Dealing With Risk, Asymmetric Information, and Incentives Paper Example

Paper Type:  Literature review
Pages:  7
Wordcount:  1816 Words
Date:  2022-06-17


Kerb Kelleher founded southwest Airlines in the year 1967. Southwest's headquarter is in Dallas, Texas. It is renowned for its provision of low-cost traveling packages within America (Gittell, 2015). Currently, the airline boasts a workforce of close to 60,000 employees and makes more than 4,000 trips during holidays. Currently, it is the largest domestic carrier but it has expanded its services to nearby destinations including Hawaii. In recent times, Southwest Airlines has introduced measures to deal with risk and uncertainty. Also, there have been adverse selection problems in the company and moral hazards that have led to mixed results regarding profit making. On a positive note, the company has been able to take advantage of the principal-agent problem arising from incentive packages to increase its profits.

Trust banner

Is your time best spent reading someone else’s essay? Get a 100% original essay FROM A CERTIFIED WRITER!

Literature Review

Dealing with Risk and Uncertainty

The company has employed the four strategies for dealing with risk and uncertainty. They include the flexible strategy, the financial hedging strategy, the operational hedging strategy, and the benchmark strategy. The benchmark strategy involves the method that is used mainly in a case where the risky components are closest to the expected values and the shocks due to uncertainty do not pose a danger to the survival of Southwest. Southwest has sufficient capital hence it can take greater shocks on the chin.

Southwest has also used the financial hedging technique to reduce the sensitivity of the value of the company to variations in risks. For instance, the airline started trading in making trades in Forward Contracts (Warren, 2015). The contracts involve jet fuel because of the volatility of prices of jet fuel hence the airline remains rightly hedged against any impacts that prices changes may have on jet fuel. When risk factors revolve around the expected value, the profitability reduces but when the outcomes at the lower tail created by risk factors lead to concerns, Southwest uses the financial hedging strategy.

The flexible strategy has also featured prominently among Southwest's strategies to reduce risk and uncertainty. In recent times, the airline has tailored its processes and operations in a manner that allows quick response to favorable conditions. The airline has put in place measures that make its profits respond more to positive shocks and less to negative shocks. This implies that the airline's profits become higher as the variation in conditions increases. These actions have enabled the airline to make very high profits when the conditions are favorable and limit the loss-making when the business is not good.

Additionally, the airline has implemented operational hedging as one of the measures to reduce risk (Warren, 2015). Operational hedging involves making adjustments to operations to reduce the sensitivity of profits to uncertainty shocks and risk factors. Diversification is one of the operational hedging strategies that the airline has put in place. The airline has invested in other businesses that have reduced sensitivity to risk factors. In recent years, there have been efforts to purchase planes that are more efficient in fuel consumption as a way of operational hedging. Such are the measures that reduce the sensitivity of profits to risk factors in Southwest.

The Improvement of Risk Management

Risk management is the identification of risks inherent in a firm and taking measures to mitigate them. Some of the risks that may affect a company include competitive pressure, technological changes, stakeholder pressure, merger integration, and regulatory changes. There are five steps that can be used to improve the risk management of Southwest airlines. First, there is a need for objectives and business strategy. Some of the frameworks that they can use to plan the strategy for the Southwest are the holistic Balanced Scorecard and the SWOT analysis (Lohmann and Spasojevic, 2018). However, these frameworks cannot address risk hence it is important for the companies to get the extra mile t ensure risk integration during the planning stage.

Secondly, there is a need for establishing key performance indicators (KPIs) for measuring results. A good KPI provides hints as to what levers the airline should pull to facilitate improvements in the overall operations of the company. For instance, it would not be advisable to use overall sales as a KPI in any business. The per-customer-sales value could be a better indicator because it allows the firm to look for answers concerning what drives sales.

It is also important to assess the risks that can be the drivers of performance variability. This may include the number of travelers that the airline will have in future for any particular year. A change in the number of travelers using Southwest airlines will determine its profits. For instance, there is a risk that the number of customers in a particular month will reduce owing to some risks and this could lead to a reduction in revenue. Therefore, traveler numbers is a risk that can lead to performance variability for the airline.

It is also a good recommendation for the airline to find its key risk indicators (KRI) as well as the critical risk tolerance level. While the purpose of the KPIs is a measurement of historical performances, KRIs are indicators that usually forward-looking hence they look for possible roadblocks (Lohmann and Spasojevic, 2018) . Using this method, the airline will be able to determine risks that the company is facing going into the future and put in place measures to mitigate those risks hence reduce its impact on profitability.

The last step is to ensure the regular provision of integrated reports. This means that companies need to examine the KRIs and results on a regular basis to reduce risks and grab the some of the opportunities that arise unexpectedly. Numerous opportunities arise on a regular basis in the industry that Southwest needs to exploit. The tenacity in taking advantage of these opportunities is what would lead to increased traveler numbers and profit in the long-run.

