Some Pleasing Monetarist Arithmetic

Simple monetary economics explains why air fares are so high & suggests how far they will fall next year

The quantity theory of money states that the amount of money circulating in an economy is sufficient to cover all the purchases and investments that are made. Or to put it another way, when more money chases the same or fewer goods and services, prices will rise.

The amount of money actually available is fixed (in the short term) to cash, bank deposits, fungible assets and any money that a central bank might choose to print. Real incomes are fixed too as the economy can only produce so much from a given stock of capital, labour and technology.

If the number of transactions goes up or down, two mitigating factors keep the balance between money and real income in check.

First is the “velocity of money”, a measure of how frequently money changes hands. If you use a twenty Pound note to buy lunch and the restaurant owner uses it to pay part of his chef’s wages the velocity is higher than if the restaurant owner pockets the note and saves it for the future.

Second is the price level, the number of Pounds, Euros or Yuan needed to actually buy a loaf of bread or a business class plane seat. The dance is simple – the amount of money in circulation multiplied by how often it changes hands is equal to the economy’s nominal income (real income multiplied by the price level).

It turns out that the quantity theory of money has some helpful power to understand the current trends in the price of airline tickets and consider what changes we might expect next year.

This is because the airlines’ actions to preserve their business during COVID have actively changed the supply of money available for travel. Airlines will need to make a careful judgement of how quickly this could change in the near future if they are to avoid costly mistakes. Read on to find out more…

Prices are sky high

“Everybody knows” that this is an expensive year to buy plane tickets. For travel ex London, economy class tickets that might have been £500 ($600) in 2019 are now more like £750 to £1,000.

Fancy business class seats are more pricey than ever, with entry fares a good £1,000 higher than in 2019. At the top end, fully flexible travel which might have been £6,000 (before a corporate discount) pre-COVID might now be £8,000 to £10,000. Hotel rates are expensive too – Rob Burgess on Head for Points recently wrote that it can often be cheaper to buy Hyatt points and pay for the room with those than to use cash directly.

High demand is only one part of the explanation

As well as seeing expensive flights, “everybody also knows” that flights are expensive because demand is high. Holidays, sales visits, client catchups and trips to see new grandchildren for the first time are just some examples of international travel that was not possible during COVID and people are raring to get on planes.

This should be no surprise. Airlines have been pricing flights on the basis of demand for decades. Whizzy revenue management algorithms figure out how much “demand to come” there is for a flight. They then decide whether or not to make a seat available for sale at a certain price point by weighing up how likely it is that the same seat can be sold for more in the future.

When the seat is likely to be sold for more money later the airline will hold it back. Otherwise they will release it for sale at a lower price today. Revenue managers know this as the so-called Littlewood Rule.

Although high demand post-COVID is no surprise, it is also not unusual. Summer season flights have never been cheap, although sometimes airlines reduce prices for comfy business and first class seats that will not be bought for business travellers.

General inflation is probably not the main driver of high ticket prices

A third thing that “everybody knows” in 2022 is that inflation is high. British newspaper The Economist reckons it is around 9% in the United Kingdom, United States and the Euro area.

Supply shocks have pushed up costs across a large number of industries, especially those involving food or energy. Meanwhile demand is not just high for travel, it is high for many goods and services as people re-start their lives after COVID.

But this general inflation may not be the main driver of high air fares for three reasons.

First is that airlines price on the basis of willingness to pay and the impact of cost on air fares is limited. Second is fuel hedging since many airlines have yet to feel the full impact of supply shocks.

Third is that travel is purchased in advance and wage-price spirals, which will be associated with increasing willingness to pay, have not been around long enough to feed back into the travel ecosystem. Many travellers decided to take a holiday before high inflation became a thing.

The money supply for air travel has increased

When COVID arrived in 2020 many airlines introduced a voucher system allowing people to buy tickets and exchange them for vouchers should the need arise. The idea was that if passengers decided not to take a trip, perhaps because they might have caught COVID themselves, they could retain the value of the ticket and use it for their next flight without any penalty.

London-based British Airways called their scheme “book with confidence”, which captured the ethos of the scheme. The idea was that people could hand the airline their money and be sure that it would not be wasted. Virgin Atlantic, easyJet and many others had similar models.

This was a significant change. Up until 2020 most airline tickets had been completely non-refundable. In some markets refunds were possible but only for a fee representing a hefty percentage of the price. Only on the most expensive full flexible tickets costing hundreds or thousands more would airlines give passengers their money back.

