4. TRANSPORT COSTS Readings for Lecture 4 •Button, K. (2005). The economics of cost recovery in transport: introduction. Journal of Transport Economics and Policy, 39(3), 241-257. •Glaeser, E. L., & Kohlhase, J. E. (2004). Cities, regions and the decline of transport costs. Papers in regional Science, 83(1), 197-228. • Learning Outcomes •How transport costs behave in the short run and long runs •Returns to scale and economies of scale in the transport industries •The relevance of production costs to the supply of transport services 4.1 Theory Introduction •A major factor affecting supply is the cost of production •Monetary costs + Time costs = Generalised costs of transport •How to maintain downward pressure on public transport costs? Cost categories •Monetary costs; Time costs •Infrastructure costs; Operators costs •Environmental costs; Accident costs Costs classification •Fixed costs (FC) = costs that are the same irrespective of the level of output that is produced •Variable costs (VC) = costs that change as the level of output changes •Semi-variable costs (SVC) = costs that are fixed over a certain range of output, but then change once the upper limit of that range is reached Short run and long run •Short run = at least one factor of production is fixed •Long run = variations in output can be achieved through variation of all of the inputs The long run average cost curve TransEcon 1-5.pdf Long run costs curves Scan 28. 7. 2015 21.29.pdf The relationship between economies of scale and cost elasticity Former equation tells us that, for constant input prices, there is an inverse relationship between production RTS and elasticity of total cost with respect to output: Therefore, analysis of firm cost s provides economically relevant information on a firm’s production technology without having to separately estimate a firm’s production function. Changes in long run market supply Estimating long run cost functions Scan 28. 7. 2015 21.31.pdf Cobb Douglas cost function Flexible cost functions (translog) Short run – level of capital fixed •In the short run at least one factor of production is fixed (we assume capital) •In the short run, a discussion of returns to scale is no longer relevant, since all inputs cannot change in the same proportion. •Adding more workers to a fixed amount of capital reduces MPL = law of diminishing returns. Short run cost curves Scan 28. 7. 2015 22.56.pdf The short run average cost curve TransEcon 1-5.pdf TransEcon 1-5.pdf TransEcon 1-5.pdf Short run cost curves Scan 28. 7. 2015 22.57.pdf Short run market supply Scan 28. 7. 2015 22.58.pdf The relationship between short run and long run costs Scan 28. 7. 2015 23.00.pdf Exercises (1) 1.Identify reasons why airlines would want to take over other airlines. 2.Please provide one particular industry as an example to illustrate that MC is not U shaped. 3.Please provide one particular industry as an example to illustrate that MC is U shaped. 4.What is the difference between economies of scale and economies of density? • Exercises (2) 1.What is the difference between economies of scale and economies of scope? 2.For many airlines in the short run, a major portion of the cost of production such as aircraft and terminal space are fixed. Should these very large FCs be ignored when the revenue managers are making output and pricing decisions? Why? 3.Critically evaluate the following statement: “All constraints on behaviour are costly, which explains why the short-run total cost curve lies above the long-run total cost curve.” • Exercise (3) •Fuel costs are important inputs to any transportation activity. Suppose that real energy prices fall. Graphically depict the impact that this would have upon a firm’s total short-run and long-run cost structure. Would you expect a firm’s long-run response to a fall in energy to be greater, less, or equal to its short-run response to a fall in energy prices? What does this suggest about the firm’s short-run input price elasticity of fuel relative to its long-run input price elasticity of fuel? • Exercise (4) •Suppose that you are given the following information on All Around Airlines: •The average variable cost of producing airline trips varies between 11.5 cents a mile when 50,000 trips per year are produced and 16.7 cents per mile when 500,000 trips per year are produced. Its lowest value is 11.5 cents a mile when 250,000 trips are produced. •The average total cost of producing trips varies between 15.3 cents per mile when 250,000 trips are produced and 17.3 cents per mile when 500,000 trips are produced. The minimum short-run average total cost is 13.0 cents when 300,000 trips are produced. •Questions: –Approximately, how many trips will be produced in the short run if the fare is 15.4 cents per mile? –Will any trips be produced if the fare is 12.1 cents per mile? If so, why; and if not, why not? –Will any trips be produced if the fare is 10 cents per mile? If so, why; and if not, why not? • Exercise (5) •The July 7, 1993 Wall Street Journal provides the following information: “Northwest Airlines averted – at least for now – a threatened federal bankruptcy-law filling after its pilots’ union agreed to a last-minute pact to save the carrier $365 million over three years.” Using Northwest’s short-run cost curves, depict where Northwest was operating before and after the agreement with the pilots’ union. • Exercise (6) •Economies of scale in railway operations •List what you believe to be the main sources of economies of scale in the rail industry. Once you have produced this list, indicate which arise as a result of returns to scale and which are cost savings. •What on the other hand do you believe are the main sources of diseconomies of