The Adverse Selection Problem

Southwest airline has always been facing an adverse section problem with regards to its travel destinations. On many occasions, the airline has chosen new destinations that have led to loss-making due to a low number of travelers using the airlines. Such problems arise when the management of the airline makes ill-informed decisions about the potential that a given destination has with regard to revenue. There are a number of methods that the airline can implement to reduce its impact on transactions.

For instance, Southwest can boost daily flight trips to destinations that they currently operate in (Thomas, 2015). The advantage of this is technique is economies of scale since the variable costs and revenue for the additional flights will become higher but fixed costs being constant will result in increased income for the airline. The fact that the Southwest has already captured the customers from these regions means that little or no extra costs will go to capturing new customers. Secondly, Southwest should maintain the cost leadership strategy that it has initiated. This way, the airline will be able to reduce costs hence maintain high income. In effect, it will be able to maintain its competitive advantage. Adoption of these measures will ensure that the adverse selection effects are not felt because their effects will be canceled out by the profit-making in other destinations.

The Moral Hazard Problem

There have been complaints that Southwest is relieving too many people of their work hence destroying the culture of the airline. The workers and flight attendants at Southwest Airlines are represented by the Transportation Workers Union. The union has brought into the limelight a case whereby 470 members of their union have lost their jobs in Southwest in the last 2 years. The union has a membership of 15,000 flight attendants and 12,000 groundwork people (Lohmann and Spasojevic, 2018). This means that Southwest has fired 2% of their members so far. Such cases are a moral hazard that can lead to the downfall of the airlines. The union has referred to the actions as hostile to the previous and current employees. Such actions damage the morale and commitment of employees towards Southwest Airlines.

As a result of these complaints, Southwest Airlines has initiated measures to deal with the moral hazard. Its leadership has been clear that the employees who have been released from their duties have posed a problem to the rest of the workforce. The Airline has increased the remuneration of the existing workforce to keep them motivated. I would suggest that Southwest initiates measures to educate their workforce on the importance of respecting their colleagues. In any organization, employees should always understand that the company is bigger than any individual (Gallo, 2014). Their mission in the airlines should be to provide a superb experience to the customers in order for the Airline to beat its competition and increase income.

The Principal-Agent Problem

Southwest Airlines created the frequent flier program to encourage customer loyalty to its brand (Lohmann and Spasojevic, 2018). This program has helped to create competitive advantage due to the similarity of flight prices across the industry. The current restriction to the program is that it awards miles based depending on the amount of money spent rather than mileage flown. This has affected the market by creating a dispute between companies that pay the travel expenses and business travelers. Business travelers have taken advantage of this option to book flights closer to their dates of departure which are costly. This incentive has created a problem between the principal and the agent, with Southwest being the third-party (Lohmann and Spasojevic, 2018) . Business travelers make decisions on behalf of the companies that pay for their travel expense but the companies are against the high traveling costs preferred by the travelers. The incentive offered by Southwest is the origin of this principal-agent problem. In the end, this tool used by the airline leads to increased profit for Southwest.

The Organizational Structure of Southwest Airlines

The top of the organizational structure consists of the CEO Gary Kelly, Vice Chairman Ron Ricks, and nine directors being members of the board. Beneath the CEO in the hierarchy is the Chief Financial Officer, the President, Chief Operating Officer, Chief Revenue Officer, Executive Vice President of Corporate Services, MD Ground Operations, Chief Information Officer, General Counsel and Corporate Services, and the Chief Technology Architect (Lemons, 2018).

The hierarchy below them is broad and consists of the Managing Directors in charge of Planning and Analysis, Investor Relations, Tax, Finance, Audit, Control, Revenue and Pricing, Marketing, Corporate Strategy, Daily Operations, Operations Control, Programs and Maintenance Safety, Operations, Air Operations, Airport Affairs, Operations and Enterprise, Cargo and Charters, Maintenance Operations, Operational Coordination, Operational Strategies, Airlines University, Technical Services, Flight Operations, Safety and Security, Network Operations, Cabin Services, BusDev, Supply Chain, Ground Provisioning, Ground Operations, Customer and Ground, IT and Infrastructure Services, Deputy Legal, Governmental Affairs, Culture, Customer Support and Services, Customer Support, Diversity and Inclusion, Human Resource, Customer and Rapid Rewards, Customer Services, Labor Relations, and Product Solutions (Lemons, 2018).

The profitability of Southwest can be improved by merging some of its functions. In the lower hierarchy, some of the functions are redunda...

Cite this page

Dealing With Risk, Asymmetric Information, and Incentives Paper Example. (2022, Jun 17). Retrieved from

Free essays can be submitted by anyone,

so we do not vouch for their quality

Want a quality guarantee?
Order from one of our vetted writers instead

If you are the original author of this essay and no longer wish to have it published on the ProEssays website, please click below to request its removal:

didn't find image

Liked this essay sample but need an original one?

Hire a professional with VAST experience and 25% off!

24/7 online support

NO plagiarism