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«The Market power of Airports, Regulatory Issues and Competition between Airports1 by Bülent Hancioglu2 Paper No., Date: July 2008 This paper ...»

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German Airport Performance

The Market power of Airports, Regulatory Issues and Competition

between Airports1

by Bülent Hancioglu2

Paper No.__, Date: July 2008

This paper originates from the research project GAP (German Airport Performance) supported by the Federal

Ministry of Research and Technology of Germany. For further details see www.gap-projekt.de. It is also

acknowledged the great support offered by the Erich Becker Foundation for the MA Thesis staying at the basis of

this paper.

Bulent Hancioglu was student at HUB and a member of the project “German Airport Performance” (GAP) at the Berlin School of Economics (FHW Berlin). Contact: email:hancioglu@yahoo.com German Airport Performance Abstract In recent years there have been major changes to both airlines and airport industries, as a result of increased deregulation and greater competition between airports. This paper analyses competition between airports in this new situation.

First we describe the market power of airports and the rationales for the regulation of the prices of airport services. Secondly, we describe the traditional price regulation practices in the airport business and talked about their advantages and disadvantages. Thirdly, we focus on competition between airports and its effects on the aviation industry.

In the last section of the paper, we attempted to bring together the concepts of regulation and competition, and considered issues like whether competition between airports will make price regulation obsolete. One conclusion of my study is that when competition between airports exists, price monitoring approach will perform better in terms of total welfare than traditional price regulation. Moreover, we analyze the competition between Düsseldorf and Cologne/Bonn airports in a case study. If it is privatised in the next years as planned we claim that there is no need for regulating Cologne/Bonn airport charges Key Words: Airport regulation, Market power of airports, Airport competition, Price monitoring approach in the airport industry WWW.GAP-PROJEKT.DE Prof. Dr. Hans-Martin Niemeier Prof. Dr. Jürgen Müller Prof. Dr. Hansjochen Ehmer Hochschule Bremen FHW Berlin Internationale Fachhochschule Bad Honnef Werderstr. 73 Badensche Str. 50-51 Mühlheimer Str. 38 28199 Bremen 10825 Berlin 53604 Bad Honnef German Airport Performance

1. Introduction Airports have an important function in the aviation system. To define it as simple as possible, airports take part in the processof transporting passengers and freight from one place to another. This way, they increase the wealth of the regions they are located in, by providing new employment possibilities and bringing more tourists to their regions. Until 1980’s, airports were regarded as natural monopolies in their role of providing the required infrastructure for passengers and airlines. However, they were not seen as active providers and they were not believed to have the ability to alter the level of the demand for airport services. But after the 1980’s, with the deregulation of the airline market which aimed to promote more economic development of the aviation industry, airlines started to search for new ways to reduce their costs. At those times, they also pressured airports to reduce the charges of the aviation services they offered. And since most of the public airports were operating inefficiently and public authorities did not want to support financially the loss making ones any more, commercialization and privatization of airports seemed to be a solution to make airports more efficient. If airports were more market oriented, they would be able to improve their cost efficiency, service quality and maximize their profits. The UK, Australia, New Zealand and Canada were pioneers in the airport privatization process and the first privatized airports in the world were the three London airports3 and BAA’s (British Airports Authority) Scottish airports (Gillen and Niemeier, 2006).

But can airports still be considered natural monopolies after these privatization processes? In other words, should airports be regulated to curb their monopoly profits? The answer to these questions was generally positive at the end of 1980’s but then different views arose claiming that airports were not natural monopolies anymore. There were also changes in the regulation of private airports and more incentive based regulation practices became more popular. Later on, competition between airports gained more attention especially after the emergence of Low Cost Carriers (LCCs) and the increase in the ability of airlines to switch their flights from one airport to another. But how does competition work in the airport business in essence and can we think of competition as a substitute for the price regulation of airports?

These three London airports were Heathrow, Stansted and Gatwick which are operated by BAA under common ownership.

German Airport Performance I started this paper by talking about the sources of the market power of airports, whether airports need to be regulated or not, what types of airport price regulation are common throughout the world and what are their advantages and disadvantages.

Further, I focused on the issue of competition between airports, gave information about how airports compete with one other, explained the strengths and weaknesses of airport competition and talked about the effect of airport competition on the price monitoring approach. Lastly, I finished my paper by examining the strength of competition between Düsseldorf and Cologne/Bonn airports in Germany and commented on the need for regulation at these airports as a result of competition they face and their reduced market power.

2. The Market Power of Airports

The main reason for regulating airports is their potential abuse of market power. To express it as simple as possible, by raising prices above costs they earn higher profits, but this increases airfares and as a result the consumption of air travel decreases.

These high prices also result in a reduction of total welfare.

2.1. Economic Costs of Inefficient Pricing

This loss of welfare is explained through the existence of several unnecessary costs.

The main economic cost of inefficient pricing is the deadweight loss resulting from prices that are higher than costs. According to basic microeconomic theory this deadweight loss depends on the elasticity of demand. And in order to observe the efficiency losses from the abusive use of market power, we have to know the shape and the slope of the demand curve. Nevertheless, even if we do not know the demand characteristic for airport services in detail, one way to reduce the efficiency costs would be the price discrimination by charging different prices for different users of airports.

