I Found Myself Seated in a Crowded Bus...

It has not been more than a week since I returned to my hometown and in a positive mood, I decided not to use a car or a bicycle but utilize public transportation to move around the city, in that way I could maybe eavesdrop on some conversations and re-catch the vibe of the city.

 

During one of my rides, I was found seated in a crowded bus and so when an elder came in at a stop, I decided to stand up and let him take my spot only to realize that another person had swiftly snooped in to take the place. The above situation, if you have studied a bit of economics and have a bit more of imagination, can be thought of as a moral hazard problem. I will analyse more thoroughly in the next paragraphs the main parts and ideas of moral hazard as well as its link with a strategic environment but before I do that let me summarize quickly game theory and its connection with moral hazard.

THE BASICS

Game theory is involved in every decision that is made daily. More formally, it is a theoretical framework under which social situations are understood among competing players. In the example above there are two players competing for the free spot, the elderly man and the “inconsiderate” one, they both get positive payoff from sitting down but in the next stop they might receive some sanctions or opportunity costs from sitting down in that particular seat and not another one. Moral hazard can stem from asymmetrical information as performance of the competitors can be unpredictable. It is not possible to run the game in your head to derive the best result. Once again put formally, moral hazard occurs when someone increases their exposure to risk, especially when another person bears the cost of those risks. Moral hazard can be solved through promoting the right incentives to those that involve themselves in the game.

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Strategy is an action that managers usually take in order to attain one or more objectives of a company, it is what bridges “where we are “and “where we want to be “. Plotting a new strategy, what needs to be taken into consideration are your own actions, what are they and which are the risks assigned to those actions, and also your competitor’s reaction. In other words, strategy is achieved through the application of game theory knowledge and the identification of moral hazards. In the example above you would make a new strategy to let the elder seat, so standing up, considering other people’s intentions, someone else arriving in the spot faster, and you would take some actions to face moral hazards, place yourself so that the elder has access to the seat.

STRATEGIC GAME THEORY - RYANAIR

Now let’s move to a more realistic example and consider Ryanair’s low-cost strategy. Ryanair’s operations strategy determines how the airline will deploy its resources and the policies it will operate by. To keep costs low they operate a ‘no-frills’ service onboard aircraft. This means the fare only includes the flight. They do however have some minimum allowances that are uniform with other companies that offer economy-class tickets. Last November they decided to lift one of those minimum allowances. This action was performed so that Ryanair can increase revenues to account for striking pilots demanding more benefits. What they did was allow only one bag on board and charge you for the extra cabin bag, that used to be included in the price. From a strategic point of view, their strategy is the same, they still are low-cost, they just change the approach of achieving their objective as the cabin luggage has no reason to be included in a no-frills service. Reactions from competitors like EasyJet were rapid reducing their cost of an extra cabin bag. Anticipating this move, Ryanair knew EasyJet would not be able to get the fee lower than a threshold and so they undercut their price at 6 pounds, EasyJet had it at 7, to ease discontent of their customer base.

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Ryanair decided to operate in a different way to achieve their low-cost strategy analyzing their competitor’s capabilities and understanding moral hazards bared by their customer base. Game theory was applied to decide the perfect price for the previously given for free service, and the incentives given to their customer base in order to face moral hazards were found in marketing, advertising their agreement with airbus for new airplanes, or providing better services for after having landed, like cooperating with car-renting companies to provide better prices for Ryanair travelers. Ryanair’s losses from adding this charge would have been greater were they not to realize the risk to be bared by their customers.

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Moral hazard identification is one of the main realizations to be made when planning a new strategy or a new approach to the same strategy and is always taken into consideration in the business world. However, it can be found everywhere as its insights are very broad, from someone granting a spot in the bus to the U.S. government saving banks during the Great Recession due to issues surrounding the stock market. Take this as a personal challenge and try realizing what where the issues that rose during the Great Recession connected with moral hazard and why were they there to begin with.

 

By Vassilis Kostakis.