Of this (via MR):
It’s an auction conducted at the airport terminal. In this auction you are a seller and you are bidding to sell your ticket back to the airline.
Optimists look at this and contemplate the efficiency gains: this is a mechanism for appropriately allocating scarce space on the plane. Pessimists detect a nasty incentive: now that the lowest bidder can be bought off the plane the airline has a stronger incentive to overbook.
The pessimists are right precisely because the optimists are right too.
Consider standard airline pricing with no overbooking. You buy a ticket in advance for a flight next month. Lots of uncertain details are resolved between now and then which determine your actual willingness to pay to fly on the departure date. One month in advance you can only form an expectation of this and that expected value is your willingness to pay for a seat in advance.
This is inefficient. Because, after the realization of uncertainty it could be that your value for flying is lower than somebody else who didn’t buy a ticket. Efficiency dictates that you should sell your ticket to him on the day of the flight.
One way to implement this is to hold an auction on the day of departure. Put aside the issue that flyers want advance booking for planning reasons. Even without that incentive, just-in-time auctions solve the inefficiency problem with conventional pricing but airlines would never use them.
The reason is that an auction leaves bidders with consumer surplus (or in the parlance of information economics, information rents.) As a simple example, suppose there is a single seat avaiable on the flight and two bidders are bidding for it. An optimal auction is (revenue-equivalent to) a second-price auction so that the winning bidder’s price is equal to the willingness to pay of the second-highest bidder. That is lower than the winner’s willingness to pay and the difference is his consumer’s surplus.
The airline would like to achieve the efficient allocation without leaving you this consumer’s surplus. That is impossible in a spot-auction because the airline can never know exactly how much you are willing to pay and charge you that.
But a hybrid pricing mechanism can implement the efficient allocation and capture all the surplus it generates. And this hybrid pricing mechanism entails overbooking followed by a departure-day auction to sell back excess tickets.
The basic idea is standard information economics. The reason you get your information rents in the spot auction is that you have an informational advantage: only you know your realized willingness to pay. To remove that informational advantage the airline can charge you an entrance fee to participate in the auction before your willingness to pay is realized, i.e. a month in advance as in conventional pricing.
Here is how the scheme works in the simple example. There is one seat available. Instead of selling that single seat to a single passenger, the airline sells two tickets. Then, on the day of departure an auction is held to sell back one ticket to the airline. The person who “wins” this auction and makes the sale will be the person with the lowest realized value for flying. The other person keeps their ticket and flies. On auction day, the winner gets some surplus: the price he will receive is the willingness to pay of the other guy which is by definition higher than his own. (Delta is apparently using a first-price auction, but by revenue equivalence the surplus is the same.)
But in order to get the opportunity to compete in this auction you have to buy a ticket a month in advance. And at that time you don’t know whether you are going to win the auction or fly. The best you can do is calculate your expected surplus from participating in that auction and you are willing to pay the airline that much to buy a ticket. Your ticket is really your entrance pass to the auction. And the price of that ticket will be set to extract all of your expected surplus.
Note that the only way that the airline can achieve these efficiency gains and the accompanying increase in profits is by overbooking at the stage of ticketing. So the pessimists are right.
(You can write down a literal model of all of the above. The conclusion that all of your surplus is extracted would follow if travelers were ex ante symmetric: they all have the same expected willingness to pay at the time of ticketing. But the general conclusion doesn’t require this: all of the efficiency gains from adding a departure-day sellback auction will be expropriated by the airline. That follows from a beautiful paper by Eso and Szentes. To the extent that fliers retain some consumer surplus it is due to ex ante differences in expected willingness to pay. The two fliers with the highest expected surplus will buy tickets at a price equal to the third-highest expected surplus. This consumer surplus is already present in conventional pricing.)
45 comments
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January 5, 2011 at 10:37 am
twicker
YIKES! Be very afraid, indeed …
January 5, 2011 at 11:18 am
dweez
I flew on Delta just earlier this week and saw this mechanism in action as I volunteered to sell my ticket. Strangely, the voucher I was offered (and accepted) at the gate was for an amount much higher than my originally reported willingness to pay. Maybe the system is just being piloted for now?
January 5, 2011 at 3:46 pm
Anonymous
They give the same amount to everyone they need tickets from (I believe by law), so everyone who bids below gets the n-th dollar amount.
