Assignment Instructions – Dealing with Risk, Asymmetric Information, and Incentives
Earlier in the quarter we discussed Southwest Airlines’ use of game theory to create new strategy. Continue to research Southwest Airlines or a company of your choice and write a seven (7) page paper in which you:
- Evaluate a company’s recent (with in the last year) actions dealing with risk and uncertainty.
- Offer advice for improving risk management.
- Examine an adverse selection problem your company is facing and recommend how it should minimize its negative impact on transactions.
- Determine the ways your company is dealing with the moral hazard problem and suggest best practices used in the industry to deal with it.
- Identify a principal-agent problem in your company and evaluate the tools it uses to align incentives and improve profitability.
- Examine the organizational structure of your company and suggests ways it can be changed to improve the overall profitability.
- Use at least five (5) quality academic resources in this assignment. Note: One of your references regarding your should have been published within the last 6 months. Note: Wikipedia does not qualify as an academic resource.
Dealing with Risk, Asymmetric Information, and Incentives – Southwest Airlines
Evaluation of Actions of Southwest Airlines in Dealing with Risk and Uncertainty
The complexities in operations that are inherent in airline business, in addition to extensive regulations and fierce competition have made exposed the airline industry players to risks. According to (Sparks, 2013) risks are defined as threats to humans with probability of suffering a loss, whereas uncertainty refers to that that one cannot be sure about its outcome. In the airline industry risks and uncertainties can result from regulations, changes in fuel prices, acts of terrorism, aircraft accidents and pandemics. In order to deal with the numerous risks and uncertainties in the airline industry, the Southwest airline has often adopted a number of ways in the recent past.
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Some of the ways the company has utilized in the past one year include the use of trust in responding to adverse situations. Early this year, Southwest airlines had an accident that involved one of its airlines, where one of the airline engine broke down, leading to emergency landing. Having built good reputation that has led to strong trust among its customers; the airline employed this to assure its customers that it would inspect all its flight engines before takeoff and that it would also investigate in collaboration with other authorities on the cause of the accident.
The other strategy that Southwest airlines have used to respond to risks and uncertainties is having a team of dedicated individuals that help in disaster response. The company has a groups of specialists named the Southwest Airlines Baker group based in Network Operations Control (NOC) nerve center (Hagel, Brown, Wooll & de Maar, 2018). Also, the company has adopted fuel hedging in order to mitigate against risks and uncertainties associated with changes in fuel prices. According to (Weener, 2018) the company has a higher growth in terms of the ASM per gallon of fuel, making it more efficient.
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Advice on Improving Risk Management in Southwest Airlines
The airline industry is often full of many risks and uncertainties. It is imperative that the Southwest airlines improve its risks and uncertainty mitigation measures in order to have a better control of its future market performance. One of the strategies that the paper offers for implementation by the company is the adoption of the concept of organizational agility. Organizational agility is the maintenance of constant state of innovation (Teece, Peteraf & Leih, 2016). This involves a comprehensive understanding of the underlying uncertainties, possible solutions and options. Since Southwest Airlines has consistently made profits in over four decades owing to its low-cost strategy, to sustain such a trend, there is need for the company to forecast, maintain redundancy and keep its options open at all times.
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Risks are often associated with outcomes that are known and the probability of their reoccurrence can be calibrated (Teece, Peteraf & Leih, 2016). Since Southwest Airlines can predict the changes in fuel prices, in addition to its fuel hedging, the company should adopt the strategy of forward contracts to minimize financial risks associated with changes in fuel prices. In doing so, the company can enter into valid contracts with fuel companies in order to ensure stable prices over the predetermined time for which the contract is valid.
Moreover, there is need for the company to manage its uncertainty in a systematic and explicit manner as a way of managing its risks. According to (Grote, 2015) uncertainty is the ability of “not knowing for sure” owing to lack of abundance in information. However, the author points that through a quantitative and qualitative exploration of uncertainty in risk assessment, a company can fully manage its risks. Through a creation of uncertainty rather than avoidance of uncertainty, a firm can have a better ways of understanding and managing risks.
The Adverse Selection Problem that Southwest Airlines is Facing
An adverse selection problem or what is also referred to as information asymmetry occurs when one party in a contract is not able to observe the characteristics of the other party (Nechyba, 2017). In the airline industry, adverse selection problem occurs when one party has more accurate information about than what the other party has. Such information asymmetry is likely to lead to one party taking advantage of the other and possible have negative impacts on the transactions. In the Southwest Airlines, one of the adverse selection problem the company faces is in its use of the Early-Bird Check-In system in the online boarding.
