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Posts Tagged ‘Moral Hazard’

Companies often run into trouble when they offer a service at a zero price.

Not always, of course. Many all-you-can-eat buffets continue to thrive even though the marginal cost of the next chicken nugget is zero. And many content providers manage to stay in business by selling radio, TV, or display ads against the free content users enjoy.

But all too often, a zero price attracts bad customers and encourages excessive consumption. Marco Arment of Instapaper, for example, discovered that a zero price attracted “undesirable customers” for his app. And AT&T famously discovered that offering unlimited iPhone data could overwhelm its capacity.

Thanks to Ken Besinger of the Los Angeles Times, we now have another juicy example: the lifetime passes that American Airlines sold to a small group of customers:

There are frequent fliers, and then there are people like Steven Rothstein and Jacques Vroom.

Both men bought tickets that gave them unlimited first-class travel for life on American Airlines. It was almost like owning a fleet of private jets.

Passes in hand, Rothstein and Vroom flew for business. They flew for pleasure. They flew just because they liked being on planes. They bypassed long lines, booked backup itineraries in case the weather turned, and never worried about cancellation fees. Flight crews memorized their names and favorite meals.

Each had paid American more than $350,000 for an unlimited AAirpass and a companion ticket that allowed them to take someone along on their adventures. Both agree it was the  best purchase they ever made, one that completely redefined their lives. …

But all the miles they and 64 other unlimited AAirpass holders racked up went far beyond what American had expected. As its finances began deteriorating a few years ago, the carrier took a hard look at the AAirpass program.

Heavy users, including Vroom and Rothstein, were costing it millions of dollars in revenue, the airline concluded.

How did things go wrong? American Airlines miscalculated how pass holders would behave:

“We thought originally it would be something that firms would buy for top employees,” said Bob Crandall, American’s chairman and chief executive from 1985 to 1998. “It soon became apparent that the public was smarter than we were.”

In economic jargon, American fell victim to both adverse selection and moral hazard. What customer wants to buy an unlimited, lifetime pass? One who’s happy to spend a great deal of time flying about in first class with friends, family members, or a random person they just met at the gate. And how will they behave? As though first class seats are costless, easy to book, free to cancel, a great gift for friends and strangers, and even, in some cases, as a revenue source.

What happened next shouldn’t be surprising. First, the passes went through a death spiral with American raising the price in a vain effort to make them profitable. When last offered, a single pass cost $3 million and was purchased by a grand total of nobody. Second, American sicced its “revenue management executives” on the most flagrant of the frequent flyers. As a result, several had their passes revoked for misuse. And American faces some lawsuits that make one wonder whether it crossed the line in trying to rid itself of these outrageously expensive customers.

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The United States can’t pursue al Qaeda alone. We need help from other nations. To encourage nations to provide that help, the U.S. created the Coalition Support Fund to reimburse coalition partners for the costs they incur fighting terrorism.

As Adam Entous reports in the WSJ, the prospect for such “reimbursement” creates an obvious incentive: our partners may exaggerate how much they are really spending:

The U.S. and Pakistan are engaged in a billing dispute of sizable proportions, sparring behind closed doors over billions of dollars Washington pays Islamabad to fight al Qaeda and other militants along the Afghanistan border.

Washington, increasingly dubious of what it sees as Islamabad’s mixed record against militants, has been quietly rejecting more than 40% of the claims submitted by Pakistan as compensation for military gear, food, water, troop housing and other expenses, according to internal Pentagon documents. Those records, reviewed by The Wall Street Journal, detail $3.2 billion in expense claims submitted to the U.S. for operations from January 2009 through June 2010.

According to the documents and interviews with officials, Pakistan has routinely submitted requests that were unsubstantiated, or were deemed by the U.S. to be exaggerated or of little or no use in the war on terror—underscoring what officials and experts see as a deep undercurrent of mistrust between the supposed allies.

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According to an article over at the Huffington Post (ht Natalie), students at 36 colleges will have a new option when they start classes this fall. Thanks to an outfit named Ultrinsic, students can now bet on whether they will get good grades. Students put up money at the start of the semester and then get payoffs at the end depending on how they do.

Calling it a bet isn’t completely fair, however, since the payoff creates an extra incentive for students to do well. So think of it as a combination of betting (if you think your odds of doing well are better than Ultrinsic thinks) and using a financial incentive to get your future self to study a bit harder. Naturally, Ultrinsic emphasizes the incentive perspective in describing its “Reward” product:

Do you like getting good grades? The right amount of cash should provide you with the needed motivation to pull all-nighters and stay awake during the lectures of your most boring professors. At Ultrinsic.com, you will be able to earn cash while working to achieve your academic goals.

Obligatory note to my new crop of students: all-nighters are generally not an optimal learning strategy.

Like a race track, the company offers packages that pay off not only if you do well on a single course, but also if you perform well in multiple courses or over an entire semester. If a new freshman is really feeling motivated, he or she can also put down $20 up front for the opportunity to win (earn?) $2,000 for maintaining a 4.0 GPA throughout college.

And if students are feeling risk-averse, they can also buy insurance against bad grades. Bomb that final and get a cash reward.

Somehow I doubt many students will want to buy such insurance. Or that Ultrinsic will want to sell it given the risks of moral hazard. Perhaps Ultrinsic will screen for “pre-existing conditions” (like failing a related class) in order to limit the adverse selection. Or just offer such high premiums that only a few extremely risk-averse (or mathematically-challenged) students will apply.

The incentives product, however, seems much more promising. Indeed, it resembles some other efforts to help people modify their own behavior through financial incentives. See, for example, the folks at stikK.com whose service allows users to create their own incentives. For example, you could commit to give $500 to your favorite charity if you fail to lose 10 pounds by Christmas. Even better, you could commit to give $500 to your least-favorite charity if you fail to drop the pounds.

Ultrinsic is just applying this logic to college grades … and kindly offering to take a cut when students fall short.

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