Transport economics Why is transport important?

For commodities the choice of mode depends largely on the physical characteristics of the goods. High cost, low volume goods are usually moved by air. Electronic component parts for expensive machines, fashion clothing and food will often be air freighted. (The air courier business is a fast growing sector in the UK.) Low value, high volume goods, such as coal and iron ore are best moved by rail or ship, although road freight is often chosen.
 Price

The demand curve for transport modes will be downward sloping. The lower the cost of transport the more journeys will be taken.

Proof of this proposition can be found in the rapid rise in demand for airline journeys when prices fall on a route due to the introduction of competition. For example – Ryanair and easyjet together with other low cost airlines have allowed massive rises in air travel including on routes that failed to be profitable previously and Virgin Atlantic in 1984 raised the number of trips taken from the UK to the USA.
 Relative prices charged by different modes or different operators

Relative prices are very important to decisions on which mode to use. For example when working in London and commuting to work a person has the choice of private car, bus, taxi or train. The relative costs of these will be one factor in making the mode decision.

The demand for traveling is income elastic for both business and leisure travel. Business travel has grown a great deal in recent decades, especially due to the growth of international trade. However new technology may reduce the need to travel in the future.

Speed is of importance to all travelers, but it is more important to some than others. Thus few holiday makers were prepared to pay the extra costs of flying on Concorde, but some business travelers did. Higher speeds also imply greater efficiency and so if freight can be moved faster by one route than another then the capital employed to move it (the lorry or train) can do more work (make more trips).

Quality covers a number of different aspects of travel;

frequency

standard of service

comfort

reliability

flexibility

Peak demand in transport operating terms is the period of maximum demand. It affects both freight and passenger services, but more data is available for passenger services. The problem of peak demand is that transport as a service must be supplied when required, it cannot be stored, unlike goods.

Morning journey to work 7.30 am to 9.30 am (factories, schools and shops).

There is a summer weekend leisure peak on roads and public transport. Fares reflect this, for example a ‘white’ saver return on Great Western Railways from London to Bath cost £36 on a Friday in 1997, not £27, the cost during the rest of the week. This fare was not available between 4 pm and 6pm when the full fare of £57 is payable.

Summer holiday traffic. Airlines operate their fleets much more during the summer to cope with demand. School holidays have the biggest effect on peak flows.

Leisure time has increased as a result of shorter working hours, higher unemployment and early retirement. As a result more leisure journeys are being made.

Improvements in services can lead to passengers switching from one service to another. For example the advent of no frills airlines such as easyJet has led to passengers switching away from traditional scheduled airlines and to BA introducing Go, their own no frills service.

The design of urban areas has changed in recent decades. Living patterns are becoming more dispersed, with people moving to suburbs, shopping in out of town centres and leaving the inner cities. With lower population densities it is more difficult for public transport to operate and car ownership becomes even more attractive.

 How essential the journey is. The elasticity of demand for rail travel into London arriving between 8 am and 9.30 is highly inelastic as demand is mainly to get to work.

 Alternative practical modes. The more alternatives the more elastic is demand for a particular mode of transport, again travel to work in London.

 Availability of an alternative supplier. Sometimes routes are dominated or controlled by one supplier, thus it is not possible to shop around for a fare and changes in fares have less impact on demand. E.g. Transatlantic air routes were dominated by three carriers until the late 1970’s.

 Proportion of income transport accounts for. Where transport is a major item of expenditure we would expect the elasticity of demand to be more elastic than when it only accounts for a small proportion.

As with other goods many of the factors are interdependent or may conflict.

Source TOC’s 2004

1979-85 1991-95

Bus

Own price elasticity -0.4 -0.62

XPED with respect to Rail +0.05 +0.16

Own price elasticity -0.54 -0.49

XPED with respect to bus +0.21 +0.2

XPED with respect to Rail +0.17 +0.08

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  the forecasts also help to inform the many individuals and interest groups who wish to know by how much road traffic can be expected to grow under present policies and give an indication of the effect of measures that they might propose to influence this growth. (The traffic database and various elasticities underlying these forecasts can be used to analyse the effect of alternative policies which could lead to different rates of traffic growth.)
  

The forecasts are subject to uncertainty. They are trying to predict the individual decisions of millions. It is possible to make forecasts only because the patterns of car ownership and vehicle use are well determined. There remains a range of uncertainty in the forecasts but, because the underlying relationships have been well determined and stable over long periods. Against this there is the particular difficulty of much transport demand being leisure based and so competition from non-traveling leisure based activities should be considered, but is very difficult to model.