Although the Early-Bird Check-In is credited for driving company revenues, it creates information asymmetry. The company often has the information about the availability of seats offered through the online boarding system, while the customers are left in a disadvantage since they often do not have any information whether the required number of travelers has been attained. This is evident in the higher number of users of the online system that has even prompted the company to issue notices that using the system may not guarantee one a seat of their liking.
In order to reduce the negative effect on transactions of asymmetric information created by the Early-Bird Check-In system, the Southwest Airlines should strive to provide more information to the travelers. Although the online boarding has added significant revenues to the company owing to the additional 10 dollars, this should not be employed at the expense of travelers. There is likelihood of negative effect of this on a traveler who uses the service more than two times and ends up on the lottery seating. Therefore, once the capacity for favorite seating has been reached, the company online booking system should notify the travelers. This will ensure continued satisfaction from the travelers and renewed interest to make an early booking next time.
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The Way the Southwest Airlines is Dealing with Moral Hazard
The moral hazard problem occurs where one party in a contract is involved in a risky event with the knowledge it is protected the other party who will incur the cost. Nechyba (2017) points the moral hazard problem as the individual behavior change upon entering into a contract, which makes the contract execution by the other party to the contract to be expensive. In the case of the Southwest Airlines, the moral hazard problem occurs when the travelers pay for their tickets and choose their seats knowing that the company will guarantee safety on the flight. In response to the moral hazard problem that occurs whenever Southwest Airlines enters into a contract with a traveler, the company has safety and security commitment.
The company security and commitment policies outline the security measures for the travelers and their employees. According to (Southwest, 2016) the company continually creates and fosters a culture of safety and security. The company makes annual reviews of its specific safety-related objectives, monitors, measures and tracks safety objectives, creates and maintains a proactive reporting culture and establishes, maintains, and periodically exercises emergency response plans and procedures to ensure smooth transition from normal to emergency operations.
Human factors have been highlighted as the contributor of over 70% of commercial airplane accidents. In regards to traveler safety, the suggested best industry practice is the use of sound scientific basis in the assessment of human performance implications in the design, training and procedures. It is important that a shift from reliance on intuition and experience in human performance be made.
The Principal-Agent Problem in Southwest Airlines
An agent refers to the individual who is hired t act on behalf of the other individual called the principal. According to (Nechyba, 2017) it is often difficult to observe the actions of another individual under ordinary circumstances. As a result, a principal-agent problem occurs where the principal cannot observe and monitor the actions of the agent. The main principal-agent problem in the Southwest Airlines occurs in the behaviors and actions of the company airline crews. The Southwest Airlines is a company that relies on high level f cooperation and teamwork from its employees. However, the principal (company President, the CEO, and stakeholders) cannot observe the actions of the airline crew but rely on the company culture of teamwork and cooperation from their employees.
There never exists a unique solution to principal-agent problem in any firm. However, in the presence of externalities, Coasian theory provides a description of economic efficiency of an economic allocation and an outcome (Nechyba, 2017). The theory is based on two outcomes namely zero transaction costs and freedom of individual choice. Different firms that have intra-organizational transactions can be structured based on the employment contracts that reflect different conditions in the firm. The common contractual forms inherent in different firms are incentives, monitoring, and cooperative. In the Southwest Airlines, the contractual forms that are in operation in the company are those of cooperation and teamwork. The tools the company uses to align incentives and improve profitability include use instilling high levels of cooperation and teamwork from its employees. For example, the company has employed debit memos for agents who make seat reservations to ensure any booked seats and not used are paid for.
The Southwest Airlines Organizational Structure
Southwest Airlines has adopted primarily a functional organizational structure. According to (Daft, Murphy & Willmott, 2010) a functional organization structure occurs where activities are grouped based on common function from the bottom to the top of the organization. In the Southwest Airlines, there is the top executive management lead by the company CEO, Gary C. Kelly, the middle level management and the junior employees.
Although the company may credit the organization structure for its success and continued profitability, even greater success can be achieved through an improvement in the organizational structure. According to (Daft, Murphy & Willmott, 2010) functional organizational structure there is consolidation of human skills and activities specific to specific activities. However, it may lead to slowed decision making, poor horizontal coordination, less innovation, and restricted view of the organization goals. In order to improve on the structure, it is suggested the organization creates a structure based on the needs of the company business model rather than the one based on the needs of the staffing levels. This would allow organization restructuring without regard of the current employees but based on the realities in place.