List of Abbreviations
3 The basic framework
3.3 Scenario-building
3.3.2 Degree of competition
The need to build an ad hoc counterfactual scenario in investment appraisal is governed by the competitive conditions that characterise the market where the investment project takes place. The degree of competition ranges from a perfectly competitive market, where the number of competitors is or can be very large, to a natural monopoly, where there can be only a single viable producer. In between these two extremes there is a continuum array of possibilities of market conditions, for which industrial organisation (or in-dustrial economics) offers a number of generic models, such as duopoly, oli-gopoly, and monopolistic competition. These models are built from premises about issues such as barriers to entry, cost economies, synergies, and product differentiation, among others.12
It is very rare to find either perfectly competitive markets, where producers readily substitute each other at no cost to the consumer or to society, or natural monopolies that have no substitutes at all. Moreover, in practice there is always some degree of product differentiation, if only because of brand image. For investment appraisal purposes, the issue is one of judging the de-gree of competition in the market where the investment project takes place.
The key judgement to make is whether, in the absence of the project, there are other firms (existing or potential entrants) that would be able to supply the market at the same or very similar conditions as the promoter. If the answer is yes, the project can be considered to be carried out in competitive markets. In that case, there is no need to build an ad hoc counterfactual, since in the absence of the project, some competitor would supply the consumers other-wise supplied by the promoter, and do so at the same, or very similar, quality and price. In effect, the counterfactual is simply the opportunity cost of the resources invested in the project.
If instead the answer is no, then in the absence of the project the con-sumer is dependent on the conduct of the promoter. The concon-sumer has either no alternative supplier, or would experience switching costs to access the closest substitute, involving a loss of welfare. In such a case the analyst must make assumptions about what supply conditions the market would face should the promoter not carry out the project, meaning that the analyst must design an ad hoc counterfactual scenario. Building a counterfactual scenario would involve two critical dimensions: the actions assumed by the promoter should the project not be carried out; and the assumed capacity
available in the market from close substitutes should the project not be carried out. These two issues are treated in turn in the next two sections of this chapter: 3.3.3 and 3.3.4.
Table 3.2 summarises the generic competitive situations that the analyst is likely to find when appraising aviation projects. Whereas the table is self ex-planatory, three issues may merit further explanation. First, note that it does not really matter whether the underlying competitive structure resembles more a perfectly competitive market or an oligopoly. In either case, should the project not be carried out, the market will be supplied by another competitor.
In the case of perfect competition this would occur either through established players or through new entrants. In the case of oligopoly it would be by existing players expanding production.
The second issue follows from the first. The fact that under sufficiently competitive conditions substitutes are available in the primary market has implications also for the impact of the project on secondary markets, whether vertically or horizontally related. If it is assumed that without the project the same or a similar product would be supplied anyway, no effect on secondary markets can be unambiguously attributed to the project. As will be seen, this is particularly relevant for the aircraft manufacturing sector, which tends to be competitive. There, the output – namely, the aircraft – is operated in a (vertically related) secondary market – the airline market – which may be subject to distortions, such as externalities. It is legitimate to attribute such externalities in the secondary market to a project (which takes place in the primary market) if the project affects perceivably the conditions in the primary market, which in turn affects the conditions in the secondary market, leading to more externalities. For example, if an aircraft manufacturing project affects prices in the primary market, and hence affects the total number of aircraft sold, there will be more aircraft in operation and more external costs in the secondary market as a direct consequence of the project. But if the primary market is sufficiently competitive, so that in the absence of the project other aircraft makers would take up the production otherwise carried out by the project promoter, no changes can unambiguously be attributed to the project in the secondary market, including external costs.
Note that the issue refers to whether the project distinctively affects output (or prices) in the secondary market, an issue discussed in Chapter 2, section 2.7.3 This is a related issue to that of adjusting prices from secondary markets affecting directly the primary market, such as taxes on inputs to the project, discussed in Chapter 2, section 2.3.2.
Third, where the promoter has market power – meaning monopoly situations and, to a lesser extent, under monopolistic competition – refraining from carrying out investments may involve serious consequences to the local economy. For example, preventing a remote location from accommodating growing demand for air transport services by denying it additional airport capacity may disrupt the economic development of the region. This issue is discussed below in section 3.3.4, but it is worth highlighting at this stage that such scenarios are sometimes
Table 3.2 Competitive conditions and scenario-building in investment appraisal Degree of competition Key characteristics Instances in aviation Treatment in investment appraisal Perfect competition • Many competitors • Airlines in dense route between uncongested airports • No need to define ad hoc counterfactual • Many potential entrants and no barriers to entry • No product differentiation and no pricing power by any firm
• Inter-hub competition on intercontinental markets • Secondary markets remain unaffected by project • suppliers of standardised components in aeronautics • Lack of project has no wider consequences • Profitability kept at opportunity cost of capital Oligopoly • Few participating firms • Large airlines competing within a hub • No need to define ad hoc counterfactual • Little or no product differentiation • High entry barriers but incumbents keep each other in check • Manufacturers of ‘industry workhorse’ aircraft models • Secondary markets remain unaffected by project • Higher profitability than in perfectly competitive market • Airports on a multi-airport city • Lack of project has no wider consequences Monopolistic competition • Differentiated product gives company market power in market segment • Airline offering ‘low- cost’ services from a distant airport • Need to define ad hoc counterfactual • Secondary markets may be affected by project • Aircraft manufacturer on niche aircraft segment • Entry possible but may be costly • Continued lack of project may involve non-extreme wider consequences
• Company enjoys monopoly rents while there is no entry, although demand curve reflects competition from differentiated products
• Airports in nearby cities with overlapping catchment areas • ANSPs on alternative routes (Continued)
Table 3.2 (Continued) Degree of competition Key characteristics Instances in aviation Treatment in investment appraisal Monopoly • Only one firm in the market • Sole airport on remote island • Need to define ad hoc counterfactual • Competitive entry de facto impossible • Sole air service to remote location • Secondary markets may be affected by project • The firm sets price and quantity to maximise profit, unless subject to government regulation
• Approach or domestic ANSP • Continued lack of project may involve extreme assumptions
• ANSP serving large areas of oceanic airspace
erroneously used in situations where there is de facto competition, even if the facility at hand, say the local airport, may be perceived as a local monopoly. Many subsidised airports are better closed down than expanded (with subsidies) if there is adequate surface transport to alternative airports. Shutting down the airport may actually help the local economy by saving it unnecessary subsidies.
The same logic underlies the often used (and erroneous) arguments of impacts on the local economy as a justification for building local airports. If sufficiently good air services are available to airports in nearby cities, there is a good chance that the local airport (despite its apparent local monopoly posi-tion) will constitute a wasteful investment. Many of the benefits registered by the project would constitute transfers from the alternative, nearby facility. The key is to define well the competitive environment. The sole service provider in town may still be engaged in monopolistic competition with service pro-viders in neighbouring locations.13