Pre Module: Macroeconomics The Beginning

Preview

Today we will look at the Airline Industry to understand the concept of demand and supply. Let’s look at a simple model: the effect of perception of safety of travelers/passengers and price of fuel on the price of airline tickets. A model is as good as its assumptions. Exogenous Variables are variables that come from outside the model. These are the variables that the model uses as input to explain the output. Output are the variables that the model explains. Today in this module we will look at Airline Industry as an example. It is a simple model based on the pandemic and used here to explain how demand and supply equilibrium works.  We will understand the impact of changes in safety (safety concerning travel) and price of jet fuel on price and the number of airline tickets sold keeping other factors constant. Herein, safety and price of jet fuel are Exogenous Variables, and the price of an airline ticket and number of airline tickets sold are Endogenous Variables that the model explains.

Graph: BCI | OECD

First, let’s look at an example of the unemployment rate. Business Consumer Confidence is the exogenous factor in this simplistic model while unemployment rate the endogenous variable. We mention keeping other factors / variables constant. This is because many other variables are affecting the unemployment rate including policies implemented by a country. Business Confidence Index & Economic Business Cycle are related to each other, during the time of expansion, business confidence index is positive/high as demand for goods and services is more, so the unemployment rate is less. On the other hand, during the recession, the business consumer confidence dips, usually there are layoffs and the unemployment rate increases. In the Airline Industry model, let’s understand the effect of change in perception of safety and cost of jet fuel on the price of an airline ticket and the number of airline tickets sold.

In the Airline Industry model, let’s understand the effect of change in perception of safety and cost of jet fuel on the price of an airline ticket and the number of airline tickets sold. We look at the model of demand and supply using the Airline Industry example. From the Demand and Supply equilibrium, at Qd = Qs the price of the airline ticket adjusts so that the quantity supplied is equal to the quantity demanded. The demand curve is downward sloping i.e. as the price of the airline ticket reduces, the number of airline tickets demanded increases. The demand curve is the relationship between price of the airline ticket and the number of airline tickets demanded keeping safety of traveler’s constant. The supply curve is upward sloping i.e. as the price of the airline ticket increases, the number of airline tickets supplied increases. The supply curve is the relationship between price of the airline ticket and the number of airline tickets supplied keeping cost of jet fuel constant.

The term market clearing is important to understand. The prices for goods and services in markets adjust quickly to the demand and supply intersections. However, wages and prices adjust slowly in labor markets. In the short run, the prices of goods and services are sticky i.e. they take time to adjust to the market equilibrium. Example automobiles, labor markets, etc. Understanding the behavior of prices over the short and long term varies and is covered in detail in later tutorials. In the short run, prices are sticky but over the long run prices flexible. Take the example of commodity prices like the price of Oil, Soybeans which are traded on exchanges are real-time adjustments. However, the retailers of crude oil follow a sticky-price model. Retailers of global crude oil employ a “sticky price method,”  during the pandemic, a demand-side shock led to falling in travel along with an oversupply of oil leading to a fall in global crude oil prices. However, retailers did decrease prices and for this model, we are considering price of global crude oil and jet fuel oil are flexible to certain extent.

Impact of the COVID-19 Pandemic on Prices for Petroleum Products

Graph: U.S Bureau of Labor Statistics

We look at the Impact of the COVID-19 pandemic on prices for petroleum products as the price of jet fuel is closely linked to global crude oil prices. The pandemic induced a jolt to the world economy and the OPEC Russian oil war jacked down the global crude oil prices. In 2016 China became the largest importer of oil. In February due to lockdown due to COVID-19, China’s Purchasing Managers’ Index fell nearly 49 percent, reaching its lowest level since it was first measured in 2005 — the largest demand-side shock to the market since 2008–09 global recession. The OPEC Russia price war along with major international lockdowns led to a further drop in global crude oil prices. By 1 May 2020, the US had a near-record level of 535.2 million barrels of crude petroleum stockpiles. Refer to the US Bureau of Labor Statistics report. Restrictions imposed due to COVID-19 due to safety concerns example lockdowns and restricted travel led to fall in demand for air travel keeping other factors constant.

