Transport Economics Course Companion - Quia...i The demand for transport is a derived demand. Travel is almost always, not demanded for Travel is almost always, not demanded for its

/transport economics course companion 2005 final • 12 Dec 04

Tutor2U ™ Transport Economics Course Companion 2005 Edition

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© Richard Young www.tutor2u.net

Table of Contents

INTRODUCTION................................................................................................................................................................................. 3

1 TRANSPORT, TRANSPORT TRENDS AND THE ECONOMY ...............................................................................................................4 What is transport? ........................................................................................................................................................ 4 Transport Infrastructure................................................................................................................................................. 6 Transport modes and modal characteristics........................................................................................................................ 7 Transport as a derived demand ........................................................................................................................................ 9 Recent trends in transport demand in the UK ..................................................................................................................... 9 The Use of Elasticity of Demand in Transport .....................................................................................................................11 Structure of Transport Operations in the UK ......................................................................................................................13 UK Transport Trends – Demand & Supply...........................................................................................................................14 Freight Transport.........................................................................................................................................................16 Forecasted demand and the economic basis of transport forecasts.........................................................................................18 The importance of the transport sector in the UK economy ...................................................................................................19 2 MARKET STRUCTURE & COMPETITIVE BEHAVIOUR IN TRANSPORT ............................................................................................ 21 An Overview of Firms & Industries ...................................................................................................................................21 Perfect & Imperfect Competition.....................................................................................................................................23 Marginal Product & Diminishing Returns ..........................................................................................................................23 Costs & Revenues.........................................................................................................................................................25 Economies of Scale ......................................................................................................................................................30 Short Run Revenues .....................................................................................................................................................32 Theory of the Firm Models in Transport.............................................................................................................................36 Imperfect Competition..................................................................................................................................................38 Price Discrimination in Imperfectly Competitive Transport Markets ........................................................................................43 The natural monopoly argument applied to transport..........................................................................................................46 Deregulation ..............................................................................................................................................................47 Bus Deregulation.........................................................................................................................................................48 Barriers to Entry ..........................................................................................................................................................52 Barriers to Entry ..........................................................................................................................................................53 Contestable Markets.....................................................................................................................................................53 How the transport industry in the UK has been privatised ....................................................................................................55 Privatisation of the UK’s railways ....................................................................................................................................58 3 RESOURCE ALLOCATION ISSUES IN TRANSPORT ........................................................................................................................61 Objectives of Transport Policy.........................................................................................................................................61 The Allocation of Resources – theory ...............................................................................................................................63 Integrated Transport ....................................................................................................................................................67 Private Sector Funding of Transport.................................................................................................................................67 Calculating Private, External & Social Costs.......................................................................................................................72 Calculating Private, External & Social Benefits...................................................................................................................74 Difficulties of Estimating Externalities .............................................................................................................................75 Cost Benefit Analysis ....................................................................................................................................................76 4 MARKET FAILURE: THE ROLE OF THE GOVERNMENT IN TRANSPORT ........................................................................................ 80 Market Failure – an overview ..........................................................................................................................................80 Marginal External & Social Cost & Benefit Curves................................................................................................................80 Transport Policies to Correct Market Failure.......................................................................................................................89 Taxation & Hypothecation .............................................................................................................................................90 Sustainability in transport.............................................................................................................................................94 Role of transport subsidy,..............................................................................................................................................97 Road Pricing ...............................................................................................................................................................98 Road pricing in transport policy elsewhere...................................................................................................................... 100


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Introduction

Welcome to this 2005 edition of the Economics of Transport. These notes will be of particular interest to students taking the OCR AS Economics Module 2885 but will also be useful for any introductory course in this area of economics

This Companion is designed as a complement to your studies and should not be regarded as a substitute for taking effective notes in your lessons. Points raised and issues covered in class analysis and discussion invariably go beyond the narrow confines of this guide.

Economics being the subject that it is, events and new economic policy debates will inevitably surface over the next twelve months that take you into new and exciting territory. Providing you understand many of the core concepts and ideas available to an economist, you will be in a good position to understand many of the new issues that arise and you will build an awareness of the problems in developing strategies and policies to combat some the main economic and social problems of our time.

Economics is a dynamic subject, the issues change from day to day and there is a wealth of comment and analysis in the broadsheet newspapers, magazines and journals that you can delve into. The more reading you manage on the main issues of the day the wider will be your appreciation of the theory and practice of economics.

Publisher Notice

Economics of Transport Course Companion 2005

Published by: Tutor2u Limited. 19 Westwood Way Boston Spa Wetherby West Yorkshire LS23 6DX

www.tutor2u.net

Online Learning Resource of the Year 2003 (BETT Awards)

1st Edition First published 12 December 2004

© Richard Young 2004. All rights reserved.

ISBN 1-84582-020-7

http://www.tutor2u.net/


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1 Transport, Transport Trends and the Economy

What is transport?

Economics in general studies the allocation of scarce resources between alternative uses. Transport economics analyses and evaluates the issues involved in the allocation of resources to move people and products between places.

Before beginning a detailed discussion of transport economics it is helpful to be aware of some specialist terms used in this branch of the subject.

Definition of Transport

Transport refers to the movement of people or products from one place to another. The word transport stems from the Latin trans (across) and portare (to carry). Americans call transport, transportation.

Types of Transport

There are two main types of transport depending on what is being moved from place to place:

i Economists refer to the movement of people over a distance as passenger transport and is measured either in terms of passenger kilometres travelled or number of journeys

i Te movement of raw materials, components or finished products between A and B is called freight transport and is measured either in terms of tonne kilometres travelled or number of journeys.

Transport Modes

There is almost always more than one method or mode of getting from A to B. A transport mode is simply a means of moving passengers or freight from A to B and is categorised as road, rail (including underground), sea, inland waterway eg canals and pipelines

Road transport can be by car, lorry, van, taxi, bus, coach, motorcycle bicycle or even walking

Public & Private Transport

Economists distinguish between private & public transport.

i Public transport is usually associated with mass transport ie moving large numbers of people by rail, coach or bus

i Private transport is usually taken to mean transport involving individuals or small groups such as families or firms by car, taxi, lorry etc that is not open to members of the general public.

Making decision about which mode of transport is best for a user is called transport operations.


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Characteristics of Transport

Transport has a number of characteristics that make it an atypical product:

i The demand for transport is a derived demand. Travel is almost always, not demanded for its own sake but to meet some other purpose eg move products to markets (distribution) or to enable commuting

i As a service, transport is perishable and cannot be stored. It is consumed immediately.

i Transport is generally an intermediate output ie just one stage in the process of creating final products

i Transport has a distance and a time dimension. All trips are:

o made over a particular distance,

o between start and end destinations,

o and for a given duration of time

o at different times of the day (peak and off peak) or during at different seasons eg summer or winter

Transport generates externalities causing market failure because the price of transport does not always reflect the full social cost to society. Eg a transatlantic aircraft generate significant negative externalities such as noise, pollution and congestion not paid for by travellers

Many journeys are indivisible. A journey by car is for 1 or 4 passengers; a bus can carry 1 or 50 passengers on the same journey. Once a train is running, 1 or a 1,000 passengers can be carried.

Loading & Peaking

Loading refers to the percentage of capacity utilised in a journey. Eg a loading factor of 80% means 20% of seats or space is unused in a given journey.

Peaking occurs when demand exceeds supply on a given network at a given period in time causing congestion eg rush hours & bank holidays. Congestion is when demand exceeds supply on a given network at a given period in time eg bank holiday on holiday routes.

This image was used in an advert in the USA to promote the purchase of cars by taking out a loan – what does it imply about consumers who elect to use public transport?

Perceptions of Public Transport


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Transport Infrastructure

The term infrastructure is surprisingly abstract and difficult to understand. Infrastructure is the stock of overhead capital used to support the economic system. Infrastructure enables economic activity, for example - in another context - the underlying network of cables and satellites allows advanced telecommunications.

Transport infrastructure facilitates the movement of goods and people. There are two categories of transport infrastructure:

i The transport network made up roads, railways, canals & pipes, air traffic control, etc

i Transport nodes or terminals where journeys begin or end eg airports, bus stations, docks and railway stations

Why is infrastructure important? Infrastructure affects the cost of travel and so influence travel patterns and traffic volumes; patterns of land use; the operation of labour markets; and the location and organisation of business.

A better transport system

i Improves the mobility of labour: workers can live many miles from work and commute

i Creates significant positive externalities and can be an initial stimulus to regional economic development. For example roads open up market and employment opportunities, to the benefit of third parties such as local businesses and workers.

i Improves UK competitiveness: efficient transport systems minimise travel times and so lower domestic unit costs

The cost of transporting freight by road in Britain is far higher than elsewhere in Europe or America. Despite doubling its motorway network during the past 30 years, the UK has Europe's busiest roads. France increased its roads by 400% during the same period. Transport has been a thorn in the side of the UK economy for too long CBI

Infrastructure is built up overtime by investment. A country’s current infrastructure is dependent on the level of previous investment in the roads & rail networks, airports & docks. Improvements over time in infrastructure require net investment ie additions to infrastructure over and above that necessary to replace worn out networks or nodes.

The UK's transport infrastructure is a mess. Nationalised in the post-war era, it suffered from years of under-investment under successive governments. The present Labour government has struggled with the Thatcher legacy and there is now a level of investment in transport infrastructure that has not been seen since World War II. However it may take decades before public transport services achieve the level of quality many of our European neighbours enjoy. Source: Eurolegal Services

Improving the infrastructure involves significant lead times: transport projects takes 5-30 years to plan and build eg rail or underground

A key issue to improving transport networks is funding - investment in infrastructure requires significant investment by the owner measured in billions of pounds.


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The government faces a real challenge channelling sufficient investment into infrastructure to make good past underinvestment. Funds must be borrowed, raised in tax or secured from the private sector eg through the Public Funding Initiative.

Modernisation of the 401-mile rail route between London and Glasgow, serving Birmingham, Liverpool and Manchester, is the largest project undertaken by Railtrack –and its successor Network Rail. The original cost estimate for the project of £2.5 billion has gradually risen towards £10 billion. The main constraint of the West Coast line is the lack of capacity imposed by outdated track layouts and signalling systems. It also crosses challenging terrain in its northern half and is hemmed-in by roads and buildings at its southern end. Source: Network Rail

Infrastructure owned by the private sector eg, the rail network, may receive a subsidy to build new track or signals

Transport modes and modal characteristics

Transport modes refer to the various methods of transferring passengers and freight from one destination to another.

Competitiveness with the Car: Despite the improvements brought by new low floor vehicles, buses are generally becoming less competitive with the car:

• car ownership is becoming more affordable as costs fall relative to disposable income • buses are often unreliable because of congestion (whereas this is not seen in the same way when

delayed in a car) • fundamental economic factors are pushing up bus operating costs ahead of the rate of inflation,

particularly labour and the costs of congestion (including the need to add resources in order to maintain a reliable service), leading to higher fares and fewer services

Source: Public Subsidy for the Bus Industry Commission for Integrated Transport (CfIT) Dec 2002

The main transport modes are road, rail, sea, air and pipelines. In deciding between alternative modes passengers take account of distance, speed, urgency of the journey, capacity (can 6 people fit into our car?) and the relative cost of using, say, road or rail. Convenience, reliability, the extent of the network and risk of delay or accident are additional factors.

Freight users also take into the nature of the product. Perishable items are not sent by waterways over long distances. Low value bulky items are not transported by air.

Each mode of transport has certain characteristics which result in advantages and disadvantages for moving people and freight


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Characteristics of transport mode for passengers

Mode Advantages Disadvantages Cars gives individuals and small groups independence and flexibility within an extensive road network

Cause significant negative externalities eg noise, pollution and congestion

Demand exceeds supply at peak times

Road eg cars & buses

Buses which are full make good use of congested urban roads

Inflexible timetables with limited off peak services

Rail train and underground

Better for transporting commuters into major cities. Faster over long distances (100 miles +) than cars

High fixed costs; limited network; rural lines require a subsidy

Air Fast and appropriate for intercontinental journeys

Generates significant negative externalities eg noise, pollution

Characteristics of transport mode for freight

Mode Advantages Disadvantages Road eg lorries Highly appropriate for short

journeys with small loads

Extensive road network

Higher negative externalities per kilometre travelled than a car

Rail train Low marginal cost of travel. Appropriate for transporting commuters into major cities

High fixed costs. Natural monopoly

Waterways canals & rivers

Slow but appropriate for heavy bulky cargo eg coal

Slow and a limited network

Air Used in urgent high value products eg flowers

Generates significant negative externalities eg noise, pollution

Sea Used for moving non urgent high volume freight between continents

Slow

Pipelines Low variable costs High initial investment

Natural monopoly


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Transport as a derived demand

With the exception of a holiday on a canal or luxury liner, transport is not usually demanded for its own sake but to help meet some other purpose. The demand for transport is said to be a derived demand stemming from the need to transfer people or products from one place to another.

In short, the demand for transport is derived (got from) from the demand for what travelling makes possible eg commuting to work, shopping trips holiday visits and the need for firms to move goods and raw materials between locations.

Reasons for Travel

… almost all demand for transport arises in connection to economic activities, that is, in order to take things from where they are produced to where they are consumed. Shopping trips arise in order to get consumers to where produced goods are available. Trips to work arise in order to get employees ("produced" by households) to employment ("consumed" by employers). Because the demand for transport is derived directly from economic activity there is no time lag in the response to changes: changes in economic relationships cause more or less instant changes in the demand for transport.

Source: Uusimaa Regional Council

Recent trends in transport demand in the UK

The demand for transport has risen steadily over the past half century, with road the dominant mode in both passenger and freight.

One consequence of the demand for labour being derived is that it results in different levels of demand depending on the time of day or season of the year. This is known as peaking.

Peaking – high demand during rush hours

The demand for travel can be graphed like any product. Note that the cost to the motorist is the ‘price’ of a journey. The cost of the journey takes into account the petrol costs, time and other factors such as the risk of delay – expressed in money terms.

The quantity demanded is measured here by the number of passenger vehicles travelling a route per time period eg per hour. An alternative measure used in Dept of Transport statistics is the number of billion passenger kilometres travelled per time period.


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Demand for the same journey varies according to the time of day.

i Off peak travel takes place outside of the ,rush hour’ immediately before the start and after the end of work hours

i Peak time refers to hours immediately before the start and after the end of work hours when most workers commute (rush hour) and is when the demand for transport is at its highest. Peaking and congestion result.

Peaking occurs when demand exceeds supply on a given network at a given period in time causing congestion eg rush hours & bank holidays

Congestion is when demand exceeds supply on a given network at a given period in time eg bank holiday on holiday routes

Peak & Off Peak Demand

Peak & Off Peak Demand

£-

£1

£2

£3

£4

£5

£6

£7

£8

£9

0 10 20 30 40 50 60 70 80 90 100

passenger vehicles

Cos

t of j

ourn

ey

Peak demand Off Peak demand

D peak

D off peak

Note that the peak time demand curve, D Peak, is

1. further to the right and

2. more prince inelastic than the off peak demand curve

Why? Peak and off peak travel are weak substitutes and so have a low positive cross elasticity of demand value. Where consumers have to be at work by 09 00, off peak travel is not an alternative – commuters have to travel at peak time not matter what the cost.


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The Use of Elasticity of Demand in Transport

Elasticity measures sensitivity or responsiveness specifically how one variable responds to a change in a second variable.

i Inelastic means unresponsive, ie a change in one variable results in a smaller change in a second

i Elastic means responsive, ie a change in one variable results in a bigger change in a second

Elasticity is a key quantitative tool in microeconomics that is used extensively to assess and predict the effect of a change in one variable eg price, on a second variable eg number or quantity of journeys demanded. In short, elasticity quantifies changes.

Transport operators take account of several types of elasticity in planning price and predicting output

Price Elasticity of Demand

Price elasticity of demand measures the responsiveness of demand to a given change in price. Firms can use price elasticity of demand (PED) estimates in transport to predict:

i The effect of a change in fares on quantity demanded

i The effect of a change in fares on total revenue & expenditure

i The effect of a change in indirect tax eg road charging or fuel duty on price and quantity demanded

i The effects of price discrimination in peak/off peak. Price discrimination is where a monopolist charges different prices for the same product to different segments of the market eg peak and off peak rail travel

Using the data used in the last diagram to plot the peak and off peak demand for a given road journey, the following table calculates the price elasticities for each demand curve as price falls by £1.00

Peak time travel & PED

Cost per journey £ 8.00 £7.00 £6.00 £5.00 £4.00 £

3.00

Peak demand 70 75 80 85 90 95

PED -

0.47 -

0.38 -0.29 -0.22 -0.16

Off peak travel & PED

Cost per journey £8.00 £7.00 £6.00 £ 5.00 £4.00 £

3.00

Off Peak demand 10 12 25 40 60 92

PED -1.17 -3.12 -1.88 -1.33 -1.04

Note that PED for a journey is inelastic for peak and elastic at off peak times


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Income Elasticity of Demand

Income elasticity of demand (YED) measures the responsiveness of demand to a given change in income. Governments and firms use YED estimates to predict impact on demand and revenues of:

i Economic growth: the demand for luxury items such as air travel (high positive YED) increases proportionately more than products with a low YED such as bus travel

i The business cycle: fluctuations in the demand for transport can be estimated

Road rail and air travel have high positive income elasticity of demand (YED). Economic growth is resulting in a proportionately greater increase in the use of these modes of transport. Economic growth raises incomes. Given the high positive YED for cars, a given economic growth rate results in a proportionately larger increase in car usage.

Note increased car usage is a result of increased prosperity and the preferences of consumers and unsustainable because of resultant congestion and environmental impacts from pollution Buses exhibit low, even negative YED, and are mainly used by low income consumers

Cross Elasticity of Demand

Cross elasticity of demand measures the responsiveness of demand for good A to a given change in price of good B

Firms use cross elasticity of demand (XED) estimates to predict the impact of a rival’s pricing strategies on demand for their own products. If a competitor cuts the price of a rival service, firms use XED to predict the effect on the quantity demanded and total revenue of their own product.

Note in the Car Elasticities Table that: 1) Elasticities are an estimate 2) The estimates are within a range

Table: Car Elasticities

Variable With respect to

Short run Long run

Petrol consumption

Petrol price -0.3 -0.6 to –0.8

Car traffic Petrol price -0.15 -0.3

Petrol consumption

Income 0.35 to 0.55 1.1 to 1.3

Car traffic Income 1.1 to 1.8

Source: Glaister and Graham (2000)

Road & public transport are weak substitutes for commuters given low, positive, cross elasticity value

Elasticities of Transport Modes


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Structure of Transport Operations in the UK

Making decision about which mode of transport is best for a user is called transport operations. Transport operations decisions have both a demand and supply side

Demand: consumers or firms must considering a journey must decide on the most appropriate mode. Do I make a journey? Do I make a journey now, during the rush hour, or later when the transport system is less busy? What mode shall I use, car or train? Which is best? How to decide which is best? How do I maximise my economic welfare?

The main demand side factors taken into account in making transport decisions include cost, journey time, distance, and flexibility

Supply: firms make decisions about what type of transport mode to provide. Once in a transport market the firm must decide about which services to offer. For example, does a bus company offer a route from an outlying village 15 miles from the city centre or not? If so, how often should it run the service – every 15 minutes or twice a day? Which decision is most likely to meet the objectives of the firm eg maximise profits?

