In a previous paper, we analyzed how Southwest Airlines successfully used the game theory approach to maximize their profits. The strategy that Southwest implemented via their EarlyBird Check-in policy was putting travelers to compete against each other through a Prisoner’s Dilemma Game. In the following paper, I will discuss how Southwest Airlines has dealt with risk and uncertainty and offer advice to improve risk management. The paper will also examine an adverse selection problem that Southwest Airlines is facing and recommend how to minimize its negative impact. Next, we will determine ways that Southwest deals with moral hazard and suggest best practices to deal with it. It will also identify a principal-agent problem facing the company and evaluate the tools to align incentives.
Finally, the paper will examine the organizational structure of Southwest Airlines and suggest ways it can change to improve profitability. Dealing with Risk and Uncertainty The airline industry is highly competitive; however, Southwest Airlines is one of the few airlines that have been able to stay consistently profitable. Eroglu (2015) explains how Southwest Airlines pursues a low-cost/low-price/no-frills strategy that features offering passengers a single class of service at the lowest possible fares. The success of that strategy reflects on their customer base topping 120 million passengers annually, making it the nation’s largest domestic air carrier (SWA, 2018). Some of the notable actions that Southwest has taken are operating with a single model aircraft on their fleet, the Boeing 737, and not charging customers for their first two checked bags. When analyzing the airline business, the levels of high risks and uncertainties are always present.
According to Froeb and colleagues (2018), a risk is an uncertainty that is model with random variables while uncertainty is outcomes that we cannot foresee or whose probabilities we cannot estimate. Essentially, a risk is the probability of suffering a loss whereas uncertainty infers that one is not sure of the outcome of a particular situation. When dealing with random outcomes and uncertain risks when making decisions, it is important to understand the concept of expected value (mean) and variance (deviation from the mean). For Southwest Airlines, calculating the expected value of each option and determining the variance will help see which option is less risky when making decisions. The variance depends on the deviation of possible outcomes from the mean and is the most common measure of risk.
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In an interview with the Global Business Travel Association (GBTA), Southwest Airlines CEO, Gary Kelly, stated that the company would lose a billion dollars in revenue after netting in the additional bag fees if they changed their policy (GBTA, 2015). Considering Kelly’s comments, we examine how they arrived at this conclusion. Suppose that Southwest estimates it would gain $2 billion yearly (based on industry average) if it charges travelers for bag fees. Now, let us consider that the airline estimates that introducing baggage fees will result in costs of $4 billion. Assuming that there is a 50% chance that Southwest loses customer loyalty, Figure 1.1 shows the calculations of how risky is the introduction of bag fees for the airline. Expected Value (Mean) p = 50% = 0.5 x1 = -4 ($-4B) x2 = 2 ($2B) E[x] = p * x1 + 1-p * x2 E[x] = 0.5(-4) + (1-0.5)(2) E[x] = -1
Based on the above calculations using the formula for the expected value of a random variable, Southwest Airlines should expect losses of negative $1 billion if it introduces baggage fees. Improving Risk Management Froeb and colleagues (2018) explain that by presenting decision-makers with analyses that account for uncertainty, you allow them to distinguish between bad luck and bad decisions. First, in any kind of industry, the best way to deal with risk and uncertainties is to have a thorough understanding of risk identification. An organization must begin to analyze its strategic objectives and then ask what can possibly go wrong with each of these objectives.
After understanding risk, an organization can align their strategies with a corporate culture that works on improving risk management. According to Schild (2009), organizations must address a collective mindset of risk awareness where employees understand and agree with intended outcomes and their individual and team roles in achieving them. When working on creating a positive culture with respect to risk management, the organization must create an environment that has greater focus, discipline, and control. Organizations should clarify the distinction between risk-taking and risk-avoidance behaviors, and improve the tools available for measuring risk exposure. Risk management works best when individuals can raise issues without the fear of retribution. Allow employees to take responsibility and ownership.
