During the height of the Covid-19 pandemic, people were advised to avoid close proximity to others. And there’s nothing more proximate than flying economy in a commercial aircraft? And so, the airline industry became an early and important casualty of the pandemic. According to a New York Post article, one airline saw a greater than 97% reduction in bookings. And what seats the airlines could fill required substantial discounting of fares.
Models are simply an abstracted description of reality. The real world is incredibly complex which makes it difficult to properly determine the potential impact of events like the pandemic. But much of this seeming complexity is simply noise. By focusing on only the most essential components of a system, decision makers can often make fairly reliable predictions about the future.
A particular useful example is the Demand and Supply model. This graphical model uses a highly abstracted representation of buyers and sellers to predict the impact of events or actions on a market. The diagram below represents the short-run market for airline tickets. Price is represented on the vertical axis with price increasing as you move upward. And ticket sales are represented on the horizontal axis with sales increasing as you move to the right. And so, a point like point A represents low sales and ticket prices, much like we saw during the pandemic. A point like B represents high prices and ticket sales, perhaps representing events prior to the pandemic when the overall economy was particularly healthy.
In the next diagram, we add a downward sloping line labelled Demand. This line represents the buying behavior of customers. When ticket prices are high, the desire to purchase tickets is low. See point C. And when ticket prices are low, the desire to purchase tickets is high. See point D. Notice the great number of things we’ve ignored. That’s the nature of a model. We simply want to focus on this one dimension of consumer behavior for now.
In the same diagram, we also have a line labelled Supply. This line represents the behavior of the sellers or, in this case, the airlines. Notice this line slopes upward. When ticket prices are low, the airlines want to offer fewer seats and so may reduce the number of flights. See point E. But when ticket prices are high the airline wants to sell more seats and so may add flights. See point F.
Now, what happens when tickets prices are really high in our model? Airlines may be at point F, but customers are at point C. The number of seats airlines want to sell exceeds the number customers want to purchase. When this happens, we often see airlines start reducing fares. As price decreases, more customers want to fly. But the airlines want to offer fewer flights. And so, as price comes down the market converges to point G. See below.
What if prices had been too low? Customers would be at point D, but the airlines would be at point E. Now there aren’t enough seats available. The airlines will be able to raise fares. This will of course cause some customers to change their minds, reducing the number of tickets desired. And it will cause airlines to want to offer more flights. The market in this case again converges to point G. See above.
And so, in our highly abstracted model we can determine average ticket price and sales. But that alone isn’t of any real value. Instead, consider this. What would be the impact of the pandemic on the airline market? It doesn’t directly cause airline to want to fly any more or less. But it does certainly affect the desire of customers to fly. At any given fare, the demand for tickets is going to decrease. The whole demand line will shift left as shown below.
Notice what happens to ticket prices. They fall. And also notice what happens to ticket sales. They fall also. This corresponds to what we actually saw occur during the pandemic.
Now consider what happened to this same market back in 1991. Iraq invaded its neighbor Kuwait and seized Kuwaiti oil fields. Among other things, one impact of this was a doubling of the price of jet fuel. How did this impact the airline industry?
First of all, customers don’t care what price the airline is paying for their jet fuel. They only care about the price of the ticket. But the increase in the price of jet fuel is very important to the airline, substantially decreasing its profitability. Many once profitable routes become unprofitable and so the airlines have to either raise fares or decrease flights, or both. This is represented below by a leftward shift in the Supply line.
The result of the Iraqi invasion of Kuwait on the airline industry is therefore to cause fares to increase and ticket sales to decrease.*
There are two other possibilities. Demand could increase. For example, the demand for airline tickets is generally much higher around the holidays. And Supply could increase. Reduced regulation might increase profitability for the airlines increasing their desire to fly. The following table lists the four possibilities and their corresponding outcomes
*As footnote to this last example, fear of terrorist reprisal also caused a substantial decrease in demand on the part of customers. I left this out to keep the example simple. You can play with the model yourself to see the combined effect of both. You’ll find sales decreased even more so but the impact on price was ambiguous.