip.

According to the general principle, for price inelastic market segments, the carrier can maintain airfare at a high and constant level where profit margin is maximized despite slightly fall of passenger turnout. On the other hand, however, for price elastic market segments the carrier should consider lowering the price in order to boost