Chapter 6
Perfect competition in
transport markets
Learning Outcomes:
On reading this chapter, you will learn:
᭿ The theory of the ﬁrm
᭿ The position of proﬁt maximisation for the provider of transport services
᭿ The underlying conditions required in order to ensure that competitive pressures on
transport operators are maximised
᭿ That such a level of ‘maximum’ competition ensures that economic efﬁciency is attained
in the provision of transport services
᭿ A formal deﬁnition for what constitutes ‘market failure’ in transport markets.
INTRODUCTION
This chapter will examine competition within transport markets by identifying the key elements
that shape both the number and the structure of ﬁrms competing in the market place. The general
view regarding competition in markets would be that it is a ‘good’ thing, and no competition, a
monopoly, a ‘bad’ thing. On the whole that lay person’s perception would be correct; however, it
neither explains why it is a good thing except in very general terms nor the actual process of
competition amongst transport ﬁrms that brings about such good things. More importantly, it does
not highlight those situations where competition may not produce the best outcome, and this is
particularly relevant where transport services are concerned.
One of the key issues in this and the subsequent chapter, if not the key issue, is to try and
provide an understanding as to how competition works to produce economically eﬃcient transport
services, why that very often is not the case, and hence give a better perspective of the need for
intervention in the form of government policy and involvement in transport markets. As you will
see, the rationale for this form of intervention would be based on the notion of market failure.
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BACKGROUND
Much of what is outlined in this chapter is drawn from what is known as the theory of the ﬁrm as
applied to transport organisations and ﬁrms. The theory of the ﬁrm is a neo-classical concept that
has been widely used and applied to examine industry structures and productive eﬃciency. It was
one of the main theoretical underpinnings for Margaret Thatcher’s privatisation programme in
Britain during the mid to late 1980s which had, and continues to have, such a profound eﬀect on
transport industries in Britain and further aﬁeld. As such, its applications have been far and wide
reaching. Much economic change concerning the organisation of transport industries over the last
30 years has as its basis a practical application of the theory of the ﬁrm. Whilst most extensively
applied in Britain, further re-organisations have followed and continue to this day throughout the
European Union and the rest of the world. The principal concern has revolved around introducing
competition into transport markets as the theory predicts that such markets are more economically
eﬃcient.
One of the major problems with transport markets however is a general lack of competition.
This leads to various problems, many of which reach far beyond ‘simple’ transport issues due to
the derived nature of demand and the close association between transport services and economic
development. Consideration of these types of ‘imperfect’ market structures however is left for the
following chapter, as here only ‘perfect’ competition is considered.
As has already been seen in Chapters 3 and 4, demand can vary between highly elastic right
through to highly inelastic. Unsurprisingly, price elasticity of demand, both in the market and that
facing the individual ﬁrm, is heavily dependent upon the prevailing market conditions the ﬁrm
encounters and thus an indicator of the level of competition within a given transport sector. This in
turn is partly dependent upon how production costs vary with the level of output, i.e. the division
between ﬁxed and variable costs, as this will determine the number of ﬁrms in the market and thus
the level of competition, i.e. the market structure. All of this you should already be aware of, since
a basic market is made up of the forces of demand and supply that interact to produce an
equilibrium price. That in turn will ultimately determine the price paid by the consumer, the level
of subsidy required in order to meet transport policy objectives and ﬁnally the level of costs and
proﬁt associated with that level of supply of transport services. In this chapter we more closely
examine the supply side of the basic market and speciﬁcally the impact of prevailing market
conditions on the price, costs, eﬃciency and proﬁts of transport companies. Taken together, all of
these factors determine the balance of beneﬁt from the provision of those services between the
consumer and the provider of the service. This adds up to what is known as ‘economic eﬃciency’.
This and the next chapter thus bring together all of the concepts examined previously to develop
a number of scenarios each of which represent a precise set of market conditions. In doing so, this
should highlight some of the problems with transport markets and why in many, if not most,
situations they cannot be left entirely to market forces.
The ideas developed in this chapter are key to understanding what follows in the rest of the
text as applied speciﬁcally to transport services. This is because much of the understanding of
the economics of transport is directly related to a basic understanding of market principles and
why they do not always ‘work’ in transport situations. The structure of the chapter therefore is
heavily dependent upon theoretical underpinnings; however, practical illustrations are given where
relevant and the chapter ends with a case study on the road haulage industry. The topic is
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continued in the following chapter, where comparisons are drawn between perfect and imperfect
markets in the provision of transport services.
PROFIT MAXIMISATION
Until now we have simply taken proﬁt maximisation as a general assumption that underpins the
transport ﬁrm’s behaviour in the market; however, the issue has not been addressed beyond that
general assumption. This issue can now be further examined by drawing together the basic
concepts covered in previous chapters. Proﬁt maximisation is said to occur at that level of output
where:
Marginal Cost (MC) = Marginal Revenue (MR)
You should recall that marginal cost is deﬁned as the ‘rate of increase in costs with respect to
output’. A more basic way of expressing this is that the marginal cost is the cost of the last unit
produced. Hence for a bus company, the marginal cost would eﬀectively be the cost of the last
person carried. We have not however come across the idea of the marginal revenue before. This
can be deﬁned as the additional total revenue gained by selling one more unit (per time period).
