Wednesday, May 9, 2012

What happens when a company forgets about Moral Hazard and Adverse Selection?

American Airlines should read chapters 19 and 20. They sold 64 lifetime AA passes for $350,000 that allowed passengers to fly first class, anywhere, at any time.  This was a big mistake:

  • Adverse selection:  only extremely travel-inclined passengers purchased the tickets; and
  • Moral Hazard: since the marginal cost of travel was zero, they used to fly to any destination where the marginal benefit was greater than zero.  

Bottom Line:  The passes ended up costing AA over ten times as much as they sold them for.

HT:  Don Marron

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