ECO11 Principles of Economics Assignment: Market Analysis and Taxation

This assignment analyzes the principles of economics in the context of the air travel market. It begins by examining the impact of rising crude oil prices on jet fuel costs and, consequently, on airline ticket prices, illustrating this with supply and demand diagrams. The analysis then delves into the pric...Read More

Running head: PRINCIPLES OF ECONOMICS
Principles of Economics
Name of the Student
Name of the University
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1PRINCIPLES OF ECONOMICS
Table of Contents
Answer to question 1..................................................................................................................2
Answer to question 2..................................................................................................................4
Answer to question 3..................................................................................................................5
References..................................................................................................................................7

2PRINCIPLES OF ECONOMICS
Answer to question 1
In the given article, it is stated that in 2018 crude oil price has increased nearly by 57
%. Crude oil price is currently marked at $75 per barrel. The price of jet fuel is likely to
increase more and it possibly will reach $84 per barrel very soon due to this rise in crude oil
price. The fuel expense shares the 25 per cent of the total operating expenses of the airlines
(Doganis 2013). Therefore, it is obvious that rise in jet fuel price will increase the operating
expenses of the airlines and as a result, the price of air tickets will rise and the burden of price
of oil will be passed on to customers.
Figure 1: Rise in
fare price
Source: (Created by the Author)
The above figure depicts that owing to rise in price of the jet fuel, the airline would
decrease their number of flights to decrease their expenses of operation. Thereby it increases
the price of the air tickets from P to P1 and the number of flights run by the airlines decreases
from Q to Q1 (Pindyck and Rubinfeld 2014). However, if the demand remains the same so

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that the airlines need to run Q number of flights, then the price charged by the airline would
be P2, which is higher than both P and P1. The difference between the price P and P2 is the
actually the amount by which the operating expenses of the company increases per unit of
ticket. Thus, it is obvious that the price of airline tickets increases in future.
The increase in jet fuel has an inducing effect on the price of the air tickets and is
evident from the part one of the question. The increase in price of the tickets will negatively
affect the air travel market and as a result the tickets demand will fall and the demand curve
will fall (Knittel and Pindyck 2016). Similarly, perceiving the declining demand of the air
tickets the airlines will reduce their purchase of fuel to decrease their operating expenses and
thereby the air travel market will shrink further.
Figure 2: Decline
in air travel market
Source: (Created by the Author)
As per figure 2, the price has risen from P to P1 owing to decrease in supply from Q t
o Q1 and the supply curve shifted from S to S1 (Romer 2015). Moreover, due to increase in
price, the tickets demand will decline and the demand curve shifts from D to D1. Owing to

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this fall in demand of air tickets the airlines further decreases their number of flights to keep
the prices high to mitigate the effect of rise in price of jet fuel (Basu and Bundick 2017).
Thus, supply curve further shifts left to S2 and number of flights reduces to Q3. Hence, the
revenue of the air travel market is P1Q2, which is lower than the previous market revenue
given by PQ.
Answer to question 2
The price elasticity of demand determines the amount of quantity demanded owing to
unit alteration in the product price (Coglianese et al. 1997). The airline travel market is a part
of transport market, thus other options of travel are available to the passengers. Thus,
passengers can opt for trains and buses to travel instead of airplane if the price of the air
tickets increases hugely. However, in many cases it is not possible for the passengers to opt
substitute mode of travel such as train because it is necessary to travel by airplane in many
instances. Therefore, the train, buses are not the perfect substitutes of the airplane (Silva,
Verhoef and van den Berg 2014). Hence, airline travel market is moderately price elastic and
thus the unit increase in the air tickets price decreases the demand of air tickets less than unit,
which means, if price increases by 10 units then the demand for air tickets decreases but less
than 10 units.
According to the discussion in the part one of the question 2, the fall in unit price of
the air tickets decreases the sales in number of air tickets by less than unity. Assuming, if the
price was $10 for a ticket of airplane and the number of ticket sold at that price is 100, and
then the total revenue of the airline travel market is $1000 (Ramondo 2014). Now, if the price
of air tickets increases by 10 per cent and increases to $11 but the fall in demand for air
tickets is 5 per cent, then number of sold tickets are 95. Therefore, the revenue would be
$1045, which is higher than the previous revenue. The effect of this can be explained with the
help of the figure 3 given below. The increase in crude oil prices increase the jet fuel price,

