4. TRANSPORT COSTS Introduction •Elasticity of demand → major factor on the demand side •Cost of production → major factor on the supply side •Generalized cost (monetary + time costs) + External costs = Total costs Public transport costs •Public transport services are vital for modern societies and economies; however, they usually need to be subsidized (because of low revenues) •However, it is crucial to keep downward pressure on the cost in order to provide more services or keep subsidies low; but this is difficult •How are costs incurred in public transport? → usually large fixed costs and small marginal costs (when operating under less than full capacity) Production process Efficiency •The inputs/outputs ratio is the main base for assessing whether a given operation can be described as efficient or not. •Measurement of efficiency is very helpful in the assessment of the performance of (subsidized) public transport operators (whether they provide good service for taxpayer's money) •It can be also utilized for benchmarking Technical, cost and allocative efficiency •Technical efficiency = minimum level of inputs to produce maximum level of outputs •Cost efficiency = most cost efficient input minimization •Allocative efficiency = cost efficiency + right quantities CASE STUDY IN RAIL EFFICIENCY Driessen, G., Lijesen, M., & Mulder, M. (2006). The impact of competition on productive efficiency in European railways (No. 71). CPB Netherlands Bureau for Economic Policy Analysis. •This paper empirically explores the relationship between competition design and efficiency in the railway industry. • It uses Data Envelopment Analysis (DEA) to construct efficiency scores, and explain these scores, using variables reflecting institutional factors and competition design. Outputs and inputs Efficiency scores Source: Driessen et al. (2006) Efficiency determinants - data Source: Driessen et al. (2006) • Efficiency determinants – results Source: Driessen et al. (2006) Conclusions •The results suggest that competitive tendering improves productive efficiency, which is in line with economic intuition as well as with expectations. •They also found that free entry lowers productive efficiency. A possible explanation is that free entry may disable railway operators to reap economies of density. •The final result is that more autonomy of management lowers productive efficiency. Most of the incumbent railway companies are state owned and do not face any competitive pressure. As a consequence, increased independence without sufficient competition and adequate regulation may deteriorate incentives for productive efficiency. COSTS IN THE SHORT RUN 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 not 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. Passenger x Freight •Production: Inputs (vehicles, drivers, power); Output (vehicle-km) •Passenger x freight → passengers load and unload by themselves! • - Are passenger services more efficient? -Are there any complementarities in producing together passenger and freight? (air, rail) -Freight rail need 1.45 higher labour component in comparison with passenger rail (Nash, 1985) - Case: Mode cost comparison Modal comparisons •Labour intensive industries: parcel and bus operations; •Capital intensive industries: railways, ferries and airlines •High fuel costs: bus, airline •High fixed costs: railways; •Low fixed costs: parcels, bus Market structure •The division between fixed and variable costs has major implications on the structure of the market •High level of FC together with capital intensive production would suggest large firms, which would act against market entry and competition in the market •On the other hand, on more labour intensive industries such as bus and parcel operations, competition in the market should be both achievable and sustainable Short run average and marginal costs Case: The importance of AC in the business model of low cost airlines •The importance of AC is highlighted in this case study that looks at the operational characteristics of low cost airlines •Their business model is based on achieving low AC; not only by cutting costs but also by other measures •Before deregulation of US (1978) and EU (1990) of air markets, there was restricted capacity on routes and regulated price and market was dominated by national operators •After deregulation, many low cost operators entered the market (Ryanair and many others…) – it is important to achieve low AC, not just low cost Low average cost model •Low staff costs •Low aircraft turnaround times •Route networks based on secondary airports •On-line ticket sales •Cabin crew perform other duties •Point to point operations (no hub and spoke) •All extras for a charge •No spare aircraft capacity in reserve •Fleet based on a single aircraft type Operational costs National x low cost operators •National operators have higher share of labour and selling costs. •When labour is salaried, then in the SR it is more FC than VC. The share of VC is around 50% for BA but about 70% for LCA •Variable cost vary with output, however fixed costs do not. The key to success is high utilization of fixed assets (costs) – aircraft, crew • Conclusion – LCA business model •The key is to achieve high utilization of pilots, crew and aircrafts – to achieve low AC •LCA changed the economics of airline operations. Traditional thinking used to be that it is an industry with a high proportion of capital costs and a relatively low level of variable costs •Under regulation, operators limited supply as this increased profits. In the LCA model, profits are maximized through low profit margins and high passenger volumes COSTS IN THE LONG RUN Economies of scale • Sources of increasing returns to scale •Specialization of labour → larger firm allow more specialization of the workforce •Scheduling of inputs → larger firms have greater flexibility in the combination of inputs •Capital input → expensive capital purchases, specialization •Indivisibilities → investment needs come when the operation is close to capacity Sources of decreasing returns to scale •Loss of control → as firm size increases, there is a loss of control over the whole organization; the emergence of X-inefficiency •Geographical location → when firm moves out of optimal location, the costs will increase •Administration procedures → large firms need middle and upper management; the emergence of bureaucracy; the longer time for decision-making SR and LR average cost curves TransEcon 1-5.pdf Minimum efficiency size •The average costs fall firstly with firm size, then they reach minimum at the optimal level of production, known as minimum efficiency size (MES) •The firm has higher production flexibility in SR than in LR •The optimalization in transport is complicated by the demand peaks and natural monopoly elements Case: Economies of scale and reform in railway operations •The general view of economies of scale within the rail industry used to be that, due to a high capital requirements, economies of scale are significant and hence company size needs to be large in order to capture them •In the past this was one of the main reasons which led to nationalization of railway industries across Europe (CH: 1901 – UK: 1948) Vertical separation •However, in the last 30 years a new approach has emerged. It argues that economies of scale are associated with the infrastructure only and not with services •Therefore the solution is to separate infrastructure from services, to keep a monopolistic provider of infrastructure and to allow competition in the provision of rail services •Vertical separation (SE, UK, CZ) x Holding structure (DE, FR, AT) Empirical evidence •Preston (1994, 1999) in a study of 15 (integrated) Western railways found diseconomies of scale for larger rail systems (W. Germany and UK) and increasing returns for smaller systems (Ireland, Switzerland). Optimal size: Danish or Belgian rail network •Implication: Germany and UK should divide their systems into three or four smaller integrated networks •Swiss private rail network would benefit from mergers Does vertical separation work? •The impact of vertical separation on the efficiency of rail operations is not clear from empirical studies (competition entry x loss of coordination) •Are there really no economies of scale in the provision of rail services? •Even if they are, the dynamic entry of low cost rail operators (RegioJet, Quigo) may overrun scale considerations • Economies of scale, density and scope •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. Empirical update •Current empirical studies state that: •Competition entries increase efficiency •Economies of scale in operation are small to negligible •Economies of scope were (vertical integration) not identified •Economies of density are strong Exercises (1) 1.Identify reasons why airlines would want to take over other airlines. 2.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 (2) 1.Fuel costs are important inputs to any transportation activity. Suppose that real energy prices rise. Graphically depict the impact that this would have upon a firm’s total short-run and long-run cost structure. 2.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? 3.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 (3) •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 USD 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 (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) 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)