Passengers were able to convert their existing bookings into vouchers too. Flights are typically open for sale just under a year ahead of time, so plenty of summer holidays set for 2020 were booked and paid for when borders closed. Since airline reservations phone lines had long waiting times for refunds, even if flights were cancelled many passengers collected a voucher.

British Airways even defaulted to a voucher for fully flexible tickets when passengers requested refunds online. Your favourite airline revenue economist had to call up to get his cash back.

The net result is that all the way through to borders opening again in 2022 there was a large stock of consumers’ money tied up in airline vouchers. When travel resumed consumers had this stock to call upon in addition to their savings from 2020 and 2021. The vouchers and the unspent income from 2020 and 2021 together represent a significant increase in the amount of money that consumers can spend on air travel. In the case of the vouchers this is money that can ONLY be spent on travel, a genuine increase in the money supply as it relates to airlines.

Consumers have an incentive to spend the vouchers too since they are not valid forever. BA's vouchers will expire on 30-Sep-2023. Not only do consumers have more money than ever before to spend on air travel, they will want to get it spent fast.

The ‘real’ supply of air travel is still lower than pre-COVID levels

British Airways is flying their A380 super-jumbos (see article). Lufthansa is flying their 747-8s. Virgin Atlantic is receiving A330-neos with snazzy new upper class (business class) suites. Almost every airline seems to have 777s, A350s, 787s and A330s back in the sky.

Capacity has returned to the industry, but although airlines are recovering fast it is still under pre-pandemic levels. IBA, a consultancy, forecast that Q2 2022 will turn out to have been just 10% below pre-pandemic levels. The impact is not evenly spread however – markets like Europe to China are completely closed.

Demand however need not be reduced in the same way as regular travellers to and from Asia look elsewhere for their holiday this year. On transatlantic and shorthaul European routes capacity is probably close to the pre-COVID normal but demand might even be a bit higher.

We have seen that consumers have more money than ever before to spend on plane tickets and the incentive to spend fast, since unlike cash airline vouchers have an expiry date.

I do not see any reason why the velocity of money should have changed. Across the air travel sector it is probably stable since although airlines are raking in the cash, most will be buying parts and maintenance, or paying airport and over-flying fees, in accordance with pre-defined contracts. Some will have hedged their fuel too.

As a result there is simply more money chasing fewer seats, so of course prices are rising to compensate.

Fares may go down when all the ‘new’ money has been spent

All the above suggests that fares are high because there are lots of fixed-value vouchers and savings from holidays foregone in 2020 and 2021 in circulation. Once this money has been spent, in large part absorbed by their year’s price rises, prices should fall.

A back of the envelope calculation suggests how much they might go down by.

Consider a large airline with $20 billion annual revenue, which works out as just under $1.7 billion revenue per month.

Suppose two months of revenue has been converted into vouchers (a bit from the lost 2020 summer holiday season plus a bit more from the time just after restrictions were implemented). That gives $3.4 billion of vouchers. Consumers also have summer 2021’s holiday budget to spend, another $3.4 billion.

Suppose capacity is at about 90% in line with IBA’s figures.

Then consumers have $20 + $3.4 + $3.4 billion = $26.8 billion to spend this year on 90% of seats. $26.8 billion is 34% more than normal so the price level should be 134% / 90% = 48%-ish higher than normal. That explains £500 tickets becoming £750, £2,000 fares becoming £3,000 and £6,000 fares becoming £9,000, which seems pretty close to what I see in the market today.

According to the quantity theory of money, once the vouchers and extra incomes have been spent, consumers should see prices fall to pre-pandemic levels.

But unfortunately this may not turn out to be the case. One of the reasons that central bankers fret so much about high inflation rates is that they tend to be sticky and get baked into the system. This happens because when peoples’ expectations of inflation change they demand higher wages and businesses put up their prices to compensate.

Most airlines will tell you that they use the market price. But the reality is that prices are set by people and the IT platforms they programme. Tickets in some markets like Europe were incredibly cheap for many years before COVID as airlines were afraid that if they put up their rates they may lose market share. Airlines were still profitable because they are efficiently run.

But now prices are high. It will be interesting to see if the commercial teams at head office will be afraid to become the first to lower prices, or even satisfied with high prices instead of market share. If that happens, fares could stay high for a while.

oliver AT ransonpricing DOT com

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