MBA201a: Economic Costs
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 1
Opportunity costs
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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 2
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 3
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 4
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 5
Southwest’s decision if it’s un-hedged
Drop route
0
Jet fuel price $1.50 [p=.5]
Buy fuel in spot market, operate route
-$.25/gallon
No hedges
Buy spot, operate route
$.15/gallon
Jet fuel price $1.10 [p=.5]
Drop route
0
Professor Wolfram
MBA201a - Fall 2009
Page 6
Southwest’s decision if it’s hedged
Exercise options, drop route, resell fuel
$.25/gallon
Jet fuel price $1.50 [p=.5]
Exercise options, operate route
0
Buy hedges at $1.25
Buy spot, operate route
$.15/gallon
Jet fuel price $1.10 [p=.5]
Drop route
0
Professor Wolfram
MBA201a - Fall 2009
Page 7
Southwest’s decision if it’s hedged
Exercise options, drop route, resell fuel
$.25/gallon
Jet fuel price $1.50 [p=.5]
Exercise options, operate route
0
Buy hedges at $1.25
Buy spot, operate route
$.15/gallon
Jet fuel price $1.10 [p=.5]
Drop route
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 8
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% @
$62/barrel
0%
0%
0%
Continental/Delta/
Northwest
0%
0%
0%
0%
Professor Wolfram
MBA201a - Fall 2009
Page 9
Professor Wolfram
MBA201a - Fall 2009
7/2/2009
5/2/2009
3/2/2009
1/2/2009
11/2/2008
9/2/2008
7/2/2008
5/2/2008
150
3/2/2008
1/2/2008
11/2/2007
9/2/2007
7/2/2007
5/2/2007
3/2/2007
1/2/2007
11/2/2006
9/2/2006
7/2/2006
5/2/2006
3/2/2006
1/2/2006
11/2/2005
9/2/2005
300
7/2/2005
5/2/2005
3/2/2005
1/2/2005
11/2/2004
9/2/2004
7/2/2004
5/2/2004
3/2/2004
1/2/2004
Jet Fuel Price (cents/gallon)
500
450
Crude (w hite)
100
250
80
200
60
Jet Fuel (black)
100
40
50
20
0
0
Page 10
Crude Oil Price ($/bbl)
Jet fuel and crude oil prices
Jet Fuel & Crude Oil Spot Prices
January 2004 - September 2009
160
140
400
350
120
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 11
Decision trees and sunk costs
Develop product
-$1mm + $2.5mm
Movie will be a hit [p=0.8]
Don’t develop product
Acquire license
for new product
0
-$.5mm
Develop product
Movie will be a flop [p=0.2]
-$1mm + $.1mm
Don’t develop product
0
Lesson: What’s behind you is not important.
Professor Wolfram
MBA201a - Fall 2009
Page 12