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The Transactions Costs Foundation for Public Utility Regulation and Its Application to the Regulation of Airports

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Economic Regulation of Urban and Regional Airports

Part of the book series: Advances in Spatial Science ((ADVSPATIAL))

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Abstract

Traditional theory asserts that a bottleneck or monopoly airport will seek to reduce the volume of services to raise the price, leading to economic harm known as a deadweight loss. But there is a problem: regulators and policymakers do not behave as though the deadweight loss is their primary concern. This chapter sets out an alternative foundation for economic regulation, based on the need to protect sunk investments from hold-up. In the case of airports, these sunk investments are made by both airlines and firms that rely on air transport services to provide services from a particular airport. When the airport has no close substitutes, such sunk investments are subject to the threat of hold-up. The economic harm is the resulting chilling effect on such investments. The threat of hold-up can be controlled through vertical integration or long-term contract. We show how government ownership and public utility regulation can be interpreted as a form of vertical integration and long-term contracting, respectively. We show how the features of airport regulation that are found around the world are consistent with this theory. We suggest that this theory provides a sound, coherent rationale for the analysis of airport regulation going forward.

The views expressed here are those of the author and do not reflect the views of the ACCC.

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Notes

  1. 1.

    For example, Crew and Kleindorfer (2006), page 63–64 write: “Elementary neoclassical economic theory shows that a monopoly left to its own devices will restrict output and maximize profit by equating marginal revenue and marginal cost. As a result it will earn monopoly profit, henceforth referred to as rents … The loss from the reduced output of monopoly is known as the deadweight loss or the welfare loss from monopoly”.

  2. 2.

    Biggar (2009), Faulhaber and Baumol (1988), Baumol (1986), Berg and Tschirhart (1995), Zajac (1995), Crew and Kleindorfer (2006).

  3. 3.

    Crew and Kleindorfer (2006), page 66.

  4. 4.

    Crew and Kleindorfer (2006), page 66.

  5. 5.

    See Biggar (2009, 2011, 2012).

  6. 6.

    “Asset specificity takes a variety of forms—physical assets, human assets, site specificity, dedicated assets, brand name capital, and temporal specificity … It is the big locomotive to which transaction cost economics owes much of its predictive content”. Williamson (1998), page 36.

  7. 7.

    There are further examples in Biggar (2009) and Gómez-Ibáñez (2003), page 9. Investments by customers are also discussed in Lyon and Huang (2002).

  8. 8.

    Crocker and Masten (1996) explain this as follows: “By allocating residual rights of control over the use and disposition of assets, ownership restricts the ability of non-owners to withhold assets from production and thus limits hold-up opportunities”.

  9. 9.

    The transaction cost literature also highlights problems that may arise in the internal organisation of firms. These bureaucratic inefficiencies ultimately undermine the benefits of internal organisation and thereby limit firm size. Vertical integration, like contracts, has both pros and cons.

  10. 10.

    The literature on transaction costs asserts that a core problem with real-world contracts is that they are incomplete and this leads to costly ex-post renegotiation (see, for example, Williamson 1998, Stern 2009, Hviid 1999, Macher and Richman 2008). However, the term “incomplete” is rather misleading. The underlying problem is not that it is costly to write a contract which specifies the action to be taken in every possible future contingency (after all the simple contract “X must do Y in every future scenario” is a trivial contract which specifies the action to be taken in every future scenario). Rather the problem is that the action specified by the contract may not be optimal when that scenario actually arises. Rather than the term incomplete it is preferable to use the term improvable. A contract is improvable if, ex post, there is a positive probability that in some future scenario the contract will specify a set of actions which the parties would not have agreed had they specifically negotiated over that scenario ex ante. The longer the duration of the contract and the greater the uncertainty in the environment, the greater the likelihood that a contract is improvable ex post.

  11. 11.

    This is, essentially, the classical role of the courts in Anglo-Saxon countries in enforcing conventional commercial contracts.

  12. 12.

    This point is emphasised by Stern (2009). See also Sidak and Spulber (1998).

  13. 13.

    So-called alliance contracts are an illustration of this principle. Alliance contracts are a form of commercial contracting which are designed to be used in situations of complexity, scope uncertainty, or complex operational constraints. Importantly, the parties to the contract enter into a commitment not to resolve disputes through the courts but, rather, to administer and adapt the contract through the decisions of an Alliance Board or Alliance Leadership Team. The Alliance Board, comprising representatives of the contracting parties, is an example of a permanent dispute resolution body empowered, in conditions of high uncertainty, to replace deferential dispute resolution by the courts (Department of Infrastructure and Transport 2011). The Alliance Board plays a role closely analogous to a public utility regulator in a conventional regulatory regime.

