Many airlines are offering zero change and cancellation fees for flights booked in March. Why are they doing this?
One story: consumers are risk averse and don’t know the severity of the crisis. They fear booking a flight and then being unable to travel because of quarantine, illness, or risk of getting sick while abroad. There are always risks in deciding to book a flight, but all of a sudden consumers face a lot more uncertainty than they did before. This should create an increase in the demand for insurance.
Airline companies can absorb the risk their customers face from bad virus-related outcomes by offering zero change and cancellation fees. In order to bear this risk, they will likely raise their prices relative to the counterfactual in which they did not offer zero change fees. It’s going to be hard to see this in the time series because of concurrent ongoing negative demand shocks from the virus (plus March is generally a cheap time to fly anyway). There also aren’t great historical data on flight prices that are easily publicly available, especially at the airline level. But theoretically, this policy change should come with higher prices.
The problem with this insurance market is that correlated outcomes make risk pooling difficult. In a car insurance market, an accident in Miami is not at all predictive of whether there will be an accident in San Francisco. By offering insurance plans to lots of different people, an auto insurer can break even with high probability since on average good and bad risk outcomes will even out.
In contrast, with epidemics adverse outcomes are highly correlated. There seems to be a lot of uncertainty about how bad the coronavirus is going to be. If it turns out really badly, then a lot of people will look to cancel their flights at the same time. This means airline companies face the prospect of flying a lot of nearly empty planes, or just canceling flights entirely.
Airlines may be willing to accept this risk for a few reasons. Perhaps they are so profitable that even if things turn out badly they don’t face excessive downside risk. This means they are basically risk-neutral, and it’s efficient for them to absorb consumers’ uncertainty. Even if they have to fly empty or cancel flights for a few months, they can continue to pay off debts and weather the storm pretty easily.
Alternatively, it could be that without zero cancellation fees, they would have seen a huge drop in demand in the next few weeks and months as consumers grappled with uncertainty, regardless of whether the coronavirus turned out really badly or not. From the airline’s perspective, this certain bad outcome may have been worse than the uncertain prospect of offering everyone insurance, with some risk that a lot of people cancelled. Such incentives might be stronger because of limited liability. People don’t seem too worried right now that the big airlines will go bankrupt, but for some airlines, a few months of hugely depressed demand could result in bankruptcy as funds stop coming in to pay off debts. Such firms may face bankruptcy with certainty if they continue to enforce change fees, or bankruptcy with some probability less than 1 if they waive them. The worst case is the same in both scenarios, so the firm may as well waive change fees and hope for the best.
Firms may also face limited liability if the government eventually decides to support the economy and bail out struggling firms, taking on the risk that airlines absorbed from consumers by offering no cancellation fees. This may matter for large firms especially if they deem the government would prevent them from failing.