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

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.