Why airports can face
price-elastic demands:
margins, lumpiness andleveraged passenger losses

23

Discussion Paper 2013 • 23
David Starkie

Case Associated, London, Uk

George Yarrow

Hertford College, Oxford University, Uk

Why airports can face price-elastic
demands: margins, lumpiness andleveraged passenger losses

Discussion Paper No. 2013-23

David STARKIE
Case Associated, London, UK
George YARROW
Hertford College, Oxford University, UK

December 2013

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WHY AIRPORTS CAN FACE PRICE-ELASTIC DEMANDSTABLE OF CONTENTS

1. INTRODUCTION ........................................................................................ 5
2. LEVERAGING OF PRICE ELASTICITIES WHEN SUPPLY OF SEATSIS A CONTINUOUS FUNCTION OF CHARGES .................................................. 6
3. A CONSTANT SEARCH FOR RETURNS ........................................................... 8
4. AIRLINE REACTIONS TO AN INCREASE IN AIRPORT CHARGES ........................ 9
5. LEVERAGING: AN ILLUSTRATION .............................................................. 10
6. CONCLUSIONS ........................................................................................ 11
REFERENCES ............................................................................................... 12
ACKNOWLEDGEMENTS.................................................................................. 12

D. Starkie and G. Yarrow — Discussion Paper 2013-23 — © OECD/ITF 2013

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WHY AIRPORTS CAN FACE PRICE-ELASTIC DEMANDS

1. INTRODUCTION

The extent to which firms face price-elastic demands for their products is important in
the application of competition law and in judgments made as to whether they havesignificant market power. In the context of the airport industry1, assessing priceelasticities is complicated by the fact that one major type of consumer of airport services,
the air passenger, is not charged directly for use of terminals and airside infrastructure 2.
Instead, the airport derives its revenues from charges to airlines and from the supply of
non-aeronautical services. The charges to airlines then become one of many input costs
that the airlines recoup from passenger fares, and this intermediation has significant
implications for the demand analysis.
How the airline reacts to an increase in airport costs will depend, inter alia, on thefinancial performance of the route(s) concerned, the type of aircraft used and the fleet
mix of the airline. Importantly, there is an interaction between (i) a (potential) loss ofpassengers if an initial increase in airport prices is reflected in fares charged and (ii) the
supply of capacity by airlines in circumstances where the supply of this capacity does notlend itself to continuous adjustment. Consequently, adjustments in lumpy airline capacity
in response to a (small) passenger loss can have the effect of leveraging the initialcharge elasticity, accentuating the losses of aeronautical and commercial revenues. The
indivisibilities or lumpiness in the supply of seats by airlines means that the leveraging
effect can be very intense at various aeronautical ‘charging points’. 3
Before considering these matters in detail it is useful first to consider the leveraging
effect in a context simpler than that faced in the airline industry, one in which supply is acontinuous function of charges; this is considered in the next section. It is followed in thethird section by an illustration of how airlines constantly search for returns using yield
management processes designed to increase aircraft load factors, revenue yields andthus route operating margins and return on capital employed (ROCE). An airline will
operate a portfolio of routes usually from several airports and routes will be ranked in theportfolio according to their ROCE. In the fourth section we consider how an airline willreact to an increase in airport charges. It can respond in several ways, but none can
avoid a negative impact on operating margins. This will lead to the affected routes
cascading down the ROCE ranking, prompting a possible reappraisal of the services. A
critical factor in the reappraisal is the constraint imposed by lumpiness or discontinuities
in the supply of seats, determined by a production unit (aircraft) of fixed size. This
constraint can result in a non-marginal change in route capacity with a similar impact onpassenger numbers. The point is illustrated in the fifth section by reference to the1.

In the UK, the 2012 Civil Aviation Act requires that a market power assessment is undertaken before
an airport can be subject to economic regulation.

2.

This is generally the case in Europe (with a few exceptions), but not necessarily elsewhere in theworld.

3.

Specifically, at those levels of charge such that a further small increase would lead to a lumpy
withdrawal of seat capacity.

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WHY AIRPORTS CAN FACE PRICE-ELASTIC DEMANDS

reaction of Ryanair to an increase in charges at London-Stansted airport in early 2013.
Finally, the concluding section considers the general applicability of the main points.

