MBA201a: Economic Costs

Professor WolframMBA201a - Fall 2009 Page 1 Economic versus accounting costs –We will discuss how economists and accountants have different motives in thinking about costs. Accountants are trying to keep track of them; Economists are trying to make sound strategic decisions on the basis of them. –Economic costs include opportunity costs & exclude sunk costs.

Professor WolframMBA201a - Fall 2009 Page 2 Opportunity costs –Payoffs from an action must be judged against the best alternative action. –Make sure you think of all the possible alternatives at a decision node, –… and think through the implications of each node. –Acquisition costs are irrelevant to opportunity costs. –Economic costs include opportunity costs.

Professor WolframMBA201a - Fall 2009 Page 3 Opportunity cost examples –What are the major costs associated with attending Haas for you? –What is the cost to Hertz of a car that is returned late? –What is the value of your frequent flyer miles?

Professor WolframMBA201a - Fall 2009 Page 4 Opportunity cost example: airline fuel hedges –A number of the airlines buy hedges on jet fuel costs. For instance, if jet fuel prices are trading at $1/gallon, an airline may hedge possible price increases by purchasing a financial option that allows it to buy 500 million gallons of fuel at that price in the future. If the jet fuel price falls below $1/gallon, the airline is out what they paid for the hedge and they buy fuel at the lower spot price. If the jet fuel price goes above $1/gallon, they can purchase 500 million gallons at $1/gallon.

Professor WolframMBA201a - Fall 2009 Page 5 Airline jet fuel hedge example –Southwest Airlines currently holds options allowing them to purchase jet fuel at a price of $1.25/gallon. –Imagine that it has a route for which its net revenue is equivalent to $1.25/gallon. * In other words, the route is only profitable if the jet fuel price is at or below $1.25. –Should Southwest’s decision to fly that route depend on whether or not it has hedged its fuel costs? * For instance, imagine a route where SWA has non-fuel costs of $5,000 per flight. Its planes get roughly.25 miles/gallon, so if the route is 500 miles, it’s using 4*500 = 2000 gallons of fuel at a cost of $1.25*2000=$2,500. If it usually carries 100 passengers who generate net revenue of $75 apiece, its passengers are paying $7,500. Net revenues on the route are negative unless fuel is less than or equal to $1.25/gallon.

Professor WolframMBA201a - Fall 2009 Page 6 Southwest’s decision if it’s un-hedged Jet fuel price $1.50 [p=.5] Drop route Buy spot, operate route Drop route No hedges Jet fuel price $1.10 [p=.5] Buy fuel in spot market, operate route 0 $.15/gallon 0 -$.25/gallon

Professor WolframMBA201a - Fall 2009 Page 7 Southwest’s decision if it’s hedged Jet fuel price $1.50 [p=.5] Exercise options, drop route, resell fuel Buy spot, operate route Drop route Buy hedges at $1.25 Jet fuel price $1.10 [p=.5] Exercise options, operate route $.25/gallon 0 $.15/gallon 0

Professor WolframMBA201a - Fall 2009 Page 8 Southwest’s decision if it’s hedged Jet fuel price $1.50 [p=.5] Exercise options, drop route, resell fuel Buy spot, operate route Drop route Buy hedges at $1.25 Jet fuel price $1.10 [p=.5] Exercise options, operate route $.25/gallon 0 $.15/gallon 0 Although SWA’s acquisition cost for jet fuel depends on whether it has hedges, its opportunity cost of using jet fuel reflects the spot price in either case.

Professor WolframMBA201a - Fall 2009 Page 9 Fuel hedge positions of major US airlines Southwest $36/barrel $37/barrel $37/ barrel $39/barrel Alaska $40/barrel $45/barrel $49/barrel 0% AirTran $56/barrel $59/barrel 0% JetBlue $68/barrel 0% American $60/barrel 0% US Airways $67/barrel 0% Frontier $62/barrel 0% Continental/Delta/ Northwest 0%

Professor WolframMBA201a - Fall 2009 Page 10 Jet fuel and crude oil prices

Southwest hedging: what’s the lesson? –Southwest’s accounting profits have been hugely affected by it’s hedging position. –But it’s economic decisions most likely have not been influenced. Professor WolframMBA201a - Fall 2009 Page 11

Professor WolframMBA201a - Fall 2009 Page 12 Decision trees and sunk costs Lesson: What’s behind you is not important. Movie will be a hit [p=0.8] Movie will be a flop [p=0.2] Acquire license for new product -$.5mm 0 -$1mm + $2.5mm Don’t develop product Develop product 0 -$1mm + $.1mm Don’t develop product