A-level Economics/OCR/2885

Transport, Trends and the Economy

Transport

Measuring Transport Output

people/passenger transport - passenger-kilometres (number of passengers \times distance travelled in kilometres)
goods/freight transport - tonne-kilometres (weight in tonnes \times distance travelled in kilometres)

Characteristics of Transport

Transport is a unique product
Demand for transport is largely derived.
As a service, it is perishable
Transport decisions recognise two key dimensions:
- distance
- time
Transport generates significant externalities not recognised in the price (Private Costs are not equal to Social Costs) therefore market fails
Journeys are indivisible
Loading is the % capacity used on a journey
Peaking: Demand > Supply, leading to congestion

Transport Infrastructure

Two components:

Network
Terminals/Nodes

Infrastructure critical to economic success because it affects:

transport costs and prices \therefore choice of mode
patterns of land use
operation of labour markets
location of business activity

Can deliver:

improved labour mobility\therefore greater efficiency
positive externalities through regional development
improved competitiveness

In addition:

Built up over time through investment:
- replacement investment (maintenance)
- net investment (additional capacity)
Under-investment since the war leading to relatively poor quality infrastructure
Investment:
- significant lead times (5–30 years)
- significant amounts of money (billions) from tax, borrowing and private funds
- long payback (decades)

Transport Modes

Methods of moving goods and passengers
Often several mode options per situation:
- Road
  - car, lorry, van, taxi, bus, coach, motorcycle, bicycle, walking
- Rail
- Air
- Sea
- Pipelines

Key issues in deciding between modes:

Relative cost
Distance
Speed
Bulk
Urgency (perishable goods)
Capacity
Convenience
Reliability
Network extent
Risk of delay/accident
Pollution
Traffic congestion

Demand for transport

Derived from economic activity
Changes in economic relationships lead to immediate changes in demand for transport
In UK, steady rise in demand
Increasing domination of road transport

Price and demand for travel

Travel can be priced and is demanded like any other product
The price of a journey includes the full cost to a passenger, expressed in £ (e.g. car: fuel, delay, risk)
Demand expressed through:
- number of passenger-kilometres
- number of vehicles
Supply is fixed (inflexible service) Although there are more services in peak times of demand.
Demand varies hugely (e.g. 8:30am vs 3:00am)
Gross under-usage or peaking/congestion
Off-peak travel is price elastic
Peak travel is price inelastic
Low positive cross elasticity of demand

Income and demand

Changes in:
- Rates of economic growth
- Business cycle

lead to large changes in demand for transport

Road, rail and air have a high YED and are sustainable
Buses have low YEDs, may even be inferior goods

Theories of market structure and competitive behaviour in transport markets

Markets Overview

Emphasis is to:

understand theoretical models of markets (at A2 level)
explain, analyse and evaluate behaviour in transport industries and markets

In market (capitalist) economies:

Entrepreneurs/firms:
- invest their own capital
- take risks
- hire/buy resources/factors of production
- produce goods and services which they judge the consumers want in order to make at least a normal level of profit
- always make decisions with competition in mind
the nature/extent of competition can be defined in terms of the number and power of firms in a market
a core factor which defines the power of firms in a market is barriers to entry/exit
- where there are low barriers, profits tend to be normal
- where there are high barriers, profits tend to be supernormal

With new entrants to a market:

the supply curve shifts right (an increase)
the price decreases
the quantity demanded expands
the consumer surplus increases
the producer surplus decreases

Perfect Competition

Characteristics

Infinite independent firms
Homogeneous product, so no advertising
Infinite buyers
Perfect information
No market power, so all firms are price-takers
No barriers to entry/exit
Perfect resource mobility
Firms are all profit-maximisers
Normal profits in LR, although losses or supernormal profits are still possible in SR
Theoretical model
Benchmark to assess all imperfectly competitive markets
e.g. window cleaners

Notes

Would deliver best economic outcome:
- Allocative efficiency
  - products which consumers want the most
- Productive efficiency
  - output at lowest AC
Yardstick to judge other markets/market structures
Framework for developing government policies in order to make markets more competitive (e.g. transport)

