Airport Infrastructure for the Airbus A380: Cost Recovery and Pricing ...

Journal of Transport Economics and Policy, Volume 39, Part 3, September 2005, pp. 341–362

Airport Infrastructure for the Airbus A380 Cost Recovery and Pricing

Peter Forsyth

Address for correspondence: Professor Peter Forsyth, Department of Economics, Monash University, Clayton, Victoria 3800, Australia; [email protected]. edu.au. The author is grateful to Anthony Bell, Nathalie McCaughey, and Neelu Seetaram for helpful research assistance, and to Anming Zhang, Paul Hooper, David Starkie, and Cathal Guiomard for helpful comments, but claims any errors as his own.

Abstract The introduction of the new large aircraft, the Airbus A380, will require investments by airports to enable them to handle it. These investments will be in the nature of sunk costs, such as in widening runways. As such they will pose problems for pricing, cost recovery, and investment evaluation. Short-run pricing efficiency involves not imposing any specific charge for the use of the aircraft, which will mean that users will not face the costs they impose. This, however, could create problems in terms of signals for investment. In addition, the ownership/regulatory environment within which most airports operate will further increase the incentives for excessive investment.

Date of receipt of final manuscript: June 2005 341

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1.0 Introduction The introduction of the new large aircraft, the Airbus A380, will pose cost recovery issues for airports. Some airports are able to handle the aircraft now, but only if they impose constraints on the use of the airport by other users. To handle the A380 without imposing these costs, they will need to invest, by widening runways, realigning taxiways, and by making modifications to terminals. Most of these investments will be in the nature of sunk costs. Once they have been made, the marginal costs of operating the A380 at an airport are likely to be negligible, and comparable to the marginal costs of operating other aircraft. This then raises a question of how best to recover costs at airports that are investing to handle the A380. As with other cost recovery problems, a number of related problems arise: . . . .

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If the marginal cost of using the A380 at an airport is zero, should any additional specific charge on its use be levied? If not, and airports need to recover the costs of their investments to handle the A380, how should price structures be adjusted? What role might two-part tariffs play in efficient pricing, and can they ensure that ‘users pay’? If prices for the use of the A380 are set at zero, how can investments by airports to accommodate them be assessed, and what signals will airlines face whether to purchase the aircraft? When efficient pricing and investment solutions can be devised, will the ownership/regulatory environment most airports operate within provide the incentives to set prices and assess investment correctly?

The nature of airport cost recovery, and the price structures that can be used to achieve it, are considered first. After this, the Airbus A380 and its airport requirements are considered. In Section 4, optimal pricing in the short run is considered, and in Section 5 investment for the long run is considered. In Section 6, the incentives for efficient pricing and investment are considered in a world where airports are either publicly owned or privately owned but subject to regulation; these incentives are weak, thus increasing the risk of excessive investment. Finally, the key points of the paper are synthesised and some broad conclusions are drawn.

2.0 Cost Recovery at Airports Cost recovery is not normally a problem for all but small, lightly used, airports. Airports typically possess considerable market power, and have 342

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discretion over the level of their prices. Cost recovery is quite straightforward. The issue is not so much whether it can be achieved as how (for a discussion of several of these issues, see Oum and Zhang, 1990). Airports are usefully thought of as consisting of two sets of facilities — the airside facilities, including runways, taxiways and aprons, and the landside facilities, including terminals. The airside facilities represent large sunk costs — ground preparation, land reclamation, and constructing runways and taxiways, are major costs that are sunk. They are very long lasting, and there are significant indivisibilities present, since one runway can handle a large amount of traffic, and very few airports have more than two or three runways. Many airports have ample airside capacity, and once it has been provided, it is generally taken that the marginal cost of using it is negligible (though for an alternative view, see Hogan and Starkie, 2004). There are elements of sunk costs and indivisibilities with terminals, though these are less prominent than with airside facilities. Terminals can be expanded, though it is cost effective to build ahead of demand, and to avoid frequent matching increases in demand with increases in capacity. In addition, there are running costs of terminals, along with congestion costs as the throughput approaches the design capacity. Thus there will be positive costs associated with additional passengers, though these will be below average costs, except for busy terminals. The indivisibility aspect of airport development creates problems for cost recovery. It often makes sense to construct very large and expensive new airports as a way of expanding capacity — this was the case with Osaka-Kansai and Hong Kong. These airports are built to a scale that results in considerable excess capacity for some time after they are built. Additions to airport capacity, such as new runways, come in discrete chunks. It is arguable that it is the indivisibility aspect of airports, rather than the presence of large sunk costs, which leads to a cost recovery problem. Large sunk costs, per se, need not impose a cost recovery problem. If there are constant returns to scale, efficient pricing (at short-run marginal cost) is consistent with cost recovery. There is some evidence that most major airports fall within the range of approximately constant returns to scale (see Graham, 2003). There are some scale economies at low scale, but these peter out at the scale of moderately small airports. However, airports involve substantial indivisibilities, and cost recovery, with efficient pricing, may need to be accomplished over a period of several decades. A new airport is built, and for a long time capacity is ample, and efficient prices are minimal. Over time demand grows, and eventually it pushes against capacity. Marginal cost rises sharply, and efficient prices generate large revenues. Under constant returns to scale, efficient prices will cover 343


