qa f584 transport economics 2013

7/25/2019 QA F584 Transport Economics 2013

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Richard Young

Q&A

A2 ECONOMICS OCRF584 TRANPORT ECONOMICS

2013 EDITION

Question and Answer format

Step by step guide to key concepts

Glossary

RAPID REVISION HANDBOOK


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| Transport and transport modes 1

A2 Transport EconomicsContentsIntroduction to Transport .................... .............. 2

Transport and transport modes ................. 2

Demand for transport ..................... ................ 3

Elasticity and transport .................... .............. 4

Structure of transport operations .............. 5

Recent trends in transport demand .......... 5

Transport forecasts ...................... .................... 6

Market Structures.................................................. 7

Revenue and profit ................... ..................... ... 7

Costs ....................................................................... 7

Economies of scale ........................................... 8

Firms and their objectives ............................ 9

Barriers to entry ..................... ..................... .... 10

Market structure ............................... .............. 11

Concentration ratios .................................. .... 11

Competitive markets .......................... ........... 12

Monopolistic competition ................... ........ 12

Monopoly .................................... ...................... . 13

Price Discrimination .................... .................. 14

Natural monopoly ..................... ..................... . 15

Oligopoly ..................................... ...................... . 16

Contestable markets .................... .................. 17

Franchising .................... ..................... ............... 18

Deregulation ...................................... ............... 19

Privatisation ..................... ..................... ............ 20

Market Failure .................... ..................... ............. 21

Economic Efficiency ................... ................... 21

Market failure .................................................. 22

Public goods ..................................................... 22

Negative externalities .................................. 23

Indirect taxes ................................................... 24

Hypothecation ................................................. 24

Congestion and Road Pricing .................... 25

Subsidies ............................................................ 27

Regulation ......................................................... 28

Sustainability ................................................... 30

UK Transport Industries ...................... ............ 31

Bus Industry ..................................................... 31

Rail Industry ................... ..................... ............. 32

Aviation industry ........................................... 33

Freight industry .............................................. 35

Transport policies............................................... 36

Resource allocation and GovernmentTransport Policy ...................... ..................... .. 36

Cost benefit analysis ..................................... 37

COBA.................................................................... 38

Integrated transport policy........................ 39

International road schemes ..................... .. 40

A2 Transport Economics Glossary .............. 41

Richard Young All rights reserved. First edition 2011. This edition 2013. The right of RichardYoung to be identified as the author of this Work has been asserted in accordance with the

Copyright, Designs and Patents Act 1988.


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2 Transport and transport modes |

Introduction to Transport

Transport and transport modes

Define transport.Transport refers to the movement of people and goods between destinations.

List the main type of transport.Passenger transportis the movement of people from one place toanother. Freight transportis the movement of goods from one place to another.

Define infrastructure.The stock of capital used to support the economic system

What is transport infrastructure?Transport infrastructure is capital items such as road and railnetworks, airports that facilitate transport operations.

What are transport operations? Transport operations are decisions about the type of transportmode to use (demand) or provide (supply). Demand side decisions are made by consumers and firmseg what journey to make, by what mode, and at what time. Supply sidedecisions are mainly made byprivate sector firms eg what transport services to offer over what routes and what time and price.

Define mode of transport. A mode of transport is a method of transferring passengers and freightfrom one destination to another

Summarise the main characteristics of each mode of passenger transport.Mode Appropriate mode for Impacts

Road

(car)

For short and long distance journeys

convenient & flexible eg door-to-door 24/7

Generates negative externalities eg air pollution and

congestion

Bus Commuting in or between cities Limited, fixed routes and timetables

Rail Commuting, city to city travel middle to

long distance travel

Generates positive externalities by diverting journeys

from roads

Air Fastest mode for long distance journeys Limited routes & timetables. Unsustainable.

Summarise the main characteristics of each mode of freight transport.

Mode Appropriate mode for Disadvantage

Road All journeys. Dominant mode Generates negative externalities eg noise, pollution &

congestion

Rail bulky items over long distances +ve externalities ie diverts freight from roads

Air for high value low bulk items over long

distances where speed is important

Limited routes & timetables. Unsustainable.