Imperfect Competition

Characteristics

Imperfect competition displays at least one of the following to some extent:

Finite firms, allowing an individual firm to affect the market
Some market power, so all firms are price-makers
Differentiated products
Barriers to entry
Non-price competition
Supernormal profits in LR

Monopolistic Competition

Characteristics

Many firms (all independent)
Differentiated product
Price-makers to an extent
Downward-sloping demand curve
Many close substitutes
Relatively price elastic
No barriers to entry/exit
In LR, only normal profits
In SR, abnormal profits/losses can occur

Oligopoly

Characteristics

Few firms
Interdependant
- actions take account of reactions
High degree of sales concentration - sales concentrated among a few firms
Firms are significant price-makers
Differentiated, branded products
Non-price competition - advertising/promotion to increase market share
Significant barriers to entry/exit
Abnormal profits in the LR possible - invested into advertising/R&D
economic efficiency is not attainable in the oligopoly

Pricing Characteristics

Generally stable prices
Loathe to start a price war
Uncertain outcomes when changing price:
- Prices cut:
  - Competitors follow suit
  - Volume gain insignificant (price inelastic)
  - Leads to a loss of revenue
- Prices raised:
  - Competitors may not follow suit
  - Large decrease in volume (price elastic)
  - Leads to a loss of revenue

Collusive Oligopoly

Firms agree to act together to restrict competition on:
- price
- location allocation
Price is likely to be higher than the market clearing price meaning output/sales are likely to be lower than they might otherwise be
May not maximise profits, in order to create a more secure environment
Most efficient firms will be tempted to break ranks by cutting prices, leading to increased market share
Inherently unstable
Illegal

Monopoly

Either a single or dominant (>25\% market share) firm in the market
Insurmountable barriers to entry
Price-maker - they can set either output or price
Abnormal profits in the long run
Potential barriers to entry
- High sunk costs
- Some legal monopolies (e.g. TOCs)
- Economies of scale
  - new firms cannot use EoS
- Predatory pricing
- Natural monopoly
  - best for consumer if there is a monopoly

Comparing perfect competition and monopoly

Perfect competition is productively and allocatively efficient
Monopolies are not
Monopolies are most appropriate where:
- there is a natural monopoly
- there are very significant economies of scale
- abnormal profits are invested in R&D or to reduce costs
- it would enable a domestic firm to compete internationally

Natural Monopoly

Occurs because:

One firm can operate more efficiently that two or more
There are high fixed costs \rightarrow significant EoS
More likely to be productively efficient
Minimum Efficient Scale leading to a high % of market volume/value
Cannot be threatened by more efficient new entrants
Regulation needed to protect captive consumers (e.g. railways)

Market Comparison Summary

Type of competition	Number of firms	Product differentiation	Barriers to entry/exit	Abnormal Profits	Transport Example
Perfect Competition	Infinite	None	None	Only in SR	Taxi driver
Monopolistic Competition	Finite	Marginal	None	Only in SR	Taxi firms
Oligopoly	Few, all price-makers	Great	High	Possible in LR	TOCs, Airlines
Monopoly	One major price-maker	None	Insurmountable	Yes	London Underground

Contestable Markets

Recent government intervention:

Focus on increasing market competitiveness:
- More customer-oriented, leading to better products
- Greater efficiency, leading to lower costs
- Lower prices
- Profits

Three policy approaches:

Deregulation (e.g. buses, taxis)
Privatisation (e.g. rail)
Contestability

Barriers to entry

Can be technical or economic
Determine the degree of competition in a market
Lead to LR abnormal profits for monopolists
Transport examples:
- British Rail - pre 1997 (legal monopoly)
- Laker Skytrain - no-frills airline (predatory pricing)
- Railways, cross-channel ferries (sunk costs)
- Economies of scale
- British Airways (branding)

Theory of contestable markets

The threat of entry leads to competitive behaviour:
- make normal profits
- productive efficiency
- allocative efficiency
The number of firms is largely irrelevant
Contestable markets have:
- one or few firms
- minimal barriers to entry
- minimal sunk costs
- differentiated product

TOC franchise

Lump sum for franchise (contract)
Legal right to operate service for a limited period (initially 7 years, now 15 years)
Invest own money (which may not be returned upon within the time period)
Termination when period ends (loss of sunk costs)

Deregulation

Not appropriate for natural monopolies such as:

National Air Traffic Control
Network Rail

Bus Deregulation

Up to 1980:

Many companies nationalised in 1947
Licensing system
Local route monopolies
Price controls
Government subsidies
Cross subsidisation

Private hire coaches always privately owned.