In our example, therefore, is this a case of identifying how much the last person on the bus paid
for their journey? In some respects the answer is yes but unfortunately it is not quite as straightforward
as that. In order to sell more journeys per time period the bus company will have
to charge a lower price for all passengers, not just a lower fare to the last person. This is simply the
law of demand. Marginal revenue therefore should not be mistaken with the idea that a ﬁrm
can sell a number of units at one price and then in order to sell an ‘extra’ unit in that time
period simply cut the price. Rather, marginal revenue is the diﬀerence in total revenue per time
period as a result of cutting the price in order to carry one extra passenger, and thus includes the
possibility of a negative value when market demand is inelastic. Marginal revenue will therefore
always be lower than average revenue as the ﬁrm must reduce the fare in order to increase
patronage, even if this is only by one. An illustration of marginal revenue would look something
like Figure 6.1.
In Figure 6.1 the demand curve has also been labelled as the average revenue curve (AR),
because if the ﬁrm sells say 100 units at £5 each the average revenue gained for each unit is simply
the price of £5. Notice also that the marginal revenue curve is twice as steep as the average revenue
curve and thus at all levels of output, as explained above, marginal revenue is always less than
average revenue. What the ﬁrm actually does regarding the price charged and the level of output
produced will be dependent upon the elasticity of demand (as cutting the price may increase
revenue) and the cost of production. It will produce where proﬁts are maximised; however, this
leads back to the key question of identifying the level of output at which that occurs. This is found
where:
MC = MR
In order to understand further why this is the case, it is easiest to consider when this position does
not exist. This is shown graphically in Figure 6.2.
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For simpliﬁcation, Figure 6.2 only shows the marginal cost and marginal revenue curves. As
output increases these two variables move in opposite directions, thus as output rises marginal
costs rise and marginal revenue falls. This is because if the ﬁrm wants to sell more it needs to
always lower its price, hence falling marginal revenue, whilst increasing output will have rising
marginal costs over most of the range of output (see Chapter 5 for a reminder). Therefore,
beginning at position a, for output level Q1 marginal revenue is greater than marginal cost. The last
unit produced therefore generated more revenue than it cost to produce, thus this unit made a
proﬁt. However, in order to increase total proﬁt the ﬁrm should actually increase production as this
Figure 6.1 Marginal and average revenue curves
Figure 6.2 Basic proﬁt maximisation
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will generate more proﬁt from these units produced. Note that this may reduce the proﬁt margin
achieved on each individual unit, but the extra volume sold will more than oﬀset any reduced
proﬁt margin and increase total proﬁts. In this way proﬁts can be maximised by increasing output.
Moving to point b, however, at the level of production Q2 marginal cost is greater than marginal
revenue. In this case, the last unit sold cost more to produce than the revenue which it generated,
hence making a loss on these units and reducing total proﬁt. The ﬁrm should therefore reduce
production and not produce that last unit, as this will increase total proﬁt. It should continue to
reduce production until marginal cost equals marginal revenue. In Figure 6.2 this occurs at point c
and output level Q3. Note that because marginal costs and marginal revenue move in opposite
directions with the level of output there will always be a point of convergence and it is at that point
where proﬁts are maximised.
In order to determine the actual level of proﬁts (or indeed losses) incurred by the ﬁrm at the
proﬁt maximising position, the demand and average cost curves need to be added to Figure 6.2,
as shown in Figure 6.3.
Whilst to some this may at ﬁrst appear as simply a mass of lines, there is nothing that has been
added to Figure 6.3 that has not been introduced before either in this or previous chapters. What
it shows is the basic production and market conditions facing a theoretical provider of transport
services. Hence, the proﬁt maximising position is found as above where marginal cost equals
marginal revenue, i.e. where the MC and MR curves intersect. This is found at point a and gives
a proﬁt maximising output level for the provision of these services of Q. At that level of
provision, the prevailing market conditions allow a fare of P to be charged, as shown by point c
on the demand curve. The average cost of each passenger carried is found at point b on the
average cost curve. Total revenue is therefore given by the area outlined by 0, P, c, Q and total
costs by the area outlined by 0, AC, b, Q. The net diﬀerence, i.e. the area AC, P, c, b, is the proﬁt,
or to be more exact the abnormal proﬁt, to the operator and this is the maximum proﬁt that can
be returned for the provision of these services under the prevailing production and market
Figure 6.3 Proﬁt maximising position for the ﬁrm
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conditions. It is also useful, certainly in the context of transport operations, to consider that the
proﬁt maximising position need not necessarily produce a proﬁt. Study the situation shown in
Figure 6.4 below.
As with above, the ‘proﬁt’ maximising position is found at point a where marginal cost equals
marginal revenue. The associated average cost of each passenger carried is again found at point b,
giving an average cost of AC. Finally, the fare that can be charged is found at point c on the demand
curve, giving a fare of P. As can be clearly seen, the fare paid by each passenger is less than the cost
to the operator of providing the resources for that journey, thus in this case the company is making
a loss. The total amount of loss is outlined by the cross hatched area P, AC, b, c. In the long run
however this is not the ‘loss minimising position’ as by simple logic that will always occur where
zero output is produced. In the short run, as long as the ﬁrm is covering its variable costs, in most
cases it will continue in operation until the capital is life expired, at which point it will close down.