Adapted from the Guardian Future of rural rail routes is on the line Nov 2004

Poor passenger take-up and the cost of maintaining infrastructure at a cost of £100,000 a mile each year mean each passenger on a rural line costs the taxpayer £8 a journey, compared with £2.60 for each journey nationally.

The community rail development strategy, aims to save the "sleeping beauties" of Britain's railways, which account for about 10.5% of the 1,154-mile national network but receive a disproportionate £300m a year out of a total £2.6bn government subsidy.

Alastair Darling launched a review of rural rail services in an effort to help Britain's least-used lines pay their way by stating “we can't be in the business of carting fresh air around the country…There does come a point where, if a line is not working, it is not carrying people and its costs are not coming down, then of course you've got to look at that.


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UK Transport Trends – Demand & Supply

There has been a 182% increase in the demand for transport since 1960. This is a consequence of economic growth over the period – people use higher real incomes to make more journeys and because of the changing pattern of economic activity. For example:

i Consumers: People choose to live further away from work and commute; Out of town shopping centres encourage more travel; Parents are less willing to let children walk to school; Holiday makers take long distance trips or take advantage of low cost short haul flights

i Firms: Improved transport and communications allows production and consumption take place in different locations, sometimes the other side of the world - globalisation

Statistics on travel are supplied by The Department of Transport which publishes two main commentaries on UK traffic statistics each year

i Transport Statistics for Great Britain published annually in October

i Transport trends published annually in December

The following tables and summaries are extracted from the latest editions of the above.

Passenger Travel

i Road is the dominant mode for all journeys of more than one mile and its share of journeys of all lengths is increasing. Cars are used predominately by high income groups and three in ten homes in Britain don't have a car (13 million people)

i Buses are used predominately by low income groups eg pensioners. Buses are perceived as a poor substitute for other modes of transport and exhibit a low, even negative, income elasticity of demand. Billion passenger kilometres have decline slightly since 1980 – except in London – while bus fares have risen in real terms

i Rail is used predominately by high-income passengers.

Passenger travel by mode: car and other modes

billion passenger kilometres

Car, van, taxi

Bus & coach

Motor cycle Bicycle All Road Rail Air Total

1960 139 79 11 12 241 40 0.8 282

1970 297 60 4 4 365 36 2 403

1980 388 52 8 5 453 35 3 491

1990 588 46 6 5 645 40 5.2 690

2000 639 47 5 4 695 47 7.6 750

2003 678 47 6 5 736 49 9.1 794

http://www.dft.gov.uk/stellent/groups/dft_transstats/documents/page/dft_transstats_031999.hcsp

http://www.dft.gov.uk/stellent/groups/dft_control/documents/contentservertemplate/dft_index.hcst?n=7545&l=2


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Use of the car has increased as disposable income has risen, with little change in the real cost of motoring but a rising real cost of public transport

Total passenger distance travelled increased by 62% between 1980 and 2003, from 491 to 794 billion passenger kilometres.

% change since 1980

Passenger 62%

Car 75%

Rail 40%

Air 203%

Coach -10%

The majority of the growth has been in travel by car, up from 388 billion passenger kilometres in 1980 to 678 billion in 2003 - an increase of 75%.

There were increases in travel by rail and domestic air, of 40% and 203% respectively. Distance travelled by bus and coach has fallen by 10% over the same period.

Dept of Transport on: roads, vehicles and congestion

Road traffic has grown by 77 per cent since 1980, although since 1990 at a lower rate than in the previous decade. Many factors have affected traffic levels, including increasing car ownership and numbers of drivers, falls in car occupancy levels, fuel price changes and varying levels of expenditure on roads, both capital and current. Over 25% of households now have two plus cars.

Passenger Travel By Mode

0

100

200

300

400

500

600

700

800

900

1955 1965 1975 1985 1995 2005

Bill

ion

Pass

enge

r kilo

met

res

Car, van, taxiBus & coach

Rail

All Modes


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Dept of Transport on: public transport

Bus patronage has declined, except in London, although at a slower rate in the 1990s than in the previous decade. Bus operators are now investing in newer vehicles, and passenger satisfaction is generally high, although buses tend to have a poorer image among non-users and infrequent users. Rail travel has increased by 38 per cent since the mid 1990s, and continues to rise despite the effects of the Hatfield crash in October 2000. Investment in national rail infrastructure has increased significantly since privatisation.

Changes in the real cost of transport and in income

0

50

100

150

200

250

1975 1980 1985 1990 1995 2000 2005

Inde

x 19

80=1

00 Disposable income

All motoringRail fares

Bus & coach fares

Freight transport by mode: goods moved billion tonne kilometres

Road Rail Water Pipeline All Modes 1980 93 18 54 10 175 1985 103 15 58 11 187 1990 136 16 56 11 219 1995 150 13 53 11 227 2000 158 18 67 11 254 2003 159 19 67 10 255

Freight Transport

Total freight moved in tonne kilometres (weight of load multiplied by distance moved) has increased by 46% since 1980.

The majority of the increase is by goods moved by road, up by 71 per cent since 1980. Road freight now accounts for 62 per cent of all goods moved compared with 53 per cent in 1980.


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Since 1980, there has been an increase in freight moved by water, from 54 to 67 billion tonne kilometres – a 24% increase. Water’s share of all goods moved is now 26%. Goods moved by rail declined slightly in the mid-1990s, but has since risen to reach nearly 20 billion tonne kilometres.

Freight transport by mode: goods moved

0

50

100

150

200

250

300

1980 1985 1990 1995 2000 2005

billi

on to

nne

kilo

met

res

Road

Rail

WaterPipeline

All Modes

Rail freight now accounts for 7% of all goods moved, compared with 10% in 1980. Freight moved by pipeline has remained fairly stable over the last twenty years, at around 11 billion tonne kilometres. Its share of goods moved is now 4 per cent, a fall from 1980 when it was 6 per cent

Change since 1980

Road 71%

Rail 6%

Water 24%

Total 46%

Dept of Transport on Freight

Total freight moved in tonne kilometres (weight of load multiplied by distance moved) has increased by 45 per cent since 1980.The tonnage of goods lifted has changed little since the late 1980s. Heavy goods vehicle tonne kilometres and vehicle kilometres have grown more slowly than GDP since 1990. The average length of haul for goods moved by road has increased by nearly 40 per cent since 1980.


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Forecasted demand and the economic basis of transport forecasts

A forecast is an estimate of what is judged likely to occur in the future. Government transport forecasts are undertaken in the UK by the Department for Transport.

Forecasts are based on assumptions eg expected economic confidence, predicted disposal income, likely oil prices and used by government to estimate the future demand & supply of travel by mode.

If demand is predicted to exceed supply the government can take action to increase capacity or reduce demand.

Model building requires accurate data and establishing predicted economic relationships to use in making predictions. Faulty data or inaccurate predicted links between key variables renders the predictions of models meaningless – garbage in means garbage out

Dept of Transport on Air Traffic Forecasts

Forecasts are based on econometric equations, which specify a relationship between passenger traffic and a number of explanatory variables, which determine it, using data from the early 1960s to 1998. The key variables determining air traffic were found to be domestic and foreign economic growth (principally GDP); air fares; trade and exchange rates. Source: Dept for Transport Air traffic forecasts for the United Kingdom.

For example if the model is built assuming income elasticity of demand for air transport is 2, and an economic growth rate of 2.5%, then the predicted annual increase air travel is 5%. What if the growth rate exceeds expectations at 3% or consumer behaviour changes and income elasticity of demand for air transport rises to 3? Demand exceeds forecasts and there may be insufficient infrastructure in place to handle the unexpectedly high level of demand.

There are three main sources of uncertainty in transport forecasts:

i The future path and values of the variables used in a model (eg GDP or oil price) may diverge from predicted values

i The specification and stability of statistical relationships used in the model may change over time

i A model may leave out of factors that do not currently affect consumer behaviour but may in future be important determinants of transport demand eg Eurotunnel predictions did not take into account the advent of low cost air flights between London and Paris

Remember: relationships based on past trends and patterns of consumer behaviour may not always be accurate for predicting behaviour in the future. Consumer tastes change and markets go through life cycle phases. Eg is air transport a growing or mature market?


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Range of forecasts

Note in the figures opposite, issued by the Department for Transport in 2004, that there is a wide projected range of future trends.

The further into the future the wider the potential upper and lower limits – and the potential for error.

Infrastructure investment projects can take 15 – 20 yeas to plan, review and build – by which time original forecasts may prove to be significant over or under estimates

Source Department of Transport 2004

The importance of the transport sector in the UK economy

One measure of the importance of transport is the sector’s contribution to overall GDP. The transport sector accounts for around 15% of UK economic activity measured in terms of GDP.

Transport systems help overcome the effects of distance and increase the size of the market by enabling regionally produced goods to be sold nationally or exported around the world.

The resultant large scale production with associated economies of scale reduces unit costs and prices, the generate additional benefits from economic integration


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Is transport a cause or effect of economic growth?

The correlation between road traffic growth and economic growth since 1945 is seen as evidence of a close link between transport and the economy. But this does not help clarify the direction of cause and effect - whether increased movement is a sign of economic growth stimulated by other factors; whether traffic growth, facilitated by transport improvements, itself stimulates economic activity; or whether there is some iteration of the two.

Source: Transport and the economy (SACTRA)


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2 Market Structure & Competitive Behaviour in Transport

In this chapter traditional economic theories of the firm and market failure are applied to the specific context of transport. The emphasis throughout is on the use of theory to analyse and evaluate the behaviour of industries and firms - not on theory alone.

However, economics models must first be understood before it can be applied. Before beginning an analysis of specific transport markets, a short detour is made and the following AS topics are revisited and developed to A2 standard.

i An overview of how firms, industries, market structures and competitive behaviour interact - the ‘big picture’

i Short run costs & revenues, setting profit maximising levels of output. Make sure you can use graphs to predict the short and long run behaviour of firms

i Economies of scale and the factors that give rise to long reductions in unit costs, as firms use more fixed and variable factors to increase their size of operation

Efficiency considerations and the implications of different market structures for resource allocation are left to Chapter 3.

An Overview of Firms & Industries

In capitalist economies, goods and services (products) are produced by firms hiring resources. A firm (or entrepreneur) takes a risk by employing land labour and capital to produce and sell goods and services in a market.

Why take a risk hiring resources – products may not sell? The entrepreneur’s reward for risking funds and marketing output is profit. Profit is the difference between revenue (money from the sale of output) and costs (money spent on inputs)

Taxi Example 1: Roberta starts her own taxi firm serving the local market. This involves raising funds to buy & insure a car and other expenses such as running costs. But why is she taking a risk? If her firm is a success and fares more than cover costs a profit is made.

A firm does not exist in isolation. There are other firms in the industry who are also making a similar or identical product. Even a monopolist, which is the only firm in an industry, has to take account of the possibility of a new competitor entering their market


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Market Structure & Competitive Behaviour

Firms make products. An industry is made up of all the firms selling a particular product in a given market. Industries are classified according to its market structure ie the number and type of firms and the degree of competition that exists.

Competitive behaviour refers to the ability of firms to compete with each other. Are new firms free to enter an industry or are there barriers to entry? Are firms able to set their own price or are they price takers? Do businesses have little or significant market power?

Barriers to entry refer to the ability of a firm to enter or leave an industry. Low barriers to entry into the market means potential entrants can enter a market easily. Minimal barriers to entry into the market means potential entrants are able to enter market quickly if abnormal profits are made. This process helps ensure normal profits only, are earned in competitive industries in the long run.

Taxi Example 2: What is to stop other entrepreneurs entering the taxi market if large profits are on offer? If more taxi firms can enter the market, then fares are likely to fall. Indeed if too many taxis are plying for trade then insufficient revenues are earned and losses mount, forcing the least efficient owners to consider their future in the taxi industry.

Given so many competitors Roberta is unable to influence the fare she charges – she is a price taker. If fares are set too high potential passengers chose other taxi firms.

But what if the taxi market is regulated by government and a limited number of licences are issued. Any abnormal profits are protected - new drivers need a licence

D (Qd) Q2

K

P1

Q1

Effect of new suppliers on price & consumer surplus S

L

0

P2 M

Here new entrants cause an increase in supply and an outward shift of the supply curve to S1.

The fall in price and leads to an expansion of demand.

Note consumer surplus increases by P1 L M P2

pric

epe

runi

t(P)

S1


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Perfect & Imperfect Competition

Markets are said to be either perfectly competitive or imperfectly competitive:

i A perfectly competitive industry is made up of a large number of small independent firms, each selling homogeneous (identical) products to a large number of buyers. No individual customer receives preferential treatment. There are no barriers to entry or exit from the industry. Few if any industries are perfectly competitive but this theoretical model is useful as a benchmark against which to judge the behaviour of imperfectly competitive firms.

i Imperfect competition occurs where any of the conditions of perfect competition are not met eg firms produce differentiated products. Imperfectly competitive firms rarely compete on price for fear of a price war. For example bus companies competing on the same route may vie with each other by offering more frequent services or better onboard facilities

Types of industry Nos of firms

Product differentiation

Barriers to entry

Abnormal profits

Example

Perfect competition

Many None None No Taxis in same firm

Monopolistic competition

Many Minimal None No Taxi firm

Oligopoly Few Yes Significant Yes Airlines eg Ryan Air

Pure monopoly One Only one! Significant Yes Network Rail

Market Power

Market power refers to the ability of a firm to influence or control the terms and condition on which goods are bought and sold. Monopolies can influence price by varying their output because consumers have limited choice of rival products.

Product differentiation is the degree to which consumers distinguish between rival firms’ products and is a method by which firms use branding and advertising to acquire market power.

One measure of market power is concentration ratio that measures the proportion of an industry's output accounted for by the five largest firms and is an indicator of market power A concentration ratio of 0.9 means 5 largest firms produce 90% of an industry’s output

The spectrum of competition ranges from perfectly competitive markets where there are many sellers who are price takers to a pure monopoly where one single supplier dominates an industry and sets price

Marginal Product & Diminishing Returns

Having given an overview of how markets are defined and categorised, the next step is to revisit the concepts of cost, revenue and profit.

Assume for simplicity that output depends on the quantity of just two resources employed: labour and capital. Firms decide the level of output to produce in a given time period by varying these two factors. However their behaviour is constrained by time:


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• In the long run, ie future time periods, production levels can be increased by using more of both capital and labour

• In the short run – the current time period of about a month - a firm’s capital stock is fixed because the firm cannot install more machines. This means the only way to increase output in this time period is to hire more workers

Worked example: output in a Bicycle Factory

Assume a small factory making bicycles. The firm has five workers and can employ between 1 and 7 workers. In the short run, firms increase output by adding extra units of labour to a fixed amount of capital. The addition to output made by each extra worker is called marginal product of labour. Marginal means the extra one and is a key concept in economics

The resulting output from different employment levels for five machines is shown below:

Short Run Output of a Bicycle Factory

Labour (L)

Capital (K)

Output (Q)

Marginal Product of labour Commentary

0 5 0 n/a

1 5 20 20 Here 1 worker has to use all five machines

2 5 50 30

3 5 90 40 3 workers apply the division of labour principle

4 5 140 50

5 5 200 60

6 5 220 20 6 workers: 5 machines: delays in access reduce MP

7 5 210 -10 the 7th worker is getting in the way!

The entrepreneur notes that

i initially each extra worker is adding more to total product than their predecessor

i Increasing returns occur when marginal product is rising

i However, eventually the addition to total product made by the extra worker is less than the previous worker

Decreasing returns occur when marginal product is falling

Economists talk of the law of diminishing returns that states that as extra units of a variable factor (eg labour) are added to a given amount of a fixed factor (eg capital), the marginal product of the variable factor eventually falls.

Diminishing returns set in the above example with the employment of the 6th worker. Remember column 3, Output (Q) shows total output from employing 1, then , 2 then 3 etc workers ie total product. Column 4 simply shows what the extra worker added following their employment ie marginal product.

It is now time to convert product data into cost data


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Costs & Revenues

Costs

A cost is an expenditure incurred by a firm in producing a good or a service. Economists distinguish between short run fixed costs and variable costs:

Cost Type Description Formulae

Total Costs (TC) refer to the amount of money spent by a firm on producing a given level of output and is made up of fixed costs (FC) and

variable costs (VC)

TC = FC + VC

Variable costs (VC) depend on the level of output. If just one more unit is made then total variable costs rise. Variable costs include weekly

wages paid to the shop floor workers, raw materials and components.

VC = TC - FC

Fixed costs (FC) Fixed costs are totally independent of output and have to be paid out even if the factory stops production. Fixed costs

include monthly salaries for managers, rent paid for the use of premises & interest paid on loans.

FC = TC - VC

Average cost (AC) or unit cost is the cost of producing one item and is calculated by dividing total costs (TC) by total output (Q)

AC = TC/Q

Marginal cost (MC) is the cost of producing one extra unit and is calculated by dividing the change in ( ) total costs ( TC) by the change

in output ( Q)

MC = TC/ Q


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Worked example: costs at the Bicycle Factory

Let us make this as simple as possible. The firm only has two cost items: capital and labour. Given this simplifying assumption its only variable cost is labour. Its only fixed cost is capital.

Now assume

i each machine costs the firm £200 to run each month in interest charges

i each worker earns £100 a month

Costs at the Bicycle Factory

Labour (L)

Capital (K)

Output (Q)

Marginal Product of labour

Fixed Costs (FC)

Variable costs (VC)

Total Costs (TC)

Marginal Cost (MC)

Average Cost (AC)

0 5 0 n/a £1,000 £0 £1,000 n/a

1 5 20 20 £1,000 £100 £1,100 £5.00 £55.00

2 5 50 30 £1,000 £200 £1,200 £3.33 £24.00

3 5 90 40 £1,000 £300 £1,300 £2.50 £14.44

4 5 140 50 £1,000 £400 £1,400 £2.00 £10.00

5 5 200 60 £1,000 £500 £1,500 £1.67 £7.50

6 5 220 20 £1,000 £600 £1,600 £5.00 £7.27

7 5 210 -10 £1,000 £700 £1,700 £10.00 £8.10


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Short Run Cost Curves

To increase output in the short run the firm hires more labour to work with a fixed capital. Now the interesting thing is that each extra worker receives an identical wage but is adding less than their predecessor. It follows that beyond the point of diminishing returns (Q1) MC rise.

Plotting marginal and average cost against output yields the traditionally shaped ‘upside down umbrella’ shape marginal and average cost curve.

Cos

t (£)

MC

Note the MC intersects the AC curve at the lowest point of the AC curve

Extra units of labour raise marginal product ie increasing returns

Extra units of labour reduce marginal product ie decreasing returns

Q1 is the point of diminishing returns after which marginal product rises and so marginal costs rise

ACAC

Level of output (Q)

It may seem that all the above is irrelevant theory. In fact an understanding of cost curves, the underlying reasoning for their shape and position is necessary for a complete understanding of firm’s decision making.


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Deriving the Firm’s Supply Curve from its Marginal Cost Curve

MC = S

Cos

t (£)

Note that the firm uses its MC curve to decide how much of a product to make at different prices

To produce Q1 the firm must receive P1

To increase output to Q2 it must receive a higher price - P2

If price rises to P3 the firm is willing and able to sell Q3

In short, the firm's supply curve is its marginal cost curve

The upward shape of the supply curve is determined by the law of diminishing returns

P3

P2

P1

Q1 Q2 Q3

Level of output (Q)


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Long Run Cost Curves

Firms increase output by using more resources. In the short run, the only factor that can be increased is labour. Adding more labour to a fixed amount of capital results in diminishing returns, consequentially the marginal cost of creating extra units rises. Hence the shape of the supply curve.

