Transport economics Why is transport important?
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- Contestable markets
- Contestability in transport
- Barriers to Entry High Low Rail passenger services Contract logistics Road haulage Rail freight
- Low contestability High contestability Monopoly as a market failure
- The loss of consumer surplus
- Productive and allocative inefficiency under monopoly
- Productive efficiency
- Contestability and efficiency
- Monopolistic competition and oligopolies
Game Theory The most difficult aspect of oligopoly is that no two markets are the same. The kinked demand curve model describes a market where there is little price competition, but there may be fierce non-price competition (but there may not be). In other markets there may be price competition. Game theory has been used to model oligopolists behaviour. When there are two firms in the market they have to consider how their price changes will affect the other. This is a ‘game’ in the sense that the outcome is uncertain, but the aim of the game is to maximize profit. Usually we show game theory by using a two firm example. 
Here both firms are initially charging £2, each making £10m profit. Firm A considers lowering price to £1.80. There are two potential reactions from firm B. They can keep price at £2 and suffer a fall in profits to £5 million, while Firm A makes £12m Or they can match the price change, leading to each firm making only £8m as they fail to gain market share, but sell at a lower price. In this example Firm B can also initiate the price drop with the same possible reactions from A. There is no reason in reality why there is such symmetry. For example where there are two bus companies and one has 80% market share they may have much less sensitivity to the price change of the rival firm. Also there are often more than one firm (difficult to represent in this format). For example easyjet and Ryanair can change prices and affect the market more significantly than BMI. The essential point comes back to interdependence of firms. Game theory is an excellent way to represent this and can be extended to more complex situations. Collusion Collusion can occur in oligopoly markets. This is where firms try to act in a way that jointly maximizes profit. This can take many forms, but examples include agreeing on prices so that all firms make a profit and there are no price wars and agreeing on which firm can operate certain routes without competition from other firms. Such agreements are illegal when they are formal. Sometimes collusion is tacit, or unwritten. Here firms agree, perhaps in a bar at a trade conference, that they will act in particular ways. This is still illegal and the Competition Commission has taken action against firms who even share cost and pricing information. It is very difficult to distinguish between tacit collusion and a Nash equilibrium. A Nash equilibrium may arise as each firm realises that if it acts to maximise the return to the group - the firms in its industry - and all the others do the same then they will collectively maximise their return. If they simply pursue their own maximum profit they may be competed out of the market, or at the least end up in a damaging price war. Hence firms may appear to be colluding, but they are just smart enough to realize their own best interest. Transport markets have a number of examples of oligopoly. In air transport there are a number of large players on short haul, and in long haul there are now three major ‘groups’ which includes the ‘Oneworld Alliance’ that includes British Airways. The local bus market contains five large groups, three of them controlling 57.4% of the market. Concentration ratios The concentration ratio is the measure of how much of a market is controlled by the biggest firms. Oligopolies of course have a high concentration ratio. The most common way to represent concentration ratios is a 3, 4 or 5 firm concentration ratio. A 3-firm concentration ratio tells us what percentage of the market the biggest three firms account for, a 4-firm ratio the top four and so on. Consider the bus market. Firm Market share 2007 Concentration ratio First Group 23% Stagecoach Group 17.8% Arriva 16.5% 3 firm 57.4% Go-Ahead Group 9.3% 4 firm 66.7% National Express 5.1% 5 firm 71.8% Concentration ratios need to be used carefully. Here the top three firms dominate and so the 3–firm ratio gives a clearer picture. The 5-firm ratio fails to show that National Express, the 5th player, is quite a small player. Also the ratio tells us nothing about market size, just share and also fails to tell us if the market is growing or if one firm is becoming more dominant. Contestable markets9 The theory of contestable markets was introduced to try to explain firms behaviour without the need to characterise markets as one of a range of theoretical models that were not exactly appropriate. One of the reasons for this was that there were monopolies and oligopolies that did not earn excess profits and restrict output as the models suggested. Indeed they kept prices low and provided good service to customers. The theory argues that the behaviour of firms in a market depends upon whether there