On April 17th, Glenn Hubbard and Tony O’Brien continued their podcast series by spending just under 30 minutes discuss varied topics such as the Federal Reserve’s monetary response, record unemployment numbers, panic buying of toilet paper as compared to bank runs, as well as recent books they’ve been reading with increased downtime from the pandemic.
Supports: Chapter 12 in Economics and Microeconomics – Firms in Perfectly Competitive Markets; Essentials Chapter 9.
SOLVED PROBLEM: HOW WILL THE CORONAVIRUS PANDEMIC AFFECT THE AIRLINE INDUSTRY?
During the coronavirus pandemic, many airlines experienced a sharp decline in ticket sales. Some airlines responded by cutting ticket prices to very low levels. For example, in early March, Frontier Airlines was offering round-trip tickets from New York City to Miami for $51 (compared to over $200 three months earlier). As one columnist in the Wall Street Journal put it, the price of many airline tickets was “cheaper than dinner or what you’ll spend on Ubers or taxis.”
- Briefly explain whether it was likely that the price Frontier was charging was high enough to cover the average total cost of a flying an airplane from New York City to Miami. Why was Frontier willing to accept such a low price? Would the airline be willing to accept such a low price in the long run?
- Some airlines believed that even after the pandemic was over, consumers might not be willing to fly on planes as crowded as they were prior to the pandemic. Accordingly, airlines were considering either flying planes with some rows kept empty or reconfiguring planes to have more space between rows—and therefore fewer seats per plane. Briefly explain what effect having fewer seats per airplane might have on the price of an airline ticket.
Sources: Jonathan Roeder, “NYC to Miami for $51: Coronavirus Slump Leads to Steep Airfare Discounts,” bloomberg.com, March 5, 2020; and Scott McCartney, “There Are Plenty of Coronavirus Flight Deals Out There, But Think Before You Buy,” Wall Street Journal, March 25, 2020.
Solving the Problem
Step 1: Review the chapter material. This problem is about the break-even price for a firm in the short run and in the long run, so you may want to review Chapter 12, Section 12.4 “Deciding Whether to Produce or to Shut Down in the Short Run” and Section 12.5 “‘If Everyone Can Do It, You Can’t Make Money at It’: The Entry and Exit of Firms in the Long Run.”. In Hubbard/O’Brien, Essentials of Economics, it is Chapter 9.
Step 2: Answer part a. by explaining why even though a ticket price of $51 was unlikely to cover the average total cost of the flight, Frontier Airlines was still willing to accept such a low ticket price—but only in the short run. As we’ve seen in Section 12.5, competition among firms drives the price of a good to equal the average total cost of the typical firm. Assuming that ticket prices prior to the pandemic equaled average total cost, then the low ticket prices in the spring of 2020 must have been below average total cost. We have also seen, though, that firms will continue to produce in the short run provided they receive a price equal to or greater than average variable cost. For a particular flight, the fixed cost—primarily the cost of aviation fuel and the salaries of the flight crew—is much greater than the variable cost—additional meals served, somewhat more fuel used because more passengers make the plane heavier, and possibly an additional flight attendant needed to assist additional passengers. So, the $51 ticket price may have been enough for Frontier to cover its average variable cost. The airline would not accept such a low price in the long run, though, because in the long run it would need to cover all of its costs or it would no longer fly the route. (Note: In the short run, an airline might have another reason to continue to fly planes on a route even if it is unable to cover the average total cost of a flight. The contracts that airlines have with airports sometimes require a specified number of flights each day in order for the airline to retain the right to use certain airport gates.)
Step 3: Answer part b. by explaining the effect that having fewer seats per airplane would have on airline ticket prices. For an airline to break even on a flight, its total revenue from the flight must equal its total cost. Flying fewer seats per plane will not greatly reduce the airline’s cost of the flight because, as noted in the answer to part b., most of the cost of a flight is fixed and so the total cost of a flight doesn’t vary much with the number of passengers on the flight. But flying half as many passengers—if every other row is left empty—will significantly decrease the revenue the airline earns from the flight. To increase revenue on the flight, the airline would have to increase the price of a ticket. We can conclude that if airlines decide to fly planes equipped with fewer seats, ticket prices are likely to rise. Note that if on some routes the demand for tickets is price elastic, raising the price will reduce revenue and the airline will be unable to cover its cost of flying the route.