2. LEVERAGING OF PRICE ELASTICITIES WHEN SUPPLY OF SEATS IS A CONTINUOUS
FUNCTION OF CHARGES

Assume that the seat capacity made available by airlines (in aggregate) at a particular
airport is K, which is a continuous, decreasing function of the airport’s aeronauticalcharges, denoted by p. That is, K = K(p), where dK/dp < 0.
Other things being equal, including air fares, the passenger demand for the services ofan airport, say Q, can be expected to be an increasing function of the seat capacity on
offer, since a higher available seat capacity will typically be associated with either higher
frequencies on routes served, or more routes served, or both.4 Passenger demand will
also be a function of air fares on routes served by the airport, which can be represented
by y, such that the lower are fares the higher will tend to be the number of passengers
wanting to use the airport.
Air fares will in turn depend upon the level of aeronautical charges, which are costs toairlines. In the simplest case an increase in aeronautical charge per passenger will feedthrough into an equivalent increase in air fares, so that dy/dp = 1. Depending on thestate of competition in the relevant airlines markets, however, other outcomes are
possible.
These considerations lead to a specification of airport passenger demand, for a given
level of non-aeronautical services, as:
Q = Q(y(p),K(p)).
In other words, demand depends on airfares (which in turn depend on the level ofaeronautical charges), and on the service frequencies and routes that can be supplied at
an airport from a given allocation of seat capacity, which again will be influenced by thelevel of aeronautical charges.
Consider, then, the effect of an increase in the aeronautical charge at the airport ofinterest, all other things being held constant, including charges at other airports. The
effect on passenger demand for the airport can be obtained by differentiating withrespect to p:

4.

Capacity can also be varied by changing the size of aircraft, but, for reasons that are discussed
below, this is not likely to be a major feature of adjustments to airline schedules in the short tomedium term, and the additional complexities that it introduces can be ignored for current purposes.

6

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WHY AIRPORTS CAN FACE PRICE-ELASTIC DEMANDS

Multiplying both sides of this equation by p/Q, we have a ‘five elasticities formula’:orwhere,
TEQp is the total elasticity of airport passenger demand with respect to aeronauticalcharges, taking account of both price and quantity/capacity adjustments by airlines,
EDy is the passenger elasticity of demand with respect to airfares charged byairlines serving the relevant airport, for given service levels,
EYp is the elasticity of airfaresw with respect to aeronautical charges, reflecting thedegree of pass-through of those charges and their significance as a determinant ofrelevant airline costs,
EDK is the elasticity of passenger demand with respect to the airline seat capacity
available at the airport (encompassing the number of routes that are served and thefrequencies of flights on those routes), andEKp is the elasticity of airline seat capacity made available at the airport withrespect to aeronautical charges.
That is, in words, the total elasticity of airport passenger numbers with respect toaeronautical charges is equal to (a) the product of the (airport) elasticity of passenger
demand with respect to airfares and the elasticity of airfares with respect to aeronauticalcharges, plus (b) the product of the (airport) elasticity of passenger demand with respect
to seat capacity and the (airport) elasticity of supply of seat capacity.
The leveraging that we are interested in occurs as a result of the termin thisequation. It is to be expected that the demand elasticity with respect to seat capacity will
be a significant number since, if an airport does not serve the routes that passengers
want to fly at frequencies that are convenient for passengers, they will likely turnelsewhere. The term of most empirical interest is, therefore, the elasticity of supply ofseat capacity, and it is to this that we now turn.

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3. A CONSTANT SEARCH FOR RETURNS

Figure 1 is taken from an easyJet presentation to investment analysts in 20085 andshows, for the Gatwick-Malaga route, on which easyJet was in competition with BA, thefare at which a seat was offered for sale by the number of days before departure. In
2008, easyJet’s entry fare was about £25, offered three months before the departure
date. The fare offer increased (not quite monotonically) towards departure, at firststeadily but finally more rapidly (to over £100). BA’s fare offerings follow a similar
pattern, but generally at a higher level, and with a more pronounced increase in the
couple of weeks before departure.
This process of managing the fare yield, a so-called Low-High pricing strategy, is aprocess that might be expected to lead overall, for any particular service, to a (large)
number of marginal purchases because there is not one product but many, each sellingat a different price and at each price one might expect a purchase at or reasonably close
to the margin6. It is a form of price discrimination7 that is designed to maximise asset
utilisation by maximising an aircraft’s load factor and revenue yield, and thus, for any
particular route, increasing its profitability or ROCE8.
A profile of the returns, route-by-route, across the whole of the easyJet network in thefinancial year 2012 is shown in Figure 29. It distinguishes routes established for morethan 3 years from more recent routes and benchmarks each in relation to a 12 per cent
ROCE. An overall pattern that distinguishes returns of longer-established routes fromthose established more recently is not immediately apparent in the data10. A number,perhaps around 20 per cent, of routes have returns well in excess of the 12 per centbenchmark, but the returns for about half the routes fall below this benchmark. There isa number, albeit very small, of routes with negative returns.
5.

