The pricing model for low-cost airline seats seems simple. As the seats get booked, so the price rises. Thus the later you leave it to book, the more expensive it will be. But, in fact, it’s not as simple as this. Seat prices sometimes come down as the take-off date approaches. So what is the pricing model?
The general principle of raising prices as the plane fills up still applies. This enables the airline to discriminate between passengers. Holidaymakers and those with flexibility about when, and possibly where, to travel tend to have a relatively high price elasticity of demand. People who wish to travel at the last minute, such as businesspeople and those facing a family emergency, tend to have a much lower price elasticity of demand and would be prepared to pay a higher, possibly much higher, price.
With relatively high fixed costs for each flight, low-cost airlines need to fill, or virtually fill, their planes if they are to make a profit. And it’s not just about the direct revenue from ticket sales. Low-cost carriers also rely on the revenue from selling extras, such as on-board refreshments, hold luggage, hotels, car hire and travel insurance. With variable costs being tiny, the pricing model is about maximising revenue for each flight. So the fuller the plane, the better it is for the airline.
The airlines are very experienced in estimating demand over the period from a flight coming on sale and the departure date. If they get it right, then prices will indeed rise as take-off approaches. But sometimes they get it wrong. If, as time passes, a given flight is filling up too slowly, then it makes sense to be more flexible on prices, cutting them if necessary. Pricing may be easy in principle; but not always easy in practice!
Article
Low-cost air fares: How ticket prices fall and rise BBC News, Erica Gornall (21/6/13)
Papers
Pricing strategies of low cost airlines Air Transport Group, Cranfield University, Keith J Mason (2002)
Pricing strategies of low-cost airlines: The Ryanair case study Journal of Air Transport Management, 15, Paolo Malighetti, Stefano Paleari and Renato Redondi (2009)
Questions
- Does a low-cost airline always charge lower prices than a traditional scheduled airline? If not, why not?
- Identify the various reasons why holidaymakers may have a relatively elastic demand for a particular flight?
- Explain the system of ‘buckets’ of seats?
- Are low-cost airlines engaging in price discrimination and, if so, which type?
- Are there any variable costs of operating a particular flight (assuming that the flight does actually take place)?
- If demand for a flight becomes less elastic as the date of departure gets nearer, why might a budget airline choose to lower the price, at least for a few days?
- Why can Ryanair operate with lower costs than easyJet?
- Would it be in low-cost airlines’ interests to charge more (a) to overweight people; (b) for using the toilet?
The UK economy faces a growing problem of energy supplies as energy demand continues to rise and as old power stations come to the end of their lives. In fact some 10% of the UK’s electricity generation capacity will be shut down this month.
Energy prices have risen substantially over the past few years and are set to rise further. Partly this is the result of rising global gas prices.
In 2012, the response to soaring gas prices was to cut gas’s share of generation from 39.9% per cent to 27.5%. Coal’s share of generation increased from 29.5% to 39.3%, its highest share since 1996 (see The Department of Energy and Climate Change’s Energy trends section 5: electricity). But with old coal-fired power stations closing down and with the need to produce a greater proportion of energy from renewables, this trend cannot continue.
But new renewable sources, such as wind and solar, take a time to construct. New nuclear takes much longer (see the News Item, Going nuclear). And electricity from these low-carbon sources, after taking construction costs into account, is much more expensive to produce than electricity from coal-fired power stations.
So how will the change in balance between demand and supply affect prices and the security of supply in the coming years. Will we all have to get used to paying much more for electricity? Do we increasingly run the risk of the lights going out? The following video explores these issues.
Webcast
UK may face power shortages as 10% of energy supply is shut down BBC News, Joe Lynam (4/4/13)
Data
Electricity Statistics Department of Energy & Climate Change
Quarterly energy prices Department of Energy & Climate Change
Questions
- What factors have led to a rise in electricity prices over the past few years? Distinguish between demand-side and supply-side factors and illustrate your arguments with a diagram.