1985/1980:

Price controls abolished
Prices reflected route costs
Social, non-profitable routes - out to tender
Offered (by local authority) to bid, requiring least subsidy
Limited subsidy funds
Licensing process abolished
Safety regulations remain
Any operator free to operate
Must notify Traffic Commissioner of closures/alterations of routes

Results:

Initial increase in competition
More entrants
More buses
More frequent services
Lower fares
Buses operated below capacity
More congestion and pollution
Prompted mergers and acquisitions:
- Arriva
- Stagecoach
- Go-Ahead
- First Group
- National Express
Nationally, an oligopolistic market
Locally a monopolistic market

This leads to:

Higher fares
Lower levels of service
Withdrawal of most marginally commercial routes
- Some small competitors operate with low margins
- Large operators cannot entirely neglect the market

Air Transport Deregulation

Air travel has distinctive characteristics:

Significant externalities:
- noise
- climate change
- diminished air quality
Short-haul particularly polluting
To internalise externalities:
- Short haul: £3
- Long haul: £20
Airports need land leading to urbanisation
Airspace and landing slots ('supply') limited
Capacity insufficient to accommodate projected demand

Operators:

Private (e.g. BA)
State-owned (e.g. Iberia)
Low-cost (e.g. easyJet)
Charter

Market segments:

1st class vs. economy/low-cost
Domestic vs. short-haul vs. long-haul
Business vs. leisure vs. holiday

Leisure is, for example, a long weekend whereas holiday is, for example, two weeks.

Infrastructure:

Airports
Air Traffic Control

Core regulation:

Flight worthiness
Air space security

Deregulation of air services:

USA: 1978
UK: 1987
Europe: 1993

Pre-deregulation:

Bilateral agreements between 'flag-carriers'
No competitive pressure
High fares

Post-deregulation:

Replication of US experience
Explosion of low-cost operators
'Flag-carriers' under immediate threat
EU "Open Skies Policy" under a common regulatory framework
50% new/unused slots allocated to market newcomers

Impact of deregulation:

Newcomers had a precarious existence
Rising profits for established low-cost operators
Premium carriers:
- Losing passengers
- Cutting prices
- Experiencing falls in profit
- Struggling to differentiate
- Avoiding competition

Future:

Air travel has increased threefold since 1975
Freight increased twofold since 1990
UK economy depends increasingly on air transport:
- Consumption
- Investment
- Tourism employment
- Competitiveness
Airport demand, on current trends, will double by 2030
New capacity being constructed at:
- Stansted
- Birmingham
- Heathrow
- Edinburgh

Privatisation

Applied to buses and trains amongst others (e.g. utilities)
Operational decisions based on the needs of shareholders

More recently, two types of quasi-privatisation have been used:

Public Private Partnership

Partnership of public sector and private sector
Shared funding of a project
Shared revenues
e.g. London Underground:
- Track, signals and stations are privately owned (for 30 years)
- Operations stay in the public sector

Private Finance Initiative

Private company finances, builds and operates the infrastructure
Government pays fee for its use
State ownership in due course
Considered suitable for Air Traffic Control

Transport Infrastructure Ownership

Roads:
- Quasi-public good
- Largely non-rival
- Partially non-excludable (to an extent)
- Owned by the state
- Funded from general taxation
- Built/maintained by private sector, under tender
Rail:
- Significant change since 1996
- Network Rail:
  - not-for-profit private company
  - Railtrack plc replaced in 2002
- Rail regulator (government body)
- TOCs (private sector)
Air:
- Airports and air service operators in the private sector
- Air Traffic Control partially privatised (PFI to ensure adequate investment funds)

