Modeling airport capacity choice with real options

Abstract

This study models airport capacity choice when a real option for expansion can be purchased. Facing demand uncertainty, an airport first determines the capacity for immediate investment (the prior capacity) and the size of the land or other resources to be reserved for possible future expansion (the reserve). Once demand is observed, the airport can use a portion of the reserve to build extra capacity and set airport charge. Our analytical results show that if demand uncertainty is low and capacity and reserve costs are relatively high, an airport will not acquire a real option for expansion. Otherwise, it can use an expansion option to improve its expected profit or social welfare. Both the magnitude of profit or welfare gain and the optimal size of the reserve increase with demand uncertainty. A higher reserve cost leads to a larger prior capacity and a smaller reserve, whereas a higher capital cost leads to lower prior capacity. A profit-maximizing airport would choose a smaller prior capacity and reserve than would a welfare-maximizing airport. Competition within the airline market promotes airport capacity investment and the adoption of real options by profit-maximizing airports, whereas airport commercial services increase prior capacity but not the reserve.