scale in larger integrated railways? •If you were a rail industry regulator in Britain today, what other factors apart from economies of scale would you take into account when deciding on the number of operators to have in the market? • Exercise (7) Exercise (8) 4.2 Applications Case: Mode cost comparison The importance of cost structure in the business model of low-cost airlines • Costs at privatized British railways • Economies of scale, scope and density •If an equal proportionate increase in all outputs and route kilometers leads to the same proportionate increase in costs → constant returns to scale •If an equal proportionate increase in all outputs holding route kilometers constant leads to the same proportionate increase in costs → constant returns to density •If splitting the production of passenger and freight outputs and of infrastructure leads to increased costs → the railway is said to experience economies of scope • Nash, C. (2011). Competition and regulation in rail transport. Handbook of Transport Economics. Economies of scale Economies of density Fixed costs issue •When fixed costs are present and there is a competitive supply, then competition will push prices down to marginal costs, but they will be insufficient for capital cost recovery •The challenge confronting the transport supplier is thus how to ensure sufficient revenue •Empty core problem • Button, K. (2005). The economics of cost recovery in transport: introduction. Journal of Transport Economics and Policy, 39(3), 241-257. Methods of capital recovery 1.Subsidies 2.Monopolies 3.Internal coalitions 4.Long term contracts between supplier and customer 5.Advance revenue 6.Vertical integration 7.Discriminate pricing 8.Two part tariff • • Decline of transport costs •The theoretical framework of urban and regional economics is built on transportation costs for manufactured goods. But over the twentieth century, the costs of moving these goods have declined by over 90% in real terms, and there is little reason to doubt that this decline will continue. •Moreover, technological change has eliminated the importance of fixed infrastructure transport (rail and water) that played a critical role in creating natural urban centres. In this article, we document this decline and explore several simple implications of a world where it is essentially free to move goods, but expensive to move people. •We find empirical support for these implications. • Glaeser, E. L., & Kohlhase, J. E. (2004). Cities, regions and the decline of transport costs. Papers in regional Science, 83(1), 197-228. Transportation costs Railroad costs • Implications (1) 1.People are no longer tied to natural resources 2.Consumer-related natural advantages are becoming more important 3.Population is increasingly centralised in a few metropolitan regions 4.People are increasingly decentralised within those regions Implications (2) 5.High density housing and public transportation are becoming increasingly irrelevant 6.Services are in dense areas; manufacturing is not 7.The location of manufacturing firm is not driven by proximity to customers or suppliers, the location of service firms is determined by proximity 8.Density and education go together 1. 4.3. Urban bus transportation cost and production Introduction •An often stated economic argument for the justification of a single bus system, a market structure that chracterizes most urban mass transit systems in the USA, is the presence of large economies of scale. •Source of scale economies: costs of administrative staff, economies of capital stock utilization, traffic density and generalized economies of scale. •Viton (1981) analyzed the cost and production structure of bus systems operating in the United States and Canada Specification Viton specified a translog empirical cost model in which short-run total variable cost was assumed to depend upon a bus system’s produced output, defined as vehicle/miles (millions), input prices for labor (pl) and fuel (pf) and a fixed factor of production (buses), which is defined as the number of buses in the bus system. Specifically, the empirical cost model is: Hypotheses 1.Bus transit systems operate under increasing returns to capital utilization → α1 < 1. 2.α2 > 0, α3 > 0 α2 + α3 = 1 3.An increase in a bus system rolling stock is expected to decrease short-run total variable costs: α4 < 0. Estimation results Utilization economies Optimal bus fleet size Long run economies Comments 1.In the short run bus companies will have trouble covering their variable costs of service. 2.Bus systems in general appear to be overcapitalized. 3.Even with optimal fleets, smaller bus systems require subsidies. Short-run and long-run cost curves Scan 28. 7. 2015 23.02.pdf Review questions 1.Viton’s 1981 study of urban transit costs found that urban transit firms operating in small cities (where fewer than 1 million vehicle-miles are produced annually) operate under increasing returns to scale, in medium-sized cities (which produce between 1 million and 5.5 million vehicle-miles annually) they operate under decreasing returns to scale. 2.Assuming that fares are set at marginal cost, what do these results imply about the possibility of small-scale profitable entry in small, medium, and large cities? 3.Based upon Viton’s results, are there any benefits to decentralizing urban transit systems in the largest cities? • 4.4 Summary Summary •Both short and long average costs curves are U shaped •In the short run it is due to the law of diminishing returns, in the long run due to economies/diseconomies of scale • Readings for Lecture 5 •Nash, C., Crozet, Y., Nilsson, J. E., & Link, H. (2016). Liberalisation of passenger rail services. CERRE Report. •