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June 25, 2008

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Milos Sugovic

Simple supply and demand analysis predicts that increasing costs and deceasing demand will reduce output (air traffic) while having an ambiguous effect on price. Problem is, airlines face oligopolitsic competition and fixed capacity, which means, profit maximization necessitates “producing” at full capacity. And that makes me wonder by how much (if at all) will output actually drop? To complicate matters even further are the subsidies injected into the industry, which have artificially depressed prices. Now that prices are increasing, consumers engage in switching away from short-distance air travel to other means. But other forms of transportation see the same gas price increases, so the question is: by how much will cross-prices change? More importantly, however, is long distance travel, especially trans-Atlantic flights, for which there are no close substitutes. Airlines face inelastic (irresponsive to price) demand in that case, and any cost of production increase can be transferred almost 1-for-1 to the consumer’s wallet. And this might cause producer switching towards long-haul flights as well. How the airline industry will be reshaped is ambiguous, to say the least, and no doubt a few carriers will go out of business. But I’m a bit of a skeptic that we’ll see fewer delays as a result. I hope I’m wrong!

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