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costs, but it will be the revenues in a few busy years that cover most of the sunk costs. Here there is not so much a problem of cost recovery per se, as one of the period over which it is to be achieved. Typically, owners wish to even out the revenue stream, and recover depreciation and the cost of capital on a year-by-year basis, even when the airport has ample capacity. The arbitrary insistence on year-by-year cost recovery results in a divergence from efficient pricing, with prices in ample capacity years being inefficiently high, and in excess demand years being inefficiently low. Cost recovery, over the long run, does not necessitate a divergence from efficient pricing; however, cost recovery on a year-by-year basis will. Most major airports have a degree of market power, due to their locations. The typical city has one major centrally located airport, and most traffic will prefer to use the convenient central airport, even if there are other airports on or beyond the urban fringe. Some large cities have more than one airport, though mostly these are under single ownership (for example, BAA owns both Heathrow and Gatwick in London). Thus the typical airport will have considerable market power, and demand elasticities will be low or very low. For an airport that does not face excess demand, prices set at marginal cost will fail to cover total cost. Marginal cost pricing of runways and taxiways would imply zero prices, and marginal cost pricing of terminals may yield non-zero prices, but ones that fail to cover all terminal costs. To cover costs, airports have traditionally set charges based on aircraft weight. Weight is a rough proxy for the inverse of the elasticity of demand. Large heavy aircraft carrying large loads of passengers on long haul flights have inelastic demand for the use of the airport. For smaller lighter aircraft on short haul flights airport charges make up a much higher proportion of total costs, and the elasticity with respect to airport charges will be correspondingly higher. Thus, weight based pricing schedules would amount to a rough approximation to Ramsey pricing, and would be a tolerably efficient means of covering costs. Recently many airports have been moving away from weight based charges to ones based on the number of passengers. Such charging schedules may explicitly recognise the marginal costs of terminal use, but they also have the property of being approximate Ramsey structures. The upshot of this is that while marginal costs at airports with ample capacity may be negligible, it is feasible to achieve cost recovery at very little cost in terms of efficiency. Few potential users of the airport are discouraged from using it by the charges (for more discussion, see Morrison, 1982). While the majority of airports do have excess capacity, there are many that are subject to excess demand. Some, such as London Heathrow and 344


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Frankfurt in Europe, and New York La Guardia and Chicago O’Hare in North America, are subject to substantial excess demand. Most of these airports still have weight or passenger based charges, even though the relevance of such charging structures has diminished or been eliminated. These airports have limited capacity, which for land availability or environmental reasons is difficult to increase. These airports have a cost recovery problem that is the reverse of that discussed above. Prices set at a level that would efficiently ration capacity would more than cover costs. In fact, prices tend to be kept to inefficiently low levels, either by regulation (in the case of London Heathrow) or by owners, perhaps as a result of pressure from users. Thus there is a problem of excess demand, and this needs to be resolved by other rationing devices: slots (London Heathrow and Frankfurt); congestion (Los Angeles); or by a combination of these two (New York La Guardia). Granted that congestion is costly, and even the best performing slot allocation methods actually used are imperfect, keeping prices below efficient rationing levels imposes an efficiency cost.

3.0 The Costs of Handling the Airbus A380 The Airbus A380 will be a substantially larger aircraft than the current largest, the Boeing 747. It will be around 50 per cent larger, at least, than the large aircraft currently selling well, such as the Airbus A340 and the Boeing 777. The larger size will enable it to achieve lower operating costs per seat kilometre. Several of the airlines that specialise in long haul routes, such as Singapore Airlines, Qantas, and Emirates, have ordered it, as have Lufthansa and Air France. It is expected to come into service in 2006 or 2007. The A380 is wider and higher than the Boeing 747. It will be able to use most airports without the need for specific investments, but this will be at a cost in terms of restrictions being placed on other users. Other aircraft may not be able to use nearby runways while the A380 is landing or taking off. Because of the size of the A380, their movement around the airport is likely to be constrained while an A380 is taxiing. The A380 will take up more space when at a gate, and this may impact on aircraft at neighbouring gates. Thus the ability of the airport to handle traffic will be lessened, and its effective capacity reduced, while the A380 is being handled. Thus use by the A380 will impose costs on other users of the airport. These costs can be avoided if the airport invests to upgrade facilities for the A380 (Barros and Wirasinghe, 2002; Holzschneider, 2004). For airports that expect to handle significant numbers of A380s, investment will be 345

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Table 1 Cost of Investment to Handle Airbus A380 Airport

Cost

New York Kennedy Los Angeles Atlanta London Heathrow Frankfurt Melbourne

$US109m $US177–1215m $US25–26m £450m ($US823m) €150m ($US194m) $A50m ($US38m)

Sources: GAO (2002, Appendix V) — New York, Los Angeles, Atlanta; Rozario (2004) — London; Airport Media Announcements — Frankfurt, Melbourne.

worthwhile. The wider wingspan of the A380 will necessitate wider runways, and several airports are currently widening their runways. Greater separations between taxiways may need to be provided, and larger parking areas created. To make effective use of the aircraft, terminals will have to be adapted. It is a double-decker aircraft, and to move passengers on and off quickly double deck aerobridges will need to be installed. Larger passenger lounges at gates will need to be provided. Some estimates of the likely cost of upgrading are given in Table 1 for selected airports. There is considerable variation in the cost. For some airports, such as Atlanta and Melbourne, the cost is not likely to be large, since they have ample land and modifications will not be difficult. Upgrading Los Angeles, by contrast, could be very costly, since this airport is very constrained by land availability, and modifications are not straightforward. In addition, there is considerable difference in the estimates for Los Angeles — Airbus considered that only $177m of proposed investment would be attributable to making the airport ready to handle the A380, whereas the airport estimated the cost at above $1billion. The estimate for London Heathrow is also high. This may be because the modifications to be made will add terminal capacity as well as tailor it for the A380 — if the terminal capacity was not augmented, the cost might be significantly less. Thus some of the quoted costs of adapting airports may be overestimates, in that they incorporate capacity increases or additional facilities that are not necessitated by the A380. To put these into perspective, Frankfurt expects to handle about twenty landings and take offs per day by 2010 (a relatively high number). Annualising the investment at 10 per cent yields a cost of about $20m PA, which amounts to $2,740 per movement. This can be compared to the current charge for a Boeing 747 movement of about $8,000 (ATRS, 2005). If a specific charge for the A380 was levied, it would not add more than 346


