now that we've taken a look at how airlines put together their Fair structures um it's time to look at how they actually choose the fair levels in the market so if you recall from the last video we were looking at this demand curve and we had uh we started out with one price we called it P1 and the airline could uh get a certain amount of revenue from one price in the market and then we Illustrated how adding uh adding different fairs P1 excuse me P2 and P3 the airline could actually increase Revenue by having
more than one fair for basically the same product the same seat uh in um in any given Market well now let's take a look at how does the airline go about choosing the fair levels what is uh the P1 Fair the P2 and P3 fair and there are two generally two circumstances where the airline has to choose those levels one is when they first enter where our market and two is when they're already in a market and they're responding to changes in demand changes to seasonality and things like that so we're going to talk about
both of those but before we do that we need to just reinforce the concept of elasticity so we're going to take a little bit of a diversion here just review basic elasticity Concepts and then we'll be ready to talk more about a hair how Airlines choose those fairs so this is going to be just a a quick review hopefully you seen uh this in your economics classes and uh we're not going to go too deep into it and we're just going to use the concepts that we need so that we can talk more about Airline
pricing so if you recall uh the law of demand is um uh represented by a downward sloping demand curve and it shows us how the quantity demanded changes as a response to a price change so um uh for example when the price increases the quantity demand goes down when the price decreases the quantity demanded goes up and just recall for um for good terminology we are talking about a change in the quantity demanded remember when you talk about a change in demand so if demand changes that's represented in a shift of the demand curve either
shift left or shift right here we're talking about movements along the demand curve as a response to price changes and that is called a change in the quantity uh demanded now we're not going to go too much sorry uh into the formulas for calcul calculating elasticity there's different ways to do it uh there's there's pros and cons for our purposes here we don't really need to do that um it's much more important that you understand the concept of elasticity when things are elastic when things are inelastic and that how that will influence what an airline
pricing analyst does uh to maximize Revenue so let's just take a quick example here um uh and you know you can you can recall the the the formulas that are used to calculate elasticity so it's simply on the numerator you have the percentage change in quantity and in the denominator you have the percentage change in price uh so as the price changes by a certain percentage the quantity changes by some corresponding percentage and that is represented by the elasticity so here I chose some very uh easy numbers just to make uh the math work so
if the price the change in price is ne02 and the resulting change in quantity is 0.001 then the elasticity is simply you know 01 divided by ne02 which is 0.5 of course you'll probably notice immediately I left off the negative sign and that's a convention often used use in economics all elasticities are negative because of the downward sloping demand curve but often we we leave off the negative uh sign because it's it's implied all elasticities are negative so whether you say it's negative point5 or positive point5 it it it means the same thing in concept
although it can be very confusing because you'll see sometimes you'll see the elasticity is a negative number sometimes you'll see it's a positive number um that's it's just by convention it's always negative because the demand curve is downward sloping the uh elasticity is always negative now you don't have to again worry too much about how we came up with those numbers it's much more important to understand these three categories of uh elasticity elastic demand inelastic demand and unit elasticity so uh recall that when we talk about Demand Being elastic it's when the elasticity is greater
than one or actually less than negative one because we're leaving off the minus sign when demand is elastic that means that a change in price a percentage change in price will result in a greater percentage change in the quantity demanded so for example uh as I've written here if the price decreases by 10% and the quantity demanded uh excuse me the quantity demanded will increase by more than 10% and Revenue will go up so um let me see if I can write on this here no um sorry let me just uh um well I'm just
going to say it to say safe time I'm G to let's make up an example let's say that the price is the fair for a given um Market is $100 and the the fair decreases by 10% from $1 100 to $90 if demand is elastic the the percentage change in quantity demanded will go up by more than 10% so let's say the number of seats demanded at $100 was 50 and when the fair decreases from 100 to 90 the demand goes up excuse me the quantity demand goes up from 50 to 60 so that's a
20% increase that that means that demand was elastic sorry about that Bell um so a 10% decrease in price resulted in a greater than 10% increase in quantity demanded and the result of that will be that Revenue goes up if you need to convince yourself of that write out the numbers and you'll see that that is the case we're not we're not talking about profit here this is just total revenue um but when demand is elastic decreasing the price will result in more total revenue the opposite opposite of that is inelastic demand so when elasticity
is less than one or uh what is greater than negative 1 uh if the price decreases by 10% the quantity demanded will increase by less than 10% so yes let's use our example again so if we decreased our fair from $100 to $90 a 10% decrease the quantity demanded will increase by something less than that so let's say by less than that percentage so let's say we started out at a demand for 50 seats and we decreased the price from $100 to $90 and the number of seats demanded increased from 50 to 52 so that's
