This was a mixed week for John Stumpf, the disgraced ex-CEO of Wells Fargo. A debacle with elements of farce occurring last Sunday on a United Airlines flight has replaced Stumpf with UAL’s CEO Oscar Munoz as hapless corporate executive of the moment.
On the other hand, the independent review last week of the Wells Fargo fraudulent account mess ordered by its board of directors was highly critical of management generally and of Stumpf in particular. The big bank’s board is clawing back $28 million from him as undeserved compensation and more from the manager directly over the unit which so pressured employees to sell new products that they created fictional accounts for real customers.
Both situations contain irony — and lessons in economics. Munoz — who made spectacularly offensive (or insensitive) comments on his firm’s handling of an incident in which a passenger was violently dragged down the aisle of a UAL plane — had just recently been named “communicator of the year” by a trade magazine. Stumpf had been widely hailed as one of the best CEOs in the banking business. And he insisted to the end that setting high ethical standards was at the core of Wells Fargo’s culture. What happened?
The two cases are now textbook real-world examples for anyone teaching managerial econ to MBA students or simple introductory microecon.
The first lesson is that both cases exemplify the “principal-agent problem” at multiple levels. This is one kind of failure of the conditions necessary for an unregulated market to reach optimal efficiency in transforming resources into goods and services. It occurs when some hired “agent” is supposed to work to best benefit some “principals” such as stockowners, but then, due to badly designed incentives, works toward another end.
Enrolling millions of customers in fraudulent bank accounts did not benefit Wells shareholders. Nor did having an already-boarded passenger dragged bodily and bloodily by police officers out of a packed jetliner improve things for people owning UAL stock. Yet in both cases, some employee, an agent, felt compelled to take those actions.
At the bank, they did so because managers, themselves responding to a perverse incentive system, applied such pressure to low-level reps that over 5,000 of them felt they had to create fraudulent accounts or lose their jobs.
The incentives in the UAL incident are not yet clear. Some gate agent had to find seats on a full plane at the last minute for some company employees, a flight crew that had to be transported to operate another flight. Clearly, failure to accomplish this, for the agent or agents, would be a failure to perform to standard. At some point, control of the situation probably was passed up one or more supervisory levels.
We don’t know what options were open to the UAL reps. First, they tried to offer compensation to passengers to volunteer to leave the flight and take another. No one bit. Myriad critics, including late-night comedians, wondered why did the airline didn’t raise its bid from $800 or $1,000 to $1,200 or $1,400 or whatever? Why not throw in hotel and meal vouchers? Or make the offer hard cash rather than vouchers? One does not need a doctorate in marketing to know that having police physically remove a passenger from a flight would create bad brand identity, not only for the other passengers, but for nearly everyone who saw the viral social-media cellphone videos that followed. UAL was not even up to the $1,350 specified as the most that the law requires carriers to pay. But perhaps the supervisor faced rules limiting his flexibility.
Others suggested that if UAL had to pay four passengers $1,000 -$2,000 to get each of the last four employees on board, it might have been cheaper to charter a small plane and fly the employees separately.
All these involve imperfect information and transaction costs. The employee may not have had the authority to offer more or had no way to get overriding authorization from some manager higher up. Such situations happen so seldom that even a company such as UAL probably does not have a quick-response contingency agreement with some smaller-plane charter firm. Employees who deal directly with passengers need to be subject to some limits and charter contracts cannot be established instantaneously. It all has an internal logic.
The biggest information failure was the UAL rep’s estimate of how a police removal would play out. The scene likely was already tense with adrenaline flowing on both sides. Rational weighing of alternatives was long out the window. The rep probably had “we’ll show that guy who is in charge” impulses clouding judgement. But he also probably had experience indicating that, when confronted by actual police, a defiant passenger would get up and walk out, albeit cursing all the way. But there must have been little past experience indicating that the situation would escalate to blood, screaming, dragging and dozens of cell phones recording it all.
Behavioral economists know that people are overly-influenced by recent history, causing them to narrow the scope of what they perceive as possible or most probable. That was at play here.
What about other passengers or outraged members of the general public? What about other passengers who encounter similar situations in the future?
In an idealized situation of perfect competition, travelers would now know to avoid UAL and buy from other carriers. There would be many, many sellers of flights just as there are many doughnut sellers. Or, if one wanted to fly UAL, one still could bargain with the ticket agent to get the small print removed saying they can bounce you if you want.
Of course, this is ludicrous. Any single passenger has no bargaining power with any carrier. Air travel is competitive, but is far from perfect competition. It is “oligopoly,” a market dominated by a few large firms, each of which has overwhelming power vis-à-vis any customer. And even without overt collusion, oligopolistic firms adopt common policies on “terms of carriage,” so you gain no advantage in legal rights by spurning UAL for other carriers.
When the assumptions of perfect competition are not met, the outcome is not necessarily efficient. Action by government may improve efficiency, though that is not automatic. Decades ago, carriers had complete freedom to overbook and bump passengers as they saw fit. Customer outrage was impotent against the firms, but customers did gain political power. So we now have the laws mandating compensation up to $1,350 and requirements for information. This helped things somewhat, both in efficiency and fairness.
Improving information through mandatory disclosures is a time-worn and somewhat knee-jerk reaction to market failures due to asymmetric information. But, as anyone who has closed on a mortgage knows, page after page of fine print soon becomes meaningless. Information still is lacking.
Technology plays a role. The emergence of on-line services to identify alternate flights and prices has made the airline industry extremely price competitive. Skeptics argue that, even after this reputational black eye, few people seeking a flight will pay more than a few dollars more to shun UAL. And a few months from now, all will be forgotten.
Airlines are correct that overbooking lowers average cost per seat. Once a flight is going to be made, the marginal cost of carrying one more body in an otherwise empty seat is near zero. Average costs depend on the total cost divided by passengers. Having higher load factors (or percentage of seats filled) does lower average cost. And you can raise these factors by overbooking. Occasional bumping costs far less than the revenue one gains by filling more seats.
But who benefits from more efficient seat-filling is not certain.
Airlines argue that in a price-competitive sector cost savings are passed directly to fliers. Some six passengers per 100,000 purportedly are bumped involuntarily. Millions of flyers benefit from lower cost tickets, the carriers argue, and only a few of those bumped do not receive satisfactory compensation.
Skeptics argue that the sector is not all that competitive, noting that when fuel costs fell a few years ago, carriers did not cut ticket prices, but rather engaged in share-buyback campaigns that benefitted stock holders. The answer of who benefits from overbooking probably lies somewhere in the middle.
Economics-savvy observers noted an element of behavioral econ in the incident, that of the endowment effect. In my column last week, I described blacksmithing tools that I would not have paid $100 for, but now that I have them, I would not sell for three times that. Once we have something, we value it more highly than before we got it. And the same is true for airplane seats. Once people are boarded and in their seats, they are angered much more by being told to get up and off than by being prevented from boarding in the first place. Filling all the seats with revenue passengers before choosing to seat four employees was a gross error.