is a real threat of competition. A market is said to be contestable if there is the potential to enter the market. For example in the rail industry a ‘Train Operating Company’ is awarded the franchise to run a line. That TOC is the only supplier of rail services on that line - a monopoly. They could raise prices and provide an infrequent and dirty service. However the next time the franchise is awarded they may lose it to another company, thus despite being a monopoly they offer reasonable prices and a good service. For a perfectly contestable market the costs of entry and exit must be zero. If there are no barriers to entry then any excess profits will be competed away by new entrants. Thus the threat of new entrants means existing firms will operate at or close to normal profits. Why are the markets with low barriers to entry that are dominated by large firms? The answer here usually lies in the cost of exiting the market. If a firm can enter the market and, if unsuccessful, leave taking all of its capital with it to use elsewhere then there is only a small penalty for trying to compete in the market. Consider a firm that must purchase specialised capital equipment to enter the market and that capital is useless in another market. All of this capital expenditure will be lost if the firm leave the market and the cost to the firm is considerable. Costs such as these are called sunk costs and are defined as costs that cannot be recouped. Where high sunk costs exist firms will be deterred from entering. Thus the behaviour of a firm in an industry will depend no upon how many firms are presently in the industry but on the potential for new entrants and the size of sunk costs. A monopolist may fear that the potential for entry is high and decide to deter entry. They could advertise heavily, reinforcing brand loyalty or promote the public image of the company by sponsoring sports events etc. for the same reason. They may even charge lower prices to limit entry. Contestability in transport The air travel industry is often quoted as an example of a contestable market. It is dominated by large firms, but they can divert their resources to new routes at little cost, thus entering another market. If the route is unprofitable or another route becomes more profitable they can switch the aircraft to that route. It is possible that airlines will just make normal profits in this market structure without being in perfect competition. The example is flawed because in reality certain routes are too congested to enter and landing slots are strictly controlled at airports so new firms find it difficult to enter. The privatisation programme in transport was designed to make these markets more contestable. The railways, for example, were broken up so that TOC’s did not have to buy expensive rolling stock (they hire it from specialist companies) or invest in track or stations (they hire these from Network Rail). Therefore a TOC can leave the industry quite easily and must beware rival firms bidding for and obtaining their franchise when it is up for renewal. The UK railway system is not perfectly contestable, but is much more contestable than it was under nationalised BR, a state monopoly, and more contestable that a system of regional railways where the firm had to own and run the track and rolling stock too. Below is a summary of UK transport and contestability. It is debatable and so we must be careful when using it. For example barriers to entry are not so high in air transport that Ryanair could not become the largest European airline (overtaking established BA and Leufthansa) in terms of passengers carried from foundation in 1985 with a single route. However barriers in air travel are high compared to taxis. Barriers to Entry High Low Rail passenger services Contract logistics Road haulage Rail freight Franchised bus services Taxi services Air transport Bus services in urban areas Coach services Ferry services Rural bus services Low contestability High contestability Monopoly as a market failure10 A perfect market is both allocatively and technically efficient in the short run and the long run. As such perfect markets are the ‘ideal state’ against which other market forms can be compared. Monopolies are sole suppliers of a good, and so face the market demand curve. They try to maximise profit (producing at the level of output where MC = MR). If we compare long run equilibrium's of monopoly and perfect competition we find a loss of consumer surplus under monopoly and that monopolies are not efficient in an economic sense. The loss of consumer surplus Assume that in the relevant range of output costs are constant, i.e. LRMC = LRAC. The monopolist produces where MC = MR, the perfectly competitive industry produces where market supply (MC curve) = market demand (AR curve). Monopolist Perfect competition Price 0Pm 0Pc Output 0Qm 0Qc Consumer surplus ABPm ACPc Under monopoly there is a “welfare loss” of consumer surplus of PmBCPc (the red and green shaded areas). The lost surplus is partly transferred to the monopolist in the form of excess profits (red box), the rest is lost to everyone as output Qc - Qm is not produced. This complete loss is known as dead