However, in the long run firms can increase the amount of capital employed. Returning to the example of Roberta the entrepreneur mini cab driver, what happens to unit cots if another taxi is purchased? There are three potential outcomes:

SAC 2 taxis

LAC

Output

Constant Economies of Scale

If unit costs are identical after buying the second taxi then the new SAC curve shifts horizontally to the right. The long run average cost curve (LAC) is horizontal

Capacity has doubled and twice as many journeys can be offered but unit costs remain constant eg it still costs, say 50p per mile to operate a cab

SAC 1 taxi

Cost

s£

SAC 2 taxis

SAC 1 taxi

LAC

Output

Economies of Scale If unit costs fall with the introduction of second taxi then the new SAC curve shifts downwards and to the right.

Capacity has doubled but unit costs have fallen eg it now costs, say 40p per mile to operate a cab. The firm experiences economies of scale and the LAC curve slopes downwards

Cost

s£

SAC 2 taxis

LAC

Output

Diseconomies of Scale

If unit costs increase with the introduction of second taxi then the new SAC curve shifts upwards and to the right.

Capacity has doubled but unit costs risen eg it now costs, say 60p per mile to operate a cab. The firm has experienced diseconomies of scale and the LAC curve slopes upwards

SAC 1 taxi

Cost

s£

The slope of the LAC curve is determined by internal economies of scale


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Economies of Scale

Economies of scale refer to the cost advantages that a firm can enjoy when the volume of production increases, in the long run.

Economies of scale can be:

i Internal: lower long run unit costs are achieved within a firm with higher levels of output. As the firm produces more, so long run average cost fall because of technical, marketing, etc, factors.

i External are long run unit cost reductions made outside the firm as a result of its location

The effect of economies of scale is to reduce the long run average (unit) costs of production over a range of output.

Economies of scale benefit firms because lower unit costs increase competitiveness and consumers because lower unit costs allow lower prices.

Internal Economies & Diseconomies of Scale

Internal Economies of Scale occurs within a firm when an increase in use of inputs results in a fall in long run unit costs. As the firm produces more and more goods, long run average cost begin to fall because of a number of factors including:

i Technical economies made in the actual production of the good. For example, large firms can use expensive vehicles, intensively. Train operators can make intensive use of expensive IT systems to manage the deployment of drivers and vehicles Large-scale production allows the gains from division of labour to be exploited.

i Managerial economies made spreading the fixed cost of in the administration of a large firm across a higher level of output.

i Financial economies made by borrowing money at lower rates of interest than smaller firms.

i Marketing economies made by spreading the high cost of advertising on television and in national newspapers, across a large level of output.

i Purchasing economies made when buying supplies in bulk and therefore gaining a larger discount.

i Research and development economies by spreading the high cost of developing new and better products

Internal Diseconomies of Scale occurs when the firm has become too large and inefficient. As the firm increases production, eventually average costs begin to rise because:

i The disadvantages of the division of labour take effect

i Management becomes out of touch with the workforce and some machinery or vehicles become over-manned.

i Decisions are not taken quickly and there is too much bureaucracy eg form filling.

i Lack of communication in a large firm means than management tasks sometimes get done twice.

i Poor labour relations may develop in large companies.


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Worked Example of Internal Economies of Scale

Economies of Scale

£2.00

£2.20

£2.40

£2.60

£2.80

£3.00

£3.20

£3.40

£3.60

£3.80

£4.00

0 500 1000 1500

Output

Uni

t Cos

t (£)

LRAC

MES

£ 3.03 4300 1420 100

80 1410 3800 £ 2.70 90 £ 2.83 4000 1415

£ 2.50 3500 1400 70 £ 2.50 3000 1200 60

40 700 1900 £ 2.71 50 £ 2.50 2500 1000

£ 3.00 1200 400 30

Capital K

Output Q

Total Cost

TC

Long Run Average Cost

LAC 10 80 300 £ 3.75 20 200 £ 3.50 700

The long run is defined as that period of time where all factor inputs, both labour and capital, can be changed. The firm can therefore alter its scale, ie, size of production.

If as a result of increasing both labour and capital, the firm experiences a fall in long run average total cost, it is experiencing economies of scale. Conversely, if long run average unit cost rises as the firm expands, diseconomies of scale are occurring.

The table above shows a simple example of the long run average cost of a firm that experiences economies of scale up to output level 1000. The minimum efficient scale (MES) is the scale of production where internal economies of scale have been fully exploited. It corresponds to the lowest point on the long run average cost curve, the MES. Beyond output level 1400, long run unit costs are rising, and diseconomies of scale are being experienced by the business.

External Economies & Diseconomies of Sale

External Economies are long run unit cost reductions made outside the firm as a result of its location and occur when:

i A local skilled labour force is available.

i Specialist local back-up firms can supply parts or services.

i An area has a good transport network.

External Economies arise from a growing local economy and industry rather than through an individual firm. Note that geographers use the term agglomeration to describe the process where firms concentrate in specific locations in order to take advantage of specialised labour and business services.

External Diseconomies of Scale occur when too many firms have located in one area. Long run unit costs begin to rise because:

i Local labour becomes scarce and firms now have to offer higher wages to attract new workers.

i Land and factories become scarce and rents begin to rise.

i Local roads become congested and so transport costs begin to rise.


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Short Run Revenues

Revenue means the income firms receive from the sale of output. There are three types of revenue. It is important to understand the difference between three types of costs.

Total Revenue (TR) refers to the amount of money received by a firm from selling a given level of output and is found by multiplying price (P) by output ie number of units sold (TR)

TR = P x Q

Average revenue (AP) or price is the unit income form the sale of one item and is calculated by dividing total costs (TR) by total output (Q)

AR = TR / Q ie P

Marginal revenue (MR) is the income received from selling one extra unit of a product and is calculated by dividing the change in ( ) total revenue ( TR) by the change in output ( Q)

MR = TR/ Q

Worked Example of Revenues

Like costs, revenues is an abstraction best explained by way of a worked example

Small firms like Roberta are price takers - they have to accept the going market price per mile travelled or risk losing custom. Potential revenue for a popular route from the city centre to the railway station is shown in the table below

Revenue for a taxi operating in a perfectly competitive market

Fare £6 £6 £6 £6 £6 £6Hires per day 10 20 30 40 50 60Total Revenue £60 £120 £180 £240 £300 £360Marginal Revenue £6 £6 £6 £6 £6

Note that marginal revenue is constant and equal to price which is always average revenue

But what if Roberta was the only taxi working in the town ie a monopolist. She can set any price she chooses and travellers must decide if the ride is worth the fare being asked.

Revenue for a taxi operating in a monopoly market Fare £8 £7 £6 £ 5 £4 £3 Hires per day 10 20 30 40 50 60Total Revenue £80 £140 £180 £200 £200 £180 Marginal Revenue £6 £4 £2 £- £2

Note now that marginal revenue is no longer constant but declines with output


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Revenue Curves

The shape of the revenue curve depends on the industry in which the firm operates. Consider the two revenue curve diagrams below.

i Perfectly competitive firms face a perfectly elastic demand curve

i Imperfectly competitive firms have diverging average and marginal revenue curves

Perfectly competitive firms are price takers and accept the market price for every unit

sold. Hence P=AR=MR

Imperfectly competitive firms are price makers and can set price or output

Price maker Marginal & Average Revenue curves

MR Quantity

Pric

e Price taker Marginal & Average Revenue curves

D=AR=MR

D=AR

Pric

e

P

Quantity

Profit

Profit (π) is the difference between total revenue (TR) and total costs (TC). As previously mentioned, profit is the reward for risk taking. The potential penalty for failure is loss of funds risked, or in the case of unlimited liability, bankruptcy and loss of personal assets of the entrepreneur.

Economists distinguish between two types of profit

i Normal profits: the minimum the amount of money a firm must receive to carry on production of a given good. Normal profit is included as a cost

i Abnormal profits occur when revenue exceeds costs so π > 0 ie TR>TC

i If costs exceed revenue then a loss is made and profits are negative

Students are often confused by this distinction. It helps to think of the entrepreneur requiring a fixed amount per unit to compensate for the administrative duties involved in running the firm. These are a cost that must be covered if they are to stay in the industry.

This means that even if no abnormal profits are made, normal profits are earned - the firm is still rewarded for managing resources


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Profit maximising output

Traditionally economics assumes firms are profit maximisers. The continue to hire extra workers up to the point where the marginal cost of producing extra units is equal to the marginal revenue received from their sale.

This concept can be illustrated by bringing together the marginal cost and marginal revenue curves.

£5

£3

£4

Deliveries per day

D = AR = MR

605040

MC

Pric

e (P

)

Firms maximise profits by setting output at the level where MC = MR

Assume a small transport firm operating in a perfectly competitive market knows that the market price for delivering a fridge for a local firm within a town is £4. How many deliveries should it offer to do in a given time period, say a day, given its marginal cost curve?

After around 25 trips, diminishing returns set in and marginal costs begin to rise. If it only takes on 40 deliveries it is forgoing profits that could be made on the next 10 trips. However, taking on more than 50 deliveries makes no sense – the cost of the extra deliveries is more than £4 - the marginal revenue earned from each trip

Remember that the entrepreneur includes an element of normal profits in the marginal cost curve so that even though MC = MR for the 50th delivery, it still worth undertaking.

It is important to understand that marginal cost and revenue curves help firms decide on the profit maximising level of output. Without the average cost curve it is impossible to infer if the firm is making an abnormal profit, a loss or earning normal profit.

Profit maximising for an imperfectly competitive firm is tackled later in this chapter.


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The Objectives of a Firm

Modern economics recognises that firms can choose between maximising one of several competing potential objectives

Growth say by increasing sales and/or market share eg from 10% to 20% in next 12 months. Growth often allows firms to enjoy the benefits of

i Economies of scale and the competitive advantage that comes from the resultant lower unit costs.

i Market leadership and the enhanced ability to set a price that meets objectives i Higher profits which mean higher salaries for managers and a higher share price for

owners.

Profit say increasing return on capital employed to 5% by 2004 thereby

Survival small and newly established firms simply want to continue say by reaching break even within 12 months

Rather than electing to maximise one objective, a firm may opt to meet the requirements of several stakeholders.

Stakeholders are groups who have an interest in the activity of a business eg shareholders, managers, employees, suppliers, customers, government and local communities. Different stakeholders have different objectives eg owners want maximum profits, customers low prices and workers high wages.

Stakeholder conflict occurs when different stakeholders have different objectives. Firms have to choose between maximising one objective or satisfactorily meeting several stakeholder objectives, so called satisficing.

In public limited companies, ownership and control are separate. Owners seek profits; managers may seek sales maximisation as these increase bonuses.

The objective chosen largely depends on which stakeholder group is most influential. Firms tend to profit maximise where owners are the dominant stakeholder. If other stakeholders are influential the firm may satisfice to meet the minimum requirements of many stakeholders.


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Theory of the Firm Models in Transport

Having taken a small detour to derive the cost and revenue curves facing the firm, and to demonstrate profit maximising behaviour, there is now an opportunity to explore how theory of the firm is useful in analysing transport markets.

Perfect Competition

A perfectly competitive industry is made up of a large number of small independent firms, each selling homogeneous (identical) products to a large number of buyers. In perfectly competitive markets:

i No individual customer receives preferential treatment.

i There are no barriers to entry or exit.

i Consumers and producers have perfect market knowledge

i There is perfect mobility of factors of production.

i Each individual firm is a price taker; in imperfect competition firms are price makers

Perfectly competitive industry Perfectly competitive firm

Pric

e

Q1

P1

MC = S AC S

D

Q1

D= AR = MR

Pric

e

Output (000) Output Bn

The left hand diagram above shows the supply and demand curves for a perfectly competitive market. P1 is the equilibrium market price which the firm shown in the right had diagram must accept. The firm increases output up to Q1 where the condition for profit maximising is met ie MC=MR.


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Long Run Supply Curve

Is there any incentive for new firms to enter this industry? No, as only normal profits are being made.

Perfectly competitive industry

MC = S ACS2

D1

Perfectly competitive firm

P1

Q1 Q1

D= AR = MR

Pric

e

Pric

e Output / t

S1

D2

Q3 Q2

B

A

KP2 C LS J

Q2

Now assume an increase in demand for the product causing D1 to shift to D2. In this time period The industry increase output through an expansion in supply from A to B. Price rises to P2.

The firm responds the higher price by increasing output from Q1 to Q2 and is now making abnormal profits

No barriers to entry and super normal profits encourage the entry of new firms shifting supply & price downward until price falls back to P1. Normal profits are restored

LS is the long run supply curve for the perfectly competitive industry.

It is hard to think of an example of perfect competition in transport. Independent self employed ‘mini cab’ drivers operating in a town or city are the closest approximation.

However the real strength of the perfectly competitive model lies in its ability to act as a benchmark against which to judge the behaviour of imperfectly competitive firms.


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Imperfect Competition

An imperfectly competitive firm produces differentiated (non identical) products to rival firms and so has the ability to set price or output. It faces a downwardly sloping demand curve.

The categories of imperfectly competitive firm are

i Monopolistically competitive

i Oligopoly

i Pure Monopoly

Monopolistic Competition

Monopolistic competition is a market structure with:

i A large number of firms producing slightly differentiated products.

i Each firm selling a differentiated (non-identical) product ie a firm is a price maker and its demand curve is downward sloping

i The large number of close substitutes means demand is relatively price elastic.

i No barriers to entry or exit mean normal profits are earned in the long run.

The monopolistically competitive firm is earning abnormal profits in this time period ie more than is

required to keep the firm in this industry

In the next time period new firms enter the industry and the firms demand curve a) shifts downwards as it loses market share and b) becomes more price elastic as normal profits are earned at P3

MC

Quantity

Abnormal profits in monopolistic competition- short run

D = AR

Q1 MR

P1

AC

P2

MC

Normal profits in monopolistic competition – long run

Quantity

D = AR

Q3 MR

AC

P3

Cost

s &

Rev

enue

s £s

Cost

s &

Rev

enue

s £s

The closest real world example to monopolistic competition in transport are rival mini cab firms.

It can be argued that the deregulation of passenger buses initially created conditions close to monopolistic competition. Abnormal profits attracted new entrants until normal profits are earned. However a process of merger has crated a monopoly structure.


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Oligopoly

An oligopolistic market is one dominated by a few interdependent firms and there is a high degree of concentration of sales.

i A high concentration ratio and each firm is a price maker

i Firms produce differentiated, branded products supported by intensive advertising and marketing

i There are significant barriers to entry & exit

i Firms are interdependent. The behaviour of one firm will influence – and be influenced by - the behaviour of its rivals eg oligopolists take into account likely reactions of rivals to price changes

i Generally stable prices as firms fear a price war where firms cut prices and rivals respond. Price wars are only initiated if a firm feels it has a cost advantage and its objective is to increase long term market share /growth at the expense of short term profits.

i Firms wishing to increase sales use non-price competition such as promotion campaigns

i Abnormal profits. It can be argued profits are not distributed to shareholder but retained to fund R&D into new products

The key characteristic of oligopoly is interdependence – there are so few firms that each one has to anticipate the actions of rivals. What will rivals do? Collusion is an option that may stabilise markets and so encourage firms to invest in new capacity & R&D?

Collusive Oligopoly

A collusive oligopoly occurs when firms within an industry agree to act together to restrict competition. Eg they set up a price fixing cartel where each firm restricts output

In the diagrams below the market price PMkt and output Qmkt are set by the interaction of supply and demand. To increase price each firm must agree to restrict output eg from Q1 to Q2 in the left hand diagram

Note Q2 is not the profit maximising level of output. Firms can increase profits by increasing output and selling on the black market at below the cartel price.

Oligopolist Industry

Pric

e

MR Q

Pric

e

D=AR

A Industry supply

Output (Q)

MC AC

Q1 Q2

PMkt

POli

QOli QMkt


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Oligopoly - Kinked Demand Curve Model

The kinked demand curve model is used as an illustration of the interdependence between firms

The kinked demand curve model argues firms face a dual, kinked demand curve for its product reflecting the likely reactions of other firms in the market to a change in its price. Assumptions Oligopolies seek to maintain their own market share and maximise profits

Q1 MR

Demand is price inelastic

D = AR

Demand is price elastic

MC2

MC1 A

C

B

Pric

e

P1

Quantity

Rival firms are likely to match, or even better, any price cut below P1 resulting in a ‘price war’ but little gain in market share and falling total revenue. The firm’s demand curve is relatively price inelastic below point A.

If an oligopoly increases price above P1 rival firms do not follow. Consumers switch to substitutes resulting in lost market share and falling total revenue. The firm’s demand curve relatively price elastic above point A.

The kinked demand curve model helps explains observed price rigidity in oligopoly markets; why price wars are so infrequent & short lived; why competition is usually non price eg advertising & branding

This model is useful in explaining and predicting the behaviour of bus companies operating the same routes.


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Pure Monopoly

A pure monopoly is a single seller of a product in a given market. The firm is the industry and has a 100% market share. Not all monopolies are pure monopolies. The government defines a monopoly as any firm that has a 25% or higher share of the industries' total sales.

In an industry dominated by a monopolist there are

i Significant barriers to entry and exit eg high costs of entry or legal restraints eg franchise.

i Monopolists are price makers and can set price or output for their own product.

i Monopolists are usually assumed to be profit makers and can set price or output for their own product.

i Monopolists are likely to earn abnormal profits in the long run.

A monopolist has market power and so can set price. A profit maximiser increases output until MC=MR at Q1. The intersection of MC with MR gives the profit maximising level of output.

To find market price, project up from Q1 to the demand curve and across to the vertical price axis, P1

Consumers are willing to pay P1 for Q1. Unit costs are only P2 so the firm is making an abnormal profit of (P1-P2) xQ1

MR

D=AR

Profit maximising monopolist

AC

Q1

MC

D=AR

Quantity

Pric

e

P1

P2

The monopolist is making abnormal profits. In competitive markets abnormal profits attract new firms and the resultant increase in supply lowers price until abnormal profits are eliminated.

A monopolist can only sustain abnormal profits by erecting barriers to entry:

i Legal monopolies eg TOCs run exclusive train services for the duration of their franchise

i Natural monopoly argument eg NATS i High sunk costs - expenditure that cannot be recovered if an unsuccessful entrant leaves an

industry – deters competition.

i Predatory pricing where monopolists lower prices to a level that forces new entrants to operate at a loss.

i New entrants cannot compete on cost and price. Established market leadership allows the monopolist economies of scale not accessible to new entrants with much lower output levels. The difference in unit costs allows the monopolist to start, and win, a price war – ie predatory pricing.


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Pure Monopoly v Perfect Competition

Profit maximising monopolists such as Train Operating Companies (TOCs) set output where MC = MR. The monopolist offers Q Mon for sale at P Mon

In perfect competition MC gives the supply curve S. Perfectly competitive industries result in a lower price, P Pc, and higher output Q oc, than monopoly.

S=MC

Quantity

Perfect Competition v Monopoly

D= MPB

L

MRQ pc Q mon

M

J

P mon

P pc

Cost

s &

Ben

efit

s £s

This analysis assumes unit costs are the same in perfect and imperfect competition – unlikely in most transport markets which typically enjoy economies of scale

Is Monopoly Always an Inappropriate Market Structure?