a 4% increase so a 10% decrease in price resulted in a 4% increase in quantity demanded uh overall Revenue will be total revenue will be less at the lower price level and that means that demand is inelastic and finally unit elasticity is where you're sort of at the indifference point of uh both elastic and and in in elastic demand so uh it's when elasticity is is equal to one or equal to negative one and a price increase a percentage change in price will will equal um the percentage change in quantity demanded and uh Revenue will
be unchanged so we're going to take a look at at all three of these things just a little bit closer here um uh oh and these are just the the theoretical uh bounds of inelastic and elastic demand it does help you to sort of remember uh the the steepness of slopes of demand Cur curves how they represent elasticity but if you're perfectly in elastic the demand curve is vertical and if you're perfectly elastic theand curve is horizontal now let's take a look at our demand curve from um this is similar to the one we used
in our previous videos and if you remember we started out looking at just one price now we're not going to complicate this by adding other prices to the fair structure let's assume we have a market with just one fair and in this case it's p and if you recall call we said when there's only one price in the market only one fair in the market revenue is maximized by choosing the point along the demand curve where the rectangle under the demand curve is maximized the rectangle the rectangle represents total revenue so um length times width
of the re of the uh rectangle is the area of the rectangle which represents total revenue you pick the point along the demand curve that maximizes total revenue we're going to see in just a second how elasticity is related to that and here it is so it turns out that the point that maximizes Revenue when you only have one Fair the point that maximizes revenue is that point where El elasticity is equal to one or where elasticity is at unit elasticity and this makes sense let's take let's take a look let's say we were up
here and we set our price above P1 uh you know above P1 at some point on this demand curve and we know from our elasticity calculation that in this area of the demand curve the uh elasticity is is elastic it's greater than one well we said that if you if you're in an area of elastic demand and you decrease price quantity demand it increases by a greater percentage than the price decrease and revenue goes up so if you you were here if you were a pricing analyst and you knew you were in this point of
the demand curve you would want to decrease your price because decreasing uh a decrease in price will incre improve Revenue similarly if you're down here in a point of inelastic demand we saw that when your when demand is in elastic a price increase a percentage price increase results in a smaller percentage decrease in quantity demanded and revenue goes up so if you're down here and um you're in a area of inelastic demand you're going to want to raise your fair and uh because increasing your fair will actually improve total revenue and if you could do
that until you found the point of unit elasticity that would be where your uh maximizing Revenue now in in reality uh no one's looking at these demand curves to to uh figure out their price levels because um well it's it's very difficult to actually estimate demand curves they're using the concept they're not using the demand curve and calculating elasticities but these concepts are what pising analysts use every day whether they're even calling it elasticity or not that's what they're doing they're trying to figure out where they can lower fairs to improve revenue and where they
can increase fairs to improve revenue and if they could find the point where um changing fairs would decrease Revenue whether you know whether it's an increase of fair or decrease in fair if they could find the point where any change in price would decrease Revenue they would be at this point of unit elasticity and they would um they wouldn't want to move off of that so that's that's essentially what they're doing now just a couple of final points I don't want to use too much more time here but um first of all uh you know
the demand curve here is linear we do that just to illustrate the concept in reality uh the demand curve would not be l here would be some kind of curve um we don't know what it looks like so we don't try to draw it um it's very difficult to actually estimate but this does lead to some confusion sometimes folks especially pricing people will look at this and think that the elastic portion of the demand curve should be down at the bottom and the inelastic portion should be at the top because that's actually how we we
view the demand curve across different pricing structures usually the more elastic customers are down in the Leisure area and the inelastic customers down at the um at the higher Fair levels um that would make sense if we were looking at all of the fairs in the market and the and the demand curve was was a curve instead of a line um uh but when we're illustrating it this way with only one fair this this is correct so um sometimes people look at this this uh uh graph and think I've gotten it backwards um the other
thing to remember uh it's often um people will remember elasticities as the elasticity being the slope of the demand curve and that's not correct um you could construct a demand curve where there was a constant elasticity of the along the demand curve but it has to do with the units um I'm not going to go into it but don't fall into that trap I I I do it myself I I I um think of well if you can just calculate the slope you have the elasticity that not correct um the elasticity actually changes along the
demand curve even when the demand curve is linear