In this case note that where only a single price can be charged in the market the operator can never
make a proﬁt from providing this service. This is because at no point is the demand curve, i.e. what
the market will bear, above the average cost curve. We will see a similar case in Chapter 8 however
where the ability to charge users of the service diﬀerent prices may enable the operator to make a
proﬁt. Whilst Figure 6.4 was produced essentially by manipulating how the diagram was drawn,
such a situation is not purely theoretical and is one that often prevails in the provision of transport
services. This is particularly the case where services are provided on equity grounds, such as those
deemed to be social necessities in which the total revenue gained from the passenger will never
cover the costs of providing the service. Subsidy is thus required in order to allow production of
the service and bridge the gap between costs and revenue, and in this case the amount of subsidy
paid would be the cross hatched area in Figure 6.4. Note however that in some ways this is a
market-based solution, i.e. where the transport company produces at the ‘proﬁt’ maximising level
of output. Given however that the provision of such a service would have little or no market basis,
the level of provision would be set at a point by the relevant authorities deemed to be consistent
Figure 6.4 Losses at the ‘proﬁt’ maximising position of the ﬁrm
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with meeting their objectives. This may mean however that the authority would have to pay a
higher level of subsidy, as would be the case for example for output levels to the right of Q in
Figure 6.4. This is an important issue to which we return later in Chapters 10 and 11.
This basic framework of proﬁt maximisation for a theoretical provider of transport services can
now be used to examine the eﬀect of competition, i.e. a change in one of the basic market and
production conditions, on the fare charged, the average cost incurred and the proﬁt attained from
providing the service. These three aspects are important, as in simple terms they add up to what is
known as economic eﬃciency, at which point the beneﬁts arising out of the production of a given
transport service are maximised and shared equitably between the operator and the consumer.
We begin with a position of ‘maximum’ competition, more commonly known as ‘perfect’ competition,
before looking at the other extreme in the form of a monopoly market in the following
chapter.
PERFECT COMPETITION
As allocative eﬃciency was described in Chapter 5 as almost the holy grail of the economics
discipline, perfect competition is the mechanism by which that holy grail is found. This is because
perfect competition is one of the major requirements in order to achieve allocative eﬃciency, and
we will see exactly why this is the case by examining the concept further. In simple terms, perfect
competition is a highly competitive market where competition itself ‘regulates’ the market and
ensures economic eﬃciency is achieved. In order for competition to be maximised, however, a
number of market and production conditions must be met. The full list of these assumptions will
be considered later in the chapter, as these are almost always overlooked in introductory texts but
many are of particular signiﬁcance to transport markets. In order to introduce the topic, however,
the basic four conditions or assumptions of perfect competition are considered, namely:
᭿ Freedom of entry and exit
᭿ Homogeneous product
᭿ High number of buyers and sellers
᭿ Perfect information.
Freedom of entry and exit means that buyers and sellers are free to enter and leave the market
as they see ﬁt, there are no obstacles preventing them from doing so. The opposite of this is where
barriers to entry exist and these may have a strong impact upon the market structure through
limiting the number of ﬁrms in the market. Under perfect competition, however, no such barriers
exist,thus new entry is always possible.Within transport markets,therefore,any operator would be
at liberty to enter the market and compete on equal terms with existing ﬁrms. Freedom of exit
means that they can exit the market without ﬁnancial penalty.
A homogeneous product means that all ﬁrms produce identical products, thus a bus service is a
bus service is a bus service, there is no diﬀerence between say a red bus service and one that is
operated by a blue bus, on the same route, with the same frequency and quality of service. As all
operators produce identical services, or at the very least services that are perceived to be identical,
the consumer can switch from one operator’s service to another’s at a zero (transaction) cost. In
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more formal terms, all services are said to be perfectly substitutable, i.e. the demand curve for the
individual ﬁrm is therefore perfectly elastic.
The third assumption of a high number of buyers and sellers is hardly one that should come as a
surprise as a pre-requisite of competitive markets. What it means however is that no single
operator or buyer of transport services has any degree of market power. If any operator was to
leave the market then their market share would be so small that in simple terms it would have
no impact on the prevailing fare charged. As a consequence, it is the market that sets the fare, not
individual ﬁrms or buyers, and all buyers and sellers are ‘price takers’ not price setters. Contrast
this with a ‘pure’ monopoly situation where there is only one operator, thus the ﬁrm would have a
very strong market position and could exercise a high degree of control on the market through the
level of output it produces. Restricting the level of output would increase the price, while
increasing output would reduce the price. The OPEC countries in the mid and late 1970s for
example operated very successfully as a cartel (née monopoly) to restrict the supply of oil to the
world market and by so doing brought about major increases in the price of oil. Similarly, a small
number of buyers in the market can impose great control over sellers – grocery retailers such as
Sainsburys, Morrisons and Tescos are in a position to exert strong downward pressure on the
prices charged by their suppliers. With a high number of buyers and sellers, however, this means
that no single individual or organisation has any control over the market, hence all are price takers.
The last assumption is perfect information. This means that buyers, sellers, potential buyers and
potential sellers know everything there is to know about the market. Hence there are no trade
secrets (as this may also be a barrier to entry) and all proﬁt and market information is common
knowledge. In simple terms, therefore, consumers know the prices of all competing services and
potential entrants know the level of proﬁts being made in the industry. Perfect knowledge is thus a
pre-requisite to ensure that buyers and sellers come to the right economic decisions regarding the
goods they purchase and the markets served.
