I need solution for the case from the book of Managerial Economics Applications, Strategy, and Tactics James r. Mcguigan, R . Charles Moyer, and Frederick h. De b . Harris 12^th Edition, page 26

MANAGERIAL CHALLENGE

Why Charge $25 per Bag on Airline Flights?

In May 2008, American Airlines (AA) announced that it

would immediately begin charging $25 per bag on all AA

flights, not for extra luggage but for the first bag! Crude

oil had doubled from $70 to $130 per barrel in the previous

12 months, and jet fuel prices had accelerated even

faster. AA's new baggage policy applied to all ticketed

passengers except first class and business class. On top

of incremental airline charges for sandwiches and snacks

introduced the previous year, this new announcement

stunned the travel public. Previously, only a few deepdiscount

U.S. carriers with very limited route structures

such as People Express had charged separately for both

food and baggage service. Since American Airlines and

many other major carriers had belittled that policy as

part of their overall marketing campaign against deep

discounters, AA executives faced a dilemma.

Jet fuel surcharges had recovered the year-over-year

average variable cost increase for jet fuel expenses, but

incremental variable costs (the marginal cost) remained

uncovered. A quick back-of-the-envelope calculation

outlines the problem. If total variable costs for a

500-mile flight on a 180-seat 737-800 rise from $22,000

in 2007 Q2 to $36,000 in 2008 Q2 because of $14,000 of

additional fuel costs, then competitively priced carriers

would seek to recover $14,000/180 = $78 per seat in

jet fuel surcharges. The average variable cost rise of

$78 would be added to the price for each fare class.

For example, the $188 Super Saver airfare restricted to

14-day advance purchase and Saturday night stay overs

would go up to $266. Class M airfares requiring 7-day

advance purchase but no Saturday stay overs would rise

from $289 to $367. Full coach economy airfares without

purchase restrictions would rise from $419 to $497, and

so on.

The problem was that by 2008 Q2, the marginal cost

for jet fuel had risen to approximately $1 for each

pound transported 500 miles. Carrying an additional

170-pound passenger in 2007 had resulted in $45 of

additional fuel costs. By May 2008, the marginal fuel

cost was $170 - $45 = $125 higher! So although the

$78 fuel surcharge was offsetting the accounting expense

increase when one averaged in cheaper earlier fuel purchases,

additional current purchases were much more

expensive. It was this much higher $170 marginal cost

that managers realized they should focus upon in deciding

upon incremental seat sales and deeply discounted

prices.

And similarly, this marginal $1 per pound for

500 miles became the focus of attention in analyzing baggage

cost. A first suitcase was traveling free under the

prior baggage policy as long as it weighed less than 42

pounds. But that maximum allowed suitcase imposed

$42 of marginal cost in May 2008. Therefore, in

mid-2008, American Airlines (and now other major carriers)

announced a $25 baggage fee for the first bag in

order to cover the marginal cost of the representative

suitcase on AA, which weighs 25.4 pounds.

Discussion Questions

_ How should the airline respond when

presented with an overweight bag (more than

42 pounds)?

_ Explain whether or not each of the following

should be considered a variable cost that increases

with each additional airline seat sale:

baggage costs, crew costs, commissions on

ticket sales, airport parking costs, food costs,

and additional fuel costs from passenger

weight.

_ If jet fuel prices reverse their upward trend and

begin to decline, fuel surcharges based on average

variable cost will catch up with and surpass

marginal costs.