There may also be some other potential efficiency costs of having market power.

One of them is the lack of competitive pressures on firms. It may lead the airports to go on operating with the higher costs and not adopt innovative and cost saving strategies. Some airports also prefer to use their market power to increase their profits by reducing their staff and investment requirements, which reduces the total quality of airport services offered. Furthermore, airports with market power can try to keep potential competitors out of their businesses by lobbying the government and German Airport Performance investing in unnecessary additional capacity. In other words, they will use their market power to keep their privileges of being alone in the market.

It is also evident that higher prices will affect other industries which are directly related to airports, airlines and passengers such as the tourism industry. We can also think about the distributional effects of market power. Higher prices of airport services will not affect the total economic surplus as long as the consumers and producers are the citizens of the same country, but we should take into consideration that airport business is a rather international one and it is really hard to measure the change in the total economic surplus of a country resulting from higher prices.

2.2. Barriers to Entry

According to the basic microeconomic theory, when the prices charged by a firm are higher than its efficient costs of production, the firm is said to have market power.

Barriers to entry and the availability of close substitutes affect the level of market power. When we consider the case of airports, natural monopoly characteristics and environmental regulations of airports can be named as the potential barriers to entry.

A firm is said to be a natural monopoly when it can produce its goods or services more efficiently with lower costs and it is the sole firm in the market. Some researchers claim that airports have natural monopoly characteristics and these characteristics arise as a result of economies of scale, economies of scope, network benefits and investment requirements. If airports are in fact natural monopolies, this will affect their industry structure, performance and efficient pricing of the services provided by airports in turn. When we look from the supply side, we can identify some natural monopoly characteristics of airports even if we do not know exactly the supply curve of the airports. In the following, I will describe the barriers to entry in the airport industry.

2.2.1. Indivisibility of Airport Investment

An investment is said to be indivisible when it is economically more efficient to undertake investments in large blocks. Land and runways seem to be the most important sources of indivisibility in the airport business since the costs of finding a large area of land to construct an airport especially in larger cities is very high.

Largely for this reason, most secondary city airports are located in less convenient areas than the already existing airports. Another barrier to entry for secondary airports German Airport Performance may be regulatory and environmental constraints. Other potential indivisible investments ate the construction of runways, instruments landing systems, lights and terminal navigation systems. On the other hand, the construction of terminals and aprons in a new airport do not seem to be significant indivisible investments since it is relatively easy to increase the capacity of terminals and aprons. Moreover, due to the existence of high number of old unused military airports, a potential competitor may enter by increasing the capacity of a domestic airport rather than building a new airport. In this case, when we consider the indivisibility of airport investment, we should take into account how extensive the existing facilities are.

2.2.2. Economies of Scale

According to Baumol et. al. (1982), the concept of economies of scale is significant for industries where high fixed costs are present. An incumbent firm can use economies of scale as a barrier to entry since it can operate with excess capacity and produce at lower costs than the potential entrant. When we consider the case of airports, we see that airports have strong economies of scale in runway investments but there exist also diseconomies of scale in other parts of airport investments like terminal facilities (Betancor and Renderio 1999). Economies of scale depend mainly on the passenger numbers. Some researchers like Doganis (1992) and Salazar de la Cruz (1999)4 claim that airports get the full benefits of economies of scale when they have about 3-3.5 million passengers per annum. On the other hand, Salazar de la Cruz (1999) claims that airports may have decreasing returns to scale and increasing average costs if they have more than 12,5 million passengers per annum. And they seem to have constant returns to scale if they have between 3.5 and 12.5 million passengers per annum. Even though these results may not be true for all airports, they may at least provide a benchmark for considering economies of scale of airports.

2.2.3. Sunk Costs

According to basic microeconomic theory, sunk costs refer to those costs that cannot be recovered once made. These sunk costs are generally related to the firm specific investments which cannot be sold near costs to other firms unless they are doing the same business. In the airport business, the building of runways, taxiways and apron facilities are regarded as sunk investments, as it is hard to recoup them As referred in Productivity Commission (2002) German Airport Performance unless the airport can create a viable passenger traffic. These potential sunk costs will affect the risk of the new airport investments and also the willingness of the potential airport to undertake a new airport investment in a negative way.

–  –  –

Economies of scope will exist for an airport when it is less costly and more efficient for one firm to offer a group of services than for different firms to offer the airport services separately. Economies of scope can derive mainly from the provision of aeronautical services in the airport case. For instance, when some of the airport services like the provision of runways, taxiways and aprons are provided by the same operator, we can claim the airport business to experience economies of scope. In addition, when different types of air traffic use the same runway, economies of scope can again show their benefits in terms of lowered operating costs. Lastly an airport may experience some economies of scope while providing non-aeronautical activities, yet this is not likely to bring much cost benefits to our firm compared to the high economies of scope resulting from aeronautical activities.

2.2.5. Network Benefits

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