January 5, 2011 at 11:25 am
peter
What to really fear: this approach growing more pervasive. How about overbooking movie tickets, or tickets to the CSO (would that the demand for those would be so high!), or Wrigley Field. Technology to implement the recapture of the consumer surplus is now in everyone’s pocket. Groupon, OpenTable, Vines are all going in this direction, and quickly…
January 5, 2011 at 11:45 am
lemmy caution
according to this site the airlines are generally required by law to give volunteers travel vouchers equal to the flight cost up to a maximum of $400 domestic ($800 international):
http://www.airsafe.com/complain/bumping.htm
The auction only really kicks in when not enough people will volunteer for the
$400. There generally are enough volunteers though. Theoretically, the auction will maximize utility by giving $400 to people who value the flight the least.
January 5, 2011 at 12:50 pm
Tim
Does this hold, though, in a world with competitive airlines? It seems the Eso and Szentes deals with a monopolist (I only read the abstract). If American institutes this system as well, they can overbook more as well, yielding more revenue. Competition between American and Delta will drive down fares on both carriers.
January 5, 2011 at 1:06 pm
jeff
yes competition matters. it’s hard to model. my guess is that even with competition there would be elements of this but definitely travelers would get a better share of the surplus.
January 5, 2011 at 1:40 pm
Bobby
One problem is that your initial willingness to pay for your ticket is not equal to what you actually pay and the airline has no way of determining the difference. Initial ticketing is not done through auction, but rather typically through competitive price comparison.
January 5, 2011 at 2:19 pm
K
What if the two buyers are loss averse and submit identical bids? Or, submit very high bids? Wouldn’t this render the auction process worthless?
January 5, 2011 at 2:33 pm
KevinH
seems like there should be an extra ripple from competition between airlines. In theory the airlines will only get full benefit if they charge an entrance fee of more than each persons perceived benefits of flying.
As long as they are the only game in town, they can enforce those entrance fees and they win. But once you have competition to keep the entrance fees down, then some fairness returns to the market.
Now, a benefit two double sell a ticket is only ensured to the airline if the entrance fee is more than the perceived benefit of flying plus half of the perceived cost of delay from the lowest person.
This benefit gets easier to ensure the smaller % of seats you over book, and approaches the perceived benefit of flying. So, I’m not sure it’s that bad of a system.
January 5, 2011 at 2:42 pm
Nate
but are the passengers (or non-passengers as the case may be) worse off with a same day sell-back auction compared to near-zero overbooking?
January 5, 2011 at 4:04 pm
Noah Yetter
Two nitpicks:
…only you know your realized willingness to pay…
Actually, you don’t know your willingness to pay. It is only through participating in the auction that you may discover your willingness to pay. This helps explain why…
(Delta is apparently using a first-price auction, but by revenue equivalence the surplus is the same.)
…is not true either. First- and second-price auctions are only equivalent in a world where participants know their own reserve prices. In actual fact, because auctions are a discovery process, first- and second-price auctions lead to different outcomes.
January 5, 2011 at 4:09 pm
John
When a non-liberal economist states the same thing I’ll consider it.
January 5, 2011 at 5:20 pm
jeff
Who are you calling an economist?
(seriously I was not aware that I am a liberal economist)
January 5, 2011 at 4:41 pm
The Pizza Man
How does this affect people who are very certain of their desire to fly in advance and will never be the low bidder in the sell back auction? Is the up front cost of the ticket to drop because of this mechanism?
January 5, 2011 at 5:07 pm
JimDesu
If Delta is going to pull that crap and not honor my ticket, then I’m never flying with them again.
January 5, 2011 at 5:28 pm
Ian
Work out an (overly?)simple model where one flight, that has one seat, sells two tickets.
If each seat sells for the same amount, then, assuming neither passenger is willing to sell for less than the initial price plus a premium to his surplus, the airline loses money. The only way the airline makes money is with price discrimination – airlines are already very good at this. Time of pre-booking is one of their methods.
My best idea (from an airline perspective) is as follows:
step 1) Book the flight to cover costs and fill the seat.
2) Sell ‘extra’ ticket to the 2nd passenger, who likely has a low price-elasticity of demand (business customers), at a much higher price.
3) Then, if the pricing spread is large enough, there is enough to buy out the first customer. Hence, the airline ends up with the higher price, less the lower price plus a bit more than the first consumer’s surplus. It then just becomes a matter of pricing the ‘extra’ tickets high enough to cover the expected 1st consumer surplus as well as the airlines profit.
The revenue equivalence theorem assumes in this sealed bid auction that the airline has the information. The theorem fails when the 1st passenger obtains the 2nd passenger’s information. And, in the real world, the 1st passenger can continue to call, checking on the current prices (call using a fake name since airlines are escaping expedia). Thus, the 1st passenger now has a ball park figure of the 2nd passenger’s reservation price.
Game system accordingly.
