ECO 550 Paper

CASE STUDY

Case Study: Use of Game Theory to Maximize Profits

Latanya Hawkins

Strayer University

ECO 550

Dr. Bonina

May 23, 2019

Describe the change in Southwest Airlines’ boarding process

Southwest Airlines had a boarding process of open seating which means that during the boarding process travelers were free to sit in any seat that were available instead of assigned seating. The problem with open seating was that groups and families could not reserve seats and their families could be split up. The cost savings were the major reason why Southwest has employed open seating for its entire 42-year history. Prior to 2007, passengers boarded on a first-come, first-served basis. The travelers who arrived at the gate earliest could board first and pick the most favorable seats. The lead to passengers “camping out” at the gate to secure a good boarding position. The problem with this was that people tried to save seats or cut in line. In 2007 Southwest decided to end this cattle call process. The new process assigned each traveler a boarding group A, B, and then C. Within each group, a traveler with a lower boarding number got on the airplane first. Travelers could still choose seats once on board the airplane, but there was much more order at the gate because people lined up in an orderly fashion. How travelers were assigned a boarding number was based on time at which the traveler checked in for the flight. Someone who checked in at the earliest time, 24 hours in advance of the flight, could secure a favorable boarding assignment. The boarding assignment changed the game by instead of rewarding passengers who waited at the gate the longest the boarding assignment generally rewarded people who could check in online in advance, usually organized and often the affluent. This process created third-party websites where they offered to automatically check a traveler in at the earliest time 24 hours before a flight. The service was reliable and cost $1, a very appealing offer for the busy traveler. (www.mindyourdecisions.com)

What was Southwest’s main goal introducing the early-bird check-in?

Southwest tolerated the third-party websites and decided to shut them down because they should be profiting instead of the third-party vendors. It was this option that lead to millions of dollars in extra fees.

Southwest has profited tremendously from the early bird check-in. Southwest reported an extra $98 million in revenue from early bird check-in, exceeding expectations. In 2011, Southwest revenue from early bird check-in grew 44 percent. The service translated to an extra $142 million in revenue.

Southwest has been profitable 45 years in a row because they understand that price and cost are unrelated. The truth is that cost and price are unrelated. The market sets the price; it’s what your customers will pay for the value you provide. But priced is also a strategic tool you can deploy to either maximize your profits or drive the growth of your business by gaining market share. Even if you are the low-cost provider in your market, that doesn’t mean you should also be the lowest priced provider. (www.inc.com) To gain additional profits, Southwest had a genius idea to charge for early bird check-in.

Southwest revenue has increased every year starting from 2010 to 2019 as follows:

Chart from (www.macrotrends.net)

Explain how Southwest Airlines used the game theory approach to increase its profits

The outcome of the game involving early bird check-in is between two travelers who compete for the best seat. The possible outcomes are:

· If neither pays for early bird, then both can expect okay seats in the seating lottery

· If only one pays $10 for early bird, that person gets a good seat

· If both pay $10 for early bird, then they both get put into a lottery for priority seats. This essentially means they are competing in a seating lottery, but they both must pay $10 to do it. (www.mindyourbusiness.com/blog)

A strategy is dominant if, regardless of what any other players do, the strategy earns a player a larger payoff than any other depending on whether better is defined with weak or strict inequalities, the strategy is termed strictly dominant or weakly dominant. (Managerial Economics, 2018)

In the case of the Southwest early bird check-in, paying $10 for early bird check-in is a dominant strategy because the customers might be better served saving $10 and playing the seating lottery. But since they compete, they end up spending $10 for the privilege of playing a seating lottery.

Prisoner’s Dilemma is a situation in which two players each have two options whose outcome depends crucially on the simultaneous choice made by the other often formulated in terms of two prisoners separately deciding whether to confess to a crime. (Managerial Economics, 2018)

The travelers face the Prisoner’s Dilemma with early check-in because if the other person does not do it, then someone who cares about a good seat will pay $10 for early bird check-in. If the other person does it, then the other traveler is better off buying early bird check-in as opposed to ending up with a bad seat. There are some travelers who never will pay $10. But a good portion are willing to pay for the privilege and are caught in the Prisoner’s Dilemma. (www.mindyourdecisions.com)

Analyze the advantages and disadvantages of the early-bird check-in process for Southwest Airlines

The advantages of the early bird check-in are that it’s a guarantee to booking a good seat. The disadvantage is that if many people pay for the early bird check-in Southwest cannot guarantee boarding within the first 60 positions. Travelers cannot stop playing the game because it can result in bad seating. As more people pay for priority boarding, this sends the remaining travelers worse and worse boarding positions, so the game essentially attracts more people to opt for early bird check-in.

Suggest ways in which other companies, or the company you work for, can utilize similar game approach to maximize profits.

Due to almost no growth in average ticket prices on the revenue side and sky-rocketing costs of fuel on the cost side, airlines have been forced to look at alternative sources of revenue. Airlines continue to raise fees and invent new ways to extract more money from air travelers. Airlines can charge baggage fees to maximize profits. The airlines that charge the most for baggage fees are: American - $35, United - $35, Continental - $32, and Delta - $32. Baggage fees usually garner relatively little pushback from customers but are such a huge source of revenue for airlines. According to data from the Bureau of Transportation Statistics, the 10 largest U.S. airlines collected $566.3 million in baggage fees during the first quarter of 2009, and the total for all airlines amounted to $1.5 billion in 2008. (www.berkeley.edu)

Baggage fee game is centered around 2008 when most of the airlines went about introducing the baggage fees. Airlines saw baggage fees as a possible solution to hedge against rising fuel and operating cost, something they couldn’t address by increasing ticket prices, but when faced with the question of how they should go about introducing them, they had to pre-empt and understand responses from the two other stakeholders in the game, Passengers and Competition.

The general research data on the airlines indicates that prior to introduction of baggage fees, on average 40% of passengers’ check-in one bag and 10% of passengers’ check-in the 2nd bag.

American Airlines (AA) had the easiest way to introduce the baggage fee by spreading the cost among all the passengers by increasing the ticket prices. The airline has decided to charge $15 as baggage fee for the 2nd checked-in bag. In order to deter discount passengers from cancelling tickets, American Airlines had decided to charge $100 as the cancellation fee per ticket. AA concluded that they would lose passengers if it included baggage fees in the ticket price, they purposely chose not to do so thus retaining the passenger with a payoff of (0,0). However, instead of not charging the passengers at all, AA broke down this game into a two staged game. In the 1st stage, it enticed passengers into buying tickets by offering the lowest price. In the 2nd stage3, it forced them to pay for the baggage fee by creating a pay-off structure where paying the baggage fee had the best payoff among all others.

REFERENCES

Froeb, L, McCann, B. Shor, M., Ward, M. (2018). “Managerial Economics, A Problem Solving Approach 5th Edition. Boston, MA: Cengage Learning.

Talwalker, P. (2013, March).” Southwest Airlines boarding and game theory” Retrieved from https://www.mindyourbody.com

Schleckser, J. (2017, May). “Why Southwest Has Been Profitable 45 Years in a Row” Retrieved from https://www.inc.com

Haas School of Business, “Baggage Fees, A Game Theory Perspective” Retrieved from https://www.berkeley.edu

YearRevenue

201821,965$

201721,146$

201620,289$

201519,820$

201418,605$

201317,699$

201217,088$

201115,658$

201012,104$