Modeling airport capacity choice with real options

Abstract

This study analyzes optimal choice of the airport capacity to invest immediately (the prior capacity) and the size of real option to acquire for possible future expansion. Facing demand uncertainty, an airport first chooses its prior capacity and real option, and then later chooses its final capacity and airport charge once demand is observed. Our analytical results show that if demand uncertainty is low and capacity and real option costs are relatively high, an airport will not acquire a real option. Otherwise, an airport can use a real option to improve its expected profit or social welfare. Both the magnitude of profit or welfare gain and the optimal size of the real option increase with demand uncertainty. A higher real option cost leads to a larger prior capacity and smaller real option, whereas a higher capital cost leads to lower prior capacity. A profit-maximizing airport would choose a smaller prior capacity and real option than a welfare-maximizing airport. Competition in the airline market promotes airport capacity investments and the adoption of real options by profit-maximizing airports, whereas airport commercial services increase prior capacity but not real option.