mba201a: economic costs. professor wolframmba201a - fall 2009 page 1 economic versus accounting...
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MBA201a: Economic Costs
Professor Wolfram MBA201a - Fall 2009 Page 2
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 Wolfram MBA201a - Fall 2009 Page 3
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 Wolfram MBA201a - Fall 2009 Page 4
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 Wolfram MBA201a - Fall 2009 Page 5
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 Wolfram MBA201a - Fall 2009 Page 6
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 Wolfram MBA201a - Fall 2009 Page 7
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 Wolfram MBA201a - 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
Professor Wolfram MBA201a - Fall 2009 Page 9
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 Wolfram MBA201a - Fall 2009 Page 10
Fuel hedge positions of major US airlines
2006 2007 2008 2009
Southwest 70% @ $36/barrel
55% @ $37/barrel
35% @ $37/ barrel
30% @ $39/barrel
Alaska 45% @ $40/barrel
20% @ $45/barrel
7% @ $49/barrel
0%
AirTran 25% @ $56/barrel
16% @ $59/barrel
0% 0%
JetBlue 16% @ $68/barrel
0% 0% 0%
American 18% @ $60/barrel
0% 0% 0%
US Airways 13% @ $67/barrel
0% 0% 0%
Frontier 4% @ $62/barrel
0% 0% 0%
Continental/Delta/ Northwest
0% 0% 0% 0%
Professor Wolfram MBA201a - Fall 2009 Page 11
Jet fuel and crude oil prices
Jet Fuel & Crude Oil Spot PricesJanuary 2004 - September 2009
0
50
100
150
200
250
300
350
400
450
500
1/2/
2004
3/2/
2004
5/2/
2004
7/2/
2004
9/2/
2004
11/2
/200
4
1/2/
2005
3/2/
2005
5/2/
2005
7/2/
2005
9/2/
2005
11/2
/200
5
1/2/
2006
3/2/
2006
5/2/
2006
7/2/
2006
9/2/
2006
11/2
/200
6
1/2/
2007
3/2/
2007
5/2/
2007
7/2/
2007
9/2/
2007
11/2
/200
7
1/2/
2008
3/2/
2008
5/2/
2008
7/2/
2008
9/2/
2008
11/2
/200
8
1/2/
2009
3/2/
2009
5/2/
2009
7/2/
2009
Jet
Fu
el P
rice
(ce
nts
/gal
lon
)
0
20
40
60
80
100
120
140
160
Cru
de
Oil
Pri
ce (
$/b
bl)
Crude (w hite)
Jet Fuel (black)
Southwest hedging: what’s the lesson?
– Southwest’s accounting profits have been hugely
affected by it’s hedging position.
– But it’s economic decisions most likely have not been
influenced.
Professor Wolfram MBA201a - Fall 2009 Page 12
Professor Wolfram MBA201a - Fall 2009 Page 13
Decision trees and sunk costs
Lesson: What’s behind you is not important.
Movie will be a hit [p=0.8]
Movie will be a flop [p=0.2]
Acquire licensefor new product
-$.5mm
0
-$1mm + $2.5mm
Don’t develop product
Develop product
Develop product
0
-$1mm + $.1mm
Don’t develop product