Economic Theory in Context of Airline Industry - Essay Example

Supervisor Prepare a 2400 word paper in APA format that provides an economic profile of the airline industry. This paper must include at least eight sources. Research and include two sources for each of the following topics. (Sources are to be included in the APA reference page). Shifts and price elasticity of supply and demand Positive and negative externalities Wage inequality Monetary and fiscal policies By: January, 2009 TABLE OF CONTENTS 1.0Introduction 1.1 Overview of the Airline Industry 1.2 Shifts and Price Elasticity of the Airline Industry 1.3 Positive and Negative externalities of the Airline Industry 1.4 The Situation of Wage Inequality at the Industry 1.5 Monetary and Fiscal Policies with respect to the airline industry 1.0 Introduction Air transport is the world’s largest industry, with a history of strong underlying growth in traffic volumes (British Airways Fact book 2006). Transaction costs economics and the new institutional economics have provided ways in which traditional economics model (On the assumptions of maximising behaviour by individuals) can be used in understanding the relationship between institutions and the reform process (Craciunesco 2006). Changes in investment activity, employment, and prices may be a recurring and frequent manifestation of economic development in a competitive and dynamic economy. This paper examines the economic profile of the airline industry paying attention to issues such as shifts and price elasticity of supply and demand, positive and negative externalities, wage inequalities and monetary and fiscal policies. The first part of the report provides an overview of the airline industry while the second part of the report focuses on the above listed variables. 1.1 Overview of the Airline Industry Air transport today is one of the largest industries in the world. For example, the scheduled airline industry generated revenues of nearly $375 billion in 2004 (British Airways Fact book 2006). According to BA Fact Book (2006), over half a billion passengers were carried on international scheduled services with this figure having grown at an annual average rate of more than 6% since 1970, when the then corresponding number of passengers was 75 million (British Airways Fact book 2006). Many commentators for example have long argued that, aviation has an overall economic impact far in excess of its turnover (Riggas 2001). Here, Boyd (2000) argues that the network of air transport services facilitates growth in output and employment, and at the same time international trade and investment, tourism, and living standards (Boyd 2000). BA Fact Book (2006) refers to Air travel as “a vital artery that reinforces the process of globalisation, allowing it to transform the way in which many other industries carry out their business” (BA Fact Book 2006:5). In response to the rapid growth in business travels in recent years, the airline industry has witnessed rapid growth in the last four decades. Rigaes (2002) postulates that, one argument in favour of the present state of the airline industry is positive externality. Thus such a higher growth in the sector is due to global mobility that outweighs the microeconomic losses and justifies continuing government intervention. The industry is also characterized by a high level of government intervention. Here commentators see this as part of a wider political consensus on strategic forms of transport, such as highways and railways, both of which receive public funding in most parts of the world (BA Fact Book 2006). Moody’s Investor’s Service however portrays a different position. According to this brand of investors, airline companies have cut back on capacity with higher fees weighing hard on them as they attempt to charge them to consumers. In the present events following the global financial crisis, the profile of the airline industry has been describe as being highly cyclical, as its growth dips sharply when the world economy experiences one of its periodic spells of weakness (Moody’s 2008). For example, the state of the industry showed a positive growth until when the global economy saw a sharp reversal of its fortunes between 2000 and 2003 as a result of the global economic downturn in 2001, and the subsequent weak recovery (BA Fact Book 2006). The industry has further been negatively affected by the Iraq war and the SARS epidemic in 2003, and continuing uncertainties in the global geo-political environment (BA 2008). 