October 2000 Real World Should Airlines and Hotels Use Short Selling? By Eyal Biyalogorsky, Ziv Carmon, Gila Fruchter and Eitan Gerstner Short selling is common in the stock market. Short sellers sell stocks that they do not own at current prices, expecting their price to fall. They plan to buy back the stocks later, return them to the account from which they were borrowed, and profit from the price difference. Is it possible to profit from short selling in other markets as well? In a recent paper [Marketing Science, 1999], we showed that any seller who has a limited number of units for sale (for example, airplane seats or hotel rooms) can profit by asking high prices for units that have already been sold. If there are buyers at the high price, the seller buys-back the units already sold, and transfers them to the high paying customers. Consider a business traveler who must travel on short notice and is willing to pay top dollar for a seat on a certain flight. If the flight is fully booked, the airline can still profit from the business traveler by short selling a seat on the flight and buying it back from a traveler who paid a low price and is willing to postpone the flight for compensation. A case in point is the frequent flyer program of Continental Airlines advertised on their Web page (www.Continental.com). Passengers who achieve the Gold or Platinum "OnePass Elite Status" can obtain a confirmed reservation — even when a flight is sold out — when purchasing a high price unrestricted Y class ticket at least 48 hours prior to departure. The difference between restricted economy tickets and the unrestricted tickets is typically large enough (it can exceed $1,000 for international flights) to adequately compensate low-paying passengers who surrender their tickets, allowing the airline to make a nice profit. Such short selling (or deliberate overselling) should not be confused with overbooking. Overbooking occurs because some consumers with reservations may not claim the service they reserved (no-shows), so sellers book more reservations than available capacity. If an airline or a hotel overestimates the number of no-shows, the available capacity is oversold, and some buyers are "bumped" from the flight or are "walked" to another hotel. These businesses typically compensate buyers who voluntarily give up their place. Airlines often conduct auctions and raise the compensation until enough volunteers are found. In contrast to overbooking, short selling increases profits even if buyers always claim the reserved service. The reason is that short selling allows the seller to obtain the highest possible price instead of turning away high paying customers when capacity is sold out. Short selling affects the optimal allocation of capacity. If a seller allocates too many units to high paying customers (a practice known as blocking), "spoilage loss" could occur if high-paying customers do not show up and the units are not sold. On the other hand, if the seller does not block enough units, "yield loss" could occur if high-paying customers do show up and some units were already sold at a low price. A seller that uses short selling does not need to block as many units because the seller does not lose the opportunity to get a high price for units that were already been sold. In contrast, without short selling a unit sold at a low price cannot be sold at the high price anymore. Thus, blocking a smaller number of units with short selling reduces expected spoilage losses and enhances economic efficiency. Short selling is also good for customers because consumers that value the product the most are more likely to get it, while those customers who give up the product do it willingly in return for appropriate compensation. Short sellers in industries such as airlines and hotels are in a privileged position of knowing the demand for their products. Using this knowledge and past experience, a seller can estimate if the high price for a short sale will be sufficient to buy back the unit from a low paying customer and leave sufficient profit to the short seller. Therefore short selling in such industries could be more attractive and less risky than it is in the stock market. Companies that sell limited capacity should consider short selling as a tactic to improve the bottom line and benefit consumers. References 1. Biyalogorsky, Eyal, Ziv Carmon, Gila Fruchter & Eitan Gerstner (1999), "Over-Selling with Opportunistic Cancellations," Marketing Science, Vol. 18, pages 605-610. Eyal Biyalogorsky (eyalog@ucdavis.edu) is an assistant professor at the University of California, Davis. Ziv Carmon (ziv.carmon@insead.fr) is an associate professor of Marketing at INSEAD. Gila E. Fruchter is with the Department of Marketing, The Hong Kong University of Science and Technology. Eitan Gerstner is professor of Marketing at the University of California, Davis. Table of Contents OR/MS Today Home Page OR/MS Today copyright © 2000 by the Institute for Operations Research and the Management Sciences. All rights reserved. Lionheart Publishing, Inc. 506 Roswell Street, Suite 220, Marietta, GA 30060, USA Phone: 770-431-0867 | Fax: 770-432-6969 E-mail: lpi@lionhrtpub.com URL: http://www.lionhrtpub.com Web Site © Copyright 1999, 2000 by Lionheart Publishing, Inc. All rights reserved.