Suppose that the price of jet fuel used by airlines has increased dramatically.

Question

Suppose that the price of jet fuel used by airlines has increased dramatically. As the CEO of Blue Sky Airlines (BSA), you have been presented with the following options to deal with this problem:

Option 1:   Raise airfares to offset cost increases.

Option 2:    Reduce the number of flights per day in some markets.

Option 3:   Make long-term contracts to buy jet fuel at a fixed price for the next two years and set airfares to a level that will cover these costs.

a.Evaluate each of these three options in the context of the economic concepts and business strategies we have learned in the course and explain how you would deal with this situation.

NOTE: You must first determine and define the nature and the structure of the market in which BSA competes before evaluating these options; otherwise, your evaluation will be meaningless. Your answers will be graded based on how you apply the relevant economic concepts and theories we have learned in this course in support of your reasoning and arguments.

Answer:

As you know, airlines practice price discrimination by charging leisure and business travelers with different prices. They could do so because of the different elasticity of demand between these two groups of travelers. Different customers pay varying prices for essentially the same coach seat because some passengers qualify for discounts and others do not. Since the discounts are substantial in many cases, the customer who qualifies for a discount pays a significantly lower airfare. Now, please answer the following question:

b.Is this consistent with profit-maximization? Given the current high cost of jet fuel, will you continue this practice? Why or why not? Please explain.

Explanation / Answer

Hi,

The correct answer is as follows;

a. According to me option 3 would be the best option. The company can get into the forward contract with fuel company to purchase the jet fuel at a fixed price for the next two years and set airfares to a level that will cover these costs. This method can save the company a lot of money over the two years as the prices of fuel are always volatile. The first two options are redundant as it would lead to inefficiency.

b. yes the process of price discrimination is consistent with profit maximization. With the increase in the cost of the fuel it makes even more sense to charge price discrimination because the company can then leverage the elasticity to maximize its profits. The business travelers comprise the inelastic component of the demand as they will travel despite the higher price. So it makes sense to charge the higher cost from them

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