Sea for bulky items over long distances where

speed is unimportant

slow

What is loading?Loading or load factoris the percentage. Eg a loading factor of 80% means 20% of

seats or space is unused in a journey. High loading indicates means few empty seats.Define private transport. Private transport is whenpeople use their own vehicles to travel.

What is public transport?Public transport involves the mass movement of people at one time -usually by bus or train and using a scheduled service on a fixed route.


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| Demand for transport 3

Demand for transport

Define the demand for transport.The demand for transport is the number of journeys consumers orfirms are willing and able to purchase at various prices in a given time period.

What does derived mean?Derived means got from or obtained from something else.

Define derived demand.Derived demand occurs when the demand for a particular product dependson the demand for another product or activity

Why is the demand for transport a derived demand? Transport is rarely demanded for its ownsake, the journey, but for what the journey enables eg commuting, taking a holiday or distribution.

Give examples of how the demand for transport is derived. People do not use transport for its ownsake, the journey, but for what the journey enables eg economic growth leads to more

Commuting asa rise in GDP increases employment hence the number of commuters

Leisure as households higher incomes totake more holidays raising the demand for eg air flights

Distribution: eg firms hire lorries to transport products to customers. An increase in GDP orinternational trade raises the demand for products increasing in the demand for freight transport

Explain an increase in the demand for transport.Transport demand is derived. Increases in GDP orpopulation raise the overall demand for travel for commuting, distribution and holiday purposes.

How does the purpose of a journey affect demand?Commuters have to be at work in a given placeat a given time. Shopping or social journeys are less time sensitive. This means the price elasticity ofdemand for commuters is more inelastic than for leisure journeys

How does a fall in the bus fares affect bus use?A fall inthe price of bus fares from P1 to P2 results in an extensionin demand. Lower fares cause an increase the number ofjourneys undertaken from Q1 to Q2

Explain the substitution effect. A price fall encouragesconsumers to buy more of a relatively lower pricedproduct and less of a higher priced substitute

Explain the income effect. A price fall leaves consumerswith income left over after buying the same amount of theproduct. Extra income may be spent buying more of thisitem if it is a normal good

What determines the impact of a price change on

demand?The bigger the price change, the greater the impact on quantity demanded. The impact of aprice change also depends on ownprice elasticity of demand. Given few close and available substitutesdemand for a product is price inelastic and so insensitive to own price changes.

Explain the rise in car use in recent years. Increased use is the result of higher demand for cars eg:

Lower carpricesor running costs causes a rise in quantity demanded. The substitution effect of

a price fall causes modal shift as some users switch from relatively higher priced substitutes egrail to using their car more often

Increases in in real GDP have increased incomeincreasing the demand for cars and causing arightward shift of the demand curve. Given the demand for cars has a high and positive incomeelasticity of demand, a rise in incomes leads to a proportionately larger increase in demand

Theprice of substituteseg bus and rail fares have risen in real terms resulting in some usersswitching to the relatively cheaper alternative, cars, increasing demand and shifting thedemand curve for cars to the right. Given cars and buses/rail have a high and positive crosselasticity of demand, a rise in the price of public transport leads to a proportionately larger risein car demand.


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4 Elasticity and transport |

Elasticity and transport

List the main types of elasticity

Price elasticity of demand(PED) is the responsiveness of quantity demanded to a change in theprice of the product. Also called own price elasticity of demand

Income elasticity of demand(YED)is the responsiveness of demand to a change in income Price elasticity of supply(PES) is the responsiveness of quantity supplied to a change in the

price of the product

Cross elasticity of demand(XED) is the responsiveness of demand for one product to a changein the price of another product.

How can transport operators make use of price elasticity of demand (PED)? Operators can usePED estimates in transport to predict a) the effect of a change in fares, indirect tax or road charging onquantity demanded and b) the effect of a change in fares on total revenue

Why do elasticity values vary with

time?The longer consumers have toadjust to a price change the betterable they are to find substitutes

How does PED affect road pricing?