January 5, 2011 at 5:36 pm
Ian
Also, Mr. Yetter, as someone who took a tedious class in auction theory, I can appreciate your comments. Tevenue equivalence is ex-ante, so the expected revenue is the same. Ex-post, they may be very different. Also, I like the price discovery comment, but doesn’t that apply more toward thinly traded goods? I’m not sure airline tickets qualify.
January 5, 2011 at 5:41 pm
kevin
I’d like to see how you conclude that a just-in-time auction would somehow be better for consumers.
On the day of the flight, people would already have committed to hotels, rental cars, meetings, etc., meaning their reserve prices for the flight would be substantially higher.
Efficient, yes, but coming with a larger sacrifice of consumer surplus.
January 5, 2011 at 6:14 pm
links for 2011-01-05 – Kevin Burke
[…] Be Very Afraid « Cheap Talk The airline would like to achieve the efficient allocation without leaving you this consumer’s surplus. That is impossible in a spot-auction because the airline can never know exactly how much you are willing to pay and charge you that. […]
January 5, 2011 at 10:19 pm
DC
But selling more tickets a month in advance increases supply at that time driving down initial prices, so people who do fly get more consumer surplus.
This would appear to mean that the benefit from A) more frequently being able to fill all airline seats (“the world’s more perishable commodity”) by avoiding empty seats from no-shows and B) increasing value delivered by having a mix of customers more heavily weighted to people who really do value flying that day is being split between the airline and the consumer.
This doesn’t seem scary to me at all… I’m more likely to be able to purchase a seat at a lower price (greater supply) and I have an option to gain more value by selling the ticket back. What is the downside?
January 5, 2011 at 11:53 pm
George
How does this benefit the airline at all?
Surely no one would be stupid enough to volunteer to sell their ticket back for less than the initial price of the ticket, therefore the airline will always be losing money through these traveler vouchers. I must be missing something here: what is it?
January 6, 2011 at 4:05 am
delta experiments with true liquidity | Hiding in plain sight
[…] via Be Very Afraid « Cheap Talk. […]
January 6, 2011 at 6:14 am
Robb
I have always been curious about the Airlines lack of interest in load balancing. For example, if you arrive at the Airport early and there is a plane leaving with empty seats, they won’t let you take one of these (now valueless) seats without paying an extra fee.
I have refused to pay this fee and then witnessed them paying off someone they overbooked on my later flight. They could have preserved my valuable later seat, by trading me for the earlier seat that became valueless as soon as the earlier flight took off.
Now of course, if the later flight was half empty, then they would not have any incentive to trade. But as far as I could see they did not consider the future.
George; Even if you give up your ticket on the current plane they always offer to get you on the next plane…so you get the transportation and the payoff.
January 6, 2011 at 5:11 pm
Pontificator
One does not need a computer to accomplish an auction. I have participated in auctions of this sort that were performed by the gate agent using the PA at the gate. Bidding in advance on a recorded means tips the asymmetric information balance in favor of the airlines allowing them to more accurately predict the cost of an overbooked seat and a leg up on where to start making bids (with an eye toward acquiring excess producer surplus as they are the consumer in the transaction). Information could also be used in their Byzantine pricing schemes to further segment the market. Nothing to fear here if you are a savvy consumer.
January 6, 2011 at 6:07 pm
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[…] Be Very Afraid Of this (via MR): […]
January 7, 2011 at 8:18 am
Nate
Do these kiosks sit right in the gate area? If so, I’d be the first one to start a wonderful little price collusion scheme. You could do this ethically, by announcing to your fellow passengers that they should all bid $500 instead of their $150 or $200 that they were planning to bid. Incentives to prevent someone from rolling the system would be a small profit-share among all participants, in cash, supplied by you, the “independent auction arbiter.”
Or you could go mafioso and stand right by the kiosk with your muscle.
January 13, 2011 at 7:29 am
Eric
Unless this is a completely new processes in the airline industry, the process of VDB (voluntariy denied boarding) does not mean that the traveller sells back their ticket for travel back to the airline. Instead, they are selling their reservation on that particular flight. In addition to a voucher with some cash value, the traveller might get other items such as a confirmed reservation on a flight to the same destination leaving the future, a hotel stay overnight or other considerations.
Of course, if no one accepts VDB at a price acceptable to the airline, they perform IDB (involuntary denied boarding) for a cash settlement set (in the US) by the FAA. Also, the airline has to report that they performed IDB to the FAA, which might have some political consequence.
For lots of discussion by people who game these systems on how these systems actually work at each airlines, I suggest http://www.flyertalk.com.
February 2, 2011 at 12:15 am
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[…] Torture on this blog. Simply put, that paper would not exist if Cheap Talk did not exist. This post I wrote recently about overbooking set me thinking for a day or two and now, with ideas from Daniel […]
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