Rationale for privatisation

Profit incentive
No operational subsidies (money can be spent elsewhere)
Investment in latest technology
Introduce a business culture (competitive approach)
Operate more efficiently:
- Lower LRAC
- Lower prices
Be more customer-oriented leading to improved service
Significant source of funding, after decades of state neglect
More contestable market

Criticisms of privatisation

Assumes competitive environment in LR (e.g. buses)
Greater neglect of negative externalities
Reduced pay/conditions\rightarrow
- demotivation
- transfer of welfare to shareholders and consumers
Profit maximisation (investors want quick return)
Profit vs. performance vs. safety (conflicting stakeholder objectives)
Natural monopoly
Regulator needed to achieve economic efficiency
Private firms ignore equity issues

Price Discrimination

Charging different prices to different customer groups for the same product for reasons unrelated to cost in order to increase profits

Examples:

(Off-)Peak Pricing - not price discrimination, the products are different
Different Classes - not price discrimination, the products are different
Discounts - tend to be price discrimination, as the price is different for the same product

Price discrimination requires:

Different price elasticities of demand in each sub-market (e.g. OAP vs. business traveller)
No market seepage (i.e. reselling between sub-markets is impossible)
Firms are price-makers (i.e. operate in an imperfectly competitive market)

There are three types of price discrimination:

First Degree Price Discrimination

Must know how much each customer is willing to pay
Not very likely
e.g. Allocation of limited seats to the highest bidder first
All consumer surplus transferred to the firm:

Second Degree Price Discrimination

Selling off excess capacity at lower prices than previously charged
e.g. Airlines after 9/11
Used when a firm is:
- left with huge amounts of capacity
- desperate to maintain cash flow
- need to increase occupancy rate
A firm sells at a price initially, but clears at the marginal cost of each unit
Employed by European low-cost airlines:
- Attempt to fill all seats
- Increase price progressively as seats are sold
- Flight revenue and profits are maximised
- Strategy explains strong sales growth over recent years

Third Degree Price Discrimination

Allows firms to increase revenue and profit by charging different prices for the same product to different market segments
e.g. rail travel:
- For students, the fare is a higher % of income meaning student demand is price elastic
- For commuters, the fare is a lower % of income meaning commuter demand is more price inelastic
- For business travellers, the fare is almost irrelevant meaning business traveller demand is extremely price inelastic

Costs

Most business decision made in SR
Businesses will initially experience "increasing returns"
Eventually, "diminishing returns" will be experienced

In SR:

Output increases at an increasing rate initially, then at a decreasing rate
Fixed costs stay the same
Variable costs increase with output
Total costs will increase with output
MC falls initially

In LR:

Businesses typically benefit from economies of scale
This leads to a lower AC in LR
At a certain point, AC plateaus (productive efficiency)
Beyond the plateau, a business experiences diseconomies of scale

Economies of scale are important because they motivate businesses to develop. There are two types of economy of scale and two matching types of diseconomies of scale:

Internal Economies of Scale

Those economies of scale accrued within a business (business-specific). For example:

Technical: Improved use of technology/machinery
Financial: More, cheaper sources of finance available
Marketing Budget: need not increase proportionally
Purchasing: Bulk-purchase discounts
Research & Development: Budget need not increase proportionally
Managerial: Cost of management become more dissipated

External Economies of Scale

Those economies of scale that a market can exploit. For example:

A readily available skilled workforce
Locally accessible specialist suppliers
Good transport network

Internal Diseconomies of Scale

These diseconomies of scale may be caused by:

Division of labour benefits fully exploited
Management out of touch
Slower decision-making
Poorer communication
Worsening labour relationships

External Diseconomies of Scale

These diseconomies of scale may arise when:

Resources are scarce
There is congestion on the transport network

Revenues

Revenue patterns depend on the type of market. For example:

In a perfectly competitive market, MR doesn't change.
In an imperfectly competitive market, $MR={\frac {1}{2}}D={\frac {1}{2}}AR$

Profit

Profit = TR - TC
Reward for risk-taking
Cost of entrepreneurship

Two types of profit:

Normal: The minimum profit needed to continue trading
Abnormal: Anything above normal profit

Economics assumes that firms are profit-maximisers.

