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The global commercial airline industry has experienced a substantial amount of volatility since the financial crises of 2007-2008. The price of oil rose sharply in mid 2008, then declined just as dramatically a few months later, then rose again for a sustained period of time, until prices began to fall in mid-2014. Consider the periods when oil prices were high. During these periods, increased fuel costs were passed along to consumers as increased airfares and air travel declined. Certain airlines had to reduce flights during these periods or even temporarily stop operations. To examine the situation facing one airline. Let’s consider a hypothetical airline, Fenwick Air. Assume that the total cost function for Fenwick Air is given by
TC=q3 – 30q2 +400q +8000 and consequently, the airline faces marginal costs of
MC = 3q2 – 60q + 400
where q is the number of passengers transported (in thousands of passengers per month) and costs are in dollars. For the purpose of this question we will assume Fenwick Air is in a perfectly competitive market, and is a price taker with respect to airline ticket pricing, and that all airline tickets are the same.
A. Suppose that prior to the decline in air travel, the market price for airline tickets was $400. How many passengers should the airline transport in order to maximize profit in the short run? What profit would it earn? She Fenwick Air continue to operate in the short run or shut down?
B. Suppose that there is a decline in air travel, and the drop in demand for airline travel causes tickets to fall to $100 each. At this price, Fenwick Air has calculated a new profit-maximizing level of q = 10 if it were to continue to operate. What is Fenwick’s profit at this price and quantity (P = 100 and q = 10)? Should it continue to operate in the short run or shut down?
C. The basic analysis of a competitive firm’s shut down decision in the short run is well accepted in economics, but it is not the case that firms will always shut down according to the “textbook rule”. Give two reasons explaining why airlines in particular might choose to continue operating in the short-run, even if the shut-down condition says they should stop operations temporarily. One or two sentences explaining each reason is sufficient.
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