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about 30 per cent to the charge based on the current schedule (and the operational cost savings from using the A380 are likely to exceed this substantially). This would be at the lower end of the scale of costs per movement of investing to handle the A380, because Frankfurt will handle a relatively large number of flights, and the costs of upgrading are about average. For those airports for which upgrading is costly, and which do not expect many A380 movements, a specific A380 per movement charge could be large relative to current movement charges. Most of the costs of accommodating the A380 will be in the form of sunk costs of investment, such as the cost of widening the runway and realigning the taxiways. Once the investment has been made, the use of the A380 will impose no more costs on the airport than the use of other types of aircraft. There will be some additional costs that using the A380 will impose — for example, it will require parking space, and where this space is valuable, the opportunity cost of using an A380 will be greater than that of using smaller aircraft. However, the major costs are likely to be the sunk costs of upgrading the facilities. This then poses a cost recovery and pricing problem. One aspect is who should pay for the costs of upgrading — the airlines that use the A380, or all users of the airport, or some subset of users, such as international movements? There are two potentially important efficiency aspects to the pricing problem. The first concerns the short-run problem of ensuring the efficient use of the airport once investments have been made. This is best solved by facing users with charges that, as closely as possible, reflect the costs they impose on the airport, so they will choose a mix of aircraft that minimises costs overall. If the A380 does not impose any higher costs on using the airport than other aircraft, then there is a case for having no specific additional charge levied on the use of the A380. This, however, would be a departure from ‘user pays’, and airlines that do not schedule the A380 will be paying for the infrastructure to handle it. This may not be perceived as fair. Nonlinear price schedules could be a way round this problem in some cases. The second concerns the long-run problem of providing the right signals for investment. If the specific charge for using an A380 is set at zero, then airlines will not face any of the costs of investing to upgrade facilities so that the airport can handle the A380. Thus they may invest excessively in the aircraft. When the airport assesses whether it is worthwhile to invest to handle the A380, it will have little information about the airlines’ willingness to pay for this, since the price it is likely to charge will be zero. If non-linear prices are feasible, they will help since they will facilitate cost recovery with shortrun efficiency at the same time as giving airlines appropriate signals for investment in aircraft, since they will be faced with the long-run costs 347


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they are imposing on airports by their aircraft purchasing decisions. These issues are explored in the following two sections.

4.0 Efficient Pricing and the Short Run 4.1 Pricing without investment One possibility is that the airport does not invest to accommodate the A380. In spite of this, it may be feasible for the airport to handle A380 flights, though at a cost. These costs will be primarily in the form of externalities imposed on other users. Before examining the nature of these costs, it is relevant to note that there need be no necessary association between the type of airport and the extent of use of A380s. Clearly, airports such as London Heathrow, Frankfurt, and Singapore Changi are busy hub airports that will attract considerable use by A380s. A380s will tend to be in heavy use at hub airports. However, they may also be used at non-hub airports, such as Melbourne. Some of the airports they use will be very busy, such as London Heathrow, but other airports they use may have ample capacity. Some very busy airports may serve only a few A380 flights, and investment to upgrade may not be worthwhile. The costs imposed by the use of an A380 at an airport that has not invested to accommodate A380s will come about because of restrictions on the use of flights by other aircraft. While the A380 is arriving or taking off, movements around the airport and on other runways will be restricted. This will impose a cost on other users, though there need not be much by way of additional cash costs. How high these externality costs are depends on the utilisation of the airport. For a non-busy airport, these costs could be low. When the A380 arrives or leaves, other users will be restricted. However, if the airport has ample capacity, output will not be reduced. Those users that are affected will face a cost as a result of delays or not being able to use the airport at their preferred time. When an airport is busy, the cost will depend on whether it is slot controlled or demand is rationed by congestion. If restrictions are imposed on other users when an A380 arrives or leaves, there will be an effective reduction in capacity. If there are slot controls, fewer flights will be able to be accommodated. Since slots are valuable, there will be a cost. On the other hand, if congestion is the rationing device, as is usually the case at busy US airports, congestion costs will increase, though no reductions in output need take place (some users may be discouraged from using by higher congestion, however). For those airports for which slots are 348


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expensive or congestion is high, the externality costs of handling a movement by an A380 could be considerable. If prices are to be set to encourage efficient use of the airport, they should be set equal to short-run marginal cost. Since A380 flights impose higher marginal costs than other flights, a specific charge for such flights, in addition to the normal airport charges, would be efficient. Such pricing will result in the users of A380s facing the costs they impose. Efficient externality pricing will raise the airport’s gross and net revenues, since the cash costs of handling the A380 need not be large. Airports that are setting prices to just cover costs will be able to reduce their overall price level (though only slightly). Possibly the main practical problem will be that of determining the marginal cost of A380 use. If there is an effective market for slots, and the impacts of the A380 on effective capacity are clear, it will be a simple matter to estimate the capacity reduction component of the externality cost. When the externality takes the form of additional delays imposed on other users, again it should be straightforward to make an estimate of marginal cost and the efficient price for A380 use. With less busy airports, marginal costs will be lower, but less easy to estimate, since the costs imposed on other users (for example requiring them to use different times) are less easy to estimate. 4.2 Pricing with investment In this section, it will be assumed that for an airport to be able to handle the A380 without imposing costs on other users, it will be necessary for it to make some capital investments, such as in widening the runways. These investments will be sunk costs in nature, and there will be no significant changes in operating costs associated with them. The marginal costs of an A380 in using these facilities will be the same as for other aircraft. For example, once the runway has been widened, it will cost no more for an A380 than other aircraft to use it. In the main, the marginal costs of using the A380 will be taken as zero, though the case of positive marginal costs will also be considered briefly. Airports may have more than enough capacity, or they may be busy and congested or subject to excess demand. These possibilities are considered in turn. 4.2.1 Non-busy airports Many airports around the world have more than adequate capacity, because investments such as runways are subject to substantial indivisibilities. Passenger related investments such as terminals can be more closely tailored to demand. Marginal costs of using the terminals are likely to be positive and closer to the average costs. 349