*GDP or Employment

* Population

* Car Ownership

* Car Fuel Costs

* Car Journey Time

* Bus Cost

* Bus Journey Time

* Bus Headway

* Air Cost

* Air Headway

* Underground Cost

* Fares

* Performance

* Non-timetable related service quality (focusing mainly on crowding, station facilities and new/refurbished rolling stock)
The system does therefore try to look at the effect of overcrowding on trains for example. Of course many of these assumptions will prove to be false, but represent a ‘best guess’ at the time. The forecasts are updated as and when a better estimate can be made.
The Consequences of the Forecasts
Some consequences of the 1997 forecast growth in traffic is an increasing proportion of urban traffic traveling in a busy direction encounters roads working at capacity or near capacity, and this forms a large proportion of traffic on urban motorways, even during the inter-peak on weekdays. Journey times are predicted to increase considerably, especially on urban motorways, where they are predicted to increase in the peaks by 70% by 2016 and to double in 2031. Average journey times on rural motorways are also predicted to increase substantially, especially in the peaks. The proportion of travel not undertaken on account of the effects of increasing journey times, or cut off by lack of capacity, taken over the week, is not great; the proportion is greatest in the conurbation's. It is to be noted that these consequences are all subject to wide ranges of uncertainty.
Reasons for Traffic Growth
Traffic is forecast to increase mostly because people are expected to become richer, and to enjoy longer lives, because economic activity increases, and because households are forecast to become more numerous. The main single factor leading to traffic growth is increasing car ownership.
Other modes
The forecasts referred to here are for road traffic, the dominant mode of travel for both passengers and freight. The principles of forecasting can be applied to any mode of transport. It is largely a matter of good past data to determine elasticities and forecasts of GDP growth. Assumptions are then made about policy options and capacity.
There seems to be two key lessons

Use the forecasts to monitor predictions against actual figures. This can then inform policy and future predictions.

Monitor changes in key assumptions to avoid major policy mistakes (this can apply to private firms as well as governments).
This is an area frequently asked in the exam. Candidates seem to try to avoid it because they feel that their knowledge is too insubstantial. The key is to remember that there is a lot of basic economics here and it also tests knowledge of the nature of transport and transport trends. Be happy to answer the question!
Note there is a bigger question that relies on more knowledge, but is based here. Should traffic forecasts be the basis of transport policy decisions. Add ‘discuss’ and the phrase ‘alone’ and there is a major essay question here.

Theories of market structure
UK Industry
In the UK most firms are small, and since the 1970’s small firms have become more important to the economy.
Small firms typically have very little market power. There are two types of small firm:

1. Those which simply accept market prices.

2. Those who try to give themselves some ‘unique selling point’ and so can have some influence over price.

The first type of small firm can be represented in a model of “Perfect competition”, the second in a model of “monopolistic competition.”

To draw sensible conclusions about how these firms will behave we must make some assumptions.

1. All firms are profit maximisers.

2. There are many buyers and many sellers, none of which can influence the market by their actions.

3. All firms produce an identical product.

4. All firms and customers have perfect information.

5. There is free entry and exit from the market.
A closer examination of the assumptions
Assumption 1 implies the firm will produce an output where MC = MR.

Assumption 2 means that if a firm doubles output there is no effect on market price. The firm is not large enough to cause a significant effect on the market supply curve and so all firms sell their output at the market price - they are price takers simply accepting the price as given.
Assumption 3 means customers cannot distinguish between the products made by each firm in the industry. (Each firms product is a perfect substitute for all of the others.) There can be no brand loyalty in this market. This condition is often stated as the firms are producing a ‘homogeneous product’.
Assumption 4 means that each firm is fully aware of the actions of its competitors, of changes in technology and of price. Customers also know what each firm is doing and will immediately be aware of any changes.
Assumption 5 means a firm may enter or leave the market at will and at no significant cost. This requires all factors of production to be ‘perfectly mobile’ as they must be able to switch from producing one good to another as the firm makes a decision.
Market equilibrium
As the firms in this industry are price takers they face a perfectly elastic demand curve. i.e. they can sell all they want at the market price.

In the diagram below the firm will produce the output where MR = MC (q*) and sell that output at the market determined price of 0P*.

The firm will generally earn only normal profit. Normal profit is the amount of profit a firm requires as a minimum to stay in a market. Because it is the minimum requirement it is included in average cost as it represents the opportunity cost to the entrepreneur of being in the industry. If the firm does not earn normal profit then it could move to another market and earn at least normal profit there.