One may wish to question the highly restrictive nature of these four basic assumptions and ask if
perfect competition exists in practice. The market which is usually given as the nearest example
is that of agriculture, as this tends to operate on a global scale and thus has many suppliers (i.e.
individual farmers) and consumers, and the produce is similar if not absolutely identical. The
US bicycle industry has also been cited as a case in perfect competition (Townley, 2006). In both
these industries however there are deviations from the perfect competition model, and thus the
simple answer is that the assumptions of the model are too restrictive to exist in reality. Perfect
competition is simply a ‘benchmark’ to be used to compare an ideal with reality to allow market
failures to be identiﬁed. Whilst the term ‘market failure’ is commonly used in everyday (business)
English as a general term for when things go ‘wrong’, by deﬁnition market failure occurs when one
of the assumptions of perfect competition is breached and hence the market does not achieve
economic eﬃciency. We will constantly return to this issue later as transport markets suﬀer from
a high degree of market failure. For now, however, these assumptions can be used to examine
the eﬀect on the price, average cost and proﬁts of perfectly competitive ﬁrms. This is shown in
Figure 6.5.
One obvious diﬀerence with Figure 6.5 to previous ﬁgures in this chapter is that there are
eﬀectively two diagrams. What is not so obvious at ﬁrst, however, is that the ﬁgure on the right is
the eﬀect of imposing the assumptions of perfect competition on the previous Figure 6.4, i.e.
changing the market conditions facing the individual operator. On closer inspection, it should be
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clear that the only diﬀerence is that the demand curve facing the individual ﬁrm is perfectly elastic,
i.e. horizontal at price PSR, due to perfect substitutability between rival services. Thus under the
conditions of perfect competition, average revenue equals marginal revenue. The rest of the ﬁgure
relating to costs is identical. Turning to the ﬁgure on the left, the market sets the price at PSR and
due to a high number of buyers and sellers the ﬁrm is a price taker. It can therefore only sell at the
market price PSR. Note that if the ﬁrm was to charge a price above PSR, demand for its service
would drop to zero. This is because all services are the same (homogeneous), and further that all
consumers know that all services are the same because of perfect information. Note also that there
is little point in the operator charging a price below PSR, as it can sell as much as it wants at the
prevailing market price, hence any price reduction is simply cutting its own proﬁts. This is a further
reason why under this scenario marginal revenue is equal to average revenue, as the ﬁrm does not
have to cut its price in order to sell more.
As normal the ﬁrm is assumed to be a proﬁt maximiser, hence produces where marginal cost is
equal to marginal revenue, highlighted by QSR for the individual ﬁrm. This however is purely a
short-run position. As the ﬁrm is making abnormal proﬁts, shown by the cross hatched area
ACSR, a, b, PSR, then perfect information and an absence of barriers to entry ensure that new
operators know of such abnormal proﬁts and enter the market in the long run to compete these
away.
This eﬀect of new ﬁrms entering the market is shown in Figure 6.6, where as a result the supply
curve has shifted to the right. The market price therefore falls to PLR. The individual ﬁrm adjusts its
level of output to the new proﬁt maximising position, which is now at QLR. Note that at this point
the ﬁrm is producing at the lowest point on the long-run average cost curve, hence productive
eﬃciency is ensured, and as this is the long-run situation there is no incentive to change from this
position. Note also that the ﬁrm is only making normal proﬁts, which means it is covering all its
costs including the cost of capital. In some ways, the abnormal proﬁts that were being made in the
short run have now been ‘transferred’ to the consumer in the form of lower prices. It is for these
reasons that perfect competition is said to be the most economically eﬃcient market structure, as
Figure 6.5 Perfect competition, short run position (proﬁts)
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the ﬁrst two conditions of allocative eﬃciency, that is technical and cost eﬃciency, are both
achieved. We will see shortly that the third requirement, producing goods and services that will
maximise consumers’ beneﬁt or utility, i.e. ones that they really want, is also met through such a
market structure. One ﬁnal point to note from both Figures 6.5 and 6.6 is that the level of output
of the individual ﬁrm will be found by the proﬁt maximising position on the marginal cost curve,
thus the marginal cost curve is the supply curve of the individual ﬁrm. Consequently, the market
supply curve is the summation of each ﬁrm’s marginal cost curves.
To further underpin the ideas of perfect competition, outlined in Figure 6.7 is an example
where there is a long-term shift in demand away from a good or service. There are numerous
examples of goods or services that have become obsolete or whole industries that have disappeared
Figure 6.6 Perfect competition, the long run position
Figure 6.7 Short run perfect competition – losses
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as they have simply been unable to continue to compete in the prevailing market conditions. The
latter is what is known as ‘structural’ economic change, and an obvious example is the long-term
decline of shipbuilding on the Clyde Estuary. In Figure 6.7, this would be represented by a shift in
the demand curve to the left, as in this speciﬁc example, substitute goods in the form of lower cost
non British shipbuilders take demand away from the Clyde shipyards.
In this situation, due to the shift in the demand curve from D1 to D2, at the market price P no
Clydeside yard can make a proﬁt. What subsequently occurs is a contraction in the industry
(supply), in this case represented by a shift in the supply curve to the left from S1 to S2, as
shipbuilders leave the Clyde and output is slowly reduced. This process would continue until the
market is back in equilibrium and the market price re-established for Clyde-built ships. Note
however the industry on the Clyde would now be smaller (Q2 < Q1). Ultimately, only those ﬁrms
that produced at the lowest cost could survive in this market. Further note however that in many
cases the shift in demand will be a long-term decline. Thus the demand curve will continually shift
leftwards increasing downward pressure on prices. Therefore only ﬁrms able to lower costs in the
long run, i.e. move to a lower average cost curve by achieving economies of scale, are ultimately
able to survive in the industry. This is exactly what happened on the Clyde through a large number
of mergers and acquisitions and considerable consolidation in the industry. Even this however
failed to stem the long-term decline, as what was ultimately required to remain competitive was a
very long-run downward shift in the average cost curve. Most shipbuilders however were unable to
keep pace with this technical change and this led to the almost complete demise of shipbuilding on
the Clyde.