Monopoly may be the best market structure where:

• There is the potential for significant economies of scale ie one large firm can produce at lower unit cost than many small firms. The natural monopoly argument

• Only monopolies can generate sufficient profits to enable large-scale high cost Research & Development (R&D).

• Domestic monopolies can compete internationally more easily than small firms.


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Price Discrimination in Imperfectly Competitive Transport Markets

Price makers are not required to charge the same price to all consumers and may benefits by charging different prices for the same product. Price discrimination is where a monopolist charges different prices to consumers in different sub markets for the same product, for reasons not associated with the costs of production eg peak and off peak rail travel

Price discrimination does not occur when charging different prices for 1st & 2nd class travel – there are different cost structures.

Price discrimination requires:

i Different price elasticities of demand (PEDs) in each sub market (eg peak and off peak)

i No market seepage (reselling between sub markets)

i Firm are price makers ie imperfectly competitive.

Three types of price discrimination are open to monopolists:

First Degree Price Discrimination

Imagine an air flight where customers are invited to bid for a limited number of seats, with tickets allocated first to the highest bidders.

The Q1st seat is sold for P1 and the Q3rd for a lower price, P3. First degree price discrimination means the seller is extracts all the consumer surplus of buyers.

fare

s

D

Q1 Q2 Q3

P3

P2

P1

seats

This type of price discrimination depends on the ability of the firm to know exactly how much each consumer is willing to pay for a journey - an unlikely occurrence.

First degree price discrimination

Different consumers have different preferences and levels of purchasing power and thus the amount they would be willing to pay for a good often exceeds a single competitive price. This difference between what a consumer is willing to pay and the price actually paid is known, of course, as consumers’ surplus. Thus a firm engaging in first degree price discrimination is attempting to extract all the consumers’ surplus from its customers as profits.

Source: Digital Economist


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Second Degree Price Discrimination

Here firms sell off excess capacity at lower prices than the previously charged.

Assume the same scenario – an airline selling seats for a given flights

The MC curve is horizontal up to the capacity of the plane. The advertised price of P1 is set where MC=MR at Q1.

However, this leaves unsold seats = Q2 – Q1 and these on are sold on a last minute stand by basis at a lower price of P2.

fare

s

MC

MR

DP2

P1

Q1 Q2 capacity

Selling Airline Capacity

In the autumn of 2001, most of the world’s main global airlines were left with a huge amount of spare capacity following the terrorist attacks on the United States and a short term collapse in demand for international travel. There followed several months of dramatic price-cutting among airlines, desperate to maintain cash flow and increase occupancy rates on flights. The low-cost airlines in Europe seemed to benefit greatly from this approach with price discounting helping to maintain the strong growth of sales volumes. Source: Tutor2U


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Third Degree Price Discrimination

3rd degree price discrimination allows producers to increase total revenue and profit by charging different prices for the same product in different market segments eg peak and off peak rail travel.

seats 400

D

£50

250

D

150

MR

Peak Sub market

MR

MC

Off Peak Sub market

MR & MC for all market

ΣMR

MC

£80

Fare

s&

Cost

s

The first diagram shows a Train Operator’s marginal cost (MC) & marginal revenue cost curves for a whole market made up of two submarkets: peak and off peak travel. The firm sets its profit maximising output level where MC=MR ie at 400 seats for a given journey. Projecting the resultant MC across to the corresponding MR curves sets output levels for in each submarket. Projecting up to the respective demand curves gives the profit maximising price for each segment: £80 per ticket for peak and £50 for off peak travel.

Third degree price discrimination

Third degree price discrimination can be achieved when the market can be segmented and when the segments have different elasticities of demand. Consider the total market for public transport journeys before 9.00am. The total market demand (Dm) is the sum of the demand of two segments, adults (Da) and students (Ds). For adults the price of a bus ticket is only a small part of their income and this means that their demand (Da) is more inelastic than that of students for whom a bus ticket is a larger part of their income.

Source: Economics For International Students Chris Rodda


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The natural monopoly argument applied to transport

The natural monopoly argument is best illustrated by reference to economies of scale and minimum efficient scale (MES) level of output

Natural Monopoly & Economies of Scale Consider an industry where there are significant opportunities for economies of scale (EoS) eg railway track and signalling.

Technical, administrative and other sources of EoS mean that the unit costs associated with one large firm are much lower than several small firms. It makes sense to have one firm ie a monopoly rather than several small firms?

Cost

s£

LAC

SAC large scale production

SAC small scale production

MES Output

The minimum efficient scale (MES) is the scale of production where internal economies of scale have been fully exploited. It corresponds to the lowest point on the long run average cost curve and is also known as the output range over which a business achieves productive efficiency.

The MES is not a single output level – more likely we describe the minimum efficient scale as comprising a range of output levels where the firm achieves constant returns to scale and has reached the lowest feasible cost per unit in the long run.

A natural monopoly occurs in industries like railways that require a national infrastructure because fixed costs make up a large proportion of total costs. It is inefficient to have several rail tracks between, say, Oxford and London. It is more efficient to build and operate a single track.

• There are significant opportunities for technical economies of scale.

• In natural monopoly industries, MES level of output is so high a proportion of total market demand that only one firm to fully exploit the potential economies of scale available in the industry.

For a natural monopoly, regulated monopoly where a government appointed regulator ensures monopoly power is not abused, is the best solution.


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Deregulation

What can governments do to increase the degree of competition within transport markets? Profit maximising firms facing increased competition have an incentive to reduce unit costs – lower costs increase profits. Consumers benefit from lower prices

Three policies have been used by recent governments to open up transport markets to rival firms:

i Privatisation by moving ownership and control of state owned firms such as British Rail into the private sector

i Deregulation removing barriers to entry and allowing new firms into previously closed markets eg buses

i Make markets contestable

Deregulation – an example in Durham

Taxi drivers in Durham are going on strike over plans by the city council to increase the number of Hackney cab licences. Durham's 55 licensed taxi drivers say they are angry with the licensing authority, Durham City Council. They have warned that granting an unlimited number of licence plates will put them out of business. The drivers say that deregulation will create a "free-for-all", with part-time drivers taking a lot of the peak-time work. The city council argues that deregulation of the taxi trade will make it more open and competitive.

Source: BBC News 24 June, 2004

S1

D

S2

Effect of deregulation of taxis in Durham

The effect of the proposed deregulation of Durham taxis is to replace the fixed number of licensed taxis of 55 with a market determined supply curve. Taxis can now operate without a licence and individual cabs decide if they are prepared to accept a job at a given fare per kilometre.

The market may decide on an equilibrium fare of 60p with 100 cabs plying for trade

Fares

£1

60p

55 100 Cabs


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Bus Deregulation

The Road Traffic Act 1930 set up a licensing system resulting in local route monopolies with price controls and subsides set by government. Profitable routes cross subsidised unprofitable routes. Bus companies were nationalised in 1947 resulting in regulated, government-owned bus operations,

The Transport Act of 1980 & 1985 deregulated the bus industry:

i Price controls abolished on all bus and coach services

i Cross subsides halted so that price reflects the cost of a route

i Socially necessary but unprofitable routes requiring a subsidy put out an open competitive tender. Operators requiring the least subside awarded the route.

i Contestable markets introduced with road service license and local monopolies abolished. Any operator now free to set up a bus route

World Bank on Bus Deregulation

Lower costs have also been found to result from deregulating bus services. For example, in the UK reductions of as much as 35-40% were achieved following deregulation of non-urban buses. This was associated with greater concentration of buses on the main routes and a wider range of services being offered.

Although the number of operators increased after deregulation, in the long term the scheduled coaching business has continued to be dominated by a single operator (although this network operator sub-contracts most operational activities to regionally-based operators). A large number of smaller operators offer non-scheduled services such as excursion and tourist services.

Fares have returned, in real terms, to those prevailing before deregulation, while level of service and quality of vehicle have increased. This demonstrates the key marketing advantage of operators who develop scheduled network services in conjunction with computer booking systems. Despite this concentration of the bus industry, there is no convincing evidence of monopoly situations occurring. In fact there is vigorous competition between bus and rail, and also between operators of scheduled and non-scheduled services. UK experience shows the important role played by long distance coaching (both scheduled and non-scheduled) in offering an alternative to passenger rail services and in stimulating competitive rail services.

There is no evidence of any increase in coach accidents due to deregulation. However this is partly attributable to increasingly higher safety standards being applied to coach operations. Within urban areas the effects of deregulation in the UK and related policy issues are more complicated, although similar reductions in cost and broadening of service range have occurred.

Source: http://www.worldbank.org/transport/roads/rdt_docs/annex4.pdf

http://www.worldbank.org/transport/roads/rdt_docs/annex4.pdf


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Bus Industry Competition

The Transport Act 1985 returned the industry to a contestable market, subject of course to safety regulation. Bus and coach firms must hold an Operator’s Licence, under which they have to register their services with the regional Traffic Commissioners, and to notify them of closures and major alterations, but there is no control of charging. Long-distance services have been subject to no such measures since 1980; and private hire was never controlled. Local authorities of various kinds have powers to provide ‘socially necessary’ bus services, usually by a process of tender, but they are constrained by limited available finance.

Source: Professor John Hibbs Running Buses ASI 2004

The criteria to evaluate the performance of bus companies include fares, the number of services, service frequency, quality of service, changes in demand, loading, number of vehicles and their quality

Deregulation of the local bus market has resulted in an initial increase in competition with more buses resulted in more entrants, more frequent services and lower fares. However

i more buses operating below full capacity ie a fall in loading adding to existing congestion

i increasing pollution especially in crowded city centres

Eventual consolidation through mergers has created an oligopoly (First Group, Stagecoach, Go-Ahead, Arriva and National Express) mean many regions now have a monopoly local bus company, resulting in higher fares, lower levels of service and the withdrawal of marginally commercial routes

Effect of Bus Deregulation on Competition

The extent of competition in the [bus] market is limited, and varies from place to place. The major groups, as we have seen, are headed by public limited companies with interests in rail as well as road transport. Some of them also operate light rapid transit systems as agents for the local authorities that have invested in them.

An early period of management and employee buyouts ended as the new shareholders took their profits and sold out, but there are examples of smaller firms going for growth and challenging the local ‘established operator’. Smaller entrepreneurs and family businesses trade at the margins, ensuring that larger companies cannot neglect the market.

Source: Professor John Hibbs Running Buses ASI 2004


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Air Transport Deregulation

Before discussing the UK’s experience of air transport deregulation, consider first the special characteristics of air travel

i Aviation generates significant externalities including noise, climate change, and diminished air quality. Planes burn most fuel during take-off. Therefore short flights are disproportionately polluting The Dept of Transport estimates a £3 tax on short-haul, and £20 on a long-haul flight, is needed to internalise the externality ie make the polluter pay.

i Airport development involves significant land use and consequent urbanisation of the surrounding area

i In the UK and Europe, the supply of airspace and landing slots at major cities is limited. i The current airports, runway and air traffic control infrastructure lacks the capacity to

handle the projected number of flights

Air transport is made up of several interlocking components:

i Airline operators in the private sector commercial airlines such as Virgin or state own ‘flag carriers’ such as Air France, low cost companies such as Ryan Air and charter airlines used by holiday firms

i Infrastructure: airports and air traffic control systems

Air travel markets are segmented into submarkets: first class & economy class, low cost, leisure & business domestic, short & long haul. Evaluation requires performance indicators. The criteria to evaluate the performance of air transport include fares, the number of services, service frequency, quality of service, changes in demand, loading.

Air transport is a heavily regulated industry because:

i Travel by air is potentially dangerous and any accident involves hundreds of people

i Air flights pass through the airspace of different countries and so pose a potential security threat

The first country to deregulate air transport and allow new carriers to enter the market was the USA in 1978, resulting in a proliferation of smaller airlines, competing against established major airlines.

During this period European air transport was dominated by state-owned 'flag carriers'. Governments negotiated bilateral agreements eg BA flies from Heathrow to Geneva and Swiss Air form Geneva to Heathrow. Resultant barriers to entry meant virtually no competition and high prices.

Ryanair

In 1991, the Ryanair took advantage of liberalisation to challenge Aer Lingus on routes between Ireland & the United Kingdom. It offered a 'low frills' service, and its fares were up to 75 per cent lower than existing prices. Its growth was dramatic: in 1990 Ryanair carried a total of 700,000 passengers, whereas in 1997 it carried 3 million passengers between the United Kingdom and Ireland alone. It became the major carrier on the London to Dublin route, carrying 1.8 million passengers.

Source: Select Committee on Environment, Transport & Regional Affairs Fourteenth Report

http://www.publications.parliament.uk/pa/cm199899/cmselect/cmenvtra/275/27502.htm


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Starting in 1987, UK air transport deregulated as part of an EU wide process. Additional 1993 reforms granted all European airlines the right to offer international flights within Europe and most domestic routes. Airlines became free to set their own fares.

The result has been to replicate the US experience. There has been an explosion of low cost operators such as EasyJet challenging established state owned carriers.

Europe is now moving towards an open skies policy where the air transport industry is liberalised and governed by an EU regulatory framework. Increasing competition involves allowing more airlines to fly to destinations. To encourage new entrants, the EU allocates 50% of unused or newly created slots to newcomers to the market.

The impact of deregulation varies between sub markets:

i Low cost operators like Easyjet and Ryanair have rising profits and are expanding by offering low cost flights.

i Premium carriers such as BA are losing business passengers and profits to cheap fares airlines.

Future of air travel

Future of air travel has increased five-fold over the last 30 years. Half the population now flies at least once a year. And freight traffic at UK airports has doubled since 1990.

Britain's economy increasingly depends on air travel, for exports, tourism and inward investment. The aviation industry directly supports around 200,000 jobs and indirectly up to three times that. Airports are important to the economies of the English regions and of Scotland, Wales and Northern Ireland.

Aviation links remote communities and helps people stay in touch with friends and family around the world. It brings businesses together and has given many affordable access to foreign travel. All the evidence suggests that air travel will continue growing over the next 30 years. But if we want to continue enjoying its benefits, we have to increase capacity.

But we can't add to airport capacity regardless of the environmental cost. So, we need a balanced approach which recognises the importance of air travel, but which also tackles environmental issues.

Source White Paper 'The Future of Air Transport', December 2003


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Social Class of UK Airport Passengers Socio Economic Group

Birmingham Gatwick Manchester

A/B 22.1 33 30.1 C1 35 37 32.5 C2 19.3 22.9 27.6 C/E 23.6 7.1 9.8 % 100 100 100 Source CAA Nov 2004

Forecast Demand for UK Airports

0100200300400500600

1990 2000 2010 2020 2030

Source: CAA 2004

Nos

of P

asse

nger

sM

illio

ns

The Rich Use Cheap Flights

The Civil Aviation Authority predicts flights from UK airports are on course to grow to 500 million by 2030. The Government proposes constructing new runways at Stansted, Heathrow, Birmingham and Edinburgh to accommodate this expansion..

Yet the CAA figures suggest the boom in air travel is caused largely by a rich minority taking several foreign holidays a year, Those in social groups D and E, which cover low-skilled workers and people on benefits, took only 6 per cent of the total flights last year, despite making up 27 per cent of the population

Adapted from the Times 2 Nov 2004


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Barriers to Entry

Barriers to entry: the technical or economic factors preventing firms from entering an industry and competing with existing firms

Barriers to entry in transport include

i Legal monopoly eg a eg Train Operating Companies have been given a regional monopolies with a time-limited franchise by law

i Vertical integration: where by acquiring suppliers or distributors a firm can exclude rivals from a producing a product or supplying a market

i Predatory pricing where established firms lower price to force competitors into losses and so force their withdrawal from industry eg Laker Airway’s Skytrain no frills transatlantic route

i Economies of scale. Initially, new entrants with low output cannot enjoy the same economies of scale and low unit costs of established firms

i Large potential sunk costs deter new entrants from risking entry

i Branding establishes products as unique. New entrants require expensive advertising to establish sales deters entrants

Monopolists sustain abnormal profits by blocking potential entrants. Barriers to entry largely determine the degree of competition in a market.

Contestable Markets

Contestability theory is associated with Baumol who argues the mere threat of new firms entering a market impels existing firms to act competitively ie earn normal profits and deliver allocative and productive efficiency.

Imperfectly competitive markets can be made contestable - another policy, alongside privatisation and deregulation, for introducing competition into transport industries.

Contestable market theory is based around four concepts:

i Barriers to entry: the technical or economic factors preventing firms from entering an industry and competing with existing firms

i Sunk costs are the costs associated with leaving an industry. Firms entering an industry incur costs. Those expenditures that cannot be recovered on exit eg promotion and R&D are known as sunk costs. Sunk costs act as a barrier to entry because new entrants know that if they are unsuccessful then some set up costs are lost

i A franchise is the legal right to operate a given service for a given period of time. Franchisees make a lump sum payment to buy a franchise, must meet quality standards as set out in a contract and invest their own capital in providing the service. Because franchises are time limited there is the threat of a potential entrant when the franchise next comes up for tender ie contestablility. However, short-term franchises that introduce contestability into transport markets also deter long-term investment where firms feel they may lose their current franchise and experience sunk costs. For this reason, the latest franchise agreements are for longer periods eg 15 years. 15 year franchises create uncontested legal monopolies.


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i Hit & Run Rival firms attracted by abnormal profits ‘hit’ ie enter an industry. As increased supply forces down prices, they then ‘run’ ie leave.

Making markets contestable by reducing barriers to entry into the market means potential entrants are able to enter market quickly if abnormal profits are made. This process helps ensure normal profits only, are earned in the long run – irrespective of the number or size of firms.

It is important to understand that contestability theory does not require firms to enter the market. The theory of contestable markets argues that changing the behaviour of existing monopolist is not actual but the threat of potential competition.

A contestable market has

i One or only a few firms in the industry ie a pure monopoly or oligopoly market structure

i No or minimal barriers to entry eg - firms can enter or leave an industry freely

i Minimal sunk costs ie the costs of entry and exit are zero or minimal

The government has sought to create contestable markets in the rail, bus, ferry and air industries through deregulation (buses) and short franchises (trains).

However, contestablility is an inappropriate policy in natural monopolies like Network Rail and NATs, where regulation is more appropriate.

Finally, do not confuse perfect competition with contestable markets – they are different

Perfectly competitive industry Contestable markets

Nos of firms Large number of small firms One or few firms

Type of products Homogenous (identical) products Differentiated products


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How the transport industry in the UK has been privatised

Privatisation – an overview

In mixed economies, some resources are owned by the public sector (government) and some resources are owned by the private sector (households). Public ownership refers to companies owned by the government, referred to as nationalised industries

Economists distinguish between the private sector made up of members of the general public and firms owned by the general public and the public sector consisting of the central government in London, local councils, and firms owned by the government (nationalised industries) eg Post Office.

Privatisation occurs when ownership of public sector firms is moved to the private sector. An important feature of recent UK Transport is the extensive privatisation of the formerly nationalised bus & rail operators. This means most supply side operational decisions are increasingly taken by profit maximising private sector bus companies and train operators.

New Labour is using the Public Private Partnerships (PPP) and Public Finance Initiative (PFI) to introduce greater private sector involvement in the management of publicly owned assets – quasi privatisation eg In 2001 National Air Traffic Services (NATS) was partly privatised and London Underground is poised for denationalisation.

