Question 1: N2009/01 H1(a) Using Figure 1:

a. Summarise the trends in international air passenger growth 2000-2004.

General An overall increase between 2000 and 2004Specific There was a sudden decrease in the growth rate between

2000 and 2001.

b. Compare these trends with the forecast trends for 2005 – 2009

Similarity Both the trends had a huge decrease in growth rates between the first 2 years (2000-2001, 2005-2006)

Difference While the growth rate increased between 2001 to 2004, the forecast trends show that growth rate would decrease between 2006 to 2009.

(b) With the help of a supply and demand diagram, explain the likely impact of both global economic growth and the entry of low-cost airlines on the market for international air passenger travel.

Rise in Demand

Extract 2“new planes attract millions of passengers who have more money to spend on travel and leisure” especially in Asia “growing wealth”Extract 1“2004 has seen a 30-year high in global GDP growth” Increase in GDP, increase in general income lecelts.

Changes in consumer’s income.As consumer’s begin to experience higher levels of income, they would want to consume more superior goods (like air travel). Hence the demand for air travel increases.

Rise in Supply Extract 1“New entry of low-cost airlines “Extract 2“packing in more seats, selling tickets directly via websites rather than travel agents and cutting in-flight services”

Changes in the state of technology.More efficient production, lowered the unit cost of production, increase in profits, suppliers are more willing and able to supply more of the good at each price.

Extent Rise in Demand > Rise in SupplyExtract 1“Higher oil prices are expected”“2005 will be the fifth consecutive year of heavy financial

losses for the airline industry worldwide”

Diagrammatic Illustration and Explanation

(c) (i) What is meant by price elasticity of demand?

Price Elasticity of demand measures the degree of responsiveness of quantity demanded of a good to a change in its price, ceteris paribus.

(ii) How far does the concept of price elasticity of demand help to explain the success of low-cost airlines such as AirAsia, Virgin Blue and Tiger Aiways?

Define PED Price Elasticity of Demand measures the degree of responsiveness of quantity demanded of a good to a change in its price, ceteris paribus.

Determining PED of the good

Proportion of income spent on good

By analyzing the factors that influences the PED, the airlines companies can determine the degree of elasticity of their airlines.

Firstly, they can analyse the proportion of income spent on airtravel. An average Asian family is most likely to spend a relatively large proportion of their income on airtravel. A small percentage increase in the price of airtravel would lead to a large percentage reduction in the quantity demanded of airtravel. Thus, PED for airtravel is high.

Nature of good

Secondly, airtravel can be a necessity or a luxury depending on the context. For those who are going on business trips or to visit their family, airtravel can be deemed as a necessity. Even if the price of airtravel was to increase, the quantity demanded would not fall as us. In such a case, airtravel is said to be inelastic in demand. On the other hand, families going on a holiday would find it more of a luxury. A higher price for airtravel would cause them to seek other leisure activities. In this case, airtravel is more price elastic in demand.

Application of analysis

Pricing Policies

Marketing strategies

Based on their analysis of the degree of elasticity of the good, they can implement policies and strategies that are targeted at increasing their total revenue.

As the producers aim is to increase the total revenue, he will have to decide on a pricing policy which will allow him to achieve his aim. As the demand of the good is generally price elastic, the producer should lower its price in order to increase the total revenue.

As seen from diagram 2, as price changes, quantity demanded changes more than proportionately. When price decreases, the less of total revenue (area A) is less than the gain in total revenue (area B) and therefore the total revenue increases.

Airline producers may make the demand for airtravel less price elastic through marketing strategies. This will help them in the long run as they will able to increase the price subsequently. One way is to make consumers loyal to their company. For example, Virgin Blue can issue cards to their consumers. During each trip taken by the consumer, depending on the destination, mileage will be offered. The mileage can be used as discounts on their next trip. Another way is by undertaking advertising. TV commercials about their services can be created to attract consumers. Also, the company can introduce different features in his airplane such as activities to keep the children occupied on their flight.

(d) (i) With reference to the data, explain how the existence of a negative externality can lead to market failure.

Define Market Failure

Market Failure occurs when free markets fail to bring about and efficient and equitable allocation of resources.

Sources of Market Failure

There are a few causes of market failure such as externalities in production or consumption, merit and demerity goods and public goods.

The external costs

In the industry of airtravel, negative externalities exist. As airtravel is consumed, external costs to others are incurred. As said in extract 3“causes carbon emissions”“noise pollution”“1.7% of all global greenhouse gas emission”

Explanation

Free Market Equilibrium Quantity

Under free market forces, the private market will be in equilibrium when MPB = MPC (assuming no externalities arising from production, MPC = MSC). Consumption would be at Qf

Negative Externality in Consumption

As the good of airtravel is consumed, harm is done to the environment and to those living around the airports. This causes a divergence between MSB and MPB.

SOQ The socially optimal quantity is the point at which society’s welfare is maximized. This is point Qs at which MSB = MSC.

Over-consumption

The good is over-consumed by the amount QsQf. The MSC exceeds MSB.

Deadweight loss.

This results in a loss of society’s welfare. This can be represented by the shaded triangle. This is known as the deadweight loss.

(ii) As a consultant economist, what options would you present to the Singapore government for responding to the alleged negative externalities of air travel, and what would you recommend? Justify your answer.

Introduction The government intervenes to achieve an efficient allocation of resources by trying to decrease production or consumption. There are many ways to do so such as tax, bans, moral suasion, regulation and marketable pollution permits.

Tax A pigovian tax can be imposed on the producer.

As seen from diagram 5, the free market originally consumes at Qf. A tax (P3P2) equal to the negative externality is imposed by the government. There is internalization of the externality. This causes the firm’s MPC to shift up to MPC*. The socially allocative efficient output is achieved and the deadweight loss is eliminated.However, for the tax to be effective, it must equate to the negative externality at the socially optimal output. It is difficult for government to achieve an optimal tax. Also, administrative costs are incurred in collecting taxes.

Regulation Laws could be implemented to reduce output or external costs. In the long run, the government could do some research to find a particular technology that can help reduce emission, perhaps a version of the catalytic converter modified for the use in airplanes. This would reduce the negative externality, reducing the divergence between private and social costs.

However, specifying the technology to use for reducing pollution is generally not favoured as it does not give firms the flexibility to reduce emissions in the most cost-effective manner, given its cost and production technology.

Bans The government may ban airtravel. When MSC exceeds MSB, the production of the good would result in a socially non allocative ooutput.However, when MSC does not exceed MSB for all output levels, banning the product would give rise to external costs involving a greater welfare loss than not doing anything to reduce the externality.

As seen in diagram 6, a ban results in a loss of area A, while eliminating the deadweight loss of area B. There is a net loss of welfare.

Conclusion In conclusion, the best method the Singapore government can adopt is to impose taxes on the producers.

A ban is definitely not feasible in Singapore’s context. As Singapore is a small country with no natural resources, it depends on the tourism industry and also has established itself as a global air hub. Everyday thousands of flights arrive and depart and a ban would result in a huge loss of income for the government.

Regulation could also be adopted alongside the imposition of taxes. As regulation would take time to be effective, the tax would help to eliminate the negative externality in the short run.

Also, the tax is a source of revenue for the government which can be invested in research and development for better environmentally-friendly technology.