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TRAVEL DEMAND

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					         COSTING AND PRICING IN
            TRANSPORTATION
KSG HUT251/GSD 5302 Transportation Policy and Planning, Gomez-Ibanez


OUTLINE OF CLASS:
1. ROLE OF MARGINAL COST IN PRICING
        Private firm (profit-maximizing)
        Public firm (welfare-maximizing)
2. COMPLICATIONS IN DETERMINING MC
        Occur because
           Investments often high cost, durable, “lumpy”
           Peaking of demand
        Complications
          1.   Increasing returns to scale or traffic density
          2.   Returns to scope, joint costs, and peak vs. off-peak
          3.   Short-run MC versus Long-run MC
          4.   Sunk costs
PRICING IN A PRIVATE FIRM
GENERAL CASE
 HOMOGENOUS PRODUCT
       Produce quantity where MR = MC
       Check shutdown (TR  TC in long run)
                                  MC
                     P


                                  MR   D
 JOB SHOP                    Q
       MC is the floor
       Get as much above MC as possible
PRICING IN A PRIVATE FIRM
COMPETITIVE MARKET
      “Price takers”: demand curve flat and MR = P
      Thus: MR = MC becomes P = MC
                          MC

                                D = P = MR



                         Q
PRICING IN A PUBLIC ENTERPRISE
ASSUMPTIONS FOR P = MC:
   1. CONSUMER IS ALWAYS RIGHT
        (Consumer is best judge of his or her own welfare, consumer
           is reasonably well informed, welfare of society is a function
           of welfare of consumers)
  2. REDISTRIBUTION NOT AN ISSUE
        (Distribution of incomes and opportunities is fair or better
            corrected by other measures)
  3. NO UNCORRECTED EXTERNALITIES
        (E.g., no uncorrected pollution or congestion externalities)
  4. OTHER GOODS AND SERVICES ARE PRICED AT MC
        (E.g., no monopolies or distorting taxes or subsidies)
  5. NO CONFLICTING MANAGERIAL OR BUDGETARY
     CONSIDERATIONS
        (E.g., if P = MC means TR  TC subsidizing the public
            enterprise through tax revenue is acceptable.)
PRICING IN A PUBLIC ENTERPRISE
ASSUMPTIONS (1) THROUGH (4) IMPLY
        SOCIAL BENEFIT = consumers’ willingness to pay
        SOCIAL COST = firms’ production costs


    Thus: P = MC becomes MSB = MSC
                           MC = MSC

               P
                                   D = MSB


                            Q
THEORY OF THE SECOND BEST
VIOLATION OF ASSUMPTION (4)
 DEFINITIONS
     FIRST BEST SOLUTION: price the other goods at
        MC too
     SECOND BEST SOLUTION: If first best not possible
 EXAMPLE: If PAUTO < MCAUTO
      PTRANSIT  MCTRANSIT ?
      PTRANSIT  MCTRANSIT ?
 LESSONS
      NO OBVIOUS SOLUTION (P  =  MC ?)
      IGNORE IF LOW CROSS PRICE ELASTICITY
COMPLICATIONS IN DETERMINING MC:
(1) ECONOMIES OF SCALE OR TRAFFIC
DENSITY
   SCALE: output or size of firm
   DENSITY: volume of traffic in a corridor or between a
      city pair
RETURNS TO SCALE OR DENSITY CAN BE:
     CONSTANT        DECREASING, OR INCREASING
                              MC
                                AC
               AC
                = MC                      MC       AC

IF P = MC, this means
       TR = TC        TR  TC             TR  TC
COMPLICATIONS IN DETERMINING MC:
(1) ECONOMIES OF SCALE OR TRAFFIC
DENSITY
IRD, IRS COMMON BUT OFTEN EXAGGERATED
 RIGHT OF WAY AND CAPITAL COSTS NOT THAT
   “LUMPY”
 AC CURVE OFTEN STEEP ONLY WHERE DOMINATED
   BY OTHER MODES

   AC
                      BUS
                                   RAIL


           AUTO

                      CORRIDOR VOLUME
COMPLICATIONS IN DETERMINING MC:
(1) ECONOMIES OF SCALE OR TRAFFIC
DENSITY
IMPLICATIONS OF IRD, IRS
 PRICING
     P = MC causes deficits that may be considered undesirable
        due to budget or incentive concerns. Possible remedies:
           Price discrimination:
               Descending block
               Ramsey (a.k.a., inverse elasticity, value of service)
           Price at AC (if close to MC)
 REGULATION
     May have “natural monopoly” (although not if competition
       from other modes or locations)
 PROJECT EVALUATION
     P = MC not sufficient for project to be worthwhile.
        Consumers’ surplus must  deficit (Jules Dupuit’s bridge
        problem)
COMPLICATIONS IN DETERMINING MC:
(2) ECONOMIES OF SCOPE OR JOINT
COSTS
ISSUE: Potential economies or diseconomies of using the
   same facilities, crews, etc. for different services
      (E.g., passenger and freight on RRs, business and leisure on airlines)

 Extreme (and old) view: JOINT vs. COMMON COSTS
      COMMON: use same facilities but can clearly allocate all parts of
          the facility to one or another service
      JOINT: provision of facilities for one service makes them available
          for other service at no cost
      Classic examples: wool and mutton; cotton seed and fiber
      Real world example: peak vs. off peak