The demand curve moves leftward leading to a new equilibrium point Q1 as the equilibrium moves from Q to Q1The number of tickets sold (demanded) reduces as the prices of airline tickets fall. A drop in the fuel cost (due to oversupply) leads to an outward/ rightward shift of the supply curve keeping other factors constant. The supply of airline tickets increases as prices of airline tickets reduce at the new equilibrium. The equilibrium price of the ticket falls from P to P1 and the supply of the airline tickets increased from Q to Q1. This part is just to explain the theoretical aspect of demand and supply equilibrium. In reality, scenarios could be different for countries depending on the pandemic response, travel restrictions, social distancing norms, etc. Conduct a research project and find the price of airline tickets (commercial) in your respective countries over the time of the pandemic.

Fig: The demand supply equilibrium – shift in the demand curve | The middle Road

Did price of tickets change? Did they remain constant, go down or increase? Why?

The purpose of this exercise is to illustrate the demand and supply equilibrium concerning the cost of goods and services. An increase or lowering of cost of goods or a service always affects the supply curve leading to a shift in the supply curve. Note: People always confuse with the cost aspect here. An increase in Cost of goods is passed on to the consumer, leading to an increase in the selling price. (This is the assumption).  Cost of goods/service depends on input cost of materials, commodities, ingredients, work hours etc.

Solved Questions

Question: Quantum is a global metropolis country and a hub in technology and biotechnology. It has a thriving e-commerce market where four large companies compete with each other. These four companies employ a sizeable population of employees as a percent of the city’s work/labor force. A major global leader enters the market and offers a 100 percent increase in the salaries of its employees at managerial level. This industry is ultra-sensitive to wages with high attrition rate. The new firm aims to employ a sizeable population of the work/labor force. The city has a young dynamic population with workforce about 65 percent of the population with a majority of the workers working within the technology and biotechnology sector. Assume that an increase in wages will lead to an increase in propensity to consume. Keeping other factors constant, answer the following questions.

1). What will other technology companies esp. in the e-commerce space do to with respect to their pay scale of their employees.

2). Now assume that Pizza and Chaas (a spicy Buttermilk beverage) are popular among the people of the city Quantum. Pizza and Buttermilk are very popular among the employees as part of their mid-day lunch/snack and generally they order both Pizza and Buttermilk together. Assume that the other technology companies increase salaries of their employees but with varying degrees of percent increases, what would be now the result of the demand curve of the pizza, keeping other factors constant. What will happen to the demand of Chaas? Please explain.

3). If you plot the price and quantity of the demand curve of the pizza, what will the slope of this curve imply.  Why is important?

4).  In the above case, consider that 60 percent of the time people order Chaas/ Buttermilk when they order Pizza. The price of ingredients required to make Chaas have increased, leading to an increase in the cost price of the Buttermilk. What will happen to the supply curve of the Chaas now? Plot the new market equilibrium.

5). For the two sets of pair 2p+7q=25 (demand) and p-2q = 7 (supply); find the equilibrium points.

1). This is an open ended question. Companies use different aspects in retaining talent. The easiest in this case would be to increase the salary although it need not be of the same amount. Companies have used changing the ecosystem in a particular sector by doubling salaries of employees to poach talent from competitions but you need to remember if these practices are sustainable.

2).  An increase in the remuneration of the employees within the technology sector will lead to increase in the aggregate demand within the economy. An increase in aggregate demand would lead to an increase in consumption — leading to increase in demand for Pizza and Buttermilk. The demand curve will shift rightward/ outward with price of the pizza increasing from P to P1. The quantity of the pizza sold will increase from Q to Q1 as the market equilibrium increases from A to B. The same applies for the Buttermilk.

3). It shares a sensitivity analysis of change in the price of pizza to the quantity of pizzas sold. The slope of the demand curve is change in price of pizza to the quantity of pizza demanded. It helps pizzerias (outlets selling pizzas) to better price their products, understand the sensitivity of consumers to change in price of pizzas etc.

4). Price rise leads to a left or upward shift of the supply curve with the price of buttermilk rising from P to P1. The market equilibrium point shifts from A to B, the quantity of buttermilk reduces from Q to Q1.  The rise in price of the ingredients leads to rise in cost of buttermilk with rise in the selling price of the beverage.

5). At equilibrium demand is equal to supply. The points of the two equation must satisfy both the equations i.e. find coordinates of the  intersection of the two equations

2p+7q=25

p-2q = 7 multiply this equation by 2 to get 2p-4q = 14 and subtract this equation from the first equation

2p+7q=25

– (2p-4q = 14)

11q = 11   or q = 1

Substitute the value of q in any of the two equations to get the value of p

2p+7q=25   2p + 7(1) = 25               ====>  2p = 25 -7 = 18    ========> p = 9

(p, q) = (9,1)