Impact of Penalty Cost on Customers' Booking Decisions

Abstract

We study a novel newsvendor‐type problem where the information on demand quantity is not exogenously given. The customer needs to make the booking decision based on her estimation on demand, which is affected by the value of shortage penalty cost. The problem is motivated by low‐cost airline service practices where passengers need to book baggage allowance for their travel. The baggage overweight price affects the accuracy of passengers' baggage weight estimation and thus their booking quantities. Through stochastic decision models, we analytically characterize the impact of shortage penalty cost on passengers' booking decisions as well as airline's profit. We consider various modeling settings, including a system with multiple passengers and a system where passengers have stochastic inconvenience costs on not‐carrying overweight baggage. The results and insights from our study provide guidelines for firms to set their optimal penalty prices.