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Verret: Efficient Markets Offer Hope of Taming Risk

Many of the problems faced by airline executives as they struggle to deal with volatile fuel prices could be eliminated by market forces, says Professor J.W. Verret, whose article on the topic appears in the September 9 edition of the Orange County Register.

The answer to the problem of rising fuel costs lies in passing the risk of rising fuel prices on to consumers through a system in which an airline ticket is sold with a future adjustment to be made for cost of fuel at the actual time of flight, according to Verret. The consumer would balance the opportunity for substantial savings over the cost of a traditional ticket against the risk of a higher cost in the event of a rise in fuel costs prior to the flight.

"Risk is a necessary element of the business world," Verret concedes. "It cannot be legislated away, and it cannot be ignored. But efficient markets, with trades based on astute observations by large groups of people, offer the hope of taming risk and ensuring that fuel crises do minimal long-term damage to the airline industry."

Ready for variable-rate airline tickets? Orange County Register, September 9, 2008. By J.W. Verret.

Excerpt:
"Why can't I buy a ticket for a set fee, subject to an adjustment for the cost of fuel on the day of the flight, similar to the way lobster and seafood is offered in restaurant menus at 'market price'?

"Restaurants have a competitive advantage in preparing seafood but are uncomfortable with some of the volatility of the future costs. And so they introduce variability into their menu of prices to pass that uncertainty through to the market, to let others share in the risk.

"To the extent that airlines are unwilling to assume the cost of fuel volatility, why not let the market of consumers share in this risk? Rather than a handful of executives (who tend to enjoy a generous severance package combined with short tenures at the helm) attempting to gauge this risk, a host of interested consumers will trade it more efficiently.

"For example, why don't I have the option to purchase a ticket in September for travel on Christmas from Washington, D.C., to New Orleans for a $200 fee plus a fuel cost rebate/increase, so that my actual cost is predicted to probably be between $50 and $350? This option would offer a chance at substantial savings over the cost of a standard ticket, but also the risk of a higher cost in the event that fuel prices increase (more than the market expects) from the date of purchase to the date of flight.

"I can do some research and determine that I'll probably end up paying $300 to fly, and there's a 10 percent chance it could go as low as $100 or as high as $600. If fuel prices drop, or if they increase by less than was expected at time of purchase, I would realize a discount. I would personally consider this option, and I doubt I am alone."

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