Glaister and Graham (2000) findpetrol consumption and car traffic ishighly price inelastic, especially in the short run, so reducing the effectiveness of road pricing policies

What is the range of YED values? If YED is positive, the product is a normal good.

If YED is positive but less than 1, demand is income inelastic: a change in income results in aproportionately smaller change in demand

If YED is positive and greater than 1, demand is income elastic. A change in income results in aproportionately larger change in demand. This is a characteristic of superiorgoodseg cars

If YED is negative, a rise in income leads to fall in demand. The item is an inferior good eg buses

How can transport operators make use of income elasticity of demand (YED)? Analysts can use

YED estimates to predict impact on demand of changes in income brought about by economic growtheg if YED = +2 and 5% rise in GDP hence national income causes a 2 x 5% = 10% rise in demand

What is the range of XED estimates? XED estimates can be positive negative or zero

XED value Relationship between

products A and B

a 10% rise in the price of this product

causes a proportionately

Positive and greater than one

eg +2

Strong substitutes: demand is

responsive to a price change

larger rise in demand for a substitute

product eg 20%. XED = 20%/10% = +2

Positive and less than one eg

0.5

Weak substitutes: demand is

unresponsive to a price change

smaller rise in demand for a substitute

product eg 5%. XED = 5%/10% = +0.5

Zero Independent goods no change in demand for the other itemNegative and less than one eg

-0.8

Weak complements: demand is

unresponsive to a price change

smaller fall in demand for a complement

product eg 8%. XED = -8%/10% = -0.8

Negative and greater than one

eg -1.5

Strong complements: demand

is responsive to a price change

Larger rise in demand for a complement

product eg 20%. XED = -15%/10% = -1.5

Summarise the elasticities of demand for transport modes.

Busesexhibit low, even negative YED. Road and public transport are weak substitutes forcommuters. Indicator: a low, positive, cross elasticity value.

Income elasticity of demand estimate is +1.4 for business and leisure air travelis +1.5 withhigher values for long-haul travel market.

There are large PED differences for different market segments: UK leisure has an elasticity of-1.0 while UK business has an elasticity of 0i

Variable With respect to Short run Long run

Petrol consumption Petrol price -0.3 -0.6 to0.8

Car traffic Petrol price -0.15 -0.3

Petrol consumption Income 0.35 to 0.55 1.1 to 1.3

Car traffic Income 1.1 to 1.8


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| Structure of transport operations 5

Structure of transport operations

What is a mixed economy? In mixed economies, some resources are owned by thepublic sector(government) and some resources are owned by theprivate sector(households). Public ownershiprefers to state owned companies eg nationalised industries.

Explain the term organisation of transport. Organisation of transport is the structure of transportoperations in terms of private or public sector ownership and responsibilities

Define nationalisation. The transfer of ownership of a firm from the private to public sectorDefine privatisation.Privatisation is where state owned firms are sold to the private sector

What is the role of the public sector in the supply of transport?Extensiveprivatisationsince the1990s means air, bus and rail transport operations is now mainly organised by the private sector

Who makes supply decisions about infrastructure? This depends on the mode of transport.

Apart from private sector schemes such as M6 toll road, virtually all roads are funded bygovernment. The Highways Agency coordinates strategic motorway and trunk roads eg A40.Investment decisions about rail track is made by Network Rail

Investment in other transport infrastructure used by other modes is in the private sector eg BAAinvests in airports such as Heathrow Terminal 5.

Why expand road networks?Depending on where they are built, new or expanded highways

Increases the supply and lowers the price of road use which increases consumer surplus

may reduce congestion and associated negative externalities so increasing allocative efficiency

creates significant external benefits eg regional multiplier effects and lower transport costs forlocal businesses using the new infrastructure

Why decline to expand road networks? New or improved highwats

uses finite resources which are not then available threatening sustainability

may generate more demand for private car travel which increases negative externalities andleads to greater allocative inefficiency

Recent trends in transport demandFor latest transport statistics and trends visit theTransport page published by UK National Statistics

How is passenger transport usage measured?Passenger transport is measured in term of either thenumber of kilometres travelled by passengers usually expressed as billion passenger kilometresor thenumber of kilometres travelled by vehicles ie billion vehicle kilometres.