Finally, continue to monitor and review any new risks that may emerge so that your organization is ready to take action when the time comes. Adverse Selection To understand the concept of adverse selection, we must first comprehend the term of asymmetric information. Asymmetric information takes place when one party has better or more information than the other party does during a transaction. This creates an imbalance of power because one party knows something that the other does not. A perfect example happens during the negotiation of pay when being offered a new job. The new hire wants to get paid the maximum amount the employer is willing to pay but does not know what that number is. However, the employer also does not know the minimum amount that the employee is willing to work for, therefore creating an imbalance of power between the employee and employer. When undesired results occur because of the asymmetric information, adverse selection occurs.
When considering Southwest Airlines, adverse selection arises when there is asymmetric information between the airline and the passengers. An adverse selection problem that Southwest currently faces is that it cannot distinguish between a business or leisure traveler. If Southwest could recognize the type of traveler, then they could use their frequent flyer reward program to their advantage. For the most part, employers pay for their employee’s tickets and due to this, employees take advantage of finding flights that can maximize their rewards. Southwest can use that information to attract business travelers towards higher price alternatives. One way that Southwest can minimize the negative impact of their current adverse selection is by designing a variety of price options and reward so that they can separate traveler types.
Moral Hazard Moral hazard is a situation in which one party gets involved in a risky event knowing they are secure against the risk and the other party will incur the cost. Moral hazard arises when there is asymmetric information and the party taking the risks has more information about the situation than does the party that suffers the consequences. Generally, the party with the additional information uses it to exploit the other party and gain an advantage. An example of moral hazard happens when a taxi driver has more information about the roads than a tourist has and therefore takes longer routes to get a higher rate. As previously mentioned in the case of a business traveler, Southwest Airlines can take advantage of the moral hazard between the employee, who is benefiting from the rewards program, and its employer, who is paying high prices for their fare. If businesses pick up on this moral hazard, Southwest Airlines reputation may be tainted and lose customers to their competition. To avoid falling into this moral hazard, Southwest can change their reward system from a per-dollar program to a per-distance incentive.
This will keep businesses happy knowing they are not being exploited with higher prices and their employees can still benefit from earning rewards. Another practice that Southwest can use to deal with moral hazard is to allow businesses to set up business accounts directly with them so they can book their employee travels and avoid having their employees exploit the rewards. Principal-Agent Problem In an agency relationship, you have two parties in which one party is doing the work on behalf of the other party. The person doing the work is the agent, while the person that is receiving the benefit is the principal. The dilemma between the agency relationships is that both parties are self-interested, and the agent’s informational advantage poses a threat to the principal.
The principal does not always know if the agent is acting in the best interest of the principal or for its self. With the use of incentives, the principal can motivate the agent to perform what its expected of him. Since its beginnings from 1967, Southwest Airlines has prided itself in providing its customers with exemplary customer service and affordable fares. Southwest Airlines has received multiple rewards for customer satisfaction all in thanks to their employees. To continue with their award-winning services, Southwest Airlines, the principal, must make sure that their employees, the agents, have the success of the company in mind. In an article by Forbes (2014), Southwest motivates its employees by highlighting positive behaviors through a variety of recognition programs and rewards. For Southwest, having employees that deliver top-class customer services and stand by the companies vision and purpose gives them a competitive advantage that improves overall profitability. Organizational Structure Southwest Airlines has a functional organization structure.
Decision-making occurs at the top levels of management, allowing upper management to have complete control over the organization. Southwest also provides a clear career trajectory for employees, starting from junior-level positions to upper management. Some of the issues that Southwest faces with this type of structure are that it can lead to poor communication between departments, and inter-departmental conflict. This issue affects customers that become frustrated when having to work with more than one department when there is a lack of cooperation between departments. Southwest Airlines can design different ways to improve the structure. First, they can look at various functions of the business and create an organizational chart to ensure each one is properly staff. Furthermore, the company can combine functions and give multiple responsibilities to different departments of function heads to save money. Additionally, they should create a chain of command that clearly designates to whom each person reports. Finally, Southwest should communicate its structure and explain how it will benefit the company.