Note also from this discussion that through the market mechanism there is what is termed
consumer sovereignty. In simple terms, ﬁrms respond to the demands of consumers by producing
what consumers want. Firms that fail to do so will be forced to leave the industry due to the losses
being incurred. Consumer sovereignty also dictates that a longer-term shift in (consumer) demand
away from a particular good or service will result in it no longer being produced. The resources
that were thus employed in producing that good are now ‘freed’ to produce something that
consumers actually want. As highlighted above, therefore, perfect competition is said to be an ideal
as it does produce economic eﬃciency, i.e. in the long run scarce resources are used eﬃciently to
produce what consumers want. An indicator of market eﬃciency, therefore, is that the price
should equal the marginal cost.
MARKET FAILURE
What has been outlined in the previous section are the four basic assumptions of perfect competition
that are normally outlined at an introductory level as the conditions required for perfect
competition. As highlighted, breach of any of these assumptions constitutes market failure. With
regard to transport markets, however, it is worth going beyond these basic assumptions and
detailing the full list that are required for perfect competition to exist. These are:
Basic Assumptions:
᭿ Many buyers and sellers
᭿ No barriers to entry or exit
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᭿ All ﬁrms are proﬁt maximisers
᭿ All consumers are utility maximisers
᭿ Perfect information
᭿ Homogeneous product.
Further Assumptions:
᭿ Non increasing production technologies, thus there are no economies of scale
᭿ Non rivalry in consumption – consumption by one individual does not preclude consumption
by another
᭿ Absence of externalities, all beneﬁts and costs are private and thus taken into account in
market based decisions
᭿ No government intervention to ‘interfere’ between the forces of demand and supply.
Whilst not explicitly mentioned, the basic assumptions of perfect competition also include producer
proﬁt maximisation and consumer utility maximisation, two underlying assumptions already
outlined in the analysis of the demand and supply of transport services. These however are
necessary conditions required to derive the market demand curve and the output level of the
individual ﬁrm. Both however require perfect information, as without it neither the ﬁrm nor the
consumer will be in a position to maximise their proﬁts or utility respectively. There are four
other conditions required however for perfect competition to exist, the ﬁrst of which is non
increasing production technologies. What this means is that there are no economies of scale and
thus no advantages in larger-sized ﬁrms. If there were increasing returns to scale, then there would
be an in-built incentive for ﬁrms to increase in size in order to lower average costs and thus be in a
position to undercut smaller rivals and gain a larger share of the market. If increasing returns to
scale existed over the whole market size, the ultimate conclusion would be a monopoly, where one
ﬁrm would face a position of no competition.
Non rivalry in consumption is often confused with non excludability in consumption. What non
rivalry basically means is that consumption by one person does not aﬀect the consumption of the
good or service by someone else. In simple terms, therefore, if one person consumes the good
it does not make it unavailable to others. Hence the market for a rare Picasso painting has rivalry in
consumption, as one person’s purchase will make the painting unavailable to others. Potatoes on
the other hand have non rivalry in consumption; hence one person’s purchase of a 5 lb bag of new
Ayrshire potatoes is unlikely to impact upon others’ consumption of new Ayrshires. Basically,
therefore, if consumers want a given product they can get it. This is often confused with non
excludability in consumption, where the beneﬁts in consumption cannot be conﬁned to only those
that pay for them. Thus consumption of rail services gives some beneﬁt to road users in terms of
reduced journey times on the roads. These come under the next assumption, externalities, in this
case an external beneﬁt. However, there can also be external costs, where the costs of a given
activity fall not only on those that beneﬁt from that activity but also on others who do not. The
problem with externalities are that they are not taken into account when making a market-based
decision as the externality has no market value. Thus the road user does not consider the costs on
the environment when deciding whether or not to use the car. As externalities are a major issue in
transport markets, these are dealt with far more extensively later in the text. In this case, however,
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it is a market failure that may lead to over or under consumption of a particular good or service
due to the presence of externalities.
The last assumption, government intervention, is also a major transport issue, hence will also be
returned to, but is outlined here in terms of a condition of perfect competition. Government
intervention is a form of market failure as it would interfere with market signals and thus lead to
an ineﬃcient outcome. For example, consumer sovereignty above was highlighted as a case where
consumers, through their market actions, indicate what goods and services they want to be
produced, i.e. the ones they buy, and which ones they don’t want to be produced, i.e. the ones
they don’t buy. Government intervention, by for example paying subsidies for certain goods or
services, interferes with these signals by encouraging consumers to buy products they do not really
want!! To be more rational, subsidies encourage the tying up of resources in the production of
goods or services at a higher cost than the beneﬁt derived from the consumption of those goods or
services. Such productive resources therefore would be better employed in some other activity,
where the beneﬁt gained matched the cost of production. Note however that this rationale is based
upon a single perspective of taking each assumption on its own, i.e. only viewing government
intervention in isolation. In most instances, intervention in the market is in order to correct for an
existing breach of one of the other assumptions, for example that of no externalities. This is why
government action to ‘correct’ for such market failures is often referred to as a second best
solution, as the best solution, the market itself, is incapable of delivering economic eﬃciency due
to market failure.
