ai) Overall there was an increase in international air passenger growth from

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1 H A levels Case Study 1 ai) Overall there was an increase in international air passenger growth from However in 2001, international air passenger growth registered a negative growth of 1%. aii) Comparison between trends would generally require students to point out one similarity and one difference in a 2 mark question. Similarity observed would be the and the forecast both showed positive growth trends. However it is observed that the forecast trends in , the growth in international air passenger is dropping, or international air passenger is growing at a decreasing rate. b) As seen in extract 1, 2004 has seen a 30 year high in global GDP growth, also in figure 1, World GDP growth have been positive, with growth occurring around the world, it could be assumed that trade and business between countries have been growing and also generally consumers around the world have been becoming more affluent than before. This would signal a rise in the demand for international air passenger travel either for the purpose of engaging in business deals or solely for leisure tourist related travels. An increase in demand from D to D1 in the graph for international air passenger travel would certainly mean in increase in prices and also an increase in quantity. Entry of numerous low-cost airlines on the market for international air passenger travel also means an increase in the supply of international air passenger travel in the market. An increase in supply from S to S1 in the graph would lead to a fall in prices of international air passenger travel and an increase in quantity.

2 An increase in demand for international air passenger travel would mean an increase in prices while an increase in supply of international air passenger travel would mean a fall in prices.the overall change in prices actually depends on which of the change in factor is more significant. However the increase in quantity is reinforced by both the shifts as seen from Q to Q1. A possible analysis would be that global demand of international air travel is very significant as growing economies around the world would require its businesses to be engaging in various parts of the world, this could be seen especially in Asia and Middle East economies which have been trying to reach European, Americas and other previously inaccessible economies. Consumers from these regions have also started to move to farther places around the world for leisure activities. However the increase in low-cost airlines coming into the market does not increase the supply of international air passenger travel as these smaller firms usually focus on regional flights as those in Asia. Airasia and Tiger Airways focus on air travel within Asia and does not cater flights to Europe and Americas and other further places, thus the supply increment from such budget airlines may not be very significant on the international air travel market. Therefore with an increase in demand that is more than supply. Prices will rise from P to P1. Logical/justified stand: Thus a possible conclusion would be that both an increase in demand and supply of international air passenger travel would undoubtedly increase quantity of such travels, the impact on prices would generally be increasing due to the increase in demand being more significant than the increase in supply. Other possible synthesis: Given how the firms are making huge losses Imply that prices may be falling Infer that demand rise less than the rise in supply. ci) Price elasticity of demand measures the degree of responsiveness of quantity demanded of a good to a change in the price of the good itself, ceteris paribus. It involves a movement along the demand curve in response to a price change. Formula Price elasticity of demand for good A = % change in quantity demanded of good A % / % change in the price of good A cii) Objective of the firm is to Increase revenue. Success as mentioned in the extract in this case would be seen as experiencing increased revenue and profits for the low-cost airlines. Price elasticity of demand is used for firms to engage in pricing strategy. The demand for low-cost air travel is relatively price elastic; this is due to the fact that there are relatively more substitutes available in low-cost airlines services. Low-cost airlines usually only provide short haul travels which were also provided by other normal airlines, thus passengers whom wish to travel to near-distanced destinations have more choices.

3 If the firm knows that the demand of its good is price elastic, then it should lower its price to increase revenue. This concept has enabled low-cost airlines from seeing an increase in their revenue when they choose to price their tickets at a lower price. When demand is price elastic, a given percentage fall in the price from P1 to P2 will lead to a more than proportionate increase in quantity demanded from Q1 to Q2, thus causing an increase in total revenue as shown in figure 1. (Gain) Area B > Area A (Loss) from the price cut. A B To attribute the success of low-cost airlines solely to the concept of PED would not be realistic as the concept of PED only infers that low-cost airlines could make more revenue through lowering their prices. The crux of the matter actually lies in the feasibility of lowering prices in these low-cost airlines. Incidentally due to the nature of low-cost airline, and expectations of consumers, low-cost airlines practices a different business model which allow them to cut cost and thus lower prices, some of these cost cutting practices include: a single type of aircraft (commonly the Airbus A320 or Boeing 737 families), reducing training and servicing costs no in-flight entertainment systems made available flying to cheaper, less congested secondary airports and flying early in the morning or late in the evening to avoid air traffic delays and take advantage of lower landing fees fast turnaround times (allowing maximum use of aircraft) emphasis on direct sales of tickets, especially over the Internet (avoiding fees and commissions paid to travel agents and computer reservations systems) employees working in multiple roles, for instance flight attendants also cleaning the aircraft or working as gate agents (limiting personnel costs) not supplying meals in a flight, but offering snacks, sandwiches and drinks instead to purchase on board