weight loss (DWL) (green shaded triangle). Productive and allocative inefficiency under monopoly The diagram used for consumer surplus was simplified. A more complex one is needed here. Monopoly Perfect Competition Price 0Pm 0Pc Quantity 0Qm 0Qc Productive efficiency? No. AC > min AC Yes. AC = min AC Allocative efficiency? No. Pm > MC Yes. P = MC Monopoly is productively inefficient because it produces output 0Qm at an average cost higher than the lowest possible (ACmin at point B). Monopoly is allocatively inefficient because it sells its output at 0Pm which is greater than marginal cost. The marginal cost of 0Qm is at point C, perfect competition operates where P = MC and AC = min AC (point B). Knowledge of productive and allocative efficiency is required. However they are simple concepts to apply. Productive efficiency: Operating at the lowest point on the lowest possible average costs curve. Allocative efficiency: Operating where marginal cost equals price (MC = P). How bad are monopolies? If the welfare loss due to monopolies is very great then governments could take action to prevent them, or reduce their power. But there is also a case to be made for monopolies. Consumer surplus Economists have tried to estimate the dead weight loss due to monopoly power. As all but perfectly competitive firms face downward sloping demand curves the DWL triangle appears in all markets. Harberger (1954) estimated the loss at 0.1% of national income. Subsequent refinements of his method suggest the figure for his data was much higher. However this still represents a very small loss. Cowling and Mueller (1978) estimated the loss at 4% to 13% of Gross Corporate Product, depending on how the loss is estimated. If they are correct the loss is significant. Many claim that even if DWL is high the cost if intervening in the market to correct this would be as high or higher. A monopolist with no economies of scale charges more and produces less than a perfectly competitive industry. A monopolist that gains economies of scale may produce more and charge less however. If supply under perfect competition is given by Spc, while the monopolist faces the marginal cost curve MC’ then consumers gain consumer surplus PcABPm’. Even though the monopolists price is greater than marginal cost the consumer is better off. Thus technical and allocative efficiency may not result in the best possible outcome for consumers. Contestability and efficiency One of the arguments for making markets more contestable is to encourage allocative and productive efficiency. Fear of competition will cause a firm to cut out waste and also price efficiently as they try to meet consumer needs. A pure monopoly that does not have any contestability will therefore have larger welfare losses than one that is contestable. Monopolistic competition and oligopolies Both these market forms result in an inefficient allocation of resources because P = MC is not achieved and the firms do not operate at the bottom of their average cost curves. The loss of welfare due to monopolistic competition will not be as great due to the larger number of firms and ease of entry into the market. Under oligopoly the result in a profit maximising industry with barriers to entry can be just as bad as monopoly. If the oligopoly market is highly contestable then losses may not ba as bad as theory suggests. Dynamic efficiency It has been argued (by Schumpeter) that monopolies and oligopolies are good for an economy because their large profits can be used to finance research and development (R&D) and so growth and innovation proceed at a faster pace. These dynamic gains outweigh the static losses, according to Schumpeter, especially as most industries are oligopolies and so wish to keep one step ahead of their rivals. The truth of this argument may rely on how contestable the market is. The more contestable the greater the dynamic gains. Natural monopolies A natural monopoly occurs when it is only economical for one firm to operate in the market. In such cases it is not possible to apply the Price = MC rule. E.g. industries with large infrastructures such as railways or electricity distribution. Whenever price = MC the firm makes a loss. Given the position of the demand curve there is no single price where the monopolist can even cover costs. There are several possible solutions. 1. Nationalise the industry. The state runs the industry in line with social objectives (e.g. greatest output) and covers the loss from taxes. 2. Allow the firm to operate by regulating prices. For example it may charge a certain price to customers and receive a ‘public service’ grant. 3. Allow the monopolist to charge different customers different prices. This is known as a discriminating monopoly. It is a matter of contention if such practice is good or bad. Price discriminaion Price discrimination in transport can be very useful. In the case of natural monopoly this allows the firm to make a profit where none could be made otherwise. This is applicable I the rail industry where fixed costs are very high if operated as a single firm. So by charging different prices the firm maximizes revenue. 
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