  14. 14.

    See Lumineau and Oxley (2007).

  15. 15.

    Contracts are often still required even in a competitive market for the simple reason that, except in the most basic market exchanges, there can arise slight timing differences between the creation of the good or service and the corresponding payment or exchange. These timing differences give rise to a hold-up problem, especially for the provision of (non-storable) services.

  16. 16.

    See Makholm (2006).

  17. 17.

    In Australia (as in other countries), the structural separation of natural monopoly sectors from related competitive sectors was a significant component of the pro-competitive reforms of the 1990s. Joskow (1991) makes the point that, to the extent that the original vertical integration was a transaction cost minimising response, it cannot be expected that structural separation in monopoly industries will be without costs. In the framework set out in this paper, structural separation represents a choice between two frameworks: The contractual control of an integrated firm and the promotion of sunk investment by downstream end-users, versus the contractual control of a separated monopoly facility and the promotion of sunk investment by both the intermediate services and the downstream end-users. The choice between these two approaches will depend on the facts in each case.

  18. 18.

    See Meade (2005). Questions remain about whether some regulatory controls remain necessary on customer-owned utilities, perhaps to protect customers who do not share in ownership or to protect suppliers. See Biggar (2022).

  19. 19.

    See, for example, Frank and Henderson (1992) and Cook (1995).

  20. 20.

    Historically, government ownership of monopoly industries in Australia (as in many other countries) was a very stable regulatory arrangement, lasting many decades and covering a period of rapid expansion of and investment in the electricity and telecommunications networks. Indeed, it may be that government ownership is the transaction-cost minimizing governance arrangement precisely in circumstances where large amounts of new investment are required in an uncertain environment.

  21. 21.

    Zeckhauser and Horn (1989): “The diffuseness and non-transferability of ownership, the absence of a share price, and indeed the generic difficulty residual claimants would have in expressing ‘voice’ (much less choosing ‘exit’) all tend to magnify the agency losses”.

  22. 22.

    See the discussion in Oum et al. (2006).

  23. 23.

    See, for example, Joskow (1987) and Crocker and Masten (1991) and the subsequent literature.

  24. 24.

    For a recent study see Athias and Saussier (2010).

  25. 25.

    Stern (2009), page 2.

  26. 26.

    See, for example, World Bank documents on PPPs.

  27. 27.

    Transport For London (2011), paragraph 24–25. See also Dassiou and Stern (2009). In the case of an alliance contract, the Alliance Board or Leadership Team is precisely a form of specialist, permanently established dispute resolution mechanism which plays the role of a regulator in administering the alliance contract.

  28. 28.

    Stern (2009), page 3.

  29. 29.

    The notion that the fundamental role of a public utility regulator is to resolve disputes may seem, at first, foreign. After all, is not the fundamental role of a public utility regulator to set prices? Yet there is a large amount of evidence that public utility regulators routinely behave like a dispute resolution entity. Littlechild (2008, 2011) provide many examples where regulators have facilitated negotiations between customers and service providers. RAP (2011) mentions that it is common for US regulators to encourage negotiation between the parties. Many US and Canadian regulators provide dispute resolution services of various kinds including mediation and arbitration. In Germany, the Federal network regulator encourages a form of mediation between the customers and the monopoly service provider. Similarly, the Canadian Transportation Agency uses an explicit arbitration procedure when deciding disputed rates for rail shippers. The Australian Productivity Commission has rejected calls to allow the ACCC to arbitrate disputes between airports and airlines precisely because it sees this function as a form of price regulation. Furthermore, the processes followed by public utility regulators in rate hearings borrow substantially from dispute resolution in other fields, including adherence to the rules of natural justice and procedural fairness. The majority of the states in the USA try to bolster the participation of customers in these processes, through the support or encouragement of a customer advocacy body. These bodies seek to represent customer interests before regulatory authorities—in a very similar manner to how these interests would be represented before a court or other dispute resolution mechanism.

  30. 30.

    The observation that public utility regulation can be viewed as a form of long-term contract can be traced back to Goldberg (1976) and Williamson (1976) and was reiterated by Crocker and Masten (1996).

  31. 31.

    Priest (1993), 301–303.

  32. 32.

    Joskow (1991), also see Crocker and Masten (1996) and, more recently, Sidak and Spulber (1998).

  33. 33.

    See, for example, Levy and Spiller (1994) and the subsequent literature which is surveyed in Armstrong and Sappington (2007).

  34. 34.

    Or, if there was a threat of “destructive competition”, through the granting of a statutory monopoly.

  35. 35.

    See Spiller and Tommasi (2005) who highlight that public utility services are usually widely consumed.

