Tag Archives: Airlines

Behavioural Economics and reclining airline seats

I picked up this topic from Michael Cameron’s blog Sex, Drugs, and Economics which looked in detail at the economics behind reclining airline seats. The issue that he refers to is – who owns the space between reclining airline seats?

Externalities

The person (Recliner) who reclines their seat reduces the amount of space that the person (Reclinee) behind has especially if they have their tray table down and becomes a negative externality to them. Some airlines are worse than others with regard to space – American carriers tend to have very little room as do the low cost airlines. However carriers that operate more long haul flights especially Emirates seem to be more generous with the space between seats. However if there is nobody in the seat behind then there is no externality. This refers to the Coase Theory (see previous blog post) in which Ronald Coase stated that problems are jointly produced by the person who creates the externality and the person who is affected by it. He argued that bargaining between parties could produce a mutually beneficial and efficient solution to problems like the scares resource i.e. the space between airline seats.

An article on the site Evonomics by Buccafusco (Cardozo School of Law) and Sprigman (NYU School of Law) looked at research into how much passengers would be willing to pay to recline their seat. They looked at the following scenarios.

Default – you have the right to recline your seat
Recliners wanted on average $41 to refrain from reclining, while reclinees were willing to pay only $18 on average. Only about 21 percent of the time would ownership of the 4 inches change hands

Default – you don’t have the right to recline your seat and have to negotiate
Recliners were only willing to pay about $12 to recline while reclinees were unwilling to sell their knee room for less than $39. Recliners would have ended up purchasing the right to recline only about 28 percent of the time—the same right that they valued so highly in the other condition.

The Coase theorem suggests that the initial allocation of rights should not matter, because if the person who values the right the most doesn’t start out with it, they will simply purchase it from the other. But what Buccafusco and Sprigman found suggests that this simple solution might not work. What they found was an endowment effect.

Loss Aversion and the  Endowment Effect

Loss aversion can be explained by prospect theory, which states that an individual’s value function (whether for money or otherwise) is concave for gains but convex for losses. In other words, people are more sensitive to losses compared to gains of similar magnitude. This is illustrated below.

Prospect theory

The reference point in the diagram is the current position of the individual concerned. Gains and losses are evaluated with reference to this neutral reference point. The value function takes an asymmetric S-shape because marginal value (or sensitivity) declines as absolute gains and losses increase in size. A dollar lost more than outweighs a dollar gained. In conventional economics, gains and losses are treated equally – a dollar lost simply cancels out a dollar gained. Golf provides a perfect example of a reference point: par. Every hole on a golf course has a number of strokes associated with it; the par provides the baseline for good – but not outstanding – performance. For a professional golfer, a birdie (one stroke under par) is a gain, and a bogey (one stroke over par) is a loss. Economists have compared two situations a player might face when hear the hole:

  • putt to avoid a bogey
  • putt to achieve a birdie

One group of economists analysed more than 2.5 million putts in exquisite detail to test that prediction and found that whether the putt was easy or hard, at every distance from the hole, the players were more successful when putting for par than for a birdie. The difference in their rate of success when going for par (to avoid a bogey) or for a birdie was 3.6%.

Note that endowment effects are working for the ‘reclinees’ as well – they are willing to give up their extra knee room for $39 if they had the right to keep it, but would only be willing to pay $18 to get that right if they didn’t start out with it.

The endowment effect means that this problem isn’t really amenable to a simple solution, because recliners already have the default rights, and are understandably unwilling to give those rights up. And any change in policy is going to incur passenger protest – because even though we may gain knee room, passengers would be giving up their right to recline, and loss aversion almost ensures that would be a painful and unwelcome trade-off for most passengers.

Elasticity of Demand for Air Travel

At the most basic level, demand for air travel is stimulated by economic activity and economic and social linkages between countries and cities. Travel is also stimulated by economic linkages (i.e. international trade) and social linkages (i.e. international migration). In general, there will be greater demand for travel between countries that have larger economies and populations. In addition, destination attractiveness is a key driver of demand for leisure travel.
There are many other factors that affect demand for air travel. When the economy grows, greater economic activity stimulates business travel and leisure travel increases as people’s income increases.

  • Demand is stimulated by lower prices, both airfares and the price of tourism expenditure (e.g. accommodation and food) ‘on the ground’ at a destination.
  • Demand for travel to any particular destination also depends on the price of travel to alternative destinations. Other factors that affect demand include distance, safety, and other one-off events such as health and terrorism scares.

The concept of elasticity is very useful for understanding demand drivers. Elasticity measures the responsiveness of demand for air travel to changes in some other variable such as prices or income. A price elasticity of -0.5, for example, means that a 10% increase in price leads to a 5% reduction in the level of demand for travel. Or an income elasticity of 1.2, for example, means that a 10% increase in income leads to a 12% increase in the level of demand for travel.