1.2 Shifts and Price Elasticity of the Airline Industry Competitive pressures have reinforced the persistent downward trend in airfares according to BA Fact Book (2006). After adjusting for inflation, average airline yield revenue per passenger kilometers have almost halved since 1970. Boyd (2000) argues that, strong historical traffic growth with declining yield has produced a picture of airline industry real revenue growth. The elasticity of the airline industry can be explained with the help of the following figures. Figure 1 and Two From figure one and two above, we see that the price elasticity of demand in the airline industry is both elastic and inelastic. Where there are alternative transportation means like in normal travel, demand tends to be largely elastic. Here a fall in price in figure one from P2 to P3 increases demands from Q2 to Q3 all things being equal. Here supply tends to be inelastic, as it takes time to increase the number of flight routes and flights services. The reverse is true, Mutatis Mutandis with all things being equal. Pleasure travel can be used as a suitable example. How ever in, Chan (2000) states that, in Business travels where time matters and parallel substitutes is absence demand in the industry tends to be inelastic. This industry can be viewed as both a luxury and a necessity. Travel by medical personnel, law enforcement, government agencies, military personnel etc, can all be considered a necessity. In this regard, demand tends to be inelastic, and likewise supply (Chan 2000, Regas 2002). 1.3 Positive and Negative externalities of the Airline Industry Airlines have a high level of fixed and variable operating costs. Labour, fuel airplanes, engines, spares and other related parts all play an important role. These chains of activities have created both positive and negative externalities. Positive externalities include globalisation, economic growth, over reliance and dependence on one nation by the others, the creation and development of auxiliary and ancillary services (Rigas 2001, 2003). The industry has also created employment, smoothening of wage differentials and facilitated global mobility. Rigas (2003) postulates that, full-service airlines have a high level of fixed and operating costs in order to establish and maintain air services: airport handling services, sales distribution, catering, training. Doganis (2001) argues that competition is the single most challenging aspect of the human resource strategies facing the airline industry Negative externalities include noise and other environmental pollution. Aircrafts emit gases and particulate emissions, and contribute to the present state of global warming and dimming (Rigas 2003). Rigas (2003) further argues that the rapid growth in the airline industry has contributed to an increase in total pollution attributable to aviation, offsetting some of the reductions achieved by automobiles (Regas 2003). According to an independent study, the industry is responsible for about 11 percent of greenhouse gases emitted by the U.S. transportation sector ( Regas 2003). 1.4 The Situation of Wage Inequality at the Industry In the last decade, airline companies have increasingly recognized the need of harmonizing wage inequality. For example, in its latest annual Report (2006), British Airways noted the importance of wage equality to employee involvement and improved industrial relations to the future success of the airline (Report 2006). BA uses its Cabin crew to represents an integral part of the airlines in-flight product offering, thus creating a barrier to differentiate the airline form its rivals. It is vital for an airline to maintain high level of employee motivation and morale, in order to protect its reputation. Wage inequality can results in increase cost for the airline, and if ignored has the potential to generate a loss in revenues. The main trade unions in the airline sector in the UK for example are the Transport and General Workers Union (TGWU), the British Stewards and Stewardesses Association (an affiliate of the TGWU), the GMB, Amicus Cabin Crew (formerly Cabin Crew 89, an affiliate of the TGWU and now an affiliate of Amicus), Amicus and BALPA (British Air Line Pilot’s Association) which represents pilots. However, in the United Kingdom There are no employers associations in the sector. In the airline industry, there is a high degree of wage inequality in the industry (BA 2007 Report. The airlines work force is unsettled by the introduction of change to their working agreement, and the increasingly poor industrial relation between trade unions and management (Craig 2005). These factors all contribute to decreasing morale and low motivation at work. Finding the right balance between employee and corporate objective can prove to be extremely difficult, but in order to secure the future success of the airline, must be achieved swiftly (Craig 2005). Craig (2005) further argues that, deregulation of the airlines changed the status of the company from a naturalized to a privatized profit oriented entity. This pushed the human resource management strategies of the airlines under serious attack. The aftermath of the terrorist attack on the World Trade Centre has forced passengers into alternative transportation method or forced some to stop traveling at all. Craig (2005) postulates that, the task of human resource management challenges at the airline industry has been to reconcile through actions by senior management to cut jobs, improve productivity and maintain quality of service. The table below summarises wage differential in the industry 1.5Monetary and Fiscal Policies with respect to the airline industry This section is aimed at defining fiscal and monetary policy so as to employ the distinction between the two policies to determine whether the Bank of England has enough policy instruments to