What is a vehicle kilometre?A vehicle kilometre is equivalent to one vehicle times one kilometretravelled. Vehicle kilometres are estimated by multiplying roadside traffic counts estimates of averagedaily flow by the corresponding length of road.

What is a passenger kilometre? If a vehicle has multiple occupancy then passenger kilometre are

found by multiplying the distance travelled by the number of people in the vehicle.How is freight transport usage measured?The movement of raw materials, components andfinished products is measured in terms of the number of kilometres travelled by one tonne of freight.

What is a tonne kilometre?This is the weight of freight lifted multiplied by the distance carried. Onetonne kilometre means one tonne of freight travels one kilometre.

Describe key current UK transport trends for each main transport mode.

Sustained economic growth means higher car ownership and more goods and workers arebeing transported.

Sustained under investment in infrastructure over 20 years means air rail and road networksare operating beyond capacity, in peak times, at current levels of demand.

The duration of peak time periods is increasing. Projected increases in demand for cartransport are unsustainable.
http://www.statistics.gov.uk/hub/travel-transporthttp://www.statistics.gov.uk/hub/travel-transporthttp://www.statistics.gov.uk/hub/travel-transporthttp://www.statistics.gov.uk/hub/travel-transport


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6 Transport forecasts |

Transport forecasts

What is a forecast? A forecast is the prediction of expected future conditions

How are forecasts used in transport economics? Analysts estimate of the likely future

growth for a mode of transporteg expected number of journeys

value of costs and benefitsas part of investment appraisal eg a cost benefit analysis

How is transport forecasts conducted? Analysts

identify factors affecting demandeg price, GDP, income, price of substitutes and complements assess the relationship between variableseg how population changes affect demand

predict the strength of relationshipsbetween variables eg income and demand (YED)

make assumptionsabout the future value of variables eg fuel prices, GDP and population levels

predict central, high and low trendsfor future levels of demand

Identify problems in making transport forecasts.

Value judgementsmust be made as to which factors to include or exclude in the forecast andthe weighting to give each factor

Forecasts require estimatesof future levels of GDP and populations size which are uncertain

Data collectionmay be difficult or costly

Inaccurate data may becollected eg by using biased surveys unforeseen eventsmay occur eg a recession

How is elasticity data used in forecasts? Elasticity data helps predict future levels of demand. Eg if:

The long run price elasticity of demand for car traffic with respect to petrol price is -0.3, aprojected 10% increase in fuel prices leads to a 3% increase in traffic levels

The long run income elasticity of demand for car traffic is between +1.1 and +1.8 then a projected10% increase in income leads to a 11% to 18% increase in traffic levels

How is transport forecasts used?The economic problem is how to allocate scarce resourcesbetween alternative uses. By forecasting likely future demand resources can be allocated to networksexperiencing the most congestion. This means forecasts result in better use made of scarce resources.

Explain the term predict and build. Traffic levels are forecast and new capacity is added to matchprojected future passenger and freight levels to avoid future congestion.

Are forecasts always accurate? Forecasts give a broad indication of behaviour based on past trendsand best understanding of future behaviour and events but are bound to be uncertain. Eg

Assumptions about future fuel prices, GDP income and population may prove inaccurate

New roads can generate unexpected additional usage and have impacts on other modes.

How does time affect forecasts?Factors affecting past behaviour are unlikely to change in theimmediate future. Forecasts become increasingly unreliable overtime as predictions are more likely tobe affected by unforeseen events and changes in established patterns or consumer behaviour..

What are the consequences of inaccurate forecasts?Government and firms use data to make

resource decisions. Inaccurate forecasts lead them to make different decisions than if they hadaccurate information resulting in a misallocation of resources.

How are forecasts used in cost benefit analysis? See the section on CBA


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| Revenue and profit 7

Market Structures

Revenue and profit

What is revenue?Revenue is the amount a firm receives from the sale of its output.

