Reforming U.S. Airports

June 8, 2001

Reforming U.$. Airports

An economist makes the case for deregulating the marketplace

By Dr. Frederick R. Warren-Boulton, Economist

June 2001

Those who currently benefit from regulation are usually well aware of those benefits, and thus defend the status quo. In contrast, the costs that regulation imposes are usually recognized by those who would benefit from deregulation only if and when those markets are deregulated. This asymmetry has helped sustain inefficient and anticompetitive regulation in a number of industries, including airports. Prices based on marginal costs would benefit passengers in three ways ...

First, much of the increase in airport revenue at congested airports would come from the reduction in the sheer waste of resources and time due to congestion.
Second, to the extent that congestion has been reduced by slot constraints, airlines get to charge passengers higher prices precisely because they no longer impose the time and aggravation costs on those passengers. Passengers escape the non-monetary costs of congestion only by paying ransom to the airlines. Slot constraints give airlines an incentive to block capacity expansions at airports and the ability to block or hinder the entry of competing airlines. Thus replacing slot allocations with higher landing fees would not increase fares in the short run, and would lead to higher capacity and lower fares in the long run.
Finally, as discussed above, any temporary airport "profits" from marginal cost pricing should be (and are likely to be) invested in capacity expansion, which can be expected to rapidly bring down landing fees.
— R.W-B.

Airline monopoly power is not in the economic interest of airports. Thus airports will not take actions that reduce airline competition unless forced or induced to do so by dominant airlines. Looking at a parallel with Microsoft, computer manufacturers as a group are harmed by Microsoft’s monopoly over the operating system, but were induced by Microsoft to take actions that helped Microsoft to preserve its monopoly power. The natural economic incentive of airports, once free of control by the airlines, would be to encourage as much competition as possible among airlines.
A major and largely unnoticed effect of airport regulation has been to inhibit the development of vigorous competition among airlines, at great cost to the American consumer and to the economy. If deregulation would allow airports to price efficiently and use the resulting revenue to expand capacity, the influence of dominant airlines at each airport would be reduced, and airports could be expected to take other actions that would increase competition.
Consider an economist’s perspective on two major (often hidden) costs of airport regulation: facilitating the ability of dominant airlines to use their influence over airports to exclude entrants and rivals; and, forcing airports to finance their capital and overhead costs with socially inefficient charges. Also consider why the group that believes itself to be a major beneficiary of airport regulation – airline passengers — is, instead, its major victim.
The most important example of such economic regulation is the constraint on airports’ ability to raise landing fees to "true" marginal cost levels because of price controls — maximum prices based on "historic costs" which ignore market values, opportunity costs, congestion, and scarcity rents. (It should be made clear this discussion is aimed at only economic regulation, not safety or environmental regulations.)

Cost of regulation 1.
Airlines use their influence or control over airports to exclude entrants

Until fairly recently, economists have regarded exclusionary and predatory behavior by dominant firms as rare and often simply irrational. Recent years, however, have seen a spate of antitrust cases where it has become clear that dominant firms have imposed or entered into arrangements with downstream (complementary) facilities to exclude rivals. In antitrust economics, this has become recognized as the ability of dominant firms to use exclusivity contracts, or pricing mechanisms with exclusivity effects, to "raise rivals’ costs" or "reduce rivals’ revenue".
With airlines, dominant carriers have allegedly engaged in both traditional horizontal predatory pricing and in exclusionary contracts (overrides with travel agents; gate arrangements with airports) that either raise costs to smaller rivals or reduce the value of services to passengers.
Current DOT and FAA regulation increases the role dominant airlines play in the financing of airport capital development, making it possible for those airlines to control or "capture" airports, and to use that control to induce airports to exclude or hinder smaller rivals in a number of ways. Airport regulation has also helped dominant airlines maintain market power by reducing airports’ ability to increase capacity, especially capacity that might be available to entrants.