- Are there likely to be power cuts in the coming years as a result of demand exceeding supply?
- What determines the price elasticity of demand for electricity?
- What measures can governments adopt to influence the demand for electricity? Will these affect the position and/or slope of the demand curve?
- Why have electricity prices fallen in the USA? Could the UK experience falling electricity prices for similar reasons in a few years’ time?
- In what ways could the government take into account the externalities from power generation and consumption in its policies towards the energy sector?
The Office for Budget Responsibility has said that the UK Treasury will face a shortfall of £13bn in motoring taxes within a decade. Although car usage continues to rise putting increasing pressure on the road infrastructure, the greener and more fuel efficient cars being produced are driving down the tax revenues generated from motoring.
A report by the IFS has put forward the case for replacing the existing system of taxes on cars and fuel by a new road charging system. If no such change occurs, the IFS has forecast that with more electric cars and hence lower revenues raised from fuel and vehicle excise duties, the shortfall facing the Treasury would require an increase in fuel duty of some 50%. Instead of this, the solution could be to charge individuals for every mile of road they use, with the ‘price’ varying depending on the degree of congestion. For example, at peak times the price would be higher, where as for those in the countryside where roads are traditionally much quieter, charges would be lower. The IFS said:
‘Such a move would generate substantial economic efficiency gains from reduced congestion, reduce the tax levied on the majority of miles driven, leave many (particularly rural) motorists better off, and provide a stable long-term footing for motoring taxes without necessarily raising net additional revenue from drivers.’
Government policy across the world has been increasingly focused on climate change, with targets for emissions reductions being somewhat ambitious. However, many car manufactures who were told to reduce emissions significantly are on the way to meeting these targets and this success is a key factor contributing towards this new road ‘crisis’ that could soon be facing the government. The following articles consider the possibility of a road charging scheme.
Report
The road ahead for motoring taxes? Institute of Fiscal Studies (link to full report at the bottom of the page) (May 2012)
Articles
Compelling case for UK road charging, IFS study says BBC News (15/5/12)
Fears tax shortfall may lead to road tolls Sky News (15/5/12)
Who’s going to pay to update Britain’s infrastructure? Guardian Business Blog (15/5/12)
Motoring taxes: a future headache for the Chancellor Channel 4 News (15/5/12)
For whom the toll bills – less traffic hurts M6 toll road owner Guardian, Ian Griffiths and Dan Milmo (14/5/12)
Charge motorists per mile, says IFS Independent, Nigel Morris (15/5/12)
Green cars to drive down tax receipts Financial Times, Mark Odell and John Reed (15/5/12)
Questions
- Illustrate the effect of a tax being imposed on petrol. What happens to the equilibrium price and quantity?
- Despite fuel duty pushing up the price of petrol, why has there been such a small decline in the quantity of petrol individuals use?
- Evaluate the case for and against a road charging scheme.
- Why are tax revenues from motoring expected to decline over the next decade?
- Climate change has become an increasingly important focus of government policy. To what extent is the current road ‘crisis’ a positive sign that policies to tackle climate change are working?
- If a road charging scheme went ahead and prices were varied depending on traffic, time etc, what name would you give to this strategy?
- Why would it be possible to charge a higher price at peak times and a lower price for cars using country roads?
- Is there an argument for privatising the road network? Is it even possible?
On 21 March, the Chancellor of the Exchequer, George Osborne, delivered the 2012 Budget for the UK. The details of the tax and benefit changes can be found in the Budget Report, with the Treasury’s summary of the tax changes here.
One of the key elements in the Budget was the reduction in the top rate of income tax from 50% to 45% from April 2013. The Chancellor argued that the introduction of the 50% rate in 2010 had raised very little extra tax revenue. Partly this was the result of people managing their tax affairs so that they could bring forward income to the year before the 50% rate was introduced – a practice known as forestalling. People are likely to do the reverse with the latest tax change and delay receiving income until next year. For details of the effects of forestalling, see the Office for Budget Responsibility’s Economic and fiscal outlook charts and tables Box 4.2a.