Apart from the previously cited US bicycle industry, however, does perfect competition
exist in any of the transport industries? One that is often cited as being close or near to perfect
competition is the road haulage industry, thus Case study 6.1 examines the extent to which
this industry meets the conditions of perfect competition. The case should also help to
develop further the ideas behind perfect competition, particularly the practical aspects, as
well as begin to introduce some of the problems that can be associated with highly competitive
markets.
Case study 6.1 Road haulage and the economist’s model of
perfect competition
Road haulage has often been cited as an example of an industry that meets, or is close to
meeting, the conditions of the economist’s model of perfect competition. This facet of the
industry has long been recognised, with Adams and Hendry stating as long ago as 1957 that:
‘The problem under study here is of interest because these authors hold that the trucking
industry epitomises the classical model of perfect competition. Here is an industry where
there appears to be no economies of scale, where the number of ﬁrms is large and where, in
the absence of restrictions, entry would be brisk.’
That premise was used as the main thrust of the authors’ argument that at that time the US
trucking industry should not be subjected to government control and regulation. Not all authors
agreed, however, with Smykay (1958), a strong advocate of continued regulation, in particular
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showing hostility to this point of view and arguing that such an important industry to the US
economy could not be simply left to market forces to decide haulage rates and the level of supply
provided. Eight years later Munby (1965), with regard to the British industry, concluded that
there was no adequate general case for any licensing system for road haulage beyond control of
drivers’ hours,the condition of the vehicles used and other safety-related measures.The basis for
this conclusion was that the industry would operate along free market principles that would,due
to its closeness to the model of perfect competition, ensure economic efﬁciency.
This case study attempts to investigate the extent to which the road haulage industry does
actually adhere to the economist’s model of perfect competition by examining industry conditions
under each of the four basic assumptions of the perfect competition model,plus the further
key assumption of non-increasing returns to scale.
Many buyers and sellers
The ﬁrst assumption of perfect competition is many buyers and sellers, with the very strong
implication that no single buyer or seller is large enough to affect the price,hence the price is set
by the market and all ﬁrms are price takers.
Examination of the relevant statistics for the UK, taken from a number of different sources,
reveals that in 2004/5 there were some 102,000 goods vehicle operator licences, i.e. qualiﬁed
ﬁrms,in the industry.This represented a signiﬁcant decline over the preceding eleven year period
since 1993 when there were some 125,000 licensed operators (FTA, 2008). Nevertheless, this
is still a very large number of ﬁrms in the industry. Furthermore, a quick look at any local
Yellow Pages under ‘road haulage services’ also produces a large number of ﬁrms within the
local area, certainly far more than listed under ‘bus, coach and tramway’. As regards registered
vehicles, the DfT (2007) report that there were some 441,000 registered vehicles in total in
2004/5,an increase of 5.6 per cent since 1993.This would suggest an average ﬂeet size of 4.25
vehicles, which compared to 1993 represents a signiﬁcant increase from 3.29 vehicles. Average
ﬁrm size would therefore appear to be increasing over time and most of this would appear to
have come through industry consolidation, i.e. company mergers and takeovers.
Despite such consolidation a high number of small ﬁrms still appear to exist in the industry.
The FTA (2008) cite that three quarters of road haulage operators operate a ﬂeet size of two
vehicles or less, with a very high percentage of single-vehicle ﬁrms operated by owner-drivers.
This on its own would suggest a highly competitive industry that despite some industry consolidation
still closely resembles the perfect competition assumption of many buyers and sellers.
The FTA also quotes however that 10 per cent of ﬂeets operate half the total ﬂeet, suggesting
some signiﬁcantly larger operators with an average ﬂeet size of around 20 vehicles. Thus
although the industry has many ﬁrms, this appears to consist of a very clear division of small
and large companies. There would thus appear to be a signiﬁcant number of ﬁrms that are of a
size to inﬂuence the market, i.e. not all ﬁrms are price takers.
A homogeneous product
Taking a somewhat simplistic view that many industry experts would undoubtedly disagree with,
road haulage ﬁrms operate a basic low-tech service to transport goods from one location to
another,i.e.a driver and a lorry.This would appear to represent an identical product and as such
conforms completely to the assumption of a homogeneous product.
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In some ways however there can be deviation from that basic assumption, and certainly an
element of product differentiation. One factor that plays a key role in the road haulage industry
is the ﬁrm’s reputation. Hauliers with good reputations for high quality services that deliver on
time could feasibly charge higher prices and will almost certainly acquire a degree of consumer
loyalty.Although the basic service provided can by argued to be identical,these are not perfectly
substitutable between suppliers due to variations in how that basic service is actually provided,
i.e. there is product differentiation. Nevertheless, most ﬁrms operate under contract to large
freight-handling ﬁrms or big ﬂeet operators (Lacey, 1990) in which there is strong downward
pressure on prices due to the relative ease of substitution between ﬁrms. How the industry
actually operates, therefore, with a high degree of substitutability between operators, would
appear to be a very close approximation to the assumption of an identical product.