The ownership of UK transport infrastructure lies in both the private and public sector.

i Roads are seen as a quasi-public good and so almost all roads are owned by the state and funded out of general taxation. However the road network are built and maintained by the private sector who tender for contracts to the government’s Highways Agency. The private sector, eg firms make operational decisions

i Rail ownership has undergone significant changes in the last decade. The infrastructure is owned by the private sector but maintained by a not for profit company Network Rail. Government appoints regulators, such as Office of the Rail Regulator (ORR), to monitor private sector transport operators like Virgin Rail.

i Air. Airports and air operators are in the private sector. Air Traffic control infrastructure is partially privatised.

Privatisation

Privatization can introduce new technological development, managerial techniques and corporate culture into 'inefficient' utilities and can provide much needed funding for capital maintenance and expansion to meet growing demand.

However, customers often see privatization as the sign of increase in tariffs. The experience around the world suggests that privatization alone is not sufficient to make monopolies efficient in the long run to the benefits of customers. Privatization must be accompanied with competition to reduce customer bills and improve quality of service. However, certain elements of transport are natural monopolies and hence cannot be subject to competition. In such circumstances, effective regulation is required to mimic competition and to achieve economic efficiency. Adapted from Pakistan Economist


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Arguments for Privatisation – theory

There are standard arguments that can be used to evaluate the impact of a particular privatisation program

As ‘efficient’ private sector firms now has the profit that encourages technical efficiency ie assets in private hands have higher productivity (Q/L)

Lower unit costs shifts the average cost curve down and are passed on in lower prices.

i

Privatisation can result in lower unit costs

Cost

s £

SAC1

SAC2

Output

A

B

i

i losses turn into profits and a reduced government subsidy is needed which allows public expenditure elsewhere eg in education and lower government borrowing

i Privatisation raises standards increasing usage of public transport and associated positive externalities

i Contestable market argument. Privatisation introduces competition. Any route generating abnormal profits will attract new entrants until profits become normal.

i Additional investment funded by the private sector to overcome decades of public sector under investment

Arguments Against Privatisation – Theory

Privatisations do not result in increased competition – public sector monopolies become private sector monopolies. Eg initial competition following bus deregulation, gave way to takeovers, resulting in local monopolies

Unlike nationalised industries, private sector firms ignore significant externalities generated by transport. Therefore their pricing/output decisions result in market failure

Productivity gains may stem from reducing pay and conditions of public sector workers. This is demotivating for workers, resulting in lost productivity. The net welfare effect is uncertain: welfare gains may be transferred to shareholder in higher profits, or consumers in lower prices.

Profit maximising PLC’s are accountable to shareholders. The city is notoriously short term and demands immediate profits. The private sector will only fund high risk, uncertain transport projects for very high returns eg 30%+ rate of return for involvement in London Underground PFI. Pay back periods for investment can be less than 5 years within a 25 year PFI contract.

Privatised transport organisations have conflicting stakeholder objectives. Do they act to maximise profits, performance or safety? Eg Network Rail

Profit maximising private operators ignore equity (fairness) issues ie the impact of reduced services on say rural areas.


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Case Study: Privatisation of National Air Traffic Services (NATS)

The National Air Traffic Services (NATS) controls air flights over the UK. The major

challenge it faced in the late 1990s was insufficient capital to manage the

predicted increase in the volume of air flights over UK airspace

NATS requires a significant injection of capital to modernise air traffic control and

overcome current capacity constraints privatisation allows private sector funding. There is the need to invest some £1bn in improving air traffic control systems.

Air Travel Projections

0

100

200

300

400

500

1998 2005 2010 2015 2020

Year

Pass

enge

rs (

mill

ions

)

National Air Traffic Services (NATS)

The future status of NATS has been under review since the early 1990s. With capital funding for new air traffic control systems reduced by the Government from a peak of £130 million in 1993/94 to £36 million in 1998/99, it has long been recognised that to meet the predicted traffic demand NATS needs freedom to invest. The only mechanisms available for financing major investments are funding approved by DETR and HM Treasury, or the Private Finance Initiative (PFI). NATS regards PFI as an inappropriate mechanism for financing large, complex software systems. Source: NATS

The UK’s response has been to part privatise NATS in 2000 with a 46% stake owned by a consortium of seven airlines including British Airways. Privatised firms can raise their own funds for investment rather than rely on the government

After 11 September a 40% fall in long haul flights meant the government was forced to make a loan of £40m or risk a vital public service becoming insolvent. The regulators are unwilling to allow NATS to increase charges to increase revenue.

However an upturn in air travel means that NATS returned to profit in March 2004 and is now handling record numbers of flights over the UK.

After initial glitches NATS still experiences occasional disruptions to services caused by software upgrades of a complex system

http://www.nats.co.uk/news/ppp.html


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Privatisation of the UK’s railways

Prior to privatisation, the state-owned British Rail owned and controlled the railway infrastructure and was responsible for the operation of passenger and freight services. The privatisation process began in the mid 1990s and split infrastructure and operations into two

i Infrastructure: Railtrack, now Network Rail, is the owner and operator of the railway infrastructure ie its operation, maintenance and renewal of 21,000 miles of rail lines, tunnels, bridges, level crossings, stations and signals. Revenue comes from charging TOCs for use of the lines and substantial government subsidies

i Passenger Operations: 26 Train Operating Companies (TOCs) have a franchise to run rail services and have two sources of revenue: ticket sales & subsidies. Franchising is where a company is given the right to operate a particular service for a given period of time

i Freight Operations: Freight Operating Companies (FOCs) are PLC’s. Any licensed can run freight trains ie a competitive market. The majority of rail freight shipments are of traditional bulk commodities eg coal.

Recent Events in UK Railways

The process of the privatisation of UK railways is complex with several reorganisations

i June 2003: Connex TOC sees its franchise withdrawn for poor performance of the

i Oct 2001: Railtrack closed and replaced by Network Rail a non-profit making, public interest company run as a commercial operation, with no shareholders.

i October 2003: Network Rail took over all track maintenance work from private contractors because of spiralling costs.

i July 2004: The Future of Rail White Paper abolishes the Strategic Rail Authority and sets out a new structure for managing the rail system

Rail Priorities

The key priorities for the rail industry are to improve performance and get a grip on costs, whilst maintaining a high standard of safety. These changes will enable the different sides of the industry to work together more effectively to provide a better, more reliable service for passengers. And they will ensure that each sector concentrates on what it does best: Government setting the strategic direction, and the private sector taking charge of delivery

Source: The railways White Paper, The Future of Rail July 2004


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Future of Rail 2004 Reforms

The government white paper The Future of Rail July 2004 sets out new responsibilities for organisations set up following privatisation

• The Dept of Transport sets the national strategy for the railways

• Network Rail has overall responsibility for the performance of the rail network of track and signals. The Government both subsidies and sets out objectives for Network Rail whose other source of revenue is fees received from TOCs Any profits made are reinvested in the rail network.

• Train Operating Companies & Freight Operating Companies are to negotiate local agreements with Network Rail to avoid the actions of one firm causing unnecessary delays to other operators

• The Office of Rail Regulation (ORR) is an independent regulator of all aspects of the rail industry ie safety, reliability & efficiency

Dept of Transportsets policy

26 Train OperatingCompanies (TOCs)

franchised passenger services

Network Railoperates infrastructure

Freight Operating Companies (FOCs)franchised to carry goods

franc

hise

cont

ract

s

Rail Regulator ensures safety, reliability & efficiency

Localagreements

sets objectives


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Impact of Rail Privatisation

Evaluation of privatisation requires criteria by which to judge the new arrangements.

Criteria to evaluate the performance of rail privatisation include fares, the number of services, service frequency, quality of service, changes in demand, loading, number of vehicles and their quality, amount of government subsidy.

The Hatfield crash has meant a one off reduction is usage. Passenger and freight numbers are now improving, once again.

However the 2004 Future of Rail reforms suggest that institutional factors are preventing the full gains of privatisation from being realised – an argument strengthened if the new arrangements result in further productivity gains.

Has Rail Privatisation Worked?

Has the restructuring and privatisation of British Rail produced savings in operating costs? The paper shows that major efficiencies have been achieved, consumers have benefited through lower prices, whilst the increased government subsidy has been largely recouped through privatisation proceeds. We find that output quality has also improved (pre-Hatfield). The achievement of further savings will be key to delivering improved rail services in the future. This paper finds that a privatised structure, where shareholders demand a return on their investment, has led to significant improvements in operating efficiency - it remains to be seen whether the new regime, with a not-for-profit infrastructure owner, will deliver the same efficiency improvements.

Source: adapted from The Restructuring and Privatisation of British Rail: Was it really that bad? Cambridge Working Papers in Economics Nov 2001

Light Railway Tram Schemes

Trams

Sheffield's trams expected 22m passengers a year by 2000 but now carry just over 12m. The Croydon tram in south London forecast 26m passengers a year; it now has just under 20m. So even though £220m has already been spent on preparatory work, the government has blocked not only the new Manchester lines but also a £500m scheme in Leeds and a £270m one in Portsmouth.

Source: The Economist Sep 30th 2004

In 2000, the Labour government proposed 25 light railway (tram). By 2004 the initial estimate of £489m rose to £900m with a subsidy up from£150m to £510m, spread over 30 years. This, according to National Audit Office, represents poor value for money.

http://netec.mcc.ac.uk/WoPEc/data/camcamdae.html

http://netec.mcc.ac.uk/WoPEc/data/camcamdae.html


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3 Resource Allocation Issues in Transport

Does the UK make best use of its transport resources? Is government policy effective? What can be done to overcome market failures such as noise pollution and congestion in road transport?

This section develops an understanding of the use and meaning of economic efficiency, both short run allocative & productive and long run dynamic efficiency, and applies it to the context of transport.

Resource allocation decisions are decided by owners/managers.

i With the recent privatisation of buses and railways most transport operation decisions as to what services to run are taken by the private sector.

i Decisions about infrastructure investment (eg new bypass) are usually taken by government. The funds needed to modernise UK transport Infrastructure after years of under investment to cope with projected usage, are beyond the means

Objectives of Transport Policy

Successful polices meet objectives. The government’s transport policy aim is better transport with specific supporting objectives ie transport that is reliable, safe, integrated transport for everyone, which respects the environment

The main transport problems facing the government are:

i Capacity Current road, rail and air networks are unable to meet current demand at peak times.

i Sustainability Projected increase in car usage is unsustainable.

i Infrastructure: past under investment means the public transport network is badly maintained and characterised by poor quality and lack of choice.

i Use of buses falling outside London. Mergers of bus companies following deregulation means a lack of competition, reduced services, higher fares, local monopolies and high subsides to operators to run non commercial rural routes

i The government is unsure if the electorate will accept road pricing or if the satellite technology for charging will work


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Current UK Transport Policy

Government policy for transport is set out in a series of White Papers

i New Deal For Transport (1998)

i Transport 20010: The Ten Year Plan (2000)

i The Future of Rail (2003)

i The Future of Air Transport (2004)

i The Future of Transport: a network for 2030 (2004)

Future Transport Policy

For the last two decades, the ideology of privatisation, competition and deregulation has dominated transport policy. Bus and rail services have declined whilst traffic growth has resulted in more congestion and worsening pollution.

As a car driver, I recognise that motorists will not readily switch to public transport unless it is significantly better and more reliable. The main aim of this White Paper is to increase personal choice by improving the alternatives and to secure mobility that is sustainable in the long term.

Better public transport will encourage more people to use it. But the car will remain important to the mobility of millions of people and the numbers of people owning cars will continue to grow. So we also want to make life better for the motorist. The priority will be maintaining existing roads rather than building new ones and better management of the road network to improve reliability.

More bus lanes, properly enforced, will make buses quicker and more reliable. Even a small increase in the numbers of bus passengers will transform the economics of the bus industry, allowing higher levels of investment in new buses and new and more frequent services.

Source: John Prescott Foreword to Future of Transport White Paper

The key document is the Future of Transport white paper published in 2004 that outlines strategy to 2030 and investment plans to 2014-15.

Transport strategy is now built around three central themes.

1. Sustained investment over the long term. Spending by the Department for Transport is to rise by an annual average of 4.5 per cent in real terms between 2005-8, a growth in real terms of 2.25% each year through to 2015.

2. Improvements in transport management by

i “reorganising the rail industry to improve performance, drive down costs and get better value from public spending.”

i “Better traffic management will ease congestion on our road network” by adding capacity to the road network, “sympathetic to the environment”. Options include road tolls, carpooling through High Occupancy Vehicle lanes

http://www.dft.gov.uk/stellent/groups/dft_about/documents/page/dft_about_021588.hcsp

http://www.dft.gov.uk/stellent/groups/dft_about/documents/page/dft_about_503944.hcsp

http://www.dft.gov.uk/stellent/groups/dft_railways/documents/divisionhomepage/031104.hcsp

http://www.dft.gov.uk/stellent/groups/dft_aviation/documents/divisionhomepage/029650.hcsp

http://www.dft.gov.uk/stellent/groups/dft_about/documents/divisionhomepage/031259.hcsp


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3. Planning Ahead. “We cannot build our way out of the problems we face on our road networks. And doing nothing is not an option. So Government will lead the debate on road pricing.”

The Allocation of Resources – theory

Resource allocation refers to a given use of land, labour, capital and entrepreneurs those results in particular amounts of goods and services being produced. The phrase best allocation of resources refers to economic efficiency and is about making:

i the best possible use of resources (productive efficiency) to

i satisfy the maximum amount of wants (allocative efficiency).

A particular static resource allocation in a given market is assessed using productive & allocative efficiency criteria (rules).

It is important to understand that efficiency has a time perspective. Economists distinguish between:

i Static efficiency is about how resources are used and products allocated at a given moment in time

i Dynamic efficiency is about how resources are used and products allocated over time.

Productive Efficiency in the Short Run

Productive efficiency can be defined alternatively as:

i Using the least amount of resources to produce a given good or service or Productive efficiency -

requires lowest SAC

B

A

Cost

s £

SAC2

SAC1

i Output is being produced at the lowest possible unit cost

Productive efficiency occurs when unit costs of production are minimised and firms are producing on the lowest point of the lowest short run average cost (SAC) curve.

In the diagram opposite, B is productively efficient; A is not. However B is only productively efficient if SAC2 lies on the lowest point of the long run average cost (LAC) curve. Output

Productive efficiency implies firms are using

i The least costly labour capital and land inputs in both the short and long run

i The best available technology

i The best production processes

i Exploiting all potential economies of scale and

i Minimise the wastage of resources in their production processes


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Productive Efficiency in the Long Run

A firm can be technically efficient - ie at the lowest point of its SAC curve - and still fails to exploit all potential economies of scale.

Cost

s £

LAC

Productive efficiency - also requires lowest LAC

B

A

SAC2

SAC1

In the diagram opposite, economies of scale mean the long run average cost curve (LAC) curve slopes downwards until the Minimum Efficient Scale of output is reached and all potential economies of scale are exhausted.

MES Output In the long run a firm can move from SAC1 to SAC2 by increasing the amount of capital used. In the diagram above, B is productively efficient; A is not.

An important issue is at stake here: static analysis can ignore potential dynamic efficiency gains through economies of scale in capital intensive transport industries with a high minimum efficient scale and R&D for innovation.

Allocative Efficiency

There is little point in producing goods and services at lowest cost if they are not the products most valued by consumers. Productive efficiency is a necessary but insufficient condition for an optimal allocation of resources. Allocative efficiency is also required.

Allocative efficiency occurs when at a given level of output, the value consumer place on a product (marginal benefit) equals the cost of the resources used in its production. This assumes no externalities are created in production or consumption.

The first step is to establish some method of valuing the benefits consumers place on consumption. In economics, money is used as a unit of account to measure value. The value of a good or service to a consumer is given by the price the buyer is willing to pay. Willingness to pay (WTP) is the maximum price a consumer is prepared pay to obtain a product rather than forego consumption and shown by the demand curve.

Willingness to pay used as a measure of a consumer’s marginal private benefit (MPB) and is shown be the demand curve.

You will remember from the previous section that, in conditions of perfect competition, the supply curve shows both:

i the amount of a good producers are willing and able to sell at different prices and

i the cost in money terms of the resources needed to produce an extra unit ie private marginal cost (MPC)


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Identifying one allocatively efficient level of output in an industry involves comparing the cost of producing an extra unit – marginal cost - with the benefit gained from its consumption – marginal benefit. Compare three possible levels of output:

10 units: under allocation. The value placed by consumers (MPB) on the 10th unit, alone, is £3. The cost of making that unit (MPC) is just £1. Increasing the amount of resources used up to the 20th unit is an improvement on resource allocation because for each extra unit MPB>MPC

£3

D = mpb

Allocative efficiency - assuming no externalities S = mpc

£2

£1

30 units: over allocation. MPB for 30th unit is £1 while the MPC is £3. Reducing the amount of resources until MPB>MPC, ie to 20 units, is an improvement on resource allocation.

20 units: optimal allocation of resources occurs when 20 units are bought and sold because the value consumers place on the consumption of the extra 20th unit exactly equals the marginal cost to the firm of producing that good. MPB = MPC = £2

20th 10th 30th

Allocative efficiency occurs when the value that consumers place on a product (ie the price they are willing and able to pay) equals the cost of the resources used up in production. The technical condition required for allocative efficiency is that price = marginal cost. Assuming no externalities, allocative efficiency occurs when for a given level of output:

i Private Marginal Benefit (PMB), the value consumers place on a good ie price, equals

i Private Marginal Cost (PMC), the cost of resources used up in producing that good ie marginal cost

Conclusion:

The interaction of supply and demand result in an equilibrium price and output that is allocatively efficient. The value consumers place on output equals the firms’ costs of production.

Traditional micro economic theory argues that only a perfectly competitive market structure, where there are no externalities, guarantees an efficient allocation of resources.

The characteristics of transport mean such conditions are not always met. Transport markets fail because:

i Operators and users fail to take account of significant externalities.

i Imperfect competition in a transport market eg in some regions local buses are a monopoly

i Roads are a quasi public good ie to some extent non-excludable and non-rival.

i Railways are a natural monopoly so a regulated monopoly is the best solution

These issues are examined in depth in the final section Market failure: the Role of the Government in Transport


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Consumer & Producer Surplus

The concepts of consumer and producer surplus are used to assess the impact of a resource allocation. For example, the effect on consumer welfare of a rail subsidy.

Consumer surplus is the difference between the maximum a consumer would pay for a good and the price actually paid, and is a measure of the welfare that consumers derive from the consumption of products

D

(Qd)

K

P1

Consumer Surplus

Q1

Consumer Surplus

L

S

pric

e pe

r un

it

In the diagram opposite, the market price is P1 with Q1 exchanged.

For every unit up to Q1 consumers have been willing to pay more that the market price. The total area of consumer surplus is given by the area (P1, K, L)

Producer surplus is the difference between the minimum price a producer would accept to supply a given quantity of a good and the price actually received. Producer surplus is a measure of firms’ welfare.

D (Qd)

K

P1

Q1

Producer Surplus S

L

Producer Surplus

In the diagram opposite, the market price is P1 with Q1 exchanged. For every unit up to Q1 producers receive more than they need to supply a given output.

pric

epe

runi

t(P)

The resultant total area of producer surplus is given by the area (0, P1, L)


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Integrated Transport

Integrated transport occurs when passengers and freight can easily switch between different modes of transport in a given journey eg it is possible for car drivers to park outside town, catch a bus to the city centre rail station and easily to switch to rail.

Transferring between different modes of transport is time consuming and requires co-ordinated timetables eg buses leave after, rather than before, a connecting train arrives.