But part of the reason for the 50% tax rate raising relatively little has been the effect on incentives. A rise in the top rate of income tax can encourage people to move from the country – or move their incomes; it may discourage top earners from working more; it may encourage people to engage in various tax avoidance schemes; it may encourage people to evade taxes by not declaring all their income.
The effect of a rise (or fall) in the marginal income tax rate (t) on taxable income is given by the taxable income elasticity (TIE). This is defined as the proportionate change in taxable income (Y) divided by the proportionate change in the net-of-income-tax rate (r) (where r = 100 – t: i.e. the percentage of an extra pound that is not paid in income tax, but is retained by the taxpayer for spending or saving). TEI is thus ΔY/Y ÷ Δr/r. The larger the disincentive effect of raising taxes, the more will taxable income fall and hence the higher will be the value of TIE.
The Office for Budget Responsibility (OBR) in 2010 based its calculations on a TIE of 0.35 for the rise in the top marginal rate of income tax from 40% to 50%. This means that for each 1% fall in the net-of-income-tax rate, taxable income would fall by 0.35%. With a TIE of 0.35, the OBR calculated that the new top rate would bring an extra £2.9bn per year by 2011-12 (after allowing for any temporary residual effects of forestalling). However, the OBR now believes that the TIE is significantly higher and that the 50% rate will bring only an extra £0.7bn in 2011/12.
In its analysis of the effects of a cut in the top rate from 50% to 45%, the OBR has assumed a TIE of 0.45.
Turning to the costing of the move to 45 per cent, measured against our baseline that reflects the new information on the 50 per cent yield, we have endorsed as reasonable and central the Government’s estimate that the underlying cost would be around £0.1 billion in 2013-14, based on an assumed TIE of 0.45. The figure is as low as this because a TIE of 0.45 implies that the revenue-maximising additional tax rate is around 48 per cent. Moving from just above to just below this rate would therefore have very little revenue impact. Moving the additional rate back to 40 per cent would take it further below the revenue maximising rate and would thus be more expensive at roughly an additional £600 million. But for the reasons set out above we would again emphasise the huge uncertainties here.
Economic and fiscal outlook – March 2012 (p110)
The government’s arguments for reducing the top tax rate, therefore, are that it will have little effect on tax revenue, but would have a significant effect in encouraging inward investment, discouraging emigration of high earners and encouraging high earners to work more.
Articles
Rich tax cuts offset by changes to relief Financial Times, Vanessa Houlder (21/3/12)
Budget 2012: A big debate about small numbers (cont’d) BBC News, Stephanie Flanders (21/3/12)
Budget 2012: End of 50p tax, but 45p rate here to stay The Telegraph, Robert Winnett (21/3/12)
Budget 2012: Top income tax rate ‘won’t go any lower than 45p’ This is Money, Tim Shipman (22/3/12)
Why is tax avoidance a reason for letting people off tax? New Statesman, Alex Hern (22/3/12)
Study: Millionaires Don’t Flee States Due To Tax Hikes Think Progress, Pat Garofalo (22/3/12)
Laffer Curve Fun, with a side serving of nepotism Mark Wadsworth blog (22/3/12)
Budget 2012: are we really all in this together? Guardian, Polly Curtis (21/3/12)
Did the 50p tax rate really raise less than £1 billion in 2010/11? Touch Stone, Howard Reed (22/3/12)
45p: Power beats evidence Stumbling and Mumbling, Chris Dillow (22/3/12)
Reports, documents and presentations
Economic and fiscal outlook – March 2012 OBR
Budget 2012 HM Treasury (21/3/12)
Budget 2012 IFS (March 2012)
The Exchequer effect of the 50 per cent additional rate of income tax HMRC (March 2012)
Can More Revenue be Raised by Increasing Income Tax Rates for the Very Rich? IFS, Mike Brewer and James Browne (2009)
The 50p income tax rate IFS, James Browne (March 2012)
Questions
- What are the arguments for and against reducing the top rate of income tax from 50% to 45%? Do the same arguments apply to a further reduction to 40%?
