Price Mechanism and Revenue in the Container Shipping Market

Question

Maritime and air freight transport provide the essential transportation services that enable global merchandise trade. In the first half of 2020, U.S. maritime container imports declined. Container shipping firms cancelled scheduled sailings to lower costs and mitigate a downward pressure on freight rates due to overcapacity.

(a) Using a demand-supply analysis, explain how container shipping firms’ decisions in the first half of 2020 worked, and how it impacted the industry’s revenue. [10]

Answer

Total revenue earned by the container shipping industry is the freight rate multiplied by the quantity of shipping services exchanged, $TR = P \times Q$. The question has two requirements: first, to explain through the price mechanism why cancelling scheduled sailings was a rational response to falling freight rates; and second, to trace the effect of that decision on industry revenue. The decision works by deliberately contracting supply to reverse a downward price pressure, and against price-inelastic demand it raises total revenue.

Requirement 1: how cancelling sailings worked. The demand for container shipping is derived from the demand for the merchandise it carries. When U.S. container imports declined, the derived demand for shipping fell, shifting the demand curve leftward from $D_0$ to $D_1$. At the original equilibrium price $P_0$ the quantity supplied now exceeded the quantity demanded — a surplus of unused shipping capacity, the “overcapacity” of the stimulus. Under the price mechanism a surplus exerts downward pressure on price, pushing freight rates down towards $P_1$. To arrest this fall, shipping firms cancelled scheduled sailings, which reduced the number of active producers and so cut the supply of shipping services from $S_0$ to $S_1$. At the depressed price $P_1$ this contraction created a shortage — quantity demanded now exceeding quantity supplied — which exerts upward pressure on price, lifting freight rates from $P_1$ back up towards $P_2$. The decision therefore worked by exploiting the price mechanism in reverse: shrinking supply to manufacture a shortage that pushes the price back up.

Requirement 2: impact on industry revenue. The supply contraction raises the freight rate but lowers the quantity of shipping exchanged, so the effect on revenue is indeterminate until the price elasticity of demand is known, as set out in applying PED. Container shipping is the only practical means of moving merchandise across borders in bulk and has no close substitute, so its demand is highly price inelastic. With inelastic demand, the rise in freight rate from $P_1$ to $P_2$ is more than proportionate to the fall in quantity exchanged, the price effect dominates, and total revenue rises. This is precisely why the cancellation was rational: by cutting quantity along an inelastic demand curve, firms raised price by enough to lift overall industry revenue.

Conclusion. The firms’ decision worked by deliberately reducing supply to generate a shortage that reversed the downward price pressure created by collapsing demand; and because shipping demand is price inelastic, the resulting rise in freight rates outweighed the fall in volume, so industry total revenue increased.