Integrated Transport Policy

i helps passengers and freight switch easily between different modes of transport in a given journey. Eg encouraging park and ride schemes outside towns and the use of containers to minimise inconvenience when switching modes from ship to lorry or rail.

i seeks to shift travel from the less to more sustainable transport modes and improvements within each mode eg cleaner fuels

Private Sector Funding of Transport

Investment is expenditure on producer goods and in transport can be either in infrastructure or vehicles, buses, rolling stock (trains) aircraft etc.

Consider the following characteristics of transport investment:

i Transport investment especially in infrastructure is very expensive and measured in £billions

i Infrastructure has a life of 25+ years ie is long term

i The costs mainly occur in the early years while the benefits are spread over the life of the project

i Transport infrastructures also create positive externalities.

Investment in local transport infrastructure can be an initial stimulus to regional economic development with improved job opportunities and a multiplier effect.

How do companies approach investment decisions? Profit maximising private sector firms focus on profitability and only take into account private costs and private benefits.

Investment appraisal involves identify predicted costs and revenues generated by an investment over its expected life, taking into account an assessment of risks and potential forecasting errors (sensitivity analysis). Projects with the highest rate of return are implemented.

Investment in public transport has been neglected for decades such that the current transport network is unable to cope with current let alone projected demand. The scale of investment needed to increase capacity is in excess of £150bn beyond the current resources of government.

Involving the private sector increase the amount of investment that can be undertaken now and, the government argues, results in an increase in productive efficiency.


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Public Private Partnerships (PPPs) are joint ventures between private sector firms and public sector agencies. The Private Funding Initiative is an example of PPP where:

i Private sector firms: design, build and finance new projects eg Chunnel high speed rail link; Maintain the infrastructure over 25-30 years

i The public sector pays an annual charge for the completed project for 25-30 years; Operates the network and ensures safety although the government is now proposing private sector management; assumes ownership of the asset at the end of the 25-30 year contract.

An alternative to raising money through PFI is to issue bonds - IOUs paying interest yearly which will be bought back sometime in the future.

Rail Bonds

Following support from leading credit agencies last week for Network Rail’s bid to raise £10 billion, the company says it hopes to delay a planned increase in track access fees by instead taking on more debt to carry out spending plans without squeezing government budgets. A spokesman said Network Rail had submitted plans on 27 February to independent rail regulator to delay a planned rise in track access charges by two years but to borrow about £3 billion.

Meanwhile. the Sunday Times reported that Network Rail is drawing up plans for a long-term "railway bond" to be issued this year as the final part of the company’s financial restructuring. The Sunday Times said bankers envisaged several billion pounds worth of 50-year bonds being issued — with a ground-breaking explicit government guarantee of repayment. The bonds would only default if the railways suffered a "total network closure." Source Railnews 01 March 2004

Arguments for Private Funding

The arguments for the Private Funding Initiative include:

i Finances expensive projects that might otherwise not be undertaken. The government can invest in transport infrastructure, in the current time period, without raising taxes, increase borrowing or diverting expenditure from other priority areas such as education and health.

i Offers better value for money than public funding by encouraging greater control of costs over the project's lifetime. Unlike public sector organisations, the private sector is motivated by the profit motive. There are incentives to be more technically efficient than the public sector resulting in cost savings. Eg:

i Penalty clauses act as an incentive for firms to finish projects on time and within budget

i As contractors are responsible for maintenance costs there is an incentive for initial high quality construction.

i Private sector firms are ‘better managers’ who can improve labour productivity.

i Transfers risk from the government to firms. Profit is the reward for risk taking. All engineering projects face uncertainty. Under PFI firms assume that risk.

Arguments Against Private Funding

Offers poor value for money. Private sector firms require high profits for assuming high risk Critics argue that increased profit margins exceed the potential savings from greater efficiency.

http://www.railnews.co.uk/displaynews.asp?ID=385


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Increase the cost of borrowing. The government can borrow money at lower rates of interest than the private sector because there is less risk of default. PFI means higher interest repayments than if the cash had been borrowed by the Treasury. Eg London Mayor, Ken Livingstone argues that a £13m bond scheme is a cheaper source of finance than PFI.

Private sector firms seek high profits to cover risk. Engineering uncertainties often result in costly project delays or even failure. Critics argue the risk of over budget run is simply transferred back to the government by increased profit margins demanded by contractors to compensate for high risk

The government must act as ultimate guarantor. Ultimately the government has to intervene when private sector firms fail in transport. Liability for failure ultimately rests largely with the state. Eg

i NATs After 11 September a 40% fall in long haul flights meant the government was forced to make a loan of £40m or risk a vital public service becoming insolvent.

i Railtrack: the government has offered £500m to compensate shareholders having place the plc into administration

Case Study: London Underground

Metronet and Tube Lines are infracos that have won a PPP 30-year contracts worth £15.7 billion to modernise the tube's tracks

In June 2004 the National Audit Office reported there was limited assurance that the price of the three Tube PPPs was reasonable, and some uncertainty about the final cost of the scheme.

The terms of the deals changed markedly during prolonged negotiations with the eventual winning bidders. After competitive bidding, the prices all rose, adding £590 million to the 30 year cost of the deals. If they deliver performance at bid levels private sector shareholders stand to receive nominal returns of 18-20 per cent a year. This is about a third higher than on recent PFI deals but London Underground considered that it was in keeping with the risks being borne.

The work will start two years later than originally planned. Recovering the maintenance backlog is now expected to take over 22 years rather than the 15 years originally intended. There has been "low productivity" during weekend closure work by the companies

It is too early to judge how successful the PPPs will be. There are financial incentives to deliver better performance Adapted from National Audit Office: London Underground PPP

http://www.nao.org.uk/pn/03-04/0304644_645.htm


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New Toll Motorway Plans

The Department for Transport is consulting on the proposed M6 Expressway, a 51-mile dual-carriageway running parallel to the M6 from junction 11A near Cannock in Staffordshire to junction 19 near Knutsford in Cheshire, linking the West Midlands to Manchester

The expressway is being considered instead of widening the junctions 11-19 stretch of the M6 from three lanes to four.

Ministers want to bring in the private sector to fund the new motorway, following the success of the M6 Toll, as an alternative to widening the existing M6 motorway. But the scheme is opposed by environmental campaigners and sections of the business community.

It would be only the second pay-as-you-go toll road, following the opening in December 2003, of the 27-mile M6 Toll from junction 4 in Warwickshire to junction 11 in Staffordshire. If approved, it will be opened by 2019.

Adapted from Birmingham Post 3 Nov 2004


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Costs Structure of Transport Operations

Total costs are made up of fixed and variable costs.

i Fixed costs independent of the number of miles travelled eg rail track road network

i Variable costs are dependant upon the number of miles travelled eg petrol costs of a car journey

The table below gives examples of examples of fixed, variable and semi fixed costs involved in operating a taxi fleet

Fixed, variable and semi fixed costs involved in operating a taxi fleet

Fixed Costs independent of mileage • Car purchase / replacement • Interest on loans • Depreciation of vehicle due

to age

Variable Costs depend on miles/usage

• Fuel • Depreciation from mileage • Time

Semi fixed costs part fixed and part variable eg

• a firm may employ a pool of drivers who may be idle at some point in the day.

Operating costs are affected by

i Load factor refers to the proportion of total space or seats sold. A load factor of 80% means 8 in 10 seats are sold. A greater load factor means higher technical efficiency, and lower units costs

i Economies of scale. Fixed costs form a high percentage of rail sea and air operations. A large lorry or airplane allows fixed costs to be spread over higher number of passengers or freight.


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Calculating Private, External & Social Costs

Private Costs

What is the cost of a commuter making a car journey, during the rush hour, from home in some leafy suburb, to work in a city centre,? One answer is to calculate the private cost to the motorist of their economic activity ie the variable costs such as petrol, depreciation from mileage and estimate the value of time used.

However such an answer is incomplete because it fails to take account of external costs.

External Costs

The economic actions of consumers and producers can often affect third parties (other people). Generally producers and consumers only take into account the private costs and benefits of production or consumption – how they themselves are affected – and ignore any unintended spill over effects on third parties (someone not directly involved) of their decisions. For example:

i A car journey by a commuter causes congestion; air pollution; noise; accidents; climate change.

i Infrastructure projects such as a new motorway link can result in loss of rural land for current and future generations (sustainability issues); loss of natural habitat for animals; visual intrusion on landscapes; blight where planning inquires create delay and uncertainty

Economists have a name for this unintended spill over effects on third parties: externalities

Negative externalities occur when production or consumption inadvertently imposes costs on third parties eg: airline passengers ignore the unintended but harmful environmental impact of C02 emissions on the ozone.

Note that externalities

i are generated by first parties (producers and consumers)

i affect third parties (someone not directly involved)

i consumers and/or producers pay no appropriate ‘compensation’ to others who are affected by their ‘selfish’ actions

The issue becomes how can externalities be valued? It is one thing to say that a journey imposes cost on third parties and quite another to place an exact value on that negative externality.

In economics money is used as a unit of account to measure costs and benefits of economic activity including the impact of negative externalities. This means that economists attempt to value an externality by placing a monetary value on a given spill over effect.

In practice estimating time savings, loss of life or limb; environmental damage, lost countryside of loss a species is highly problematic. Taking a non transport example, how can the impact of ‘passive smoking’ on non-smokers be valued using moneys? Will everyone agree with a given valuation of the negative impact on non smother for every cigarette smoked? Should that value be eg 10p or £1?


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So external costs are the costs of negative externalities expressed in terms of money. Eg the Adam Smith Institute estimate annual external cost of road congestion in the UK is £18Bn.

Social Costs

Social costs refer to the total cost to society of an economic activity ie

i the private cost to first parties and

i external costs inadvertently imposed on third parties.

i Social costs are found by adding together the private and external costs of a given economic activity: social costs = private costs + external costs ie SC = PC + EC

Private Costs + External cost = Social Costs

Cost to consumers or firms of their economic activity

Cost to others of someone else’s economic activity

Total cost to society of a given economic activity

Cost to first parties - individuals Cost to third parties - others

Total Cost to society - everyone

Opportunity cost measures the cost of any economic choice in terms of the next best alternative foregone. Ignoring external costs and using only private costs is an incomplete measure of opportunity cost. Establishing both private and external costs means social cost is a ‘complete’ measure of the full cost to society of an economic choice.

Why Should Aviation Pay for its External Costs?

i Government policy supports the principle that polluters should meet the costs that they impose on society.

i Aviation is one of the fastest growing transport sectors world wide and is already responsible for 3.5% of climate change emissions resulting from all human activity - as much as the total greenhouse gases emitted by the UK.

i By 2050, aviation's contribution to climate change could grow to as much as 15%.

i Those affected by noise pollution from aircraft is estimated to increase by 42% across Europe (between 2002 and 2020) - a rise from 2.23 million to 3.17 million.

i Aviation Passenger Duty (currently between £5 and £40 per passenger) raises £800 million a year, yet Climate Change costs are around £1.4 billion per year, which means that UK industry only covers around 50% of the climate change costs it generates. This does not include other external costs.

i By not paying for its full external costs, the aviation industry contributes to the over-consumption of its services.

Source: Commission for Integrated Transport Factsheet 14 The external costs of aviation

http://www.cfit.gov.uk/factsheets/14/index.htm


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Calculating Private, External & Social Benefits

A similar argument applies to calculating social benefits – the true benefits of economic activity can be greater than the gains experienced by users.

Private Benefits

How can economists measure the benefit to a rail commuter from a journey? Again, money is used as a unit of account to measure the value of a product to the consumer. This is done with reference to the demand curve for a good which reveals consumer’s willingness to pay for an item – an expression of the value they place upon consumption of the product.

To take a non transport example, Q: ‘what is the direct value of a can of coke?’ A: ‘the price paid in the shop eg 60p’.

Willingness to pay (WTP) is the maximum price a consumer is prepared pay to obtain a product rather than forego consumption and shown by the demand curve. WTP is used as a measure of a consumer’s private benefit (MPB). In short, the value of a good or service to a consumer is given by the price the buyer is willing to pay.

Note private benefit has two components: direct and indirect.

• Direct private benefit is measured by the total amount consumers pay eg the price of the ticket, say, £60, times the number of journeys bought at this market price, 500. Direct private benefit = £30,000

• indirect private benefit is measured by consumer surplus – the difference between the ticket price and the maximum consumers are prepared to pay for a seat – estimated here as (£100-£60) x 250 = £10,000: the amount of indirect private benefit.

D

pric

e pe

r un

it

(Qd)

£100

£60

Consumer Surplus

500

Consumer Surplus

L

Total revenue

S

The overall private benefit to of economic activity is measured in terms money by adding up direct private benefits and indirect private benefits. Here £30,000 + £10,000 to derive a total of £40,000

Private Externalities

Externalities are not always adverse and can be positive. Private benefits ignore any beneficial spillover effects enjoyed by third parties and for which no money is paid by beneficiaries.

Positive externalities occur when third parties benefit from the spill over effects of production or consumption eg a rail commuter switching modes from road to rail usage benefits other road users by reducing congestion on a given route.


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Social benefits

Social benefits refer to the total benefit to society from a good ie the benefit to individuals and any beneficial unintended spill over effects on third parties. Social benefits are found by adding together the private and external benefits of a given economic activity. Social benefit = private benefit + external benefit SB = PB + EB

Private Benefits + External benefits = Social Benefits

Benefits to individual consumers or firms of their economic activity

Benefits to others of individual consumers or firms economic activity

Total benefits to society of a given economic activity

Benefits to first parties - individuals Benefits to third parties - others

Total benefits to society -everyone

Difficulties of Estimating Externalities

Valuing external costs and benefits is difficult and controversial. It is important to remember that the monetary value placed on externalities are ‘best guess’ estimates. Different economists may place a different monetary value on the same spillover effect because

i Alternative methods used to estimate externalities. There are two methods:

o Ex-ante (before the fact) valuations estimate the amount of money consumers are prepared to pay to avoid an externality

o Ex-post (after the fact) valuations estimate the cost of putting right the externality

i Many externalities have no markets therefore no market determined price. Prices must be estimated. But can the effects of externalities always be expressed in terms of money? Eg how can economists value the loss of a species of butterfly caused by the Newbury bypass?

The Dept of Transport assess environmental, accessibility, and integration impacts qualitatively ie without any attempt to place a monetary value on the externality

The techniques and difficulties involved in estimating externalities are the focus of cost benefit analysis


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Cost Benefit Analysis

Governments face difficult choices: do we build new roads or new rail track? Given limited resources how can government decide which projects to prioritise and build and which to reject?

Cost Benefit Analysis (CBA) offers a systematic framework for measuring and evaluating the likely impact of public sector project, takes into account both private and external costs and benefits over the entire life of the project.

Cost benefit analyses was used in the original M1 motorway, the third London airport, London's Victoria Line underground, and more recently Birmingham Northern Relief Road

CBA Worked Example: a project to build a toll bridge over a river:

CBA seeks to measure the value to society as a whole of the resources used by, and the benefits created by, an investment project such as a new toll bridge over a river over its expected life eg 25 years

Step 1: Economists identify all costs and benefits – both private and external:

Private Costs borne by the supplier eg construction costs, operating costs and maintenance costs

External Costs incurred by non users eg pollution, noise, loss of countryside,

Private benefits to consumers

i direct ie the amount consumers are prepared to pay eg the tolls paid as shown by the demand curve

i indirect ie consumer surplus – the difference between the toll and the maximum consumers are prepared to pay for a crossing

External benefits ie benefits to non users eg time savings for all travellers and fewer accidents

Step 2: Place a monetary value of costs and benefits

Height is measured in feet or metres. Economists measure benefits and costs using money as a unit of account. Economists estimate:

Private costs eg Construction costs: £5,000, 000 to build the bridge; operating costs: say £200,000 a year; Maintenance costs: Repair and maintenance say £5,000 a year

External Costs are more difficulty to estimate. How do we value the effects of negative externalities such as congestion, accidents, noise, loss of countryside and air pollution?

Private Benefits eg

i Direct 1,000,000 journeys each paying £1 toll = £1,000,000 a year

i Indirect consumer surplus eg £500,000

External Benefits eg time savings. What value do we place on work time saved or leisure time saved? Is the time saved worth the same to everyone? If 100,000 hours are saved and valued at £4 per hour, benefit = £400,000 Fewer accidents. Economists value human life using money! One life = £750,000. One limb = £80,000. If the bridge reduces accidents and saves on life a year, annual benefit is £750,000


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Step 3: Estimate Future Costs and Benefits

The major costs of the project occur straight away eg £20m in Year 1

The benefits occur over the life of the project eg If the expected life of the bridge is 25 years consumers benefit by £1m a year now and for the next quarter of a century. However, how do we value now £1m of benefit in 25 years time? Economists use a technique called discounting to establish the present value of future benefits.

Present discounted value PDV is the value today of an expected stream of future net benefits ie costs – benefits for each year of the project discounted using the equation PDV = (B-C)/(1+r)n

The net present value of a future amount of money is the maximum amount you would be willing to pay today for the right to receive that amount of money in the future. Eg you may pay £100 today for the right to receive £1,000 in 10 years time.

Step 4: Is a Project worth Undertaking?

This involves establishing the present discounted value (PDV) of future costs and benefits

Present discounted value PDV is the value today of an expected stream of future net benefits ie costs – benefits for each year of the project discounted using the equation PDV = Σ(SB-SC)/(1+r)n where Σ is the sum of; SB is social benefits; SC is social costs; r the discount rate of interest used eg 5% and n the life of the project.

A project is worth undertaking if the stream of current & future benefits, exceed current & future costs ie PDV is positive.

If the government has to choose between competing projects then the ones with the highest positive net present value should be undertaken.


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The Limitations of CBA

A CBA is simply a money value estimating the value today of all the costs & benefits, both private and external, associated with a given investment project such as a new runway for Heathrow. The following qualifications need to be taken into account:

i Have all relevant costs and benefits been included? COBA ignores environmental impacts and so is not comprehensive

i Many external costs and benefits are hard to measure using money. What is the value in money terms of loss of a species of butterfly? For this reason, Dept of Transport Appraisal Summary Tables AST’s use qualitative indicators

i Is it better to use ex ante or ex post valuations? In the ex ante willingness to pay (WTP) method, £1 is assumed to be of equal value to different people. Equity issue: £1 means ‘more’ to a poor person than a rich one.

i What rate of discount is appropriate? Do current market interest rates reflect long-term social opportunity cost of borrowing?

i Uncertainty. How reliable are the forecasted costs and benefits? Is there a significant margin of error or risk in figures and projections used? Sensitivity analysis is used to try to take account of future uncertainty. This result in a rang of valuations depending on best and worst case scenarios

i CBA ignores the effect on income distribution of a project that creates ‘winners and losers’. CBA assumes the value of £1 is the same even where the rich gain at the expense of the poor from a proposed project.

CBA Using COBA

The COBA Model

The COBA model is designed to compare a 'do minimum' scenario with a 'do something' one -- typically, the construction of a new road. following magnitudes enter into the COBA accounts.

i consumers' surplus, ie the excess of the WTP of road users (non-work trips) or their employers (work trips) over Pi, the perceived cost of trips. This is measured in relation to a demand function which relates the number of trips to the perceived cost.

i fuel cost of trips, including indirect taxes.

i non-fuel money cost of trips (eg depreciation), including indirect taxes.

i 'perceived' time cost of trips. For work trips, time is valued at the gross wage rate, interpreted as a measure of the marginal product of labour. For non-work trips, COBA uses the equity value of time, i.e. a travel-weighted average of WTP.

