Final answer:
The price elasticity of demand for air travel in this scenario is calculated to be -0.60, indicating inelastic demand. Raising fares may be a necessary strategy for airlines due to increased fuel costs, and it can potentially increase total revenue. Elasticity differences between business and economic classes are likely due to different consumer behaviors and the availability of substitutes.
Step-by-step explanation:
The price elasticity of demand for air travel can be calculated using the percentage change in quantity demanded and the percentage change in price. The formula for price elasticity is: E_d = (\% \Delta Q_d) / (\% \Delta P).
In this scenario, the fare increased from $0.75 to $1.25, which is an increase of 66.67%, and the quantity demanded dropped from 2.5 million passenger kilometers to 1.5 million passenger kilometers, which is a decrease of 40%. Plugging these numbers into the elasticity formula: E_d = (-40) / (66.67) = -0.60. The negative sign indicates the inverse relationship between price and demand. A price elasticity of -0.60 suggests that the demand for air travel is inelastic over this price range, as the percentage change in quantity is less than the percentage change in price.
Whether raising fares is the correct pricing strategy for airlines depends on several factors. Generally, when demand is inelastic, total revenue can increase after a price increase even though the quantity demanded decreases. In the face of higher fuel costs, raising fares might be a necessary strategy for airlines to cover increased operating expenses. However, the long-term effects on customer satisfaction and competition in the market must also be considered.
The equilibrium price and quantity of air travel are expected to increase and decrease, respectively, when fuel costs rise due to the increased operating costs for airlines, which may often result in higher prices for consumers. This is based on the four-step analysis, which pairs the supply and demand curves to determine equilibrium. If the supply is elastic, shifts in demand will generally have a larger effect on equilibrium quantity than on price.
The difference in elasticity of demand between business class and economy class can be attributed to the nature of consumers and the availability of substitutes. Business travelers may be less sensitive to price changes as the trips are often essential and paid for by their companies. Economy passengers may have more alternatives and thus show a higher elasticity.