Many studies have attempted to estimate various demand elasticities for air travel. In terms of price and income elasticities, a meta-study by Gillen et al (2008) summarised 254 different estimates from 21 published studies and found an overall median price elasticity of -1.1, indicating that demand for air travel is relatively sensitive to price changes.

As would be expected, the results also indicate that travel for business purposes is less price sensitive than travel for leisure purposes with business short/medium hail elasticities between -0.8 and -0.6 and long haul elasticities between -0.5 and -0.2, compared to -1.5 to -0.9 for short/medium haul and -1.7 to -0.5 for long haul leisure travel. Gillen et al also report a median income elasticity of 1.4, suggesting that demand for air travel is relatively sensitive to changes in income. The table below represents the median for each market segment – Source: Air Travel Demand Elasticities: Concepts, Issues and Measurement.

PED Air TravelGiven that someone has decided to travel, their choice of airline and airport, when such a choice exists, depends on a number of micro-level factors including purpose of travel, ease of access to the airport, flight frequency, expected delays, and departure/arrival times (Ishii et al, 2009). Thus the demand faced by a particular airline depends on macroeconomic factors as well as other factors more directly under its control.

Source: The New Zealand Aviation Operational Environment: A Guide for the Tourism Sector 2010

End of Airbus and Boeing dominance?

Yet another hat tip to A2 student Andrew Larkey for this piece on the challenge to the airline manufacturers duoploly.

The duopoly of Boeing and Airbus appears to be coming under pressure. The Bombardier CSeries seems to be gaining traction amongst commercial carriers and airline customers believe that they now have the ability to negotiate with the two established manufacturers as the Bombardier CSeries and the Comac C919 have become viable options. For Lufthansa the power over suppliers is partly what motivated them to buy the Bombardier.

EasyJet Founder v EasyJet Board
Stelios Haju-Ioannou, the founder of EasyJet, had a disagreement with the easyJet Board over the expansion of the company’s fleet. The Board plans to spend money on the Airbus A320’s but Stelios was thinking about the cost saving by purchasing the CSeries.
In his letter attacking the airline’s decision this year to exercise options fo 15 A320s, Stelios writes that “the board has a duty to benchmark the price with the other suppliers before placing more orders.” He includes a table of list prices and notes that “from the table, it is apparent that based on list prices, a similarly sized Boeing aircraft (737-700) can be purchased for $10 million dollars less than the A319 and a Bombardier CS-300 is even less expensive.”

The Irishman Michael O’Leary, CEO of Ryanair, is also putting pressure on its normal supplier Boeing. Although it is thought that he wouldn’t seriously buy Airbus aircraft he is now using Comac C919 with whom he stuck a deal at the recent Paris air show. It is believed that he would consider the Chinese narrowbody for a future fleet order of at least 200 planes.

Emirates reduces fares to fill A380’s

Another hat tip to Andrew Larkey for this piece from the Arabian Business website. It seems that in order to fill their 517 seat A380 Airbus planes Emirates have decided to reduce its fares considerably.

Emirates will resist the urge to cut routes and flights as oil prices threaten the profitability of some destinations and instead aims to stir up demand with cheaper tickets.

It is estimated that 43% of the daily cost to airlines is fuel which is out of their control. However, Emirates believe that capacity reduction is not an option as it has been responsible for the collapse of so many carriers. Industry practice has generally been to halt growth when times are hard and costs high, focusing on the most profitable routes that can sustain higher fares. Emirates will stick with a rapid-growth model based on building Dubai into a high-volume, inter-continental travel hub using a wide-body fleet featuring 90 A380 superjumbos with 45,000 seats.

While cutting fares to sell tickets on the 517-berth planes will push up the occupancy level needed to break even, the impact of government spending cuts in many overseas markets means that strategy is more likely to succeed than one based on curbing capacity and raising fares.

That strategy is not advised as it reduces sales and dampens consumer confidence which ultimately affects, airports, holiday companies and businesses in destination cities, so that traffic often never returns. US-based Trans World Airlines (TWA) and Pan American World Airways are examples of major carriers that went bust by reducing the amount of destinations that they flew to.

Emirates engine overhaul shop – economies of scale

A hat tip to A2 student and airline fanatic Andrew Larkey, for this piece from the Emirates website.

Emirates Airline has unveiled plans for the construction of the most technologically-advanced Engine Overhaul Shop in Asia. The state-of-the-art Engine Shop will complement the present Test Cell Facility in Dubai and will be constructed on a 90,000 square meter piece of land at an estimated cost of US $120 million. The growth of the Emirates fleet and the subsequent number of operating engines have necessitated the need for an in-house Engine Shop in Dubai to provide the most cost-effective, efficient engine maintenance.

The Engine Shop will have the capability of performing 300 engine repairs per annum for the GE90 and GP7000 engines fitted to the B777 and A380 aircraft. Emirates has signed a Letter of Intent with General Electric (GE) to oversee the design and construction of the Shop using the most advanced technology, equipment and best practices in the industry.