control inflation. To achieve this objective, the IS/LM model will be employed to see how various policy measures affect the interest rate, national income and inflation rates (Visser (2004: p. 40). I begin by giving a brief description of fiscal policy, monetary policy, fiscal dominance and monetary dominance in the first. Fiscal and monetary policies are among the most important public policies available in promoting growth and stability within the institutional framework of a free, competitive society. By definition, fiscal policy is customarily defined as a manipulation of the government financial transactions, why on the other hand monetary policy is governmental control over the quantity of money or its terms of exchange (Winston, Holt &Hall (1960). In other words, these are tools being manipulated by the government to achieve desired economic and government objectives. Fiscal policy refers to a situation whereby the government restores equilibrium in the economy by making changes to taxes or government expenditure on public goods and services (Smullen and Hand 2005). When there is under-utilisation of capacity, the government can increase capacity utilisation by reducing taxes (that is through a reduction in tax rates or tax base) or by increasing spending on public goods and services as well as subsidising the production of certain goods and services (Smullen and Hand (2005); Visser (2004: p. 43). Fiscal policy aimed at increasing money supply is referred to as easy fiscal policy (Smullen and Hand 2005). On the other hand, when there is over-utilisation of capacity, the government either increases taxes (through and increase in tax rates or tax bases) or reduces spending on public goods and services (Black (2002). It also reduces subsidies and transfer payments. This type of fiscal policy is referred to as tight fiscal policy (Black 2002). Monetary policy is referred to as a means by which the central bank tries to sway the economy to equilibrium by influencing the supply of money (Black 2002). This is achieved through four main approaches, which include: printing more money; direct controls over money held by the money sector; open market operations and influencing the interest rate. Both tight and easy monetary policies can also be identified. Like easy fiscal policy, easy monetary policy is one whereby the central bank embarks on a policy to increase the supply of money. On the other hand tight monetary policy is a policy whereby the central bank embarks on a policy to limit the circulation of money such as increasing interest rates (Black 2002 Smullen and Hand 2005). Through either of these policies the government through the central bank regulates the activities and actions of the airline industry. For example through higher interest on credit facility the government can hinder the ability of an airline industry to borrow more money. Figure 2 Monetary Policy. a). Easy monetary policy b). Tight monetary policy In the IS/LM model above, the intersection of LM and IS represent the equilibrium state of the economy. At this point, the national income is given by Y1, and the interest rate by i1. In the first case lets assume that the central bank embarks on an easy monetary policy by purchasing debt securities in the open market. This will lead to an increase in the supply of money and thus the national income. The LM curve will shift to the right creating a new equilibrium position at a higher national income Y2 and a lower interest rate i2. This is represented in figure 1a above. On the other hand, if instead the central bank decides to embark on a tight monetary policy by raising interest rates from i1 to i2, it will result to a decrease in the national income from Y1 to Y2 and a shift in the LM curve from LM to LM’. This is represented in figure 1b above References Boyd, C., (2000). HRM in the airline industry. Strategies and outcomes. Journal of Personnel Review, Vol. 30 No 41pp438-453 British Airways Corporate Report 2005, 2006 Chan, D., (2000). The development of the airline industry from 1978-1998. A strategic global overview. Journal of Management Development Vol. 19N0.6 2000pp 489-514. MCB University Press. Craciunescu C., (2006). Interest and Prices: Economics, Journal of Management, and Financial Markets .2006 Vol: 1 Issue: 2 Craig L (2005). Key Notes Limited. Airlines industry Analysis Doganis R., (2002). Flying off course. The Economics of international Airlines London, New York:Routledge. Flying Off Course: The Economics of International Airlines," 3rd edition. Rigas Doganis, Routledge, New York, 2002. "The Airline Business in the 21st Century." Rigas Doganis, Routledge, New York, 2001. Airlines Business Award. ( Jurgen Weber, Rod, Edington, Jim Ream) Flight international ,July 2003. Smullen J., Hand N. (2005). Monetary Policy. A Dictionary of Finance and Banking. Oxford University Press. Oxford Reference Online. Visser, H. (2004). A Guide to International Monetary Economics: Exchange Rate Theories, Systems and Policies 3rd Ed. Cheltenham, UK, Northhampton, MA Edward Elgar Publishing, Inc. Winston. Rinehart H. & Hall A.C. (1960). Fiscal Policy for Stable Growth: A Study in Dynamic Macroeconomics. Read More