Source: Dept of Transport Multi-modal transport appraisal investment 2002

Since the 1970s, trunk road schemes have been appraised Dept of Transport a restricted type of CBA, COBA or Cost Benefit Analysis computer program to establish the net present value of a new trunk road scheme compared with a traffic scenario without the road scheme.


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COBA Worked Example £ million

Net benefit to project users (excluding accidents) 50

Net increase in indirect tax revenue 6

Net benefit of change in accident risks for project users 2

Net benefit of change in accident risks for non-users, and external effects of accident risks for users

2

Total benefit 60

Construction and maintenance costs (borne by sponsoring agency) 45

Net present value 15

The stream of costs and benefits over 30 years are discounted at 6% to establish a net present value (NPV) ie a current valuation of 30 years net benefit from a new road scheme

Note that COBA only estimates the safety and economy impacts of projects to direct users of the proposed road schemes. Wider effects such as the impact on the local economy are ignored.

Critics argue that a full-blown CBA including an attempt to value environmental externalities offers a more comprehensive assessment of a proposed road scheme

Appraisal Summary Table

Decisions on new road schemes are made by government ministers. If there are alternative methods of improving a road schemes, then an Appraisal Summary Table (AST) is developed for each. An AST is a one page summary of the main economic, environmental and social impacts of a road scheme, set out in tabular format.

ASTs include a

i statement of the problems which the scheme aims to resolve;

i a note of the other options for dealing with the problems;

i safety effects;

i integration effects

i and results of the cost benefit analysis

ASTs therefore make use of

i quantitative Cost Benefit Analysis (CBA) and

i qualitative Environmental Impact Assessment (EIA) assessing the environmental, accessibility, and integration impacts of a scheme qualitatively on a seven-point scale (large negative; moderate negative; slight negative; neutral; slight positive; moderate positive; large positive).


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4 Market Failure: the Role of the Government in Transport

Market Failure – an overview

Market failure occurs when free markets, operating without any government intervention, fail to deliver an efficient allocation of resources.

Market failure results in

i Productive inefficiency. Firms are not maximising output from given factor inputs and is a problem because the lost output from inefficient production could have been used to satisfy more wants and needs

i Allocative inefficiency. Resources are misallocated when firms produce goods and services not most wanted by consumers, given their costs. This is a problem because resources can be put to a better use making products consumers value more highly so that more wants and needs are satisfied and economic welfare increased.

Markets can fail because of the following factors:

i Externalities either negative (eg pollution) or positive (eg public infrastructure) causes private and social costs and/or benefits to diverge

i Imperfect information means merit goods are under produced while demerit goods over produced

i Markets cannot make an ‘appropriate’ profit from producing public goods such as light houses and quasi-public goods such as roads

i Market power: imperfect competition results in market dominance such as the abuse of monopoly power to set prices higher than if the industry were competitive

i Factor immobility eg geographical & occupational causes unemployment hence productive inefficiency. This aspect is not really relevant to transport economics

i Equity (fairness) issues. Markets can generate an ‘unacceptable’ distribution of income and social exclusion where people on low income – the relatively poor - are denied access to essential goods and opportunities considered ‘normal’ by a society eg food, clothing, housing, and education. Note that air rail and private cars are used disproportionately by the rich while those least off are more likely to use public transport

Be sure to appreciate that there can be more than one cause of market failure in a transport industry – Markey failure may occur form several reasons eg externalities, imperfect information and local market dominance and equity issues in bus transport.

Before developing an analysis of market failure in different transport industries there is the need to develop further the marginal analysis of costs and benefits explained in Section 3 - and to revisit the concept of allocative efficiency.

This involves learning some new theory and wherever possible transport examples are used.

Marginal External & Social Cost & Benefit Curves

Economists are interested in decisions taken by consumers and firms, ‘at the margin’. Marginal means the extra unit. Does society gain if an extra journey is undertaken?


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Allocative efficiency in a given market involves comparing the full social cost of producing an extra unit – marginal social cost - with the full benefit gained from its consumption – marginal social benefit. If the marginal social cost of an extra unit is less than the marginal social benefit derived from its consumption, then it makes sense to increase production up to the point where SMB=SMC.

Analysis of market failure in transport is best illustrated graphically by introducing marginal external cost and marginal external benefit curves:

Marginal External Cost & Social Cost Curves

Marginal social cost (MSC) is the cost to society of producing one extra unit of a product. In the diagram opposite:

i The marginal private cost curve (MPC) shows the cost of an economic activity to the decision maker eg a firm. MPC is given by the firm’s supply curve.

Marginal Social Cost

MEC

MSC= MPC + MEC

S = MPC MEC

Cost

s &

Ben

efit

s £s

i The marginal external cost curve (MEC)

shows the estimated cost of an economic activity imposed on third parties

i The marginal social cost curve (MSC) is the total cost to society of producing an extra unit of a good ie MSC = MPC + MEC

Quantity

Do marginal external costs necessarily remain constant as output rises? More likely is increasing negative externalities as more journey are undertaken. For example, the traffic congestion as extra drivers join a crowded road means external costs such as time lost through jams, rise for all motorists.

Constant or increasing negative externalities?

MEC – increasing externalities

MEC – constant externalities

A horizontal MEC curve assumes that the value of negative externalities stays constant as journeys rises.

An upward sloping MEC curve assumes that the value of negative externalities increase with more use of a transport network.

Cost

s &

Ben

efit

s £s

Journeys


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Marginal External Benefit & Social Benefit Curves

Marginal social benefit (MSC) is the benefit to society of consuming one extra unit of a product and can be illustrated graphically. In the diagram opposite:

i The marginal private benefit curve (MPB) shows the benefit of an economic activity to the decision maker eg a consumer. MPB is given by the market demand curve.

Marginal Private, External and Social Benefits

MSB= MPB + MEB

MEB D= MPB

MEB

Cost

s &

Ben

efit

s £s

i The marginal external benefit curve (MEB) shows the estimated benefit of an economic activity enjoyed by third parties

i The marginal social benefit curve (MSB) is the total benefit to society of using an extra unit of a good ie MSB = MSB + EMB

Quantity

An Efficient Allocation of Resources – a Marginal Approach

The efficient allocation of resources requires output to be increased up to the point where social marginal benefit equals social marginal cost.

In a free market firms only take into account the private costs of their production. Given negative externalities - such as noise pollution from travel - private and social costs diverge. Consequentially, an unregulated (free) market consequentially overproduces the good.

Market Failure through negative externalities – over production

MSC = MPC + MEC

Quantity Qeff Qmkt

In the diagram opposite, the supply curve S shows the firm’s marginal private cost of production (MPC) but ignores any spill over effects on third parties. S= MPC.

Given negative externalities such as pollution, marginal external costs must be added to the MPC to give the marginal social costs curve (MSC). MSC = MPC + MEC.

The demand curve is a measure of private marginal benefit. Given no positive externalities D also shows social marginal benefit D = PMB = MSB.

MPC = S

D = MPB = MSB

J

K

L

MEC

Cost

s &

Ben

efit

s £s

The equilibrium level of output delivered by a free market, QMkt, is allocatively inefficient. SMB = SMC at Qeff. The market has overproduced by (QMkt – Qeff).

A welfare loss triangle measures the loss to society when markets are allocatively inefficient. They are a quantitative measure of inefficiency. The welfare loss triangle JKL gives the amount of welfare loss from overproduction.


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Worked Example: Market Failure through Externalities from Congestion

Earlier analysis has indicated that externalities are the unintended spill over effects on third parties of economic activity for which no appropriate compensation is paid.

Externalities are generated by first parties (producers and consumers) and affect third parties (someone not directly involved). Externalities cause market failure because they cause private and social costs and benefits to diverge. Consider the case of road congestion.

J Of peakf

Marginal external cost (emc)

Marginal social cost = pmc + emc

Marginal private cost (pmc)

D2 Peak Demand = pmb

D1 Off Peak Demand = pmb

J eff J PeJ Capacity

Cost

s &

Ben

efit

s £s

P1

Number of Journeys ak

In the above diagram there are two demand curves for travel along a given route:

i D1 is off peak demand for travel. The number of journeys, J off peak, is less the capacity of the road and so there is no congestion. The marginal cost of each extra journey is constant at P1.

i D2 is peak demand for travel At J Capacity the network is at full capacity. Beyond J Capacity

peaking occurs. Extra cars generate negative externalities eg congestion reducing speed of other vehicles

i Marginal external cost is a monetary estimate of the externality imposed on third parties by rush hour motorists and operates beyond J Capacity. It diverges from because as extra cars join, the degree of congestion increases.

i The government needs to take measures to reduce congestion to J eff, where MSC= MSB

Congested road space can be rationed by

i Queuing: the resultant traffic jams waste time and generate pollution

i Regulation: banning some motorists from driving eg Florence bans cars from their narrowest streets or pedestrian central shopping areas

i Price: allocating road space to those who value it most – ignoring income distribution and equity issues

The implications and advantages of each method are covered in depth later in this section.


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S = MPC = MSC

Market failure also occurs when firms ignore the positive external effects of their production.

In the diagram above the supply curve S shows SMC because there are no negative externalities. S = MPC = MSC.

The demand curve is a measure of private marginal benefit. Adding marginal positive externalities to D gives social marginal benefit. MSB = MPB + MEB.

MSB= MPB + MEB

Market Failure through positive externalities – under production

D= MPB

MEB N

M L

Cost

s &

Ben

efit

s £s

QuantityQmkt Qeff

The equilibrium level of output delivered by a free market, QMkt, is allocatively inefficient. SMB = SMC at Qeff. The market has under produced by (Qeff – QMkt). The welfare loss triangle LMN quantifies the amount of welfare loss resulting from underproduction

Summary

In free unregulated markets, externalities cause private and social costs or benefits to diverge so that the equilibrium and allocatively efficient level of output are different and markets fail.

i Negative externalities mean social costs exceed private costs resulting in overproduction

i Positive externalities cause social benefits to exceed private costs resulting in underproduction

Market Failure from Imperfect information

Consumers and producers make economic decisions based on available information. Perfect information allows them to make informed choices. Imperfect or misunderstood information can result in ‘wrong’ choices. Private and social costs and benefits diverge so that the equilibrium and allocatively efficient level of output are different and markets fail.

Imperfect information can be caused by

i Misunderstanding over the true costs or benefits of a product. Eg the health benefits of cycling

i Uncertainty about costs and benefits eg hybrid car technology

i Complex information eg choosing between petrol or diesel requires specialist knowledge of cars

i Inaccurate or misleading information eg some advertising may ‘oversell’ the benefits of private motoring


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Market Failure from Merit & Demerit Goods

A merit good is a product, eg education, the government believes consumers undervalue because of imperfect information. A merit good is ‘better’ for a consumer than the consumer realises eg measles inoculation.

It could be argued ‘healthy’ forms of transport such as walking or cycling are merit goods which consumers undervalue because they fail to appreciate the long term value of exercise

MSB= ‘correct’ valuation

S = MPC = MSC

Market Failure through information failure – merit goods

In the diagram, opposite, the demand curve for higher education is a measure of private marginal benefit. Consumers do not take account of the full value of learning when calculating their willingness to pay. Adding the ‘true value of benefits’ to D gives social marginal benefit.

The equilibrium level of output delivered by a free market, QMkt, is allocatively inefficient. SMB = SMC at Qeff. The market has under consumed by (Qeff – QMkt).

Cost

s &

Ben

efit

s £s

Quantity

D= MPB = consumers‘ incomplete valuation

L M

N

Qmkt Qef

The welfare loss triangle LMN quantifies the amount of welfare loss from under consumption.

A demerit good is a product, such as tobacco, that the government believes consumers overvalue because of imperfect information. A demerit good is ‘socially undesirable’ and ‘worse’ for a consumer than the consumer realises

Again, it could be argued some consumer over value their motorcycles by ignoring the potential cost of a road accident on this ‘dangerous’ choice of transport mode

The welfare loss triangle LMN quantifies the amount of welfare loss resulting from over consumption

S = MPC = MSC

Quantity

Market Failure through information failure – demerit goods

D= MPB: consumers‘over valuation

Qef Qmkt

L

M

N

MSB= ‘correct’ valuation

In the diagram for motorcycle trips opposite, the demand curve is a measure of private marginal benefit. Consumers do not take account of the accident costs when calculating their willingness to pay.

Deducting disbenefits from the demand curve D gives marginal social benefit.

The equilibrium level of output delivered by a free market, QMkt, is allocatively inefficient. SMB = SMC at Qeff. The market has over consumed by (Qeff – QMkt).

Cost

s &

Ben

efit

s £s

The decision as to what constitutes a merit or demerit good is highly controversial. Who is to say that consumers undervalue products because of ‘information failure’? Governments?

i Free market economists argue views are on what is ‘good’ or ‘bad’ for consumers and producers involves value judgements and state paternalism.

i Others argue that only the government has sufficient information to place an accurate and complete value on socially desirable goods such as public transport.


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Market failure through non-production of public goods

A private good is both rival and excludable. A good which is both non-rival and non-excludable is called a public good:

i Non-rival means an individual's consumption of the good does not reduce the amount of the product available to other consumers

i Non-excludable means once a good is provided others cannot be excluded (stopped) from benefiting from the product.

Examples of public goods include lighthouses and flood defence systems.

Public goods are non-excludable. Once the product is provided, other consumers cannot be excluded (stopped) from benefiting from the good eg a lighthouse. This means some consumers may avoid payment and become free riders ie benefit without contributing to the cost of provision.

Because public goods are non-excludable, profit-seeking firms will not provide them. The non-excludability of a public good encourages some consumers to avoid payment and become free riders. Firms cannot collect all the revenue needed to supply the public good and make a normal profit.

Roads as a quasi-public good

Is the road network a public good? A pure public good is non-excludable and non-rival. Tolls and licences can be used to exclude motorists; once operating at capacity road space becomes rival. In short, road space is a quasi public good

Quasi means near, close, almost. A quasi-public good is a near-public good ie it has many but not all the characteristics of a public good. Eg

i Semi-non-rival: up to a point extra consumers using a road do not reduce the amount of the product available to other consumers. Eventually additional consumers cause peaking and congestion and so reduce journey times and the benefits to other users.

i Semi-non-excludable: it is possible but often difficult or expensive to exclude non-paying consumers. Eg building toll booths or IT based satellite tracking and to charge for road usage on congested routes.

The difficulty and expense of seeking to exclude free riders deters firms from supplying allocatively efficient amounts of quasi-public goods such as roads and so there may be market failure.


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Market failure through market dominance

Market dominance occurs when a firm acquire monopoly power. In the UK monopolies are defined as occurring when firms have 25% or more of the market. Monopoly power can result in:

i Productive inefficiency - firms do not minimise costs

i Allocative inefficiency – the market under produces

Unregulated dominant firms can be inefficient because a lack of competition and their monopoly power allows them to:

i Produce goods at a quality and price largely determined by the firm. Consumers face restricted choice and have no alternative supplier eg Network Rail

i Have less incentive to maximise outputs from given inputs or minimise unit costs. The result is market failure through productive inefficiency.

Set price above marginal (private) cost. Profit maximising monopolists set Q where MR=MC. The resultant price (SMB) does not equal SMC. The result is market failure through allocative inefficiency.

Some transport industries are monopolies and so have the potential to abuse their market power. Eg:

i Natural monopolies such as operating the rail track infrastructure

i Legal monopolies such as Train Operating Companies with an exclusive contract to offer rail tickets over a route

A monopoly can keep price above marginal cost and increase total revenue and profits as a result. In the diagram opposite:

Profit maximising firms set output where MC = MR. The monopolist offers Qmkt for sale at PMkt.

However the socially efficient level of output occurs where MSC = MSB ie Qeff. Market failure occurs because of under production.

The loss to society from under production is given by the welfare loss triangle JLM

MPC = MSC

Market Failure through market dominance

Quantity

D= MPB=MSB

Qeff Qmkt

L

MR

M

J

Cost

s &

Ben

efit

s £s

Pmkt

Peff

In perfect competition MPC gives the supply curve S. Perfectly competitive industries result in a lower Peff – where S=D – and an allocatively efficient level of output Qeff, than monopoly.

This assumes unit costs are the same in perfect and imperfect competition. Monopolists may enjoy economies of scale. See the section on The natural monopoly argument applied to transport


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Market failure through an unacceptably unequal distribution of income

Transport has an equity side. Equity means fairness and any analysis of, say, a government decisions that affect the price of a particular mode of transport should take account of any equity implications.

Excluding people from travel opportunities considered ‘normal’ by the majority is a type of social exclusion in two ways.

i It restricts access to activities that enhance people's life chances, such as work, learning, health care, food shopping, and other key activities.

i Deprived communities suffer disproportionately from pedestrian deaths, pollution and the isolation which can result from living near busy roads.

Economics traditionally distinguishes between

i Positive economics dealing with statements of fact that can be proved or disproved, and shows how the economy actually works.

i Normative economics dealing with statements of opinion which cannot be proved or disproved, and suggests what should be done to solve economic problems. Some commentators argue that in seeking to be positive economists are being normative!

Where possible it is best to refer to accepted and ‘neutral’ criteria such as horizontal or vertical equity to avoid straying into normative areas.

i Horizontal equity requires equals to be treated equally eg people in the same income group should be taxed at the same rate

i Vertical equity requires unequal treatment of unequals to promote greater fairness eg higher income groups taxed at higher rates.

The number of trips made and distance travelled increase with income. Adults in households with two or more cars travel on average nearly four times further than those in households without a car.

On average, men travel over 30 per cent further than women do. Over a quarter of people without access to a car find it difficult to get to hospital. Disabled people are more likely to live in households without a car

Dept of Transport on equity in passenger travel


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Transport Policies to Correct Market Failure

Government Intervention in Markets – an overview

In a free market economic system, governments take the view that markets work, assume a laissez faire (let alone) approach, step back, and allow the forces of supply and demand to set prices and allocate resources.

Where markets fail to deliver an efficient allocation of resources there is an argument for government intervention to correct market failure

When attempting to correct market failure from externalities governments seek to ensure that the firms and consumers who create the externalities include them when making their decisions ie they internalise the external costs and benefits

The government can use the following policies and methods to intervene in market to attempt to correct market failure:

i Legislation eg laws that prohibit (ban) large lorries crossing London at night; parking bans

i Regulation eg government appointed utility regulators who impose strict price controls on privatised monopolists eg Train Operating Companies

i State provision either through

o State production eg (re)nationalised Network Rail

o State funding eg the government might pay private sector bus companies to run late nigh services to rural areas

i Fiscal measures (financial intervention) that use the tax and benefit system to alter market prices or affect income distribution:

o Indirect taxes to raise the price of demerit goods and products with negative externalities ie petrol taxes or subsides to lower the price of merit goods and products with positive externalities eg rail journeys

o Direct taxes on the ‘rich’ and benefits in cash or kind for the poor to improve the distribution of income eg free bus passes for senior citizens

Road users are taxed on the purchase of vehicles (VAT); ownership of vehicles (VED) and use – fuel and employer-provided transport benefits


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Market Failure & Government Intervention Options Summary

Market failure in a given industry may occur as the result of several factors eg externalities, imperfect information and local market dominance and equity issues in bus transport. It is therefore impossible within the confines of this booklet to assess every potential combination of market failure and transport problem open to the government.