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With this cost structure, there will be a cost recovery problem if prices are set efficiently at marginal rather than average costs. Efficient prices will fail to cover the costs of building and operating the airport. If cost recovery is imposed, as it is for most airports in this situation, then second-best pricing will be required. Ramsey pricing, which sets prices proportional to the inverse of the elasticity of demand for a particular user, will achieve cost recovery at minimum cost in terms of efficiency. Ramsey prices are often regarded as impractical and demanding of too much information. However, airports have long implemented an approximation to Ramsey prices. Charges for most non-busy airports are based on aircraft weight, or passenger numbers. Terminal costs depend on passenger numbers. Furthermore, aircraft size and passenger numbers are roughly correlated with the inverse of the elasticity of demand. Thus this pricing structure is tolerably close to a Ramsey price structure, and if so, cost recovery can be achieved at little cost in terms of efficiency (Morrison, 1982). Suppose the case of a non-busy airport incurring a sunk cost to accommodate flights by A380s. How should these sunk costs be recovered in the way that is most consistent with efficiency? Should specific charges be levied on users of A380s, or should the extra sunk costs be included in the cost base to be recovered from all users? Since the marginal costs associated with the A380 are the same as for other users, they should not be priced differently. There would be no specific charge for using the A380. The price structure would then be adjusted to recover the higher costs, including the sunk costs of the investment. This means that all users will pay more. The all-up price for using an A380 will be higher than for smaller aircraft, though the per kilogram or per passenger charge will be about the same. The choice of aircraft will be based on the operating and other costs of using different aircraft, and will be efficient. It is possible that the airport will recover the costs from a subset of users of the airport, such as international flights only. In general, this would be less efficient than spreading the cost recovery problem as widely as possible. If there are positive marginal costs specifically associated with the A380, then it will be efficient to allow for these in the pricing schedule. Just as aircraft that stay longer in parking areas impose greater costs on the airport, the use of a very large aircraft may impose additional costs, such as provision of more land for parking, which it is efficient to recognise in the price structure. This result, whereby sunk costs are recovered from all users, may not be seen as very ‘fair’, and it can be seen as a divergence from the principle of ‘user pays’. A small number of airlines schedule A380s into an airport, 350


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which is then required to incur costs to accommodate them. The airlines that operate the A380s will enjoy reduced operating costs. Other airlines will shoulder most of the burden of the costs of providing for the A380s. However, once the facilities are upgraded, it is then efficient to make the best use of them, and this requires that airlines face no disincentive to schedule the A380 rather than other aircraft. While this may be an efficient solution, it could be regarded as not fair. Fairness is a concept that economists do not often use, but public decisions are often conditioned by perceptions of fairness (for a discussion, see Zajac, 1995). 4.2.2 Busy airports The significance of the distinction between busy and non-busy airports is that while the pricing structures of the latter are mostly tolerably efficient, the pricing structures of busy airports are often quite inefficient. Three types of busy airports can be distinguished: . . .

Ones with slot limits and efficient price structures; Ones with slot limits and inefficient price structures; and Ones that use congestion to ration excess demand.

These are considered in turn. 4.2.2.1 Slot limited airports with efficient prices Pricing efficiency for slot constrained airports requires that both slots are efficiently allocated and prices for use of the airport reflect marginal costs and opportunity costs of capacity. Efficient allocation of slots will be present if there is a slot auction, or effective, unconstrained trading of slots. An efficient price structure for use of an airport subject to excess demand involves a flat charge for use of the runway and associated facilities, combined with a per passenger charge that reflects the marginal costs of terminal use. One efficient solution would be for the user charge for the airport to be sufficiently high to eliminate the slot premium. This rarely occurs — mostly, airport charges are held down by owners or regulators, and there is a premium for slots. The price to an airline for an aircraft to use the airport includes a flat amount equal to the slot premium and runway charge, plus a per passenger charge reflecting passenger related costs. There are few airports that meet these conditions. The closest approximation is London Heathrow Airport. The pricing structure has a large fixed element in it, though there is also a per passenger charge, which, to an extent, reflects the costs of terminal use. Slots are tradeable, and there is a market for slots. However, there are few trades that take place and it is difficult to determine exactly how efficient this slot market is (see Humphreys, 2003). 351


