Question

Explain how the events listed in (a) through (d) would affect the following costs at Southwest Airlines: 1\. Marginal cost 2\. Average variable cost 3\. Average fixed cost 4\. Average total cost a. Southwest signs a new contract with the Transport Workers Union that requires the airline to increase wages for its flight attendants. b. The federal government starts to levy a \(\$ 20\) -perpassenger carbon emissions tax on all commercial air travel. c. Southwest decides on an across-the-board 10 percent cut in executive salaries. d. Southwest decides to double its television advertising budget.

Short answer

a. Wages increase would raise all the costs except for average fixed cost. b. Carbon emissions tax would raise marginal cost, average variable cost, and average total cost, while average fixed cost would remain constant. c. An executive salary cuts would reduce both average fixed costs and average total costs. d. Increasing the advertising budget would raise average fixed costs and average total costs but would have no effect on marginal cost and average variable cost.

Step-by-step solution

Event (a) Impact

a. An increase in wages for flight attendants would raise both marginal and average variable costs since wages contribute to variable costs, which are directly related to the production level. However, average fixed costs and average total costs would also increase as more cost is incurred per unit of output.

Event (b) Impact

b. A \(\$20\) -perpassenger carbon emissions tax on all commercial air travel effectively increases variable costs, as the tax depends on the number of passengers, which varies with each flight. Consequently, this event raises marginal and average variable costs. Also, it heightens average total cost since a larger cost is incurred per unit of output. The average fixed cost would remain constant as the output level does not influence it.

Event (c) Impact

c. A 10 percent cut in executive salaries would primarily reduce Southwest's fixed costs since these salaries usually don't vary with the level of output. Thus, this reduction reduces average fixed costs and average total costs since a lesser cost is incurred per unit of output.

Event (d) Impact

d. Doubling the television advertising budget would increase Southwest's fixed costs as the advertising cost doesn't vary with the output level. Thus, this would raise the average fixed costs and average total costs. However, marginal cost and average variable cost remain unaffected since advertising is a fixed cost and isn't directly linked to the production process.

Key concepts

Marginal Cost

Marginal cost is a crucial concept in understanding airline economics and refers to the additional cost that is incurred when producing one more unit of a good or service. In the context of an airline like Southwest Airlines, this could relate to the additional cost of accommodating one more passenger on a flight.

For instance, if Southwest Airlines increases wages for its flight attendants, as mentioned in the exercise, the marginal cost of each flight could increase because the cost of cabin crew is higher per additional passenger. This is because crew salaries are directly tied to the number of flights, making it a variable cost.

Real-World Application

Every decision that affects variable costs, like changes in fuel prices or, in this case, wages for flight attendants, will directly influence the marginal cost. Understanding this helps airlines make informed decisions on pricing and the number of flights they operate.

Average Variable Cost

Average variable cost (AVC) can be best understood as the variable cost per unit of output. The variable costs for airlines include fuel, in-flight services, and personnel such as flight attendants whose compensation may vary with the number of flights they work on.

When Southwest Airlines faces an increase in attendant wages or a new carbon emissions tax, their AVC goes up, because these costs are spread across the number of passengers or flights, indicative of higher operational costs per unit.

Cost Management

Airlines often strive to manage AVC by optimizing their operations to remain competitive. By doing so, they can keep fares low and manage profitability, a delicate balance in the competitive airline industry.

Average Fixed Cost

Unlike variable costs, average fixed cost (AFC) does not vary with the volume of goods or services produced. It is the fixed cost, such as leases on space or planes, salaries for executives, and marketing expenses, divided by the quantity of output, which in the airline industry is often measured in available seat miles (ASM).

A reduction in executive salaries or a change in advertising budget, will affect AFC, since these costs do not change with the number of flights or passengers. If the airline reduces executive salaries, the AFC decreases, allowing more flexibility perhaps in pricing strategies.

Budget Allocation

Airlines like Southwest must carefully decide how much they invest in fixed expenses, as it impacts their overall cost structure and ability to offer competitive pricing.

Average Total Cost

Average total cost (ATC) is the sum of all costs, both variable and fixed, divided by the quantity of output. It provides a comprehensive picture of the overall cost structure for providing air travel services. Any increases in either variable or fixed costs, like the wage bump for flight attendants or a heightened TV advertising budget, will cause the ATC to rise.

For an airline, managing ATC is essential for long-term sustainability. It impacts pricing, profit margins, and strategic decision-making.

Strategic Implications

Airlines need to monitor their ATC to determine the most efficient scale of operations and to find the right balance between costs and ticket prices to consistently generate profits.