The following table summarises the main types of option related to the cause of market failure:

Cause of market failure Government Intervention options Negative externalities or Demerit Goods

• Indirect environmental tax on perpetrators so that externalities are internalised – polluters are made to pay

• Legislation or regulation to prohibit activities leading to external costs

• Standards to limit permitted pollution levels eg MOT exhaust fume levels

Positive externalities or Merit Goods

• Subsides to suppliers to increase output • Legislation to make school attendance compulsory until 16

Information failure • Provide information through leaflets, television advertising & information centres

• Legislation to ban misleading advertising Public & Quasi-Public goods • State provision either free or heavily subsidised and funded by

taxation –ideally progressive Market dominance • Legislation eg

o Prevention by blocking merges and takeovers that threaten competition by creating monopolies.

o Regulation of Monopolies by an industry regulator including price capping and fostering competition.

o Anti cartel. Banning price fixing ensures competition is sustained.

• Deregulation to remove barriers to entry in a market introduces contestable markets

‘Unacceptable’ income distribution – equity issue

i Redistributive tax ie progressive taxation

i Means tested Redistributive benefits i Subsides of essential product mainly consumed by the

poor eg bus transport

Taxation & Hypothecation

Hypothecation occurs when revenues raised from one area of economic activity are ‘ring fenced’ ie only used by government to finance additional spending in area taxed. eg according to the Adam Smith Institute (ASI), road users pay £32bn in tax revenues but receive back only £6Bn in road investment.

i Should the £26bn be hypothecated ie funds only used for roads or transport in general? Os

i £25bn needed to compensate third parties for road externalities and to fund public investment in infrastructure eg trains


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Track costs refer to the ratio of taxes raised from a given group of road users eg lorry drivers to the costs or providing infrastructure for that user group. A high ratio implies unfairness ie more tax is paid than cost of provision. This argument is flawed because it ignores externalities imposed. The ASI estimate the external cost pence/km of rural car users as 0.87p with urban central peak 43.4 p.

In 1999 road users paid around £32 billion in total road taxation, which includes fuel duty, vehicle excise duty and VAT. In the same year total road expenditure was

close to £6 billion, representing an apparent surplus of over £26 billion that would seek to be siphoned off into

general Government revenues.

External costs of road transport £bn (1999)

Congestion £18bn

Accidents £3bn

Air Pollution £3bn

Noise Pollution

£1bn

Total £25bn

While motoring groups complain about this as highway robbery’ or ‘milking the motorist’, this revenue surplus can equally well be viewed as compensation paid to society for the damage caused through noise, air pollution, congestion and road accidents. Road users are therefore paying not only enough to cover the costs of supplying and maintaining roads, but also enough to reflect these wider costs and to support health, public transport, and other social services.

Source: The Road from Inequity Fairer Ways of Paying the True Costs of Road Transport Peter Mumford Adam Smith Institute 2000

True Costs of Road Transport


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Supply & Demand Side Transport Policies

Government measures to intervene in transport markets to correct market failure can be classified as demand or supply side

Demand side policies include

i Use taxes (road) and subsidies (rail) to affect the relative price of journeys and encourage commuters and freight to switch from road to public transport eg rail.

i Congestion charging equal to external marginal cost. Cause peaking where demand exceeds supply to raise price to encourage motorists to:

o switch to substitutes eg buses and rail

o or travel at off peak time when peaking is not an issue - especially freight.

However where motorists divert to non-toll roads congestion is simply displaced to another geographical area

i Workplace parking charge: tax employees who have a parking space at work i Introduce quotas to limit the number of cars that can be owned. i More/improved park & ride schemes (P&R) Cause ineffective integrated transport so locate

P&R near motorway nodes

i Improve public transport capacity & quality Cause no substitute to car so make train, trams or buses as convenient as using a car.

i Subsidise substitutes Cause substitutes too expensive so lower price eg increase subsidies or offer tax relief on train/bus season tickets

i Use planning regulations to halt new out-of-town super stores and build houses near work

i Encourage teleworking where employees work from home through tax incentives

Parking Control

Parking controls may take several forms, including:

i Better Enforcement of existing or modified controls, either directed at the driver or the supplier of parking;

i Changes in the Cost of Parking, which may be diluted if enforcement is ineffective, and noting that the 'cost' may be the charge for proper use of space or the penalty cost of misuse;

i Changes in the Amount of Space Available, either in absolute terms or through restrictions at certain times or to types of parker, or some combination.

Source: South & West Yorkshire Multi-Modal Study Working Paper Demand Management (2001)

http://www.goyh.gov.uk/multimodal/swymms/site/files/PlanDevelopment/WP7.3e_v5.doc


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Supply side policies include

i Build more roads Cause too little supply. However, new roads generate extra traffic and new roads are unsustainable

i Enable constant traffic speed to reduce congestion caused by stop-start driving eg variable speed limits

Supply Side Measures adopted in other countries to tackle congestion

Tidal Flow involves reversing the direction of traffic in one lane or more on a motorway or trunk road to cope with peaks in traffic volumes. Signals above the carriageway indicate which lanes are in use and the direction of traffic in those lanes. Tidal flow has been used since the 1970s.

Dedicated Lanes are restricted for use by a specific type of vehicle, such as buses or heavy goods vehicles and can be used on both motorways and trunk roads. High Occupancy Vehicle (HOV) lanes are a form of dedicated lane, intended for vehicles carrying more than one passenger to encourage, for example, commuter car-share schemes. HOV lanes have been widely adopted in the United States since they were introduced in the 1970s.

Ramp Metering involves using traffic signals, similar to traffic lights, to control the rate at which vehicles join a motorway from a slip road. Ramp Metering originated in the United States, where it has been used extensively since the 1970s, while the authorities in The Netherlands and Germany have used Ramp Metering since 1989 and 1995, respectively.

Variable Speed Limits involve adjusting speed limits on motorways depending on traffic volumes in order to improve traffic flow, reduce the number of accidents and thereby reduce congestion. Normal speed limits apply when traffic is free flowing. Speed limits are reduced when traffic volumes reach a predetermined level, with signals above the carriageway indicating either advisory or mandatory speed limits. The authorities in The Netherlands and Germany have used Variable Speed Limits since the 1980s and 1990s, respectively.

Hard Shoulder Running involves temporarily opening the hard shoulder on motorways to traffic during peak periods. Signals above the carriageway indicate when the hard shoulder is open. Used in the Netherlands & Germany have since 1996 and 1999, respectively.

Dynamic Lanes use lights similar to cats’ eyes set in the surface of the road to alter the number and width of lanes on a motorway, usually in order to increase the capacity of the road. For example, three lanes of normal width could be changed into four narrower lanes to accommodate more vehicles. Dynamic lanes are a new measure, under trial in The Netherlands and Germany.

Source: Edited extract from Tackling Congestion by making better use of England’s motorways and trunk roads National Audit Office November 2004

Improve existing roads Cause inefficient management of roads. Manage road speeds eg variable speed limits, 40 mph at rush hour, effective on the M25. Road humps; Improve traffic light and junction design; high occupancy priority eg special land for motorists with full car


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No one demand side or supply side solution alone will work. Policy makers need a combination of supply and demand side policies. For example, the success of congestion charging depends critically on the capacity of public transport to handle more passengers.

Sustainability in transport

‘Sustainable development meets the needs of the present without compromising the ability of future generations to meet their own needs' (Brundtland 1987).

Sustainability means meeting the needs of the present without compromising the ability of future generations to meet their own needs.

The concept of sustainable development has broadened beyond stewardship to include environmental, equity, social inclusion and appropriate economic growth issues.

Transport poses real sustainability issues eg it

i uses up non renewable resources and impacts on land use

i The pollution generated by increased traffic threatens the environment eg contributing to global warming

i New roads mean visual intrusion, loss of land for current and future generations.

i Increased car usage depletes world stocks of fossil fuels and contributes to global warming.

i Is an expansion of Heathrow sustainable? An extra runway at requires the demolition of three villages and 5,000 houses, and will further increase noise pollution.

Sustainable Forms of Transport

A sustainable form of transport involves an infrastructure and travel use that does not exceed the capacity of the environment to withstand their impact.

i Does not consume natural resources eg does not use fossil fuels

i Has minimal impact on the environment through negative externalities such as pollution

i Has little infrastructure needs so that valuable land is not required

Against these criteria walking and cycling are ‘sustainable’ ie they consume no fossil fuels and generate no negative externalities in use and have very small infrastructure needs

SACTRA on Sustainable Transport

a 'sustainable' transport system can be viewed as one which promotes economic efficiency and accessibility, whilst also maximising the safety of travellers and protecting and enhancing the environment, and which is equitable, financially sustainable and publicly acceptable. However, a definition of sustainable transport would need to consider other broader issues, such as depletion of resources and reduction of choice for future generations, all of which is outside our remit.

Source: Transport and the economy: full report (SACTRA) 1999

http://www.dft.gov.uk/stellent/groups/dft_econappr/documents/page/dft_econappr_022512.hcsp


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Road Transport & Sustainable Transport

Road transport is least sustainable because it consumes fossil fuels, creates pollution and congestion at peak times and the road network has a significant impact on land use. A new road means visual blight and the loss of countryside that is now no longer available for present and future generations to enjoy

However the degree of unsustainability depends on the:

i Size of the vehicle and the amount & source of energy used. HGVs have a bigger impact than small cars

i Place time and distance travelled Urban travel in city centres during peak times is less sustainable

i Occupancy of the vehicles. Well occupied cars are more sustainable than several driver only cars

One solution to traffic congestion is to increase supply eg build more roads. Proposed new toll lanes on motorways and acres of concrete car park mean a loss of countryside for current and future generations. Given current forecasts we cannot build enough roads to meet demand without compromising land usage and running down non-renewable resources.

Integrated Transport Policy seeks to shift travel from the less to more sustainable transport modes and improvements within each mode eg cleaner fuels

Monitoring Transport Sustainability

Since 1999, the UK Government publishes a national set of indicators to measure what is happening and to monitor progress sustainable development in the UK, against 15 headline indicators, including H11 road traffic. The Dept of Transport targets are

Cost Benefit Analysis & Sustainability

Journeys impose external costs on third parties eg congestion; air pollution noise and accidents. Infrastructure projects can result in visual intrusion and permanent loss of countryside. The cost of these projects can be balanced against the benefits by using a cost benefit analysis (CBA) approach

Importantly, the use of discounting within CBA allows a present value to be placed on future costs. The impact of a current project on the next generation is included in the calculation.

CBA ensures all costs and benefits are evaluated ie both private and external. Choosing an appropriate social rate of discount ensures future impacts are given a present value that reflects the impact of a project on future generations.


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Royal Commission of Environmental Pollution

The Royal Commission on Environmental Pollution is an independent standing body established in 1970 to advise Government and the public on environmental issues including transport.

It has published a series of reports in the area of transport:

i Transport and the Environment (1994 & 1997) considered the environmental effects of transport systems, and the implications of rapid growth in road and air travel. It proposed objectives and a number of quantified targets as the basis for a transport policy for the UK; made wide-ranging recommendations about integrating transport policy and land use, increasing the use made of environmentally less damaging forms of transport for passengers and freight, and minimising the adverse impact of road and rail transport. It recommended a fuel escalator to raise fuel prices by more than 6% per year.

i The Environmental Effects of Civil Aircraft in Flight (2002) expresses concern about the global impacts of the rapid growth in air travel and the implications for global warming.

Royal Commission of Environmental Pollution on Air Traffic

As short-haul passenger flights make a disproportionately large contribution to the global environmental impacts of air transport, a shift away from the use of air transport to rail could reap considerable environmental benefits. Instead of encouraging airport expansion and proliferation, the government should facilitate a modal shift from air to high-speed rail for short-haul journeys. The Commission recommends that action is taken to include international aviation emissions in the emissions trading scheme envisaged as one of the Kyoto Protocol's implementing mechanisms

Source: The Environmental Effects of Civil Aircraft in Flight (2002)


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Role of transport subsidy,

A subsidy (SU) is a payment by the government to producers. Governments seek to encourage the consumption of merit goods such as higher education, or products with positive externalities such as rail journeys, by offering subsides.

Economic Argument for Subsidising Railways

Subsidies can be justified on social equity grounds: subsidies mean low-income groups are now more able to afford public transport and loss making but socially essential services maintained.

Encouraging users to switch modes from road to rail usage generates significant positive externalities by reducing congestion and pollution from car journeys.

Cost

s &

Ben

efit

s £s

MSB= MPB + MEB

S = MPC = MSC

D= MPB

Correcting Market Failure from positive externalities using subsidies

For example, Rail travellers only take into account private benefits (MPB). Adding positive spill-over external marginal benefits (MEB) to MPB (D curve) gives social marginal benefits (MSB)

P 1

P Mkt

P 2 In the diagram opposite, the rail market is failing because of under consumption. The market equilibrium number of journeys (J mkt) is less than the optimum number of journeys given by the intersection of MSCand MSB ie J eff Journeys Jmkt Jeff

One policy solution is to offer a subsidy to lower price and increase the quantity demanded from J mkt to J eff. The subsidy needs to be set to lower price tp P2 so that J eff journeys are demanded. However, rail operators require P1 to offer Jeff journeys. The cost to the government of the subsidy is (p1-P2) x J eff

The government pays a public service obligation to TOCs and bus operators to subsidise essential loss making services.


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Effectiveness of Public Transport Surveys

How effective are subsidies in encouraging road users to switch modes?

Road and rail are substitutes. A rail subsidy makes tickets cheaper and encourages car commuters to switch, depending on the cross elasticity of demand coefficient (XED) between cars and trains. Where commuters cannot easily switch from cars to rail, the subsidy is ineffective.

Price is not the only factor commuters take into account when deciding which mode of transport to use for a journey. Non price factors include:

i transport integration: can I easily park at station

i comfort will I get a seat

i performance will I arrive on time

i current network congestion will I sit in a traffic jam

Road Pricing

Arguments for road pricing

i Flexible: price can be raised during high levels of demand to reduce congestion

i Generates revenue to improve and subsidise substitute services eg buses or undergrounds

i Increased traffic speed for all commuters including those travelling by bus

Arguments against:

i Substitutes are unreliable and overcrowded - eg underground -means demand for road usage in urban is highly price inelastic

i Public hostility to paying for something previously received for free

i Fixed charge of £5 is a regressive tax – however low income household do not own a car and use public transport

i High set up and maintenance costs

Congestion Charging

Marginal external cost (emc)

Marginal social cost = pmc + emc

Marginal private cost (pmc)

D2 Peak Demand = pmb

D1 Off Peak Demand = pmb

J eff J PeJ Capacity

Cost

s &

Ben

efit

s £s

P1

Number of Journeys ak


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Congestion Charging Alternative Schemes

Urban congestion charging schemes may take many forms, including:

i Congestion Metering - The charge levied would reflect the congestion caused by each driver, and would vary according to traffic conditions, both across the charged area and by time;

i Time-Based Charging - A version of congestion metering, where the charge would be directly proportional to the time spent travelling within the charged area;

i Distance-Based Charging - Drivers would be charged directly for the distance travelled within the charged area;

i Point-Based or Cordon Charging - Drivers are charged when they pass a point which forms part of a continuous boundary, with charge levels potentially varying by direction; and

i Supplementary Licences - A charge is levied to either enter an area (an entry permit) or to be within an area (an area licence).

d h f ll ( )

Case Study: London Congestion Charging

London once suffered the worst traffic congestion in the UK and amongst the worst in Europe resulting in £2-4 million every week in terms of lost time. Traffic in London moved at less than 10mph, with drivers spending as much as half their time in jams.

CIT on the Central London Congestion Charging

Charging makes us consider whether our journey is really necessary, whether driving is the best way of getting there and if we really need to travel at peak times. Cities around the world and in the UK are now studying the London initiative with a view to developing their own schemes for tackling the growing blight of traffic congestion. In the meantime, plans for a Lorry Road-User Charging scheme, which involves distance-based charging offset by reductions in fuel and road taxes, are making good progress.

i Congestion inside the charging zone reduced by 30%

i Traffic levels reduced by 18%

i 30% reduction in number of cars and 65,000 fewer car movements

i 20% increase in movements by buses coaches and taxis

i Increase of 29,000 bus passengers entering zone during morning peak

i Bus reliability and journey times improved - additional time passengers wait at bus stops caused by service delays or missing buses improved by 20% across all of London and by 30% in and around charging zone

i Bus routes serving charging zone experience 60% less disruption due to traffic delay

Source Commission for Integrated Transport report: Results so far

From Feb 2003 motorists entering a central zone during working hours face a £5 daily charge aimed at reducing traffic volume by 10-15%, leading to a 30% reduction in traffic delays. Cameras record the license plates of cars entering the congestion zone, and fines are issued to those who don't pay.


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A successful project meets its objectives. 30% less traffic is entering the zone with 70,000 fewer vehicles entering the zone each day – the target was 15%. The charge raised £79.8 million in its first year and is expected to raise about £100 million in subsequent years. This means less revenue is being raised to finance transport improvements. Bus usage is up 14%. Journey reliability has improved but local traders report a fall in turnover.

Ken Livingstone, the Mayor of London, has predicted an increase in the congestion charge of at least one pound to prevent congestion and to raise more funds for investment in public transport. “I think doubling it would be too much.” The automated pre-payment scheme to make payment easier will not be in place before 2007.

Durham

A £2 congestion charge operates in one street Durham's historic city centre since October 2002. Intended to cut traffic by half, it has actually cut the number of cars from 2,000 a day to 200 within three months.

Road pricing in transport policy elsewhere

Athens

Athens has tried:

i Closing the city centre to cars for 2 1/2 hours to encourage Greeks to try public transport. The resulting traffic jams increased carbon monoxide level by 50%.

i Alternate-plate driving days, whereby cars are allowed in every other day depending on the last digit of their license number. Car ownership actually rose: drivers bought a second car with different plates so that they could drive every day.

Melbourne

Melbourne is Australia's second city with a population of 3.3 million. In 2000 it opened a 22 kilometre privately-operated, electronic City Link toll road. There are no toll booths with cameras on overhead gantries reading a pre-paid e-tags fixed to windscreen

The system uses similar vehicle identification technology to the London scheme. The CTI reports:

i Reduced journey times were calculated to save a typical commuter (10 peak period trips a week) between 2.8 and 3.25 litres of fuel a week.

i 89% of motorists surveyed said that City Link saved them time and 86 per cent indicated that the toll road made getting around the city easier.

Singapore

Singapore is a small island that uses a coordinated transport polices to reduce congestion:

i 10-year licenses permits to own a car are sold at monthly auctions in limited numbers at up to $75,000. Sales tax and import duty are double the price of a car. The fixed cost of putting a car on the road is almost $200,000

i Introduced in 1997 electronic road pricing (ERP) charges motorists a variable toll by time of day and type of vehicle – according to the level of congestion and to maintain traffic


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speeds. Cars are fitted with a radio unit holding a pre paid debit card. Cars pass under overhead gantries that deduct charges direct form the motorist. As tolls vary with congestion levels, tariffs more accurately reflect the marginal external costs of a trip.

i Subsidised buses and extensive railway network that covers much of the 25-mile-long island means there are substitutes for cars.

i Traffic control: police use closed-circuit television to coordinate traffic lights and manage traffic flows

Documents

Transport Economics Course Companion - Quia...i The demand for transport is a derived demand. Travel is almost always, not demanded for Travel is almost always, not demanded for its