Profit-maximising output is where MC = MR

Profit-maximising price is AR above MC = MR

Economics does recognise other objectives:

Survival
Growth
Profit
Meeting needs of stakeholders

Definitions

Allocative efficiency: the efficiency with which markets are allocating resources. A market will be allocatively efficient if it is producing the right goods for the right people at the right price. Alternatively, you cannot make anyone better off without making someone else worse off.
Average revenue (AR): the TR divided by the level of output. It is equivalent to the price because it is the revenue the firm receives for each unit.
Barriers to entry/exit: barriers that prevent the entry of new firms into a market. Barriers to entry may be technical barriers, legal barriers, cost (or investment) barriers or barriers that arise from strong branding of the product.
Bilateral: affecting or undertaken by two sides equally, binding on both parties.
Business cycle: the tendency of economies to move, over time, through periods of boom and slump. In other words, the fluctuations in the rate of economic growth that take place in the economy. (aka trade cycle)
Captive consumers: consumers who do not have any choice as to how they access a service/product. Often occurs within a monopoly.
Congestion: over-crowding of a particular service/resource.
Consumer surplus: when people are able to buy a good for less than they would have been willing to pay. In other words they are receiving an effective benefit from buying the good. The consumer surplus is shown as the area between the equilibrium price and the demand curve.
Contestable market: a market in which there is always a threat or possibility of competition. This will still have the effect of making firms in the industry behave as if it is competitive as they will be concerned about the threat of other firms entering the market.
Cross elasticity of demand (XED): a measure of the responsiveness of demand for one good to a change in the price of another. $XED={\frac {\%\Delta P_{A}}{\%\Delta P_{B}}}$ . If the value is positive then the goods are substitutes, and if the value is negative then the goods are complements.
Cross subsidisation: where one group pays a relatively high price and thus enables another group to pay a relatively low price.
Deregulation: the removal of regulation or the removal of controls on a particular market.
Derived demand: where the demand for one thing depends on the demand for another. In other words the amount of demand for good A depends in turn on the amount of demand for good B.
Diminishing returns: a situation where the addition of a variable factor of production results in a fall in marginal product. The firm may be trying to expand by using more of its variable factors, but finds that the extra output they get each time they add more of the variable factor gradually falls.
Diseconomies of scale: a situation where average costs increase as production increases. This is the opposite to economies of scale and often happens where there are communication problems in larger organisations. They are also known as decreasing returns to scale.
Economic growth: an increase in a country's total output of goods and services. It is measured by changes in real GDP.
Economies of scale: where average cost falls as production increases. They are happening because larger firms are able to lower their unit costs. This may happen for a variety of reasons. A larger firm may be able to buy in bulk, it may be able to organise production more effectively, it may be able to organise cheaper loans and so on. They are also known as returns to scale.
Equity: a situation where the distribution of income is considered to be 'fair' or 'just'. An equitable distribution will not be the same as an equal distribution of income.
Externalities: spillover effects from production or consumption for which no payment is made. Externalities can be positive or negative.
Government intervention: when the government intervenes in a particular market. This may mean the introduction of price controls or it may mean intervention buying and selling in an attempt to stabilise the market.
Homogeneous product: all products are perceived to be of the same nature and value by the consumer.
Income elasticity of demand (YED) a measure of the responsiveness of demand to a change in income. $YED={\frac {\%\Delta D}{\%\Delta Y}}$ . A positive figure means that the good is a normal good whilst a negative figure means that the good is an inferior good.
Increasing returns: a situation where increasing the quantity-variable factor of production causes marginal product to rise.
Inferior goods: goods where an increase in income leads to a fall in the quantity consumed. They will have a negative income elasticity of demand.
Infrastructure:7 the basic underlying networks necessary to support economic activity. This includes roads, bridges, ports, sewers, hospitals and schools.
Interdependence: when the actions of one firm has an effect on its competitors. It is common in oligopolistic market structures where there are only small numbers of firms.