http://corporate.easyjet.com/~/media/Files/E/Easyjet-PlcV2/pdf/investors/presentations/analyst_and_investor_day_2008.pdf. Accessed 06.12.13

6.

The purchaser at any particular offer-price is forgoing slightly different products (a seat purchased a
day earlier or a day later) each offered at a small price difference.

7.

See C Alves and C Barbot (2009). The paper finds that the existence of different probabilities ofconsuming the good and of different willingness to pay makes it possible to separate markets in time
and to profitably price discriminate.

8.

It is a constrained maximisation problem. Capacity supplied to the market is predetermined by theaircraft type; seats are offered at different prices (differentiated by time of booking) with the aim of
maximising revenues which is achieved by maximising load factors.

9.

http://corporate.easyjet.com/~/media/Files/E/Easyjet-Plc-V2/pdf/investors/resultscentre/2013/2013-q1-roadshow-presentation.pdf. Accessed 14.11.13.

10.

This suggests that new routes can establish themselves quickly but equally that mature routes too
can be marginal. CE/SEO data (Copenhagen Economics, 2012) indicates that 15 per cent of 4 year
old routes operated by LCCs were closed during the period 2002-2011 and 13 per cent of 5 year oldroutes, underlining the extent to which LCCs are willing to call into question well established routes in
the constant search for higher returns.

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WHY AIRPORTS CAN FACE PRICE-ELASTIC DEMANDS

An interesting and highly relevant feature of the curve shown in Figure 2 is that a large
number of routes in the airlines’ network are of relatively similar profitability (since theresults are shown for one year, the curve may be flatter still over a two or three year
period). This suggests that, if operating from a particular airport becomes more costly,routes from that airport may move many places to the right in the ranking of profitability
shown in Figure 2. The flat profile implies, therefore, that small changes in relatively
profitability can lead to significant changes in route structure.
The curve also illustrates the importance of assessing effects at the margin. A significant
number of routes are highly profitable, and will be retained even if there are substantialchanges in the relevant airport charges. These routes, because they are so profitable,
serve to raise the average ROCE for routes as a whole. What matters, however, is theflatness of the curve at the margin, i.e. the part of the curve close to the ROCE level atwhich routes will be considered candidates for withdrawal of services.
Although the above picture reflects the whole of easyJet’s route network, its basic
features are likely be replicated for each of its operating bases; some routes from aparticular base will perform better than others and a base’s portfolio of routes might havea route-return profile that lies towards the left hand side of Figure 2, or it might have aprofile more to the right, the latter signifying underperformance relative to other airports.
It is also a picture based on one particular low cost carrier’s data, but it is probable that
it is representative of the situation faced by other low cost airlines, and indeed by airlines
in general. LCCs and full-service carriers (FSCs) now compete more actively than in thepast, especially in the context of the single European market (see again Figure 1), and all
have to be sharply focussed on returns at the margin if they are to be successful.

4. AIRLINE REACTIONS TO AN INCREASE IN AIRPORT CHARGES

If an airport increases its charges, an airline has to assess the impact of the higher costs
across its portfolio of services from that airport. To the extent that the cost increase ispassed through to the passenger, the effect will be to increase, i.e. to shift upwards, theoffer curves shown in Figure 1. As a result, there will be a negative impact on passenger
demand and consequently on load factors: average seat yields will be reduced thus
reducing operating margins. If, alternatively, the airline’s initial reaction is to absorb(rather than to pass-on) the increase, this will also adversely affect operating margins
and (consequently) the profitability ranking of each of the relevant routes within theoverall route portfolio. If we imagine a profile for the portfolio such as that in Figure 2,
the effect will be to push the ROCE of each of the affected routes downwards, making
more routes at the relevant airport marginal and further weakening the performances of
those already marginal. Moreover, at existing service levels, the airport itself will havebecome relatively more marginal to the airline in terms of its contribution to overall
airline profits.
The airline might respond to this by looking to reduce the seat capacity it provides fromthe airport with a view to re-establishing acceptable operating margins in line with thebenchmark ROCE. It can potentially reduce capacity in two, principal ways:

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WHY AIRPORTS CAN FACE PRICE-ELASTIC DEMANDS(a) reducing service frequencies (but holding aircraft size constant), including
reducing frequency to zero (i.e. withdrawing the route), and then re-allocating
capacity to other routes or reducing fleet capacity, and(b) reducing the size of the aircraft used on particular routes (holding service
frequencies constant).
In practice and particularly for LCCs, the latter response will be often be constrained by
the airlines fleet mix and commitments of aircraft to other routes. Airlines with aircraft
fleets made up of fairly homogeneous aircraft types cannot easily adjust the size of
production unit (the size of aircraft) in order to re-establish margins; they do not have acontinuous, smooth supply function, but one that is lumpy and discontinuous.
Consequently, faced with such constraints on the supply side, output adjustments tend to
take place by cutting route frequencies, cutting entire routes and, in some cases, byclosing operating bases.
Any reduction in seat capacity made by cutting service levels (i.e. reducing flightfrequencies, withdrawing routes) will in turn affect the level of passenger demand. A
more infrequent service (that is, a lower quality of service) will have the effect of shifting
the demand curve for a particular route downwards to the left; there will be a fall in thelevel of demand. This will occur irrespective of any change in the quantity demanded
should the airline choose to increase fares in response to an increase in airport charges.
An initial price elasticity effect, therefore, is effectively leveraged through a combinationof downward adjustments in the supply of lumpy capacity, and the reaction ofpassengers to the resulting deterioration in the quality of service provided (see Figure 3).

5. LEVERAGING: AN ILLUSTRATION

That leverage does take place in the manner described can be illustrated by some
calculations based on (a) numbers cited in the context of the UK CAA’s February 2013
London-Stansted Market Power Assessment (MPA), (b) an increase in charges by
Stansted Airport Limited in April 2013, and (c) the reaction of Ryanair (much the largest
user of the airport) to this charges increase. For its assessment the CAA set out tocalculate a charges elasticity of demand for Stansted by considering general estimates ofaviation elasticities and estimates based on various approaches specific to the airport. Its
conclusions were that the appropriate elasticity, which appears to correspond with thefirst term on the right hand side of the five-elasticities formula above, fell within a fairly
wide range from -0.2 to -0.6.
Soon after these estimates were published, the airport announced increases inaeronautical charges of about 6 per cent11. On the basis of a charges elasticity of about-0.5 (towards the top end of the CAA’s calculated range) and a then current passenger
base of approximately 17.5 million we might have expected the increase in airport
charges to have resulted in a loss of just over 0.5 million passengers overall or a loss for
11.

This increase was announced just before the transfer of ownership of Stansted (from BAA to MAG)
took effect. The increase was permissible within the then price cap set for the airport.

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WHY AIRPORTS CAN FACE PRICE-ELASTIC DEMANDS

Ryanair, which accounted for about two-thirds of Stansted’s annual passenger numbers(i.e. about 11.55 million), of 346,500.
However, Ryanair reacted to the announcement of an increase in charges 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, removing 170 flights potentially used by 1.1mn
passengers, around three times higher than implied by a price-elasticity of -0.5.12 The
key point here is not the precise numbers involved but the nature of the airline reaction,(reduction in services offered at the airport) and its implications for passenger demand:
if a service is withdrawn the airport will lose not only passengers who would haveremoved their custom on account of higher airfares, but also those who would have still
been willing to fly at the new airfares but are driven away by the reduction in service
availability.