Define total revenue. The total amount a firm receives from selling a given level of output.

How is total revenue calculated?Total revenue (TR) is found by multiplying price (P) by the numberof units sold (Q). TR = P x Q

What is average revenue?The amount a firm receives per unit sold - another name for price.

How is average revenue calculated?Average revenue (AR) is found by dividing total revenue (TR)by the amount sold (Q). AR = TR/Q ie P

What is marginal revenue?The amount received from selling one extraunit of a product

How is marginal revenue calculated? Marginal revenue (MR) is found by dividing the change intotal revenue (TR) by the change in output (Q). MR= TR/ Q

What is profit? Economists talk about two types of profit:

Normal profitis the minimum amount that must be received to keep a firm in its current

industry. In economics, normal profit is a cost of production. This means all costs curvesinclude an element of payment to the entrepreneur required for organising production.

Supernormal profitis any extra profit made in excess of normal profit. Firms earn supernormalprofits () when total revenue (TR) exceeds total cost (TC). = TR TC

Link normal profit and costs curves. All costs curves (eg AC and MC curves) include an element ofnormal profit. Normal profit is treated as a cost ie a reward to entrepreneurs like wages for labour.

Are there benefits from supernormal profits?Supernormal profits are a source of internal financefor R&D which, if successful, leads to new or improved products or processes and dynamic efficiencies.

Costs

Define total costs.Total Costs (TC) refer to the amount of expenses incurred in a transport operationand is made up of fixed costs (FC) and variable costs (VC). TC = FC + VC

Explain variable costs. Variable or direct costs (VC) are vehicle operating costs and depend on thelevel of usage. Travelling increases variable costs which include fuel. VC = TC FC.

Give examples of variable costs for transport. Fuel, travel time and accident risk are variabletransport costs because they increase directly with vehicle mileage.

What are fixed costs? Fixed costs (FC) are totally independent of the level of use of a vehicle and haveto be paid out even transport operations cease. Fixed costs include car insurance and vehicle exciseduty (tax disc). FC = TC VC. Also called overheads or indirect costs

Give examples of fixed costs in transport. Age depreciation and insurance are fixed transport costsexamples because vehicle owners pay the same amount, regardless of vehicle mileage.

Explain average costs. Average cost (AC) or unit cost is the cost of producing one item and is foundby dividing total costs (TC) by total output (Q). AC = TC/Q.

Explain marginal costs. Marginal cost (MC) is the cost of producing one extra unit and is found bydividing the change in () total costs (TC) by the change in output (Q). MC = TC/Q

How is output levels measured in transport?For passenger quantity can be measured by number ofpassenger kilometres or journeys. Freight output is measured in tonne kilometres


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8 Economies of scale |

Economies of scale

Define the long run. The time period when firms can adjust all factors used in production, ie bothlabour and capital, and enter or leave an industry

Define economies of scale. Economies of scale (EoS) are the benefits, in the form of lower unit costs,from increasing the size of operation. There are many types of EoS eg technical and managerial.

How do economies of scale benefit economic agents?Falling long run average costs (LAC)

represent an improvement in productive efficiency and may be passed onto consumers in the form oflower prices thereby improving consumer welfare.

State the two categories of economies of scale. Internal EoS lowers a firms unit costs because thefirm is growing. External EoS lowers a firms unit costs, because the industry is growing

What are internal economies of scale?Internal EoS arise from the long term growth of the firm.

Explain technical economies of scale. Technical EoS arises from productivity gains in the productionprocess itself. Eg as airlines grow and invest in bigger airplanes they find capacity increases by a largerpercentage than operating costs so LAC fall the law of increased dimensions. The fixed cost of an ITsystem can be spread over a larger level of output reducing LAC as the firm grows in size.

Explain managerial economies.Managerial EOS arises when firms employ specialist accountants, HR

managers, etc. Employing specialist managers increases productivity and so reducing LACExplain purchasing economies of scale. Purchasing EOS arise when firms gain discounts from bulkbuying thereby reducing LAC eg airlines can negotiate discounts for buying dozens of planes at once.