The excess profits will attract firms into the industry (as they will be presently earning only normal profits elsewhere). This will cause the market supply curve to shift to the right and this will continue until the market price has fallen to 0P* and only normal profits are being earned by firms in this industry.

 There is perfect knowledge on the part of firms.

 Entry into the market is costless.

 Factors of production are perfectly mobile.

 There is no brand loyalty and new firms can find customers at the market price.
In more modern jargon the perfectly competitive market is perfectly contestable. Whenever excess profits are earned the existing firms are unable to prevent competitors from entering the market.
When the price in the market has reached 0P* and all firms are earning normal profit there is no incentive for firms to leave or enter the market. Under perfect competition any excess profits are competed away and any losses will be short lived as some firms leave the market (there is costless exit) to earn normal profits elsewhere (the supply curve shifts to the left raising price back to 0P*).
Monopolistic competition⁶
It is relatively easy for a firm to step from perfect competition to monopolistic competition. Most of the conditions of perfect competition apply.

1. All firms are profit maximisers.

2. There are many buyers and many sellers, none of which can influence the market by their actions.

3. All firms and customers have perfect information.

4. There is free entry and exit from the market.
The main difference to perfect competition is that the firms do not all sell an identical product, they are all in some way different from each other.
It may be that the firms all sell an identical good, but they locate in different places. For example many shops sell baked beans. If a customer can buy the beans in a shop in their own road they will not go to a shop two miles away. Thus the two shops are not in perfect competition as the near shop could sell the beans at a higher price but still get the persons custom.
It may be that the firms sell slightly different products, known as differentiated products. The consumer will be able to develop a ‘brand’ preference. In effect each firm is a monopoly supplier of its individual product, but is in competition with suppliers of similar goods which are close substitutes for its product.

Examples of monopolistic competition:

Garages, Cinemas, Grocery shops, Newsagents, Garden centres.
Because of the distinct difference between the products each firm faces a downward sloping demand curve. Unlike in perfect competition where a firm will lose all its customers if it raises price brand preference or location allows a monopolistic competitor to keep some of them. When a firm is making excess profits in this market because of free entry and exit they will be competed away. The diagram below shows a monopolistically competitive firm earning short run excess profits (P*ABC).

As there is perfect knowledge, free entry and exit and mobile factors of production new firms will enter the market. Each new firm will take part of the market supplied by existing firms. This results in the shifting of the individual firms demand curve to the left. New firms will continue to enter the market until only normal profits are earned (price = average total cost).

Few markets comply with this definition of monopoly. Often the Post Office letter delivery service is quoted, however a fax is a substitute to a letter. Electricity and gas supply were often used examples, but today there is competition in these markets (an important point, a monopoly situation need not last forever).

As in a pure monopoly;

 there is only one supplier of the good.

 there are no close substitutes.

 there are barriers to entry.

 the firm is a profit maximiser.

As the only supplier the monopolist faces the market demand curve.

Patents or copyrights: These prevent any other firm from copying another’s ideas.

E.g. The copyright on ‘Modern Economics’ means nobody else can publish the material in it until 50 years after the death of myself and David Heathfield.

A patent is a right granted in law to have exclusive control over a new invention for a certain period of time. No one can produce the good or use the technology without payment. For example Polaroid successfully sued Kodak when they produced an instant camera in the late 1970’s.

Regulated industries: The law allows private firms to operate in the industry, but only under certain rules or with a licence. Many nationalised industries were privatised and became regulated industries between 1983 and the present. E.g. British Telecom, British Gas.

This would include the scale of production necessary to compete in the market. A high minimum efficient scale implies a high capital outlay which many firms cannot afford. (They may feel that they cannot afford to leave the industry if they did enter as the high capital outlay could not be recovered, known as ‘sunk costs’.)

Some industries are described as natural monopolies. The nature of the industry is such that having more than one firm would be wasteful.

The best known examples occur where economies of scale are realised at all levels of potential output for the market (i.e. no matter what the price the industry never demands enough to allow the supplier to reach even constant returns to scale). Such a situation arises in the railway industry.

If two tracks are laid between two cities fixed costs are doubled, yet the tracks are idle most of the time. The more trains that run the lower average total cost becomes.

A monopolist can earn excess profits at any output between a and b. If there were two firms each supplying half the market neither would be able to cover their costs.

In the diagram the Oligopolist charges price 0P1 and sells quantity 0Q1. It believes that the demand curve is kinked at price 0P1, being more elastic at higher prices than lower prices. This is essentially the combination of two demand curves which meet at 0Q1. However the marginal revenue curves for those two demand curves don’t meet anywhere near 0Q1 and so there is a gap or discontinuity in the MR curve of ab.