Strategic Analyses of Applying an Option-Based Hedging Mechanism in Parallel Airline Alliances

Introduction

Overbooking refers to airlines intentionally overselling the actual number of seats on an aircraft (Coughlan, 1999). Airlines use overbooking as a revenue management instrument to minimize lost revenue due to passenger cancellations and no-shows (Rose, 2016). Although having the potential to increase capacity utilization on a flight efficiently and thus bring extra revenue to airlines, overbooking introduces a new risk that passengers in excess of the total capacity show up for a flight but are denied boarding because of oversales (Smith et al., 1992). After a temporary pause in the pandemic year 2020, air travel started to recover, and at the same time, overbooking has become common again. In 2021, around 183,000 passengers were bumped from oversold flights of the largest U.S. air carriers, up from as few as 81,000 in 2020 (U.S. Department of Transportation, 2022). Specifically, Figure 1 shows the number of passengers denied boarding voluntarily and involuntarily from 2012 to 2021. Around 11,000 passengers holding confirmed reservations were involuntarily bumped from oversold flights in 2021. Note that this figure only covers domestic and outbound international flights of ten U.S. airlines. Considering the enormous total passenger volume worldwide, the risk of oversales inherently brought by overbooking could be a big problem.

In the case of denied boarding due to overbooking, the airline must compensate the bumped passengers. Depending on how late the passenger arrives at their destination, the compensation payment can be costly (Oh & Su, 2022), let alone the reputational risk and loss of goodwill that are detrimental to the airlines’ long-term survival and development (Dalalah et al., 2020; Nazifi et al., 2021; Wangenheim & Bayón, 2007; Zhang & Chen, 2013). On the other hand, airlines cannot avoid the risk of undersale, which occurs when they do not overbook flights enough, resulting in empty seats. The consequences of undersale can be equally unaffordable because the value of unsold seats will diminish upon flight departure. This issue will affect the ability of airlines to fully utilize their finite capacity and absorb the high fixed cost of operating a flight (Guo et al., 2016). Overall, it is probable that the ex-ante optimal overbooking policy ends up in ex-post oversale or undersale risk, even though overbooking per se is a risk-hedging tool used by airlines.

Figure 1.

Number of passengers denied boarding by the largest U.S. air carriers from 2012 to 2021, by type (in thousands) (U.S. Department of Transportation, 2022)

In a previous study, Wang and Fung (2014) proposed an option-based passenger transfer mechanism to address the issue of oversale and undersale inherent in overbooking for parallel airline alliances. Their work is the only one that studies mechanism design for airline alliances to reduce the ex-post overbooking risks. As there has been no further research aiming to extend the applicability of their mechanism, two questions remain unexplored. First, does the best strategy for applying the option-based mechanism exist? Second, if so, how to identify such a best strategy? These two unanswered questions drive the authors’ interest, leading to the current study.

The remainder of this paper is organized as follows. Section 2 reviews the pertinent literature on airline overbooking. Section 3 presents a concise summary of the hedging mechanism showing the model formulation, parameter setting, and simulation procedures. Section 4 offers a comprehensive discussion of the simulation results and introduces a two-stage simulation-based algorithm to identify the best strategy for applying the hedging mechanism. Finally, Section 5 concludes this work.

Literature Review

The existing literature related to overbooking can be broadly divided into two categories. The first category focuses on mathematical and technical advancement in optimizing the ex-ante airline overbooking decision. The second category looks for ways to reduce the ex-post negative impacts due to overbooking.