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due to this the air tickets price increases for P to P1 as the airline runs less number of planes
to reduce the operating expenses. This shifts the supply curve to S1 from S. The price rise
from P to and number of flights decreases from Q to Q1. However, P1Q1 rectangle is larger
than the rectangle PQ, depicts that total revenue increases.
Figure 3:
Revenue of the airline market
Source: (Created by the Author)
Answer to question 3
The Australian government imposes tax on the air tickets. This would rise the air
tickets price and as a result, the air tickets demand will fall. Due to the decline in demand for
the air tickets, the airlines will reduce the number of flights to keep the prices up and to
maximize the profit per unit of ticket sold. Therefore, fall in number of tickets sold at the
same prices, the revenue and overall profit of the airline companies will fall. Hence, producer
surplus will reduce (Zhang et al. 2016). On the other hand, due to rise in the air tickets price
due to the tax the consumer surplus will also decrease. Thus, there will be social welfare loss

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due to tax imposition on air tickets. The mechanism of tax imposition on the air tickets and
the effect of in the surplus of the consumer and producer are discussed in the diagram given
below.
Figure 4: Tax
imposition and surplus loss
Source: (Created by the Author)
In figure 4, P* and Y1 are the free market ticket fare and number of flights
respectively, whereas P2 and Y2 are the ticket fare and number of flights after the imposition
of tax on ticket fare. The yellow rectangle depicts the loss in consumer surplus due to
imposition of tax (Lam and Liu 2017). It happens because the airlines reduced the number of
flights perceiving that if not reduced in advance the rise in price due to imposition of tax will
lead to fall in demand and force the airlines to decrease number of flights. Therefore, after

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imposition of tax producer also loses surplus that is shown as orange coloured rectangle. The
blue triangle in the above figure depicts the deadweight loss due to imposition of tax.
Therefore, it shows that tax imposition creates inefficiency in the market.

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References
Basu, S. and Bundick, B., 2017. Uncertainty shocks in a model of effective
demand. Econometrica, 85(3), pp.937-958.
Coglianese, J., Davis, L.W., Kilian, L. and Stock, J.H., 2017. Anticipation, tax avoidance,
and the price elasticity of gasoline demand. Journal of Applied Econometrics, 32(1), pp.1-15.
Doganis, R., 2013. Flying off course: The economics of international airlines. Routledge.
Knittel, C.R. and Pindyck, R.S., 2016. The simple economics of commodity price
speculation. American Economic Journal: Macroeconomics, 8(2), pp.85-110.
Lam, C.T. and Liu, M., 2017. Demand and consumer surplus in the on-demand economy: the
case of ride sharing. Social Science Electronic Publishing, 17(8), pp.376-388.
Pindyck, R. and Rubinfeld, D., 2014. Microeconomics GE. Pearson Australia Pty Limited.
Ramondo, N., 2014. A quantitative approach to multinational production. Journal of
International Economics, 93(1), pp.108-122.
Romer, P.M., 2015. Mathiness in the theory of economic growth. American Economic
Review, 105(5), pp.89-93.
Silva, H.E., Verhoef, E.T. and van den Berg, V.A., 2014. Airlines’ strategic interactions and
airport pricing in a dynamic bottleneck model of congestion. Journal of Urban
Economics, 80, pp.13-27.
Zhang, Y., Zhao, Q., Zhang, Y., Friedman, D., Zhang, M., Liu, Y. and Ma, S., 2016, April.
Economic recommendation with surplus maximization. In Proceedings of the 25th
International Conference on World Wide Web (pp. 73-83). International World Wide Web
Conferences Steering Committee.