6. CONCLUSIONSIn a competitive aviation environment, a number of factors can be expected to influencepassenger demand for a particular airport, most notably its relative location but also
including the airfares on offer from airlines using the airport and, of central interest here,
the set of services offered by those airlines, characterised for example by the set ofroutes served and their service frequencies. When changing aeronautical charges,
airports are faced with two routes by which such changes may affect passenger numbers,both indirect and each operating via decisions made by airlines.
The first effect occurs as a result of pass-through of airport charges into airfares, giving
rise to a classic price elasticity of demand effect (i.e. a fall in the quantity of seats
demanded). The second effect follows from this reduction in passenger demand and theconsequent reduction in the profitability of marginal services at the airport. Unless allroutes at the airport happened to be untypically supra-marginal, this decline in operating
margins is likely to lead to a reduction in services offered. Because the airport is now lessattractive to a sub-group of passengers who favoured the withdrawn services, thisdecline in services will lead to a fall in passenger numbers (i.e. a fall in the level ofdemand). Given the ability of airlines to move planes from routes served by one airportto routes served by another, the latter effect can be substantial, especially if the demand
response to the initial adjustment of services triggers further service adjustments13.
Thus the overall effect can be to greatly leverage the initial impact of aeronauticalcharges on passenger numbers.
12.

We stress at this point that the implications of this analysis for the purpose of a Market Power
Assessment (MPA), which was the CAA’s objective, is not direct. This is because the effect of an
actual charge increase for the purposes of an MPA will depend not only on the existing level ofcharges but whether that level is above, at, or below what might be assessed as a competitive
charge level. At the time of the increase, the competitive level of charge for Stansted remained
undetermined. Furthermore, for the purpose of an MPA, an analysis such as this would have to take
into account whether prices changed at or about the same time at other (substitute) airports.

13.

It can also be noted that, all other things being equal, an increase in charges at one particular airport
will alter its relative standing with respect to margins earned at all other airports in an airline’s
network.

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WHY AIRPORTS CAN FACE PRICE-ELASTIC DEMANDS

Although this leveraging effect is more likely to bear upon airports serving LCC’s,because of the homogeneous nature of their fleets14, the same issues that give rise toleveraging will not be entirely absent with respect to FSC operations. Competition in theliberalised European short-haul sector, a sector that dominates the activities of most
European airports, has increased the incentive for FSCs to reduce costs by rationalising
their fleets so that at some airports FSCs also operate fleets of a reasonably standard
type15. Competition will have also have increased the requirement for FSCs to focus on
operating margins. Consequently, we would suggest that the leveraging process we haveoutlined is a potent factor at airports throughout Europe and it should be taken into
account in competition assessments concerning an airport’s market power16. It is not
sufficient to focus the assessment on a narrow view of the price elasticity of demand.

REFERENCES

C Alves and C Barbot, “Price Discrimination Strategies of Low-cost airlines”, Journal ofTransport Economics and Policy (JTEP), Volume 43, Number 3, September 2009
, pp. 345-363(19).
Copenhagen Economics (2012) Airport Competition
https://www.aci-europe.org/policy/positionpapers.html?view=group&group=1&id=6

inEurope,Available

at

ACKNOWLEDGEMENTS

We would like to thank Salvatore Nava for assistance with Figure 3.

14.

Ryanair fleet March 2013 comprised of 305 aircraft, all B737-800s. easyJet’s fleet as at September
2012 comprised of 214 aircraft split between 156 seat Airbus A319s (160) and 180 seat A320s (54).

15.

For example, at London Gatwick BA have a short-haul fleet of 23 aircraft, 18 of which are 737-400s.

16.

Moreover, airports need only to be served by one major airline with a homogeneous fleet to facediscontinuities in demand associated with lumpiness in airline capacity.

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WHY AIRPORTS CAN FACE PRICE-ELASTIC DEMANDSAPPENDIX

Figure 1.

Figure 2.

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WHY AIRPORTS CAN FACE PRICE-ELASTIC DEMANDS

Figure 3.

Average seat yield

No of rotations
per period
1
2

D^
D*

Threshold yield
D^
D*

Seats demanded/supplied

The Figure illustrates schematically the discontinuities in the supply of airline seats andthe marked change in passenger volumes at certain charge points. For a notional air
route, it shows the relationship between the average seat yield (also a proxy for theretail price of air travel) on the vertical axis and the quantity of seats demanded/suppliedon 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 tworotations (using aircraft of a fixed size). This supply is conditional on demand being highenough for the service to achieve a yield that meets a threshold consistent with arequired 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 flightrotations. As drawn, at two rotations, demand D* is only just sufficient to meet therequired yield.
An increase in airport charges requires a higher hurdle yield (requiring a higher retailprice), 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 levelof demand (the demand curve D* is below the upper bar) so that the frequency ofservice 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 tomeet the hurdle yield. This is in spite of the decrease in demand due to the lower qualityof 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 isinsufficient to cover the (higher) threshold yield and the service is withdrawn completely.

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