Cost of regulation 2.
Socially Inefficient Financing Mechanisms

One of the longest standing issues in economics has been how best to price the individual products of a multi-product firm so as to recover fixed costs that are common to all those products (i.e., overhead). The profession’s answer: an efficient set of prices can be arrived at through a two-step process that might be called "adjusted marginal cost pricing."
The first step is to determine the full short-run marginal cost. The short-run marginal cost of an aircraft landing at a particular time at a particular airport consists of several components. The first is the incremental cost incurred by the airport, an amount that is generally both relatively small and readily quantifiable. The second is the increase in cost imposed on passengers on other flights or their airlines, a cost that is positive only if the airport is "congested" — that is, allowing an additional aircraft to land increases the costs of those other flights or reduces their value to the passenger. If allowing the flight to land does not actually result in another flight not landing, then this component of marginal cost is the sum of all the additional costs imposed on all the other flights affected.
If allowing the flight to land means that some other flight cannot land (as when an airport is "slot controlled"), then this second component of short-run marginal cost is the "opportunity cost" of that flight (i.e., the amount the prevented flight would be willing to pay to land).
No airport can choose both market-clearing prices and quantities. Like any supplier, the airport can set prices (landing fees), and allow its customers (the market) to determine quantity, or it can set quantity, and use a market mechanism (like an auction) to determine price. Which is preferable depends on the situation.
Short-run marginal costs, by definition, take capacity (fixed assets) as a given. But the prices generated by efficient short-run pricing (i.e., short run marginal cost) also give the correct signals to airport managers with respect to increasing capacity. With prices based on true short-run marginal costs, airport managers can value any increase in capacity, and compare that value with the cost of increasing capacity.
Efficient pricing also permits the financing of that increase in capacity. If congestion is sufficient to warrant an increase in capacity, efficient pricing will result in sufficient revenue to finance that investment.
Moreover, the value of adding capacity depends critically on whether the expanded capacity will itself be priced efficiently. Expanding capacity by itself, without reforming pricing, is grossly inefficient. As transportation planners have discovered, building or widening roads to relieve congestion often just results in more drivers on those roads, so that within a short time period congestion is almost as bad as before. Airports need to plan capacity expansions long before congestion appears, but implementing congestion pricing as soon as congestion rears its ugly head is an essential complement to any capacity expansion strategy.

This problem cannot be dealt with by looking only at supply. Demand management is essential.

Instituting efficient congestion pricing would not result in some huge permanent windfall to airports. While simply instituting congestion pricing with no change in capacity could result in a substantial increase in revenue to airports in the short run, little of that windfall will be left after the subsequent capacity expansions. The same characteristic that creates concern as to the distributional effects of congestion pricing in the short run (that a low price for landings would mean controlling congestion through landing fees and result in astronomic fees) also means that efficient landing fees will also be very sensitive on the downside to increases in capacity.
The "second step" of further adjusting prices based on marginal costs becomes necessary only if, with efficient (i.e., marginal cost) pricing, airport revenue is insufficient to cover accounting costs, and some additional source of revenue must be found. This is unlikely at major airports where congestion is significant or where congestion has been only controlled in the past through slots.
But for airports that do not have outside sources of funding and whose capacity is expected to exceed demand for the foreseeable future, pricing at least some products above marginal cost becomes necessary. Marginal-cost pricing would not allow them to cover overhead or fixed costs.
Economists provide a prescription ("Ramsey pricing") which is seldom acceptable to incumbent players: If the goal is to raise revenue while minimizing the adverse effect on output, raise that revenue by taxing (or taxing most heavily) those products for which the demand is relatively insensitive to price. At the same time, keep relatively low markups over marginal costs for those products whose demand would fall the most as a result of pricing above marginal cost.
On its face, implementing this for uncongested airports with excess capacity would probably imply that their fixed costs should be covered by charging landing fees in excess of marginal cost, rather than by taxing passenger services at the airport.
But my suspicion is that any inefficiencies caused by failure to Ramsey price at uncongested airports are dwarfed by the simple failure to price at marginal cost in congested airports. An alternative solution would be the combined funding of congested and uncongested airports. Particularly when capacity expansion is difficult at congested airports, the revenues raised by efficient pricing could be used to keep down prices to efficient levels at uncongested airports.

About the Author

Dr. Frederick R. Warren-Boulton is a principal of MiCRA (Micro-economic Consulting and Research Associates, Inc.), a Washington-based economics consulting and research firm specializing in antitrust litigation and regulatory matters. He holds a B.A. degree from Yale University, a Master of Public Affairs from the Woodrow Wilson School of Princeton University, and M.A. and Ph.D. degrees in Econo-mics from Princeton University. He has served as an expert witness on consultant mergers and other anti-trust matters, starting in 1981 as an expert witness for the DOJ in U.S. v. AT&T, and recently, for the States and the DOJ in United States of America v. Microsoft .