Perfect information
In reality, there is always a limit to perfect information. In simple terms, no one can know all
relevant market information and in any case the transaction costs involved in actually acquiring
such information may be economically inefﬁcient. We therefore concentrate only on three
aspects of perfect information – prices, production and performance. Regarding haulage prices,
another look at the local Yellow Pages or the Internet would suggest that there exists a position
that is near to perfect information. It would be relatively easy to make a round of phone calls to
produce a reasonable data set of prices on which to base a rational decision as to which haulier
to choose on the basis of price, although it is recognised that this is a considerable oversimpliﬁcation
of the issue.
As regards the production of road haulage services,as highlighted above,at the basic level of
the transport component this tends to be a relatively low-tech industry. All that is required is a
vehicle and a driver and there are few ‘secrets’ in the basic production of road haulage services.
The wider issues of building a company reputation or in successfully running the business may be
different issues; however, in this respect there is no reason to suspect that road haulage should
be any different to any other type of business and therefore these constitute basic business
skills.
The ﬁnal aspect considered is information relating to performance of the industry. This
would obviously be an important dimension for potential new entrants. Certainly in comparison
with passenger-related transport, information appears to be far more difﬁcult to obtain. A
simple look at government statistics reveals few related to freight whilst many more related to
passenger movements. This may reﬂect a policy bias where there is far more legislation related
to passenger services than freight activities, hence the government collects and publishes far
more statistics on the former than the latter. Furthermore, information on proﬁtability in the
industry has, perhaps not unsurprisingly, proved virtually impossible to obtain in the course of
writing this case study. Whilst both the Road Haulage and the Freight Transport Associations
provide some general information and support for those within the trade, this does not include
market information, hence in the aspects considered here this falls short of what could be
termed ‘perfect information’.
Information on market prices and production technologies therefore would appear to be
relatively easy to obtain;however,potential entrants to the industry may be limited to those with
an inside knowledge of the prevailing business environment. In some respects therefore, this last
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aspect may be no different to any other industry,where those inside the industry are best placed
to take advantage of market opportunities (as exempliﬁed by the numerous insider trading and
banking scandals that have occurred in the city over the years!). Thus information may not be
‘perfect’ as such, but is probably as close as is realistically possible.
No barriers to entry or exit
As with perfect information, the position of no barriers to entry or exit can never be achieved in
reality, there will always be some form of cost, either ﬁnancial or in terms of the opportunity
cost, in setting up in business. The issue therefore surrounds the existence of signiﬁcant barriers
to entry that restrict entry to only medium- or large-sized ﬁrms.The basic components required
for a road haulage ﬁrm are a qualiﬁed driver, an operator’s licence and a suitable vehicle. All
of these aspects are in the bounds of possibility for the small ﬁrm. The large number of ownerdrivers
in the industry would also suggest that small ﬁrms do enter and survive in the industry.
Therefore there would appear to be few barriers to entry and thus this condition of perfect
competition in practice would appear to be largely met.
Non-increasing returns to scale
One further crucial element to examine is the assumption of non-increasing returns to scale. In
other words, are there any advantages for larger ﬁrms with regarded to improved productivity
or lower average costs? Most research on the topic relates to the trucking industry in the US
because of more readily available data and because it is a crucial element in the operation of the
market. It was thus a critical aspect of the whole de-regulation debate in the US before and
after deregulation of the market in 1980.
To summarise what is a considerable research area, the balance of evidence would tend to
suggest that economies of scale do exist in road haulage, but are not as extensive as in other
industries such as rail freight. There are however inconsistencies in the ﬁndings. For example
Nebesky et al. (1995) found no evidence of returns to scale in the less than truck load (LTL)
segment of the US market. Giordano (1997) on the other hand examined the 100 largest less
than truckload carriers over a period of 20 years. The author found evidence of increasing
returns to scale up to ﬁrm size that would be consistent with signiﬁcant ﬂeet sizes, speciﬁcally
around 28 vehicles.1
Constant returns to scale were then found beyond that to a point of around
70 vehicles, after which decreasing returns were found. Furthermore, Ying (1990) examined
the US trucking industry at three points in time, 1975, 1980 and 1984, in order to assess the
impact of the 1980 Motor Carrier Act, the actual act that deregulated the interstate trucking
market. With regard to scale economies, a massive swing was found from constant returns
to scale in 1975 and 1980 under the regulated market, to very strong increasing returns in
1984 under the deregulated market. The author suggests that the restrictive nature of the
regulated market prevented ﬁrms from fully utilising their own large networks, hence once
the market was deregulated ﬁrms exploited the advantages presented with regard to the scale of
operations.
As regards the British experience, there is far less evidence and almost all of it dates from
the period prior to the Transport Act 1968 which deregulated the UK road haulage industry. As
an example, Harrison (1963) reviews studies carried out up to that period and concludes there
is little evidence of economies of scale in road haulage. This is despite an apparent increase in
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ﬁrm size; however, the author attributes this to the greater restrictions on market entry than on
increasing capacity in what was then the regulated market.A second factor highlighted interestingly
was imperfections in knowledge that inﬂuenced choices between established and nonestablished
operators in favour of the former.
This inconsistency in the ﬁndings on the existence or otherwise of economies of scale in road
haulage would perhaps suggest that within certain sectors there are other factors present
that may allow smaller ﬁrms to compete with larger competitors on a relatively equal basis.
In other words, economies of scale do not destroy competition. As such, therefore, this
would appear to be consistent with a near to perfect competition model rather than perfect
competition per se.