Lead time: the time interval between the initiation and the completion of a production process.
Legal monopoly: a market in which the government has allowed a particular firm to become a monopolist.
Long run (LR): all factors of production are variable.
Marginal cost (MC): the cost of producing one extra unit. It is the increase in total cost when one more unit is produced.
Marginal revenue (MR): the revenue earned from selling one more unit of a good or service. It is the increase in total revenue that occurs when one more unit is sold.
Market clearing price: the price at which equilibrium between supply and demand is reached.
Market seepage: no reselling between sub-markets.
Minimum Efficient Scale: lowest level of output at which the lowest AC occurs.
Modes of transport: methods of moving goods and passengers.
Natural monopoly: a situation where a single company tends to become the only supplier of a product or service over time because the nature of that product or service makes a single supplier more efficient than multiple, competing ones.
Non-excludability: once the good is provided it is not possible to stop people benefiting from it.
Non-rivalry: consumption by one person does not reduce the amount available for another.
Normal profit: the level of profit required for a firm to keep the resources they are using in their current use. In other words it is enough profit to keep them in the industry. Anything in excess of normal profits is called abnormal or supernormal profits.
Peaking: demand for a good is higher at a particular time.
Perishable goods: goods which have a limited life-span from when they are produced.
Predatory pricing: where a firm reduces price in the short run to try to force competitors out of the industry.
Price elasticity of demand (PED): a measure of the responsiveness of demand to a change in price. $PED={\frac {\%\Delta D}{\%\Delta P}}$ If a good is elastic (a value for the elasticity of more than one), it is considered to be responsive to changes in price. If inelastic (a value below one) then it is unresponsive.
Price makers: firms who are able to influence price as their output represents a significant share of the market. Firms in monopoly and oligopoly will tend to have a high level of price setting power.
Price takers: firms whose output does not influence price.
Private sector: the part of the economy privately owned and in the control of individuals and companies.
Privatisation: the process of moving economic activity from the public sector to the private sector. The most common form of privatisation is the sale of government-owned shares in private sector companies or the sale of whole companies to private investors.
Producer surplus: the difference between the minimum price a producer would accept to supply a given quantity of a good and the price actually received. It is the gap between the marginal cost curve (supply curve) and the equilibrium price.
Productive efficiency: when a firm produces at the lowest unit cost. This will be at the minimum point of the average cost curve (where MC = AC).
Profit maximisers: firms which aim to make the highest level of profit possible (the largest surplus of revenue over cost) as opposed to other objectives.
Public goods: goods that would not be provided in a pure free-market system. This is because they display non-rivalry and non-excludability.
Public sector: the section of the economy under government control. In the UK it includes the health and education services, the police, fire service and ambulance service.
Quasi-privatisation: the use of private sector money within the public sector.
Quasi-public good: a near-public good. It has many but not all the characteristics of a public good.
Real: excluding the effects of inflation.
Resource mobility: the ease with which resources can move between different uses and locations.
Revenue: the money received from the sale of output.
Short run (SR): at least one factor of production is fixed.
Subsidies: payments made to firms or consumers designed to encourage an increase in output. A subsidy will shift the supply curve to the right and therefore lower the equilibrium price in a market.
Sunk costs: unrecoverable past expenditure.
Supernormal profit: when profit exceeds the amount a firm must receive to carry on production. If supernormal profits persist in an industry this will tend to attract new firms in, supply will increase, prices will fall and normal profits will be restored in the industry.
Tender: companies bid for the lowest subsidy they would need to complete the work required.
Total revenue (TR): the number of goods sold multiplied by the price charged for each one.
Total cost (TC): the total amount spent by a firm on producing a given level of output. It is made up of the fixed costs and the variable costs of production.
Transport: the movement of goods and passengers from one place to another.
Urbanisation: the social process whereby cities grow and societies become more urban.