Cross price elasticity of demand and airline safety – how much should be invested?

You are no doubt aware of the two catastrophic accidents in 2018 involving Boeing 737 Max aircraft which led to the Federal Aviation Administration (FAA) to ground all 737 Max aircraft and make regulatory changes. The compliance costs incurred by the FFA were significant and can ultimately drive up fares and cause consumers to substitute higher-risk road travel for air travel – cross price elasticity of demand. See table below:

Before the 737 Max crashes the last major fatal US airline disaster was in 2009 when Colgan Air Flight 3407 crashed near Buffalo, NY, killing all 49 passengers aboard and one person on the ground. This contrasts sharply with the 36,560 fatalities on the nation’s roadways in 2018 alone, the most recent year for which data are available. The numbers show that US road fatalities are more than twice the number of lives lost in the two 737 Max crashes. Therefore if the cross price elasticity of demand of road travel with respect to air travel = 0.2, this means that a 10% increase in airfares would result in a 2% increase in the demand for road miles traveled – 2% / 10% = 0.2. Table 1 below estimates that a 10% increase in airfares an estimated 33 billion additional passenger-miles would be driven. This would have an expected increase in road fatalities of 240 – 70% of the 737 Max crashes.

Analysis of Automobile Travel Demand Elasticities with Respect to Travel Costs,” by Jing Dong, Diane Davidson, Frank Southworth, and Tim Reuscher. Prepared for the Federal Highway Administration, August 30, 2012. Table 27.“Comparing the Fatality Risks in United States Transportation across Modes over Time,” by Ian Savage. Research in Transportation Economics 43: 9–22 (2013). Table 2.

The graph below shows the impact of an increase in airfares due to increased safety regulations. With the price rise the quantity demanded for air travel decreases and given that road and air are substitutes, the increase in the price of air travel shifts the demand curve for road travel.

The FAA’s mission is to provide the safest and most efficient air travel in the world. However the society’s optimal amount occurs when the marginal benefit of airline safety = to the marginal cost of airline safety – MB=MC. This theory does not say that society should invest in airline safety up to a point where the chance of a crash is zero, although an airline might have the resources to do so. As the investment in airline safety is subject to the law of diminishing returns, the cost increases are significant and the airline attempts to recover these through higher fares which, to a rational consumer, reduces demand. The theoretical relationship between investment in airline safety and net lives saved is shown below. I1 = more investment in airline safety will save more lives I2 = less investment in airline safety will save more lives. I* = the optimal amount of investment to save the most lives.

Of course, there are always opportunities to do better and Boeing and the FAA should avail themselves of all “efficient” opportunities to do so (i.e., those that save lives on net). Still, there is a real risk of reflexive over-regulation that costs more lives than it saves.

Source:

The Risk of Too Much Air Safety Regulation – Regulation Spring 2020