Conclusion
From this albeit simplistic review of the road haulage industry,it would appear that the industry
does closely resemble certain aspects of the perfectly competitive model. What this produces is
a very competitive industry, even in specialised segments where the number of ﬁrms may be
relatively small, e.g. the less than truckload market.
In the past, road haulage has been heavily regulated and controlled, not only in Britain
but throughout the whole developed world, not because of market failure but rather due
to the strategic importance of the industry to the workings of the whole economy. With
the subsequent shift in general economic thinking towards far less state intervention in the
economy, the poor economic case for intervention has been exposed and the industry largely
de-regulated.
Note however that having a highly competitive market in an industry such as road haulage,
where there exist operational safety issues,is not without drawbacks.This breaches the assumption
of no externalities, as the cost of operations includes the potential human cost to others in
terms of injuries and fatalities if things should go wrong. What it produces therefore is a cut
throat scenario in which there are very strong pressures to keep costs down and thus a temptation
for some to not follow all of the qualitative regulations that exist. This leads to the idea of
cowboy operators and ﬂy-by-night type operations.Building and construction is another industry
that exhibits the same characteristics, i.e. a high level of competition and the need for extensive
safety precautions.
Due to the presence of such externalities, therefore, road haulage still requires effective
qualitative regulation, where the chances of offenders being caught are high and the cost of the
penalties imposed far outweigh the potential beneﬁts that may arise from getting away with it.
The industry therefore cannot be entirely left to the market;however,the state’s role is to ensure
that minimum operating standards are set at an appropriate level and that these standards are
enforced and maintained. Economic forces should then be able to take the industry forward
from there. Of increasing concern with regard to road haulage, however, is the presence and
impact of another externality, that of air pollution, and that may require stronger market
intervention from the relevant authorities in the future.
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CHAPTER SUMMARY AND REFLECTION
This chapter has examined the issue of perfect competition in transport markets. That was deﬁned
as the position where the level of competition within the market is maximised. For this to take
place, a number of conditions or assumptions are required, and if fulﬁlled, the market will ﬁnd
the ‘right’ answer in transport markets. In other words, the correct level of transport services will
be produced in a cost eﬃcient manner to those that value them. Operators will only earn a ‘fair’
reward in the form of normal proﬁts for providing such services.
What we also saw however was that transport markets, even in the case study industry of road
haulage, breach at least one of the assumptions of perfect competition. Whilst that is probably true
of all industries, in certain transport sectors the problem is that it is particularly acute. We
examine some of these issues in subsequent chapters; however, the following chapter considers
breaches of at least one of the basic four assumptions of perfect competition, which results in the
creation of imperfectly competitive markets.
CHAPTER EXERCISES
The two exercises that follow can be completed after reading this chapter, particularly the ﬁrst;
however, you may wish to also read the following chapter before attempting these questions.
Exercise 6.1 Perfect competition in bus markets
If we assume that a given bus market is in perfect competition which charges a ﬂat fare of £1, and if
the formula for the total demand (in thousands) in the market is given by the equation:
Qd = 250 − 60P
Where Qd is the quantity demanded in thousands at a given price P.
If we further assume constant returns to scale, then:
a) What is the total market demand at the £1 ﬂat fare?
b) If the market is shared equally by 4 ﬁrms, what is the number of passengers carried by each
company?
c) If the cost per vehicle kilometre is £1.60, average utilisation 20 passengers per vehicle kilometre
and average trip distance 10 kilometres:2
What is the level of bus kilometres required to service this market?i
What proﬁts are being made?ii
What type of proﬁt is this, normal or abnormal?iii
What is the cost per passenger carried (as opposed to the cost per vehicle kilometre)?iv
d) As this is perfect competition,new ﬁrms may enter the market and compete these proﬁts away.
What price therefore will ensure that only normal proﬁts are made?
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e) The answer to part d should be the same as the answer to c(iv), why?
f) At the lower ﬂat fare, why has market efﬁciency now been achieved?
g) This exercise assumes that the four ﬁrms in the market will behave consistent with the perfect
competition model, however is that in their own best interests? What does this tell us about
market structures where only a few ﬁrms exist?
h) Why in this exercise however would the ﬁrms be forced to behave consistent with the perfectly
competitive market?
Exercise 6.2 Transport industries’ market structures
In this chapter we have only examined perfect competition in transport markets.Nevertheless,this was
stated as the position where the level of competition within the market is maximised. As we will see
in the following chapter, the other end of the spectrum is where there is no completion at all, i.e. a
monopoly. From the following list of transport industries given below therefore:
᭿ The British Bus Industry
᭿ Road Haulage
᭿ Domestic Air Services
᭿ Suburban Rail Services
᭿ National Intercity Rail Services
᭿ Long Haul Air Flights originating in the European Union
᭿ All land-based forms of public transport in Britain
᭿ Rail freight services
᭿ Urban taxi services
Place those industries on a spectrum of market structures that should look something like this:
where perfect competition represents the position of ‘maximum’ competition and monopoly the
position of no competition.
Questions:
a) What criteria did you use in your assessment of where on the spectrum a particular industry
should be placed?
b) On a scale of 1 (very low) to 5 (very high), mark against each industry this (very!) rough
indicator of government intervention in that particular transport market. Does there appear to
be any particular order in your assessments?
c) What have you learned from this exercise, particularly with regard to the deﬁnition of a
particular transport market and its associated market structure?
᭹ ᭹
Monopoly Perfect Competition
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