- According to the OBR, at what top tax rate is the top of the Laffer curve?
- Why are the OBR’s calculations subject to considerable possible error?
- Why might a fall in the top tax rate from 50% to 40% not exactly reverse all the effects of an earlier rise in the top tax rate from 40% to 50%? In other words, why may the effects not be symmetrical?
- Distinguish between the income and substitution effects of a change in income tax rates. Which is assumed to be larger by the OBR in the case of reducing the top rate of income tax from 50% to 45%? Explain.
Advertising is a costly venture, but for firms in a highly competitive market it can be essential for success. During the recession, many firms had to make a variety of cut backs and reduced advertising for many was one of the key areas to go.
However, one of the leading advertising companies – WPP – has posted significant profits this year, which are up by some 18.5%, reaching £1.008bn. According to Sir Martin Sorrell, a key factor in this success is that many firms, whilst not looking to increase their market share, have felt the need to continue advertising, simply to maintain their existing market share. This has become especially important in growing markets, as competition has become more and more intense.
This new is not only good for the company in question, but also for the UK economy, as the firm has said that it will be moving its headquarters back from Ireland to the UK. This is assuming that legislation is passed concerning the taxation of profits earned abroad. If this relocation does go ahead, it could mean the creation of many more jobs in the UK and a boost to tax revenues, both of which are crucial for the UK economy. As Sir Martin Sorrell said:
‘I am delighted to say that the last remaining issues I think have been removed subject to legislation being introduced in Parliament. We will be coming back subject to shareholder approval’.
WPP believes growth throughout 2012 will be high, due to events such as the Olympics and the US Presidential elections, together with its strength in emerging economies. At the moment, this all looks like good new for the UK and oh how it’s needed!
WPP profit up ahead of 2012 Olympics boost Reuters (1/3/12)
WPP’s Martin Sorrell says he is likely to move HQ back to London Guardian, Mark Sweney (1/3/12)
Olympics, Election to boost WPP Wall Street Journal, Kathy Gordon (1/3/12)
WPP breaks £1bn profit barrier Guardian, Mark Sweney (1/3/12)
WPP boosts dividend after strong year Financial Times, Tim Bradshaw and Mark Wembridge (1/3/12)
WPP profits reach record in 2011 BBC News (1/3/12)
Questions
- What is market share and how can it be calculated?.
- What is the purpose of advertising. Using a supply and demand diagram, illustrate the effect the advertising should have. Think about the position and the shape of the curves.
- Why is advertising an area that did see cut backs throughout the recession?
- Do you think that advertising is more important for firms in growing markets? Explain your answer.
- Why did WPP relocate to Ireland and what may bring it back to the UK?
- How have WPP’s dividend payments been affected by this latest profit information?
- During a recession, competition tends to become more intense. Why is this and what role does advertising play?
The pricing model for low-cost airline seats seems simple. As the seats get booked, so the price rises. Thus the later you leave it to book, the more expensive it will be. But, in fact, it’s not as simple as this. Seat prices sometimes come down as the take-off date approaches. So what is the pricing model?
With relatively high fixed costs for each flight, low-cost airlines need to fill, or virtually fill, their planes if they are to make a profit. And it’s not just about the direct revenue from ticket sales. Low-cost carriers also rely on the revenue from selling extras, such as on-board refreshments, hold luggage, hotels, car hire and travel insurance. With variable costs being tiny, the pricing model is about maximising revenue for each flight. So the fuller the plane, the better it is for the airline.
The airlines are very experienced in estimating demand over the period from a flight coming on sale and the departure date. If they get it right, then prices will indeed rise as take-off approaches. But sometimes they get it wrong. If, as time passes, a given flight is filling up too slowly, then it makes sense to be more flexible on prices, cutting them if necessary. Pricing may be easy in principle; but not always easy in practice!