  36. 36.

    Of course, combinations of these approaches are also possible. It is possible to envisage arms-length regulation of government-owned or partially privatised firms. However, these combinations often suffer from a lack of clarity over roles and responsibilities. In the case of arms-length regulation of a government-owned firm, who is responsible for maintaining a stable price path and maintaining productive efficiency: The government as owner, or the regulatory framework?

  37. 37.

    The same principles apply to the regulation of air traffic control services, but for reasons which are not entirely clear the charges for air traffic control services have, to date, been less controversial and there appears to be less academic interest in the regulation of air traffic control services. For a survey on economic regulation of airports, with a focus on the UK, see Littlechild (2018).

  38. 38.

    Starkie (2012) emphasises that for some smaller airports an individual airline may account for a large share of the airport’s business. In addition there may be substitute airports or, as in the case of low-cost carriers (LCCs), the airline may retain flexibility to adjust its routes over time. If the airport is unlikely to easily make up for lost revenues if the airline takes its business elsewhere, it is the airline which holds the market power (or “buyer power”). In this case it is the airport which may fear to make sunk investments in reliance on the services of a particular airline.

  39. 39.

    See for example, Forsyth (1997, 2001, 2008), Niemeier (2009), page 6,11, Czerny (2006), Czerny and Zhang (2011), Basso (2008), Basso and Zhang (2010). For a different perspective on the role of economics in airport regulation policy, see Niemeier (2021).

  40. 40.

    See, for example, Productivity Commission (2002).

  41. 41.

    See, for example, Niemeier (2009), page 9.

  42. 42.

    In Australia, the Productivity Commission (2002, 2006) has argued that because the elasticity of demand for airport services is low, the deadweight loss arising from charging above marginal cost is small and therefore there is little need for conventional airport price control regulation.

  43. 43.

    See Bel and Fageda (2010), Biggar (2012).

  44. 44.

    On price discrimination see Forsyth (1997) and PC (2006). On Ramsey pricing of airports see Morrison (1982), Martin-Cejas (1997), Czerny (2006), and Hakimov and Scholz (2009). On congestion pricing, see Carlin and Park (1970), Brueckner (2002), Brueckner and Van Dender (2008), Czerny and Zhang (2011).

  45. 45.

    On rules against price discrimination see Biggar (2012). On the tendency of tariffs to depart from the Ramsey ideal see Morrison (1982, 1987). On the rejection of price-based rationing of airport capacity see Starkie (2005) and Forsyth and Niemeier (2008).

  46. 46.

    ICAO policies state that “increases in charges should be introduced on a gradual basis”.

  47. 47.

    See Biggar (2012), Fuhr and Beckers (2006).

  48. 48.

    For example, passenger routes from Australia to Europe require at least one refuelling stop in Asia or the Middle East. Airlines such as Qantas face a range of choices for such stops. If these choices are essentially equivalent in the mind of the travelling public, Qantas can, in principle, protect any sunk investment it makes in, say, marketing these European routes by switching to another stopover airport. At the same time, the airports in the Middle East may attempt to differentiate themselves in the eyes of the travelling public so as to limit the ability of the airports to switch in this way.

  49. 49.

    Some sunk investment may still be required. Contractual arrangements may still be necessary to protect those investments, but those contracts will typically be shorter (say, 1–5 years) than in the case where the airport faces no good substitutes.

  50. 50.

    This option is discussed further below. Starkie (2012) reports the deputy CEO of a regional airport expressing exactly this concern and the need for contractual arrangements to solve it: “The airport needs an operational commitment from the airline as to the number of aircraft and time period it will commit to operate from that airport as a base, so that the airport can then derive some comfort from the costs it may then incur in paying for improvements to infrastructure and other facilities at the airport”.

  51. 51.

    Although airlines can, in principle, choose to relocate their hubs, “the intensity of hub competition is limited by the high switching costs for airlines due to specialised investment and non-tradable slots”. Niemeier (2009).

  52. 52.

    Niemeier (2009), page 5: “Today airports are … a heterogeneous group with ownership structures ranging from state-owned to partial and even full privatisation, with regulatory systems ranging from cost regulation to price cap and even to complete deregulation”.

  53. 53.

    Here we are looking at vertical integration with the airport as a whole. Event at airports with limited market power, airlines may enter into ownership arrangements for particular assets. For example, airlines often own and operate terminals or maintenance facilities at key airports. Lufthansa has an ownership stake in Frankfurt’s terminal 2.

  54. 54.

