Hand Out -- Class 1 (Marginal Approach)

MGT 5149

The economic approach to achieving maximum profits involves a marginal approach.  This is an application of the optimization principle -- continue expanding an activity so long as the extra benefit is not less than the extra cost. In practice this usually means expand the activity until marginal benefit equals marginal cost.

This approach is sometimes overlooked in business.  Some economic reasoning can be very helpful:

A.        You have an airline.  You are sitting around thinking of ways to improve profitability.  You begin to think: we have plane that sits overnight in Atlanta waiting for their next-day flight. You ask: what about a late night flight to Jacksonville, and an early-bird morning return flight?  Marketing dept. says will pull an average of 40 passengers each way, at $70 per person. So the additional revenue is $70x40x2=5600. 

1.         You ask the accounting dept. for cost figs. and they provide the following: the average cost is 3400 each.

a.         The accounting dept. says: "We got that number by dividing the number of flights into total costs for running the airline, and since our flights are mostly of the same length, we feel it is a reliable figure."  They mention that since flights must cover average cost, if the airline is to be profitable, revenues per flight have got to exceed that.

2.         They urge against adding the flights (it will cost 6800 and bring in 5600).  What do you think?  Ans: need to know add'l cost, not average cost.

a.         For example, their figure of 3400 may include something for the cost of terminal facilities, which (say) will not be affected at all by these flights -- thus are irrelevant to this decision.  We need to know the marginal cost -- the additional costs incurred as a result of flying the new flights.