A note on optimal airport pricing in a hub-and-spoke system

Abstract

This paper deals with the socially optimal pricing of airports in a hub-and-spoke network, taking into account explicitly the fact that demands for airport services at hub airport and spoke airports are complementary. It is shown that a welfare gain is to be made by switching from the regime of pricing each airport independently of other airports in the network to the regime of pricing the hub and spoke airports jointly. Intuitively, given the demand complementarity, the optimal pricing of a hub-and-spoke airport network as a system may require for the hub airport to subsidize the money-losing spoke airports. Our result implies that there may be a welfare loss due to the reduction in allocation efficiency if a network of airports currently being managed by a national government are to be defederalized (or privatized) separately for each airport as being carried out in Canada and in Australia. Since one of the major reasons for defederalization (or privatization) of airports is to reduce x-inefficiency caused by the centralized, bureaucratic and inflexible management, the welfare loss due to the allocative inefficiency should be weighed against the one-time gain in x-efficiency expected from defederalization of those airports. This result calls for a caution on the current debate on airport devolution which focuses mainly on the expected one-time reduction in x-inefficiency in airport operation and management and the need for flexible attitude toward local community needs, without even discussing its effects on reduced allocative efficiency which will continue to occur in perpetuity.