Getting the price right

On the first day of college, the Dean addressed the students, pointing out some of the rules: “The female dormitory will be out-of-bounds for all male students, and the male dormitory to the female students. Anybody caught breaking this rule will be fined $20 the first time.”
He continued, “Anybody caught breaking this rule the second time will be fined $60. Being caught a third time will cost you a fine of $180. Are there any questions?”
At this point, a male student in the crowd inquired: “How much for a season pass?”
From: “School Jokes“, Wednesday, February 6, 2008

Can incentives make the skies friendlier?

For years, economists doing incentive-centered design have thought airport landing slots were a natural application. Indeed, one of the seminal research papers on “smart markets” (combining high-powered computation with incentives for resource allocation) was Rassenti, Stephen J., Vernon L. Smith, and Robert L. Bulfin (1982), “A Combinatorial Auction Mechanism for Airport Time Slot Allocation,” Bell Journal of Economics, 13, 402-417 (Smith later won the Nobel Prize for his pioneering work in experimental economics and market design). Economists have been advising the Federal Aviation Administration for the past several years on the design of auctions for landing slots at New York metropolitan area airports (JFK, La Guardia, Newark), and this spring the Dept. of Transportation announced it was implementing a scheme to auction a small number of slots at each airport.
Today, the N.Y. Port Authority announced it would block the use of auctioned slots. Opponents claim that the auctions would raise prices and not reduce delays. Supporters claim that creating a market for scarce slots would increase competition, which would keep prices down, and put the slots in the hands of airlines who at a given time have the busiest schedules, thus reducing delay. The opponents argue that the best solution is to spend money to modernize the air traffic control system and hire more controllers.

This battle over an incentive-centered design scheme highlights key issues in many market-based allocation schemes. It is quite typical for market opponents to argue we should simply increase supply: but without some sort of value-based mechanism to allocate supply, simple economics and lots of history show us that increasing supply will just lead to more overuse and continuing congestion. (See urban highway development; see the continued overload of Internet capacity.)
It is also common for market opponents to argue that creating a market will increase prices. This is rarely true for a well-designed market. By increasing the efficient use of the scarce resource, waste and cost should be reduced, and overall, assuming some degree of competition, prices tend to come down. In the case of landing slots, the slots that will charge high prices are presumably during peak times: airline prices are already higher then, and even if they do raise a bit, we should see prices during off-peak times fall as those who don’t get peak slots compete for passengers off-peak. Higher peak prices and lower off-peak is one of the oldest, and most effective ways to smooth demand over limited capacity, and leads to better use of an expensive facility (and lower overall costs to consumers).
I haven’t seen what DOT (or whoever would run the auctions) would do with the revenue. Fundamentally, though, this is not a cost: no resources are being used up by the auction (well, a few people to run them). The revenues could be transferred right back to the airline industry (say through reduced landing taxes) to keep the overall cost of running airlines the same.
I don’t know that the particular design of the slot auctions was good: that is, how much it would increase efficiency, what would be done with the revenues, whether they would be run with a lean team rather than a bulging bureaucracy. But the arguments that have been raised by opponents seem to be a mix of misunderstanding about resource allocation, and the anguished cries of those who have market power and control over existing slots that they might actually face more competition.