What is a long run average cost curve?A long runaverage cost curve (LAC) shows the firms minimumunit cost of producing each level of output for eachscale of operation.

Each scale (size) of operation has its own short runaverage cost curve eg SAC1. Using more capital andlabour shifts the SAC curve outwards and downwardsif the firm experiences internal economies of scale.

The LAC curve shift outwards and upwards if firmsexperience diseconomies of scale from growth.

What is minimum efficient scale?(MES) is thelowest level of output needed to produce at lowestunit cost. The firm has grown to the point where thereare no internal EoS left to exploit.

Define diseconomies of scalediseconomies of scale are the disadvantages to the firm, in the form ofhigher unit costs, from increasing their size of operation

Why can internal diseconomies of scale occur?Internal diseconomies can arise from problems with

Communication: as firms grow and take on more staff communication becomes problematic egstaff may misunderstand a task resulting in productivity falls and LAC increases

Control: as firms grow it becomes more difficult to coordinatethe work of employees,efficiently. Extra management costs are incurred with increase LAC

Workers in large firms may feel uninvolved, experience alienation, and so lose motivation. Lostproductivity results in in higher LAC

Explain external economies of scale.External EoS is the benefit, in the form of lower unit costs, froman increase in the size of the industry. External EoS are shared by all firms in the industry.

Give examples of external economies of scale. When firms in the same industry locate closetogether, transport costs fall. A pool of skilled labour reduces recruitment costs.


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| Firms and their objectives 9

As the industry grows, government may improve local roads which cut the cost of delivering suppliestherefore lowering LAC.

Give examples of external economies of scale in

transport. Support services such as catering, couriers,and airplane servicing companies tend to locate nearairports lowering the LAC for all firms in the industryeg from LAC1 to LAC2 in the diagram.

Illustrate external economies of scale.Growth of theentire industry reduces the LAC of all firms in theindustry. Eg the LAC for firm Y in the diagram oppositeshifts downwards at all levels of output. This means theLAC of making Q1 falls from A to B

Firms and their objectives

Define a firm. A firm is an organisation that hires and organises resources to make products eg a soletrading taxi driver or multinational airline eg Virgin Atlantic

What is an objective?An objective refers to the aim of a firm eg maximise profits

Explain profit maximisationTraditional theoryassume firms aim to make as big a profit as possible iethey areprofit maximisers

Illustrate profit maximising. Profit maximisationoccurs by setting output where marginal cost = marginalrevenue: MC=MR at Q1.

Note that Q1 includes an element of normal profit in theMC curve. Producing beyond Q1 means MC>MR: a loss ismade on each extra unit made. Making less than Q1means forgone profit

Identify issues with MC=MR pricing. Firms can find ithard to identify marginal costsand revenuesand insteadadd a profit margin to long run average costs. Not all firms are profit maximisers eg they may be keento avoid attracting the attention of rivals or regulators by setting profit maximising prices.

Illustrate other objectives.

Revenue maximising levelofQ: where MR = 0.Firms aim to maximise TR rather than profit

Sales maximisationlevel of Q: where AC = AR. Firmswant to maximise market share rather than profits

Distinguish between limit and predatory pricing.In limit pricingmonopolists set a price to earnnormal profits and so deter (limit) potential entrants. Predatory pricingoccurs after the arrival of anew firm. The incumbent sets a low price trying to force the exit of competitors


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10 Barriers to entry |

Explain the term stakeholders.Stakeholders are groups who have an interest in the activity of a firmeg shareholders, managers, staff, customers, government and local communities.

Define stakeholder conflict. When different stakeholders have incompatible objectives.

How does the agent-principal problem affect firms? Ownership and management are separate incompanies. Shareholders (the principal) elect directors (the agent) to act on their behalf and tomaximise shareholder value. Managers may instead take decisions that meet their own objectives eghiring extra staff to reduce manager workloads. The result is organisational slack and x-inefficiency.

How can the agent-principal problem be resolved? By linkingmanagers pay toshare prices eg byoffering an option to buy shares in the company at some point in the future at the current price

What is satisficing?When firms decