Reference no: EM1372256

Continental Airlines was doing something that seemed like a horrible mistake. All other airlines at the time were following a simple rule: They would only offer a flight if, on average, 65% of the seats could be filled with paying passengers, since only then could the flight break even. Continental, however, was flying jets filled to just 50 percent of capacity and was actually expanding flights on many routes. When word of Continental's policy leaked out, its stockholders were angry, and managers at competing airlines smiled knowingly, waiting for Continental to fail. Yet Continental's profits-already higher than the industry average-continued to grow. What was going on?
There was, indeed, a serious mistake being made-but by the other airlines, not Continental. This mistake should by now be familiar to you: using average cost instead of marginal cost to make decisions. The "65 percent of capacity" rule used throughout the industry was derived more or less as follows: the total cost of the airline for the year (TC), was divided by the number of flights during the year (Q) to obtain the average cost of a flight (TC/Q = ATC). For the typical fight, this came to about $4,000. Since a jet had to be 65 percent full in order to earn ticket sales of $4,000, the industry regarded any flight that repeatedly took off with less than 65 percent as a money loser and canceled it.
As usual, there are two problems with using ATC in this way. First, an airline's average cost per flight includes many costs that are fixed and are therefore irrelevant to the decision to add or subtract a flight. These include the cost of running the reservations system, paying interest on the firm's debt. And fixed fees for landing rights at airports-non of which would change if the firm added or subtracted a flight. Also, average cost ordinarily changes as output changes, so it is wrong to assume it is constant in decisions about changing output.
Continental's management, led by its vice-president of operations, had decided to try the marginal approach to profit. Whenever a new flight was being considered, every department within the company was asked to determine the additional cost they would have to bear. Of course, the only additional costs were for additional variable inputs, such as additional flight attendants, ground crew personnel, in flight meals, and jet fuel. These additional costs came to only about $2,000 per flight. Thus, the marginal cost of an additional flight-$2,000-was significantly less than the marginal revenue of a flight filled to 65 percent of capacity-$4,000. The marginal approach to profits tells us that when MR>MC, output should be increased, which is just what Continental was doing. Indeed, Continental correctly drew the conclusion that the marginal revenue of a flight filled at even 50 percent of capacity-$3,000-was still greater than its marginal cost, and so offering the flight would increase profit. This is why Continental was expanding routes even when it could fill only 50 percent of its seats.
In the early 1960s, Continental was able to outperform its competitors by using a secret-the marginal approach to profits. Today, of course, the secret is out, and all airlines use the marginal approach when deciding which flights to offer.