4 Thus with the ability to lower cost and also with the fact that the demand for low-cost airlines is price elastic, lowering of ticket prices have been a major factor in the success of such airlines. di) In Extract 3, it was mentioned that the manufacture of solar panels requires polysilicon, which is an important resource, is causing adverse environmental concerns for the country. There exists negative production externalities which results in market failure (define) Private marginal cost (PMC) measures the cost to airlines (producers) of providing additional flight/trip such as cost of wages of crew and aviation fuel. Private marginal benefit (PMB) measures the benefit to passengers (consumers of air travel) from taking an additional flight such as utility/satisfaction derived. Carbon emissions by air travel into the atmosphere will lead to acid rain which destroys buildings and infrastructures. There are also noise pollution suffered by nearby residents of airport. Cost to repair damages on buildings of third parties and possible medical cost incurred by residents are not compensated for by the airline companies who run the air travel services. As airline companies and passengers are only concern with their own private cost and benefits, they do not take into consideration such external costs. Thus result in SMC > PMC (divergence between SMC and PMC graphically). Hence, the market quantity of air travel will be greater than that of socially optimal quantity (Qm > Qs). This means that there is over-production/overconsumption of airline services, resulting in deadweight loss. dii) **Students must explain and evaluate at least 2 measures before making a justified stand. Economist usually make decisions by weighing the cost and benefits of the outcome, decisions are usually made when the outcome shows that the benefit outweighs the cost. It is important to agree that such negative externalities do exist and due to these externalities, goods are being over-produced. This is other wise known as allocative inefficiency, which really means that scared resources are being allocated inefficiently; these resources could be channeled into other sectors. Therefore government needs to intervene to reduce air travel to a socially optimal level. However Singapore being one of the busiest airports in the world, carbon emission levels from aircrafts could genuinely pose an issue. [At least 2 for 8m] Options available to the government would generally be: Market-Based Solution: Imposition of Taxes on the airlines

5 The objective of the government here is to reduce production (flight) levels to the socially efficient level, where SMB=SMC. The government might force the airlines to pay a fee (an indirect tax on each unit of output), the amount of the tax corresponding to the external marginal cost i.e. Tax=EMC at Q SE, distance BD. This shifts the PMC upwards so that the new PMC, PMC 1, now coincides with SMC since PMC 1 = PMC + tax. The tax is designed to get airlines to "internalize the externality" by considering the external costs of production. The imposition of the tax equivalent to the EMC at Q SE (distance CD) results in an output that corresponds to the socially efficient level of output, Q SE. Also, if the tax is seen as payment for the use of the environment, there may be incentives to reduce pollution. The imposition of the fee moves the equilibrium to the socially efficient level where SMC = SMB because when the firm attempts to maximize profit now and produce at where PMB=PMC 1, the outcome will be QSE which will be the socially efficient outcome. If this fee accurately reflects the external marginal cost, the firm is now in effect paying for the use of the environment. The externality has then, in a sense been internalised and is thus now taken into account by profit maximising firms. Figure 1: Market for Air Travel (Note: PMC 1 = PMC + Tax) Price B PMC 1 = PMC + tax C PMC Tax = EMC at Q SE D A PMB=SMB since EMB=0 QSE Q E Quantity of flights Evaluation: The problem with using this method is the difficulty in measuring the external cost of an activity as they may be difficult to monetize and estimate. In addition, different airline firms may create different amount of pollution. This makes imposing the correct amount of tax difficult. While undertaxing brings the economy closer to the optimal level, over-taxing may discourage producers from producing and output produced will be lower than the optimal level. In some circumstances, foreign airlines may even decide to locate elsewhere to avoid paying such high taxes. In the latter, society s welfare is even lower than before tax. This greatly compromise Singapore s position as an aviation hub in Asia.

6 However, one advantage of taxes is that it gives the firm an incentive to develop cleaner technologies, since a cleaner technology would reduce the amount of tax the firm has to pay. Another possible option that the Singapore government could look into is Legislation This is a process of controlling business activities through licences, setting standards, laws and administrative rules. The government may lay down the maximum pollution levels. Airlines have to adhere to the standard. This requires firms to install pollution abatement equipment (such as filters or scrubbers that remove harmful materials from the emissions) to reduce pollution, i.e. reduce EMC so that this will reduce the gap between Qm and Qs, moving closer to the socially efficient level. Firms that are unable to meet the standards will be punished, e.g fine. Evaluation: For this measure to be effective, the government needs to inspect the airlines regularly to make sure that these restrictions are adhered to. This requires large amount of manpower to monitor and enforce, which involves high opportunity cost as such resources could have been put to more productive uses. The penalties for violations also need to be severe enough for the measure to be deterrent. In addition, legislations are also considered to be a blunt instrument compared to market-based solutions as it is not sensitive and customised to the needs and circumstances of the individual firms. Conclusion A good way to manage the issues without jeopardizing the flow of air traffic to and out of Singapore is very important. Imposing high taxes and strict legislations can certainly endanger and discourage airlines from operating in Singapore. For info: Some of the following airlines have pulled out of Singapore due to high cost and increase competitions. AIRLINES that have pulled out of Changi Airport in recent years include: Air New Zealand Finnair Scandinavian airline SAS Gulf Air A good balance of fair increment in taxes to compensate the third parties and also a fair implementation of legislation will perhaps be a good cocktail solution without significantly impacting the airline industry in Singapore.