    Although such vertical integration is theoretically possible for airports with close substitutes, in the case of airports with material market power, vertical integration is usually discouraged. The reason is straightforward: vertical integration raises the threat that the integrated airport-airline will deny or degrade access to rival airlines, reducing competition in air services, extending the monopoly problem from the airport segment to the entire range of air services. The policymaker seeking to address the monopoly problem is faced with a choice: Regulation of the entire range of end-user air services or regulation or the prices of airport services. Rather than regulating the prices of an integrated airline-airport providing a range of air services (or regulating access to an airport owned by an integrated airline-airport), it is usually easier to require structural separation, to regulate the prices of the separated airport and to allow competition between airlines to dictate the prices and range of air services.

  55. 55.

    See, for example, Serebrisky (2003).

  56. 56.

    CAPA, “The airline-airport battle intensifies. Lufthansa-Fraport link unravelling?”, 24 July 2009.

  57. 57.

    Fuhr and Beckers (2006), page 399.

  58. 58.

    Oum et al. (2006) cites a claim that “the US airports are among the most ‘privatised’ in the world, as US airports routinely turn to airlines for financial help in facility expansion and modernisation and in return offer long-term leases that often given airlines strategic control of airports through majority-in-interest (MII) arrangements”. As emphasised later, vertical arrangements between airports and airlines does not eliminate the public policy concerns - as those arrangements can be used by incumbent airlines to restrict competition in the airline sector. Morrison and Winston (2008) argue that restrictions on the use of gates and the routes airlines can fly has restricted competition in favour of incumbent airlines.

  59. 59.

    Oum and Fu (2009). There is more detail on airport-airline agreements in TRB (2010).

  60. 60.

    As before, we will focus on long-term contractual arrangements for take-off and landing rights. Long-term contracts are common for the use of individual airport assets, especially when some customisation is required. See TRB (2011). For example, Qantas holds a 31-year lease, signed in 1987, over the northern end of the domestic terminal at Brisbane Airport. Sydney Morning Herald, “BNE: Qantas to sell Brisbane Airport for $112m”, 27 February 2014.

  61. 61.

    “There are many cases where airlines and airports secure their co-operation via long-term contracts. In recent years the Low Cost Carriers (LCCs) have organised this type of long-term contract with airports. Many secondary airports offer LCCs favourable usage terms in order to attract their traffic. However, once an airline incurs sunk costs in establishing its services out of the airport, the airline loses bargaining power because of the high cost of switching to a new base. Therefore, many LCCs choose to sign up long-term contracts with airports in order to lock in the favourable terms”.

  62. 62.

    The arrangement at Hamburg airport was renewed after the first term, but the experience at the other airports has been mixed. Where the agreements are not renewed the airports fall back into a statutory rate-of-return regulatory framework.

  63. 63.

    Littlechild (2012), page 5.

  64. 64.

    Littlechild (2012), page 5. The recent pandemic represents another major shock to the air transport sector which will likely require similar exercise of discretion by regulators. See Forsyth et al. (2020).

  65. 65.

    Fuhr and Beckers (2006).

  66. 66.

    Biggar (2012), page 378.

  67. 67.

    Biggar (2012), page 378.

  68. 68.

    Morrison and Winston (2008), page 21.

  69. 69.

    The transactions cost approach to competition law and competition policy is discussed in Biggar and Heimler (2021, 2022).

  70. 70.

    Gillen and Niemeier (2008).

  71. 71.

    Littlechild (2012).

  72. 72.

    See, for example, http://ppp.worldbank.org/public-private-partnership/ppp-overview/practical-tools/checklists-and-risk-matrices/airport-concession-checklist

  73. 73.

    See, for example, Littlechild (2008, 2012).

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Author information

Authors and Affiliations

  1. Australian Competition and Consumer Commission (ACCC), Canberra, Australia

    Darryl Biggar

  2. Monash University, Melbourne, Australia

    Darryl Biggar

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  1. Darryl Biggar
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Correspondence to Darryl Biggar .

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Editors and Affiliations

  1. Monash University, Clayton, VIC, Australia

    Peter Forsyth

  2. Berlin School of Economics and Law (HWR), Berlin, Germany

    Jürgen Müller

  3. University of Applied Sciences School of International Business, Bremen, Germany

    Hans-Martin Niemeier

  4. Department of Spatial Economics, Vrije Universiteit Amsterdam, Amsterdam, The Netherlands

    Eric Pels

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Biggar, D. (2023). The Transactions Costs Foundation for Public Utility Regulation and Its Application to the Regulation of Airports. In: Forsyth, P., Müller, J., Niemeier, HM., Pels, E. (eds) Economic Regulation of Urban and Regional Airports. Advances in Spatial Science. Springer, Cham. https://doi.org/10.1007/978-3-031-20341-1_4

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