Why A Small Increase In Airport Charges Might Lead To A Large Passenger Loss
By David Starkie
A major issue that underlies much of the debate on airport policy is the extent to which airports face price-elastic demands for their services. It is important, for example, in judging whether an airport firm has significant market power (the less elastic the demand the greater the market power). But this issue is far from straightforward. Generally, the air passenger (or shipper of airfreight) is not charged directly for the use of airport infrastructure1. Instead, the airport imposes an aeronautical charge on the downstream airline and this is but one of the many costs that, when added together, form the basis of the fares paid by passengers. The typical airport charges elasticity (the passenger demand response to a change in airport prices) has been judged to be inelastic2.
Thus far, however, consideration of the size of the charges elasticity has neglected two factors. The first, (which we will not pursue in this note) has been the tendency to overlook differences between the price sensitivity of the marginal and average passenger. The second overlooked factor has been the potential impact of the charges elasticity on the aircraft’s load factor and, subsequently, on the airlines’ supply of seats to the market. The latter impact is the consequence of the interaction between an initial (probably very small) loss of passengers in response to an airline passing-through into fares an increase in aeronautical charges and the airlines’ ability to adjust capacity at the margin in circumstances where the supply of this capacity does not lend itself to continuous adjustment.
This lumpiness in the supply of seat capacity is due to a combination of factors. Different types of aircraft come in discrete sizes (measured by seat numbers) and airlines utilise only a limited number of aircraft types. Seat capacity can also be adjusted by changing service frequencies but this too is a lumpy adjustment (unless the frequency of service is extremely high). Consequently, in response to an increase in aeronautical charges, the airline might choose to absorb this additional input cost thus reducing operating margins; or pass-through to passengers the increase without an adjustment in seat capacity, so that with fewer passengers per flight the airline will face lower load factors, again affecting operating margins. In the longer term, reduced margins, especially following a series of tariff increases, might lead to a secession of the service. Alternatively, if the airline passes-through the increase but tries, in response to the fall in passenger demand, to maintain route margins by reducing flight frequencies, this reduced quality of service can be expected to reduce passenger demand still further (by shifting the demand curve to the left, see Appendix, Figure 1).
Thus, in these various ways, lumpy reductions in airline capacity can have the effect of leveraging the initial charge elasticity. Moreover, this leveraging effect can be very intense at various aeronautical ‘charging points’, with the consequence that following the supply adjustment, the overall change in the level of passenger demand could be large and significant. A small increase in airport charges has the potential to result in a large fall in the number of passengers using an airport, a much larger number than indicated by the initial charges elasticity.
This leveraging effect was illustrated earlier this year when, just before the change of ownership of London Stansted airport, the outgoing owners (BAA) hiked charges by about 6 per cent (albeit within the limits of the price cap applied to the airport by the regulator). Ryanair (the major airline using the airport, accounting for nearly 70 per cent of the airports’ scheduled movements) reacted to the increase saying that it would reduce its capacity at the airport by 9 per cent and that this would be done by cutting frequencies on 43 routes and by removing 170 flights. From this one can deduce that Ryanair anticipated that if the charges increase had been passed-through, passenger demand would have been impacted to an extent that many marginal services would no longer have been viable.
Ryanair, Europe’s eponymous low-cost airline, has only one aircraft type and only one series of that type so that it faces particular rigidities in adjusting the supply of seats. But all low cost airlines are noted for the homogeneity of their fleets and face the same problem to a greater or lesser degree. Full service airlines operate more mixed fleets (contributing to their higher cost base) but they too have tended to rationalise in the face of intensifying competition and at some of their bases operate one or two aircraft types/series only, again limiting their ability to fine-tune the supply of seat capacity to (small) changes in passenger demand3. Moreover, airports need only to be served by one airline with a homogeneous fleet to have some lumpiness in their downstream supply function4.
Consequently, when assessing the overall impact of an increase in aeronautical charges at an airport it is necessary to take into account not only the initial passenger demand effects but also the repercussion of this initial response for the supply of seat capacity by the downstream airlines. Overall, a small increase in aeronautical charges can result, in spite of a price inelastic passenger demand, in a significant reduction in passenger numbers at an airport.
David Starkie - Case Associates London, University of Adelaide and Hochschule Bremen.
References
Gillen D. and Mantin B. (2013). Transport Infrastructure Management: One-and Two-sided Market Approaches. Journal of Transport Economics and Policy, 47, (2), 207-227.
UK CAA (2013). Stansted Market Power Assessment, Annex 3.
Acknowledgements
I would like to thank Guillaume Burghouwt for useful comments and Salvatore Nava for assistance with the Figure.
Notes
1. Gillen and Mantin (2013) note exceptions including Canada and parts of Asia.
2. For example, recently the UK CAA (2013) considered the average charges elasticity for London Stansted Airport to be in a range of -0.2 to -0.6, therefore quite inelastic. It is probable that for low cost carriers in particular, marginal elasticities will be much higher.
3. For example, at London Gatwick BA have a short-haul fleet of 23 aircraft, 18 of which are 737-400s.
4. For example, at Amsterdam Schipol, LCCs and charters account for 17 per cent of scheduled direct flights. Although specific details of flight equipment used by these airlines is not to hand, it is likely that they are operating homogeneous aircraft types and therefore represent a significant fringe of lumpy supply at this major hub airport.
Appendix - Figure
The Figure illustrates schematically the discontinuities in the supply of airline seats and the marked change in passenger volumes at certain charge points.
Shown in the Figure is the relationship for a notional air route, between the average seat yield (also a proxy for the retail price of air travel) on the vertical axis and the quantity of seats demanded/supplied, on the horizontal axis.
The demand curve D* is the passenger demand when there are two daily/weekly rotations (services); the curve D^ when there is only one rotation.
The solid vertical lines correspond to the fixed number of seats supplied at one and two rotations (using aircraft of a fixed size). This supply is conditional on demand being high enough for the service to achieve a yield that meets a threshold consistent with a required return on capital employed (ROC). This hurdle, or threshold yield, is indicated by the bottom bar on the vertical supply curves. The required yield is higher for one rotation because of the fixed costs of serving the route being carried by one rather than two flight rotations. As drawn, at two rotations, demand D* is only just sufficient to meet the required yield.
An increase in airport charges requires a higher hurdle yield (requiring a higher retail price), shown by the higher bar in the case of both the single and double rotation. At the newly required hurdle yield, two rotations can no longer be sustained at the existing level of demand (the demand curve D* is below the upper bar) so that the frequency of service on the route is cut to a single rotation, thus halving the supply of seats.
As drawn, the single rotation can be sustained because demand D^ is (just) sufficient to meet the hurdle yield. This is in spite of the decrease in demand due to the lower quality of service, a decrease indicated by the difference between D* and D^. But one can also imagine a case where, following an increase in airport charges, demand overall is insufficient to cover the (higher) threshold yield and the service is withdrawn completely.