An Airline Takes a

Marginal Route
A handout that can help you to
solve Case Study 1

Background
We will review a few concepts from micro-economics so that we are
all on the same page.

• Costs
• Average vs Marginal Costs

• Revenue
• Total Revenue
• Average vs Marginal Revenue

• Profit

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 Costs Functions
Cost TC
TC=Total Cost = FC+VC

FC=Fixed Cost (not f-n of output)

MC
VC=Variable Cost

AC
AC=Average Cost =TC/Q
Cost Quantity (Q)
Quantity
AC MC=Marginal Cost =MCQ-MCQ-1

MC Minimum AC is at the point where it equals MC

Quantity (Q)

Marginal and Average Cost

Marginal cost is an additional cost that will be
incurred from producing an additional unit (you can
think of it as the cost of producing the last unit sold).

dTC
MC  TCQ  TCQ 1 or MC  dQ

Average cost is the total cost divided by the quantity

sold.
TC
AC 
Q

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 Linear Cost Function
TC=Total Cost = a + bq

FC = a ; VC = bq
TC
AC=Average Total Cost =TC/q
AFC=Average Fixed = FC/q =a/q
AVC=Average Variable Cost = VC/q = b/q

MC= Marginal Total Cost =dTC/q =b

a MFC=Marginal Fixed = dFC/q = 0
MVC=Marginal Variable Cost = dVC/q =b
Quantity (q)

Real world cost functions are more complex than simple

linear forms.

Total Revenue

The total revenue is the amount of money that someone makes by

selling a certain quantity of product (Q) at a given price (P).

TR (Q )  P * Q
- the product of a price and a quantity (number of units) sold at a
given price.

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 Marginal and Average Revenue
 Marginal revenue is the additional revenue that can be
obtained from the sale of an additional unit. (You can
think of it as the revenue from the last unit sold).

dTR
MR  TRQ  TRQ 1 or MR 
dQ
Average revenue is the total revenue divided by the quantity sold.

TR
AR 
Q

Profit
Profit () is given by:

 = TR(Q)- TC(Q);

The necessary condition for maximum profit:

d dTR dTC
 0    0  MR  MC  0
dQ dQ dQ

MR  MC

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 Goals of Pricing
 Maximize Net Social Benefits
Price = Marginal Cost
 Maximize Firm Profits
Marginal Revenue = Marginal Cost

 Promote Efficient Investments

 Promote Efficient Utilization
 Provide Incentives for Innovation

Example of Defining Relevant Costs

Think of Average Rail vs Motor Carrier

Variable Cost and
Marginal Cost being
about the same level

AFC AFC

Price
AVC
AVC

Rail Motor

Minimum Prices should be based on average, variable or marginal

costs. Of course, actual prices can be higher. In 1980, US Congress
defined relevant cost as variable costs.

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5
 The Issue – Case 1
Does pricing at price P = MC generate enough revenue to cover the total
cost?

If you price at price P = AC (average cost) then by mathematical

definition the total revenue covers the total costs (i.e., TR = TC)!

Why?
Proof: TR = P*Q =AC*Q ; TC = AC*Q, and from there TR=TC

Producing at Q1, and Cost

Quantity
P=MC: AC
TR <<< TC

Producing at Q2, and

P=MC: MC
TR >> TC Loss
Total Cost
Total Revenue
Q1 Q2 Quantity (Q)

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The Issue – Case 2

Does pricing at price P = MC generate enough revenue to cover the total
cost?

If you price at price P = AC (average cost) then by mathematical

definition the total revenue covers the total costs (,i.e., TR = TC)!

Why?
Proof: TR = P*Q =AC*Q ; TC = AC*Q, and from there TR=TC

Producing at Q1, and Cost

Quantity
P=MC: AC
TR <<< TC

Producing at Q2, and

MC
P=MC: Total
ProfitRevenue
TR >> TC Total Cost

Q1 Q2 Quantity (Q)

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6
 A few important points

Put most simply, marginalists maintain that a company should undertake

any activity that adds more to revenues than it does to costs, and not limit
itself to those activities whose returns equal average or "fully allocated"
costs.
The approach, of course, can be applied' to virtually any business, not
just to air transportation.

Proving that this is so, demands economists who can break the crust of
corporate habits and show concretely why the typical manager's
response - that nobody ever made a profit without meeting fully allocated
costs - is misleading and can even reduce profits.

To be sure, the whole business cannot make a profit unless average

costs are met; but covering average costs should not determine whether
any particular activity should be undertaken. Because this would unduly
restrict corporate decisions and cause management to forego
opportunities for extra gains.

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Whether to fly or not?

Here is the relevant marginal analysis in a nutshell:

Problem: Shall Continental run an extra daily flight from City X to City Y?

The facts:
Fully-allocated costs of this fight. . . . . . . . . . . . $4,500 (Cost of owning or leasing
plane)

Out-of-pocket costs of this flight. . . . . . . . . . . . $2,000 (Cost of labor, fuel, food)

Flight should gross. . . . . . . . . . . . . . . . . . . . . . . $3,100

Decision: Run the flight! It will add $1,100 to net profit be cause it will add
$3,100 to revenues and only $2,000 to costs. Overhead and other costs,
totaling $2,500 ($4,500 minus $2,000), would be incurred whether the flight is
run or not. Therefore, fully-allocated or "average costs of $4,500 are not relevant
to this business decision. It's the out-of-pocket or “additional” or “marginal"
costs that count.

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