Platform pricing and consumer foresight: The case of airports

• Date: 01 October 2018
• Author: Ricardo Flores‐Fillol,Alberto Iozzi,Tommaso Valletti
• DOI: http://doi.org/10.1111/jems.12253
• Published date: 01 October 2018

705

J Econ Manage Strat. 2018;27:705–725. wileyonlinelibrary.com/journal/jems © 2018 Wiley Periodicals, Inc.

Received: 5 April 2017 Revised: 20 December 2017 Accepted: 27 April 2018

DOI: 10.1111/jems.12253

ORIGINAL ARTICLE

Platform pricing and consumer foresight: The case of airports

Ricardo Flores-Fillol1Alberto Iozzi2,3 Tommaso Valletti4,5,6

1Departament d'Economia and CREIP,

UniversitatRovira i Virgili, Reus, Spain

(Email: ricardo.flores@urv.cat)

2Universitàdi Roma ‘Tor Vergata', Rome,

Italy (Email: alberto.iozzi@uniroma2.it)

3SOAS Universityof London, London, UK

4Imperial College London, London, UK

(Email: t.valletti@imperial.ac.uk)

5Universitàdi Roma ‘Tor Vergata, Rome,

Italy

6CEPR, London, UK

Abstract

We analyze the optimal behavior of a platform providing essential inputs to down-

stream firms selling a primary and a second complementary good. Final demand is

affected by consumer foresight, that is, consumers may not anticipate the ex post sur-

plus from the secondary good when purchasing the primary good. We first set up a

reduced-form platform model and evaluate the effects of consumer foresight on the

platform's optimal decisions. Then, we specialize the analysis in the context of air-

ports, which derive revenues from both aeronautical and, increasingly, commercial

activities. An airport sets landing fees and, in addition, it chooses the retail market

structure by selecting the number of retail concessions to be awarded. We find that,

with perfectly myopic consumers, the airport chooses to attract more passengers via

low landing fees, and also sets the minimum possible number of retailers in order to

increase the concessions’ revenues. However, even a very small amount of anticipa-

tion of the consumer surplus from retail activities changes significantly the airport's

choices: the optimal policy is dependent on the degree of differentiation in the retail

market. When consumers instead have perfectforesight, the airpor t establishes a very

competitive retail market. This attracts passengers and it is exploited by the airport

by charging higher landing fees, which then constitute the largest share of its profits.

Overall, the airport's profits are maximal when consumers have perfect foresight.

1INTRODUCTION

The airport business is increasingly becoming a platform activity. Airports derive revenues not only from the traditional aero-

nautical activities, but also from the commercial activities taking place at the terminals, such as shops, food and beverage, and

car parks. The Economist (2014) refers to airport shopping as the “sixth continent” to highlight its importance. According to

industry reports, airports achieve at least 50% of their revenues from non-aeronautical activities, with retail representing the main

source (ACI, 2012; ATRS, 2014). Massive investments have supported this trend, with airports increasing their duty-free space

significantly. In 2008, the project at Beijing Airport T3 was completed with the design of the star architect Norman Foster and

a staggering floor space of 1,000,000 sqm. It was the largest terminal in the world, soon to be surpassed by Dubai International

Airport's T3, which is twice as large.

To do their shopping at airports, passengers need to buy a flight ticket first. This decision is influenced by airfares, which, in

turn, are affected by the landing fee charged byair ports. A role is also playedby the anticipation of the utility that can be der ived

We thank the Editor, Ramon Casadesus-Masanell, a Co-Editor and three anonymous refereesof this jour nal forinsightful and detailed comments. We are also

grateful to Leo Basso, Jan Brueckner, Achim Czerny,Tiziana D'Alfonso, Walter Ferrarese, Anming Zhang, and audiences in Amsterdam (Option Conference),

Barcelona (Jornadas de Economía Industrial and Meeting on Transport Economics and Infrastructure), Bolzano-Bozen (Free U. of Bozen), Hong Kong (Hong

Kong Polytechnic U.), Munich (EARIE Conference), Oslo (ITEA Conference), Pescara (U. di Chieti-Pescara), Reus (International Conference on Regional

Science, Trobada URV-UA, and INFER Annual Conference), Turin (Workshop NERI), and Valencia (Workshop ANAECO) forvery useful comments. The

usual disclaimers apply.