 More nuanced (modern) view: ECONOMIES OF SCOPE
      There may be cost advantages (or disadvantages) of producing
         two different products with the same firm. If so, MC  AC.
      Beware of diseconomies of scope!
COMPLICATIONS IN DETERMINING MC:
(2) ECONOMIES OF SCOPE OR JOINT
COSTS
PEAK LOAD PRICING: Some costs of peak and off
   peak are typically joint
     NORMAL SOLUTION: Assign all joint costs to the
      peak
     SHIFTING PEAK PROBLEM: if joint costs are
      assigned to peak, peak volumes may fall below
      off-peak volumes
      SOLUTIONS:
      1. Broaden definition of peak
            (Peak will shift if peak period defined too narrowly)
      2. If shifting peak persists, allocate joint costs so
         that peak and off-peak volumes equal
COMPLICATIONS IN DETERMINING MC:
(2) ECONOMIES OF SCOPE OR JOINT
COSTS
SIMPLE PEAK LOAD EXAMPLE: HIGHWAY
      Two periods—peak and off-peak—with zero cross-price elasticity
      Two types of costs, both constant returns to scale (so AC = MC):
           Capacity costs (joint) = CC per unit of traffic
           Operating or maintenance costs (not joint) = OC per unit traffic
                    DOFFPEAK            DPEAK
      PPEAK                                                     OC + CC

                                                                CC



    POFFPEAK                                                    OC

                            VOFFPEAK   VPEAK                    VOLUME
COMPLICATIONS IN DETERMINING MC:
(2) ECONOMIES OF SCOPE OR JOINT
COSTS
PEAK LOAD EXAMPLE
      SHIFTING PEAK




                 DOFFPEAK   DPEAK
      PPEAK                                   OC + CC

                                              CC



    POFFPEAK                                  OC

                             VPEAK VOFFPEAK   VOLUME
COMPLICATIONS IN DETERMINING MC:
(2) ECONOMIES OF SCOPE OR JOINT
COSTS
PEAK LOAD EXAMPLE
      SOLUTION TO JOINT COST ALLOCATION IN SHIFTING PEAK

                          DCOMBINED PEAK AND OFF PEAK
               DOFFPEAK DPEAK

                                                        2OC + CC
                                                        OC + CC
      PPEAK
                                                        CC

    POFFPEAK
                                                        OC

                                VPEAK AND OFFPEAK       VOLUME
COMPLICATIONS IN DETERMINING MC:
(3) SHORT-RUN VS. LONG-RUN MARGINAL
COSTS
 DEFINITIONS
     SHORT-RUN COSTS: when some input fixed
     LONG-RUN COSTS: when all inputs variable
 EXAMPLE: with CRS in long-run costs

   SRAC1   SRAC2   SRAC3   SRAC4



                                       LRAC = LRMC
   SRMC1   SRMC2   SRMC3   SRMC4
COMPLICATIONS IN DETERMINING MC:
(3) SHORT-RUN VS. LONG-RUN MARGINAL
COSTS
 LRMC  SRMC MEANS PLANT NOT OPTIMAL
  FOR CURRENT OUTPUT
     LRMC = SRMC      plant just right
     LRMC < SRMC      plant too small
     LRMC > SRMC      plant too big
           SRAC



                                          LRAC = LRMC
        SRMC
COMPLICATIONS IN DETERMINING MC:
(3) SHORT-RUN VS. LONG-RUN MARGINAL
COSTS
IF LRMC  SRMC, WHICH TO USE?

  SRMC
   Optimizes use of existing plant


  LRMC
   If long-run price signals are important to consumers
    or prices are “sticky” because of reputational
    concerns or public regulation
COMPLICATIONS IN DETERMINING MC:
(4) SUNK COSTS
SUNK COSTS: committed, irretrievable
      OFTEN APPEAR LARGE
           because transport capital is often durable, immobile, specialized
      BUT RARELY COMPLETELY SUNK
          Usually some opportunity cost, especially in long run
LOW OPPORTUNITY COST OF “SUNK” COSTS MAY INDICATE
   EXCESS CAPACITY
       Compare opportunity cost with investor or replacement cost:
          Opportunity cost > investment cost  buy more
          Opportunity cost < investment cost  buy less
WHERE DIFFERENCES PERSIST, REASONING IS ANALOGOUS
  TO SRMC vs. LRMC
      Normally use opportunity cost
      But use investment or replacement where long-term price
       stability important
    TIPS ON BACK OF THE ENVELOPE
         COSTING AND PRICING
    ESTIMATE MC
    1.   WHAT DO VARIOUS COSTS DEPEND ON? (COST DRIVERS)
           E.g, peak vehicles, vehicle miles, passengers?
    2.   ARE THERE (DIS)ECONOMIES OF SCALE OR DENSITY?
           If not, can use AC. If so, what is source and size?
    3.   ARE THERE JOINT COSTS OR (DIS)ECONOMIES OF SCOPE?
           If so, who is responsible for joint costs? Beware shifting peak
    4.   ARE THERE SUNK COSTS OR LRMC ≠ SRMC?
           Can you resize the plant so it is more appropriate? Is long-run price
               stability important?
    IF PROFIT MAXIMIZING FIRM:
        GET AS MUCH ABOVE MC AS POSSIBLE
        CONSIDER BROADER IMPLICATIONS
           Competitors reactions, effects on other business/customers
    IF PUBLIC ENTERPRISE (OR REGULATOR):
         MORE COMPLEX: P=MC UNLESS COMPELLING SECOND BEST,
           EXTERNALITY, EQUITY OR BUDGETARY ISSUES

				
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posted:3/29/2013
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