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Given a starting point of a tolerably efficient pricing structure, it would be efficient not to impose a separate charge on the use of the A380 to recover the sunk costs of accommodating it. If the sunk costs are to be recovered from airlines, the most efficient way of doing so would be to raise the flat per-flight charge for using the airport, while leaving the passenger charge unchanged. The price for using the airport would move closer to the market clearing level, and the slot premium would fall accordingly. There would be no efficiency cost in recovering the additional sunk costs in this way. Unless demand elasticities are very high, the substitution of smaller aircraft by the A380 will lead to a fall in the demand for slots, and the slot price will. As against this, the A380 will also encourage substitution of point-to-point services by services through the hub, and the demand for slots by feeder flights will increase. The ultimate impact on the slot price and premium is not clear. With this pricing structure, airlines will face the right incentives when choosing whether to schedule the A380 or smaller aircraft. Each type will face the costs it imposes on the airport system. The price per flight will be the same, reflecting the fact that they impose the same cost of using scarce capacity. The A380 will pay more in total per passenger charges, reflecting its higher passenger load and greater passenger related costs. If slot prices are very high, as they are for London Heathrow, there will be an incentive for airlines to consider replacing smaller aircraft by the A380, thus economising on the scarce capacity. If there are positive marginal costs of use, then it will be efficient for prices to reflect these. Thus if the A380 uses more parking space, and space is valuable, it will be efficient to charge it more than smaller aircraft. As with the airports that are not busy, it will be the airlines in general that use the airport who will pay for the costs of accommodating the A380. Those who do not benefit from the use of the A380 will pay the costs associated with it. This will be essential if efficiency in the short run is to be achieved. Indirectly, some airlines may gain or lose, though changing slot prices or increased opportunities for feeder traffic, but there are not likely to be any systematic patterns of gain or loss. 4.2.2.2 Slot limited airports with inefficient pricing Inefficient pricing is the norm with slot limited airports. Except for the London airports, and a few US airports, slot trading is prohibited in many parts of the world, especially in Europe (NERA, 2004). In addition, most airports still operate with weight or passenger related charging systems, which, while efficient for non-busy airports, are quite inappropriate for busy airports. Even though capacity to handle flights is at a premium, it is cheaper for smaller aircraft with smaller passenger loads to use the airport than for large 352


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aircraft. The structure of pricing discourages the substitution of small by large aircraft, even though this would lead to better utilisation of the airport. In this situation, the case for not imposing a specific charge on the A380 to recoup the sunk costs of accommodating is stronger than before. Such a charge would further discourage the use of the A380, and would compound the disincentives to use large aircraft noted above. Assuming that airport charges are levied to recover costs, airlines that use smaller aircraft will pay the costs of accommodating the A380. In this case, while the fairness issue also arises, most of the flights that pay increased charges are underpriced, and efficiency is enhanced, rather than reduced, by imposing the costs on them. Even where there are some marginal costs specific to the A380, it may be efficient to absorb them in the general price structure, rather than to relate charges to them, as was the case when price structures were efficient. Because large aircraft are overpriced, an additional charge will lower, not raise, the efficiency with which the airport’s scarce capacity is used. 4.2.2.3 Congested airports Most busy airports in the US that are subject to excess demand ration this demand by congestion. Service is predominantly on a first come first served basis, and queues form. In addition, airports recover costs with weight based or passenger based charges. Granted that each movement imposes the same external delay cost, this means that while prices are, in general, below marginal cost, large aircraft are relatively discouraged and small aircraft are encouraged. A specific charge for the A380, to recover the sunk costs of its infrastructure, would lower allocative efficiency, since the marginal cost of the A380 would be the same as that for other aircraft, but the higher charge would discourage its use. A zero specific charge for the A380 would enhance efficiency in the short run by encouraging some substitution of small by large aircraft, thus reducing congestion. 4.3 Non-linear pricing So far, it has been assumed that simple unit pricing would be imposed. When there is a cost recovery problem, non-linear prices, such as twopart tariffs, are often more efficient (Brown and Sibley, 1986). This possibility needs to be considered in the context of recovering the sunk costs of accommodating the A380. One possible solution would be to offer a contract that involved airlines that commit to using the A380 making a contribution to the sunk costs, in advance or by an annual subscription, and for those that do so zero specific charges for using the A380 would be levied. Other airlines, which do not 353


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contribute to the capital costs, would be charged a specific price when they use A380s at the airport. This solution would ensure efficient utilisation by airlines that contribute up front, since they face the marginal costs of use — namely zero. This would be attractive to the major users of the A380 at the airport. Other airlines would face a charge for use, and would not use the A380 to its full potential. Thus there would be some cost in terms of efficiency in the short run, though it would be small. This would have to be compared to the efficiency cost of recovering the cost from all users. While, in principle, a two-part pricing schedule has desirable properties, it may be difficult to determine the up-front contributions. These might be on the basis of expected use of the aircraft, though this would result in some airlines making larger up front contributions than others. This could result in a de facto charge per use being levied. Alternatively, a fixed up-front contribution might be charged. As usual with two-part tariffs, this fixed charge would discourage some users, and would thus have some efficiency costs. Two-part tariffs work well if most users have similar demands. Where users have widely differing demands, it is difficult to determine the optimal fixed charge. This is a particular problem for airports where there might be considerable variation in the use by airlines of the A380. This said, however, the two-part tariff option might be suitable for some airports. The two-part tariff approach thus has some efficiency costs — though these need to be compared to the efficiency costs of setting zero specific charges for the A380. While such a pricing policy optimises the use of the aircraft, it does have an efficiency cost in terms of raising prices to all users a little further above marginal cost. This cost is likely to be small if demand elasticities for use of the airport are low, as is likely to be the case. A possible efficiency advantage of the two-part tariff is that it creates the right signals for airlines to take into account the infrastructure costs of choosing the A380 (see Section 5). Other than this, the main practical advantage of the two-part tariff is that it results in users of the A380 paying for its infrastructure — it thus achieves a good mix of efficiency and fairness.

5.0 Efficient Investment and the Long Run The long-run decision for an airport is whether to invest to accommodate the A380. Suppose that welfare maximisation is the objective. Whether an airport invests will depend on the likely use of the airport by airlines scheduling A380s. If there is only likely to be limited use by airlines of the aircraft, investment will not be worthwhile. For many airports it will 354


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be still possible to handle flights by the A380, but this will be at a positive marginal (externality) cost. For some airports, such as London Heathrow and Singapore Changi, investment will be well worthwhile, since the A380 is likely to be used extensively. For many airports, there is a choice — for these, there is the risk of inefficient decisions if excessive investments are made, or provision is not made when warranted. Given the welfare objective, the appropriate course of action is to undertake a cost benefit analysis of investment, balancing the costs of such investment against the benefits from it. In some situations, it may be that investment is essential for the airport to handle the A380. As noted earlier, for some land constrained airports (for example Los Angeles), the costs of such investment may be very large, while for other airports with ample land (for example Melbourne), the costs of upgrading for the A380 are modest. Airlines will gain from lower operating costs if they use the A380. For a slot limited airport, the use of the larger aircraft may make more slots available, which will be a benefit that will accrue to the airline. If the airport is capable of handling the A380 without investment, but at a cost, then investment will eliminate these costs. These costs are essentially the externality costs imposed on other users when restrictions are imposed on them to allow use by the A380. If the airport is congested, an increase in congestion arising from the use of the A380 will be avoided, and if the airport is slot controlled, a reduction in effective capacity of the airport is avoided. These costs could be substantial for busy airports. For airports that are not busy, the costs avoided will be smaller. If the additional infrastructure is provided, unless a two-part tariff is feasible, the optimal specific charge for the A380 will be zero. In this context, there will be only a limited role for prices to signal investment. The choices facing an airport are summed up in Figure 1. Suppose that the marginal cost of handling the A380 without investment is constant (MC ). A fixed sunk cost is required to enable the airport to handle the A380 at zero marginal cost — the average fixed cost is shown as AFC. If the number of A380 movements at the airport is less than N, it is efficient not to incur the sunk cost. If the use is greater than N, investment is worthwhile. If the airport is not upgraded, the efficient price P is equal to the marginal cost, MC. If upgrading takes place, the efficient price is zero. If a substantial number of A380 movements is expected (demand curve D1 ), investment is clearly worthwhile, the efficient price will be zero, and the number of movements X1 . If only a few flights are expected (demand curve D2 ), upgrading is not worthwhile, the efficient price is P, and the number of movements will be X2 . The airport’s prices will not always give the airlines the right signals as to whether to schedule the A380. Suppose that airlines expect zero prices if use 355


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Figure 1

exceeds N, and the airport only knows that this number of movements will be scheduled (that is, it does not know the full demand curve D3 ). The airport invests, sets a price of zero, and X3 movements are scheduled. However, the benefits from upgrading (as indicated by the area under the demand curve) are less than the cost of the investment — upgrading is not worthwhile. The airport can inform the airlines of the price schedule, but this will not be sufficient information to ensure that the airlines make an efficient choice of aircraft to serve the airport. The airport can make the correct decision on upgrading if it accurately knows the size of the benefits to the airlines from using the A380, that is, it knows the full demand curve. In practice it may not have such accurate information, and there is the possibility that it will invest when not worthwhile. In this situation, it is assumed that neither the airport nor the airlines are behaving opportunistically — both groups are making efficient choices based on the information available to them. There is a possibility that airlines may behave strategically, by purchasing the A380 and then facing the airport with a fait accompli — the airport may then find it worthwhile to upgrade even though it would not have if the airlines had not incurred the sunk cost of purchasing the A380. This is a dynamic inconsistency problem, in which optimal actions at all points of time can lead to less the optimal outcomes over time (it is explored in Forsyth, 2004). Just as with the short-run problem, a two-part pricing structure can be a way around the investment signalling problem. Under such a structure, airlines will be faced with the costs they impose on the airport as a result of scheduling the A380. They will take this cost into account when 356


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determining whether to purchase and use the A380 on routes into this airport. Thus they will take all costs and benefits into account and will be given the incentive to make decisions that are efficient overall.

6.0 Airport Ownership, Regulation, and Incentives In the discussion so far, it has been assumed that airports have the objective of maximising efficiency — pricing to maximise efficiency in the use of facilities, and investing where the net benefits are positive. This is the standard assumption of much public enterprise theory, and it has the merit of establishing a benchmark — if the enterprise is to seek to maximise efficiency, this is how it should do it. This said, however, most airports do not behave in this way. Historically, many airports have been publicly owned, though there has been a significant move towards privatisation over the past two decades. In North America, airports are often owned by local communities or governments. While some airports are still operated by government departments, most publicly owned airports have been corporatised. Even though airports may be publicly owned, they need not be welfare maximisers. The objectives of airport managements may be complex, but they could include size maximisation, quality maximisation, and maximisation of business for the local community. Typically, these airports will be subject to an overall cost recovery constraint. Such airports will not necessarily seek to implement price structures that make the most efficient use of their facilities (the widespread presence of inappropriate price structures for busy airports is clear evidence of this), or seek to invest only when benefits exceed costs. Many airports are now privatised. These airports may be seeking to maximise profits, but all major private airports are subject to either explicit regulation or indirect regulation through price monitoring. Some are subject to either explicit or de facto rate-of-return regulation (Niemeier, 2004), while others are subject to price caps, which may or may not approximate rate-of-return regulation in fact (see Toms, 2004; Hendriks and Andrew, 2004). The critical issue, for present purposes, is how they respond to investment proposals, such as proposals to invest to accommodate the A380. It is likely that public and private rate-of-return regulated airports will respond in a similar way. They will both seek to expand their capital base, to increase total profits in the case of the private airport, or to increase size, in the case of the publicly owned airport. In neither case do they have 357


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any incentive to subject investment in accommodating the A380 to rigorous scrutiny, and to invest only if benefits exceed costs. If they make an investment, they will be permitted to pass on the costs to users. The size maximising airport will wish to invest because this is a way of increasing size. The quality maximising airport will see investment as being justified because it improves the range of services available to users. The profit maximising airport increases its regulated capital base and total profit. All have an incentive to invest in accommodating the A380 regardless of whether such investments are warranted or not. The incentives facing the price capped airport are different, and depend on how the price cap is implemented. If a simple, unchanging, price cap is imposed over airport charges, the airport will have no incentive to invest to accommodate the A380, no matter how worthwhile doing so would be. Investment will increase the costs of the airport, but it will not lead to any price increases, and it will thus reduce profits. This disincentive to invest is frequently recognised (Hendriks and Andrew, 2004) and regulators devise methods to allow the regulated firm to recoup the costs of investment (Forsyth, 2002). If this is done, it will result in the regulator exercising discretion over the investment. The firm will come to the regulator with a proposal to allow pass-through of investment costs (that is, to allow a price increase on top of the cap) and the regulator then assesses the investment and chooses whether to allow pass-through. In effect, the regulator evaluates the investment, and could choose to use welfare maximising/ cost benefit criteria or alternative criteria. In this situation, there will be an explicit evaluation of whether the investments needed to accommodate the A380 are worthwhile or not. Just as in the case of welfare maximising airports, discussed in the previous section, there is the chance that the regulator will be pressured into allowing accommodation by airlines committing to purchase the larger aircraft. Pure price caps are rare, though they have been implemented on occasions (for example in Australia from 1997 to 2002). A more common form of regulation is a hybrid of price caps and cost based regulation. With this arrangement, price caps are set so as to be able to recover forecast costs, including capital costs. Prior to setting the price cap for a period, the regulator makes a forecast of capital expenditure, and evaluates whether all the airport’s forecast expenditure is efficient. Under these arrangements, the costs of accommodating the A380 will be forecast, and the regulator may set the price cap at a level that allows recovery of them. If the regulator simply accepts the airport’s own capital expenditure programme, then this will be similar to rate-of-return regulation, and there is a chance that inefficient investments will be made. If the regulator assesses the proposed capital investment on cost benefit criteria, then the outcome will be similar 358


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to that under the pure price cap, where the regulator determines whether to allow pass-through or not. Regulation and ownership also have implications for incentives to price efficiently. Public size maximising or quality maximising airports and private rate-of-return regulated airports do not have clear incentives to price efficiently. While pricing of non-busy airports is tolerably efficient, pricing of most busy airports is seriously inefficient. Pricing incentives under price caps are better and interestingly, the busy airports that have the best price structures are those in London, which are subject to a price cap regime, albeit not a pure price cap. It has been suggested above that the best pricing structure for the A380 would involve either no specific charge for use of this aircraft, or a two-part tariff scheme as outlined. What incentives are there for airports to price in this way? It is likely that public and regulated airports will choose not to implement a specific charge, partly because it is simpler not to do so, and partly because they will seek not to discourage traffic. To an extent, they (and in particular, local communities) may see being able to accommodate the A380, and encouraging its use, as a matter of prestige. They may also wish to encourage the use of the airport by A380s in the hope that this may foster the development of the airport as a hub. To this end they will choose to avoid specific charges. It is also possible that they may respond to the fairness argument. Their existing airlines will not like being charged more to provide facilities for a small number of airlines. If so, they will be under pressure to ensure that users of the A380 cover the costs of the infrastructure they require. They can do this at least cost in terms of efficiency by implementing a two-part tariff schedule if this is feasible, though whether they have a strong enough incentive to handle the issue in this way is not obvious.

7.0 Synthesis and Conclusions There are several main propositions in the discussion above. These include the following points. .

The introduction of the Airbus A380 imposes pricing and investment problems for airports and airlines, especially since there are significant sunk costs associated with upgrading airports to accommodate the A380, along with possible sunk costs when airlines commit to purchasing the aircraft. Achieving cost recovery is not a problem, since most airports have market power. However, there is an issue of how cost recovery can be achieved at minimum cost in terms of efficiency. 359


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There are two aspects of choice that are important from an efficiency point of view. These are first, achieving efficient use of airports and aircraft in the short run, and second, ensuring that efficient investments are made, and especially ensuring that investments that are not warranted in terms of net benefits are not made. From a short-run perspective, to optimise the use of the A380 it is desirable that airports that have upgraded do not levy specific charges for the use of the A380 in addition to normal airport charges. This is so for most airports regardless of the price structures already in place. For most busy airports price structures are already inefficient in that they discourage the use of larger aircraft. In this environment the case for zero specific charges is stronger. If zero specific charges are levied, so airports can recover the additional costs of accommodating the A380, charges will have to be increased across the board. This will imply that other airline users of the airport will pay most of the costs so that users of the A380 enjoy the cost savings. This may be seen as unfair. A two-part tariff approach, which involves zero charges for users that make an initial capital contribution, and specific charges for others, could achieve the goal of fairness at little or no cost in terms of efficiency. In this situation, the primary reasons for the imposition of a two-part tariff would be to achieve fairness, and to provide signals for investment by airlines, rather than the more usual short-run efficiency goal. To the extent that the A380 imposes additional operating costs, and the marginal costs to the airport of it being used exceed zero, there is a case for specific charges based on these, but only if initial price structures are efficient. If they are not, there may be a case for absorbing them within the general pricing structure. When there are no specific charges for using the A380 at airports, prices cease to serve as signals for investment by airports and airlines. Granted this, the role of investment criteria in determining whether investments should go ahead becomes more critical. It is possible for airports to use cost benefit analyses to determine whether investment to accommodate the A380 should be made. However, granted that airlines will face only some of the costs they impose when purchasing and scheduling A380s, they may schedule too many. This in turn could lead to airports investing to handle the A380 when it would otherwise be more efficient not to make the investments. While airports may make efficient choices about investments, the ownership and regulatory environments in which most operate create


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incentives for inefficient choices. Publicly owned and rate-of-return regulated airports have an incentive to invest excessively, and to pass on the costs to users. In this type of environment, many airports will invest to accommodate the A380 even when doing so is not worthwhile. Price capped airports have no incentive to overinvest in this way. Their incentive to invest to accommodate the A380 will depend critically on the cost pass-through arrangements that the regulator imposes. The regulator effectively decides whether an airport should accommodate the A380.

It may well be that the short-run aspects of the problem are easier to solve, in a practical way, than the long-run aspects. It is easy for airports to make investments to accommodate the A380 and recover the costs of doing so by raising charges across the board. This is a violation of ‘user pays’, and it may not be regarded as fair, though it will lead to efficient choices of aircraft. In cases where there is pressure for user pays, the two-part tariff option is an efficient one, though not always feasible. Implementing an efficient solution of the long-run aspect of the problem is more difficult to achieve. There are at least two forces that will lead to pressure for airports to invest excessively, and upgrade facilities to accommodate the A380 in situations where this is not worthwhile. Excessive investment in accommodating new aircraft types has arguably happened more than once in the past. The fact that airlines will not face the full costs of using the A380 can lead to this result, and coupled with this, most airports operate in a regulatory environment that weakens incentives to scrutinise investment proposals. For them it is easy to make questionable investments and pass the costs on to users. It is likely that many airports that need not upgrade their facilities to accommodate the A380 will nonetheless make the investments, and pass the costs on to airlines, and ultimately, their passengers.

References Air Transport Research Society (ATRS) (2005): 2005 Airport Benchmarking Report: Part II Full Results and Analysis, Vancouver, Air Transport Research Society. Barros, A. and S. Wirasinghe (2002): ‘Designing the Airport Airside for the New Large Aircraft,’ Journal of Air Transport Management, 8, 121–12. Brown, S. and D. Sibley (1986): The Theory of Public Utility Pricing, Cambridge, Cambridge University Press. Brueckner, J. (2002): ‘Airport Congestion when Carriers have Market Power,’ American Economic Review, 92, 1357–75.

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Doganis, R. (1992): The Airport Business, London and New York, Routledge. Forsyth, P. (2002): ‘Privatisation and Regulation of Australian and New Zealand Airports,’ Journal of Air Transport Management, 8, 19–28. Forsyth, P. (2004): ‘Pricing the Airport Infrastructure for the Airbus A380: Efficient Pricing and Dynamic Inconsistency,’ Mimeo, Monash University, Dept of Economics. General Accounting Office (GAO) (2002): Airport Infrastructure: Unresolved Issues Make it Difficult to Determine the Cost to Serve New Large Aircraft. Report to Congressional Requesters, GAO -02-251, US GAO, Washington. Graham, A. (2003): Managing Airports – An International Perspective, Oxford, Elsevier Butterworth Heinemann. Hendriks, N. and D. Andrew (2004): ‘Airport Regulation in the UK,’ in P. Forsyth, D. Gillen, A. Knorr, O. Mayer, H.-M. Niemeier, and D. Starkie (eds), The Economic Regulation of Airports: Recent Developments in Australasia, North America and Europe, Aldershot, Ashgate. Hogan, O. and D. Starkie (2004): ‘Calculating the Short-Run Marginal Infrastructure Costs of Runway Use: An Application to Dublin Airport,’ in P. Forsyth, D. Gillen, A. Knorr, O. Mayer, H.-M. Niemeier, and D. Starkie (eds), The Economic Regulation of Airports: Recent Developments in Australasia, North America and Europe, Aldershot, Ashgate. Holzschneider, M. (2004): ‘Are Airports Fit for the Next Decade? Integrating the New Super Jumbo in the World’s Airport System,’ mimeo, Dornier Consulting. Humphreys, B. (2003): ‘Slot Allocation: A Radical Solution,’ in K. Boyfield (ed), A Market in Airport Slots, London, Institute of Economic Affairs. Morrison, S. (1982): ‘Landing Fees at Uncongested Airports,’ Journal of Transport Economics and Policy, 14, 151–60. National Economic Research Associates (NERA) (2004): Study to Assess the Effects of Different Slot Allocation Schemes – A Final Report for the European Commission, London, D. G. Tren. Niemeier, H.-M. (2004): ‘Capacity Utilization, Investment and Regulatory Reform of German Airports,’ in P. Forsyth, D. Gillen, A. Knorr, O. Mayer, H.-M. Niemeier, and D. Starkie (eds), The Economic Regulation of Airports: Recent Developments in Australasia, North America and Europe, Aldershot, Ashgate. Oum, T. and Y. Zhang (1990): ‘Airport Pricing: Congestion Tolls, Lumpy Investment and Cost Recovery,’ Journal of Public Economics, 43, 353–74. Rozario, K. (2004): ‘Boarding the A380,’ Jane’s Airport Review, September, 27–9. Toms, M. (2004): ‘UK-Regulation from the Perspective of the BAA, plc,’ in P. Forsyth, D. Gillen, A. Knorr, O. Mayer, H.-M. Niemeier, and D. Starkie (eds), The Economic Regulation of Airports: Recent Developments in Australasia, North America and Europe, Aldershot, Ashgate. Zajac, E. (1995): The Political Economy of Fairness, Cambridge, MA, MIT Press.

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