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from shopping at the airport. Indeed, according to Mintel, about 20% of British and German leisure travelers anticipate airport

shopping. Asian-pacific international travelers are also committed shoppers (Mintel, 2013). These are different from impulse

buyers.

Thus, in general, aeronautical and commercial revenues are interdependent. Landing fees generate aeronautical revenues but

also have a sizeable external effect on the airport retail activities by affecting the number of passengers making use of the

airport facilities. An increase in the landing fee may have a positive effect on the aeronautical revenues but, at the same time, a

countervailing negative effect on commercial revenuesdue to the reduction in t he number of passengers.On t he other hand, when

consumers anticipate airport shopping, commercial activities can attract flyers and, therefore, increase aeronautical revenues.

We propose a model to study the optimal strategy of an airport platform that can generate revenues both from traditional

aeronautical activities and from non-aviation (retail) activities. Should an airport use its market power to set high landing fees,

even though this may shrink the demand for commercial services? Should the airport allow for several concessions for similar

services, or should it instead limit within-airport competition by awarding few concessions, thus enhancing the revenues that

can be extracted from concessionaires? The answer must lie in unraveling the extent to which a better customer experience at

the terminal can enhance the demand for flight services.

Our model introduces three important contributions to the airport literature. First, we make explicit the one-way complemen-

tarity between the demand for air traveland retail products. Although this link is already present in other models, its role has not

been investigated in depth. In our setting, air services are bought by consumers as a primary product, while retail services play

the role of the secondary product, being demanded exclusively by those who consume the primary product. Second, we intro-

duce what we call the degree of consumer foresight, that is, the extent to which passengers anticipate, at the time of purchasing

their flight, the retail surplus they will obtain at the terminal. Third, our paper is the first to recognize the endogenous nature of

the retail market structure, which is determined by the airport.1

We derive the demand functions for air travel and retail services where the demand for air travel depends on the surplus that

the consumer anticipates to obtain from the consumption of the retail good. Then we perform a two-stage equilibrium analysis.

In the first stage, the airport sets the landing fee and chooses the number of retailers allowed to operate concessions. In the second

stage, retailers and airlines compete. Wefirst look at this problem in a general set-up in which we leave the modes of downstream

competition unspecified and impose minimal restrictions on consumer preferences; this analysis illustrates the general relevance

of our approach. We then turn to analyze a specific model to better illustrate the airport case.

Our main findings can be summarized as follows. In the presence of perfectly myopic consumers, the airport chooses the

minimum possible number of retailers and a landing charge lower than the standard monopoly charge. The airport exploits the

complementarity between aeronautical and retail activities by attracting more passengers to the terminal by setting low landing

fees. Maximum retail profits are extracted, with no impact on the ex ante demand for flights.

In the other extreme case with perfectly forward-looking consumers, the relative importance of the two revenue sources is

reversed. The airport chooses a very competitive retail sector, which expands the demand for air travel because consumers

anticipate the benefits they will receive from purchases at the terminal. Thus, the airport can charge higher landing fees and

makes most of its profits from the aeronautical business.

In the case of limited myopia, the result depends on the degree of product differentiation in the retail sector. When there is

little differentiation, strong retail competition makes the retail business less attractive to the airport, so that the airport prefers the

most concentrated retail structure, but it also raises the landing fee (as compared to the case with perfectly myopic consumers)

because some retail consumer surplus is now anticipated by air travelers. When differentiation is large,the air port instead prefers

not to derive profits from aeronautical services (thus setting landing fees to zero) and boosts the expected consumer surplus by

awarding a certain number of concessions to additional retailers.

In equilibrium, we find that the highest aggregate profits are obtained when consumers have perfect foresight. As illustrated

above, the balance of the airport's aeronautical and retail profits changes dramatically with the degree of consumer foresight.

Beyond airports: other platform settings

Although airports represent the motivation for our analysis of platform pricing, it is easy to think of other settings to which the

model could be applied, with suitable adaptations. In general terms, we consider an intermediary supplier that derives revenues

from a core good and a second strictly complementary good. We describe a situation where the core good is more “salient” in

the initial purchasing decision, compared to the side good's consumption that can be decided after the initial purchase. In the

case of airports, the core good is a flight, while the side good is some retail activity at the terminal; saliency here cor responds

to our notion of consumer foresight.

The platform cannot control directly the price of these two goods, but it can influence them. It affects the wholesale cost of

the primary good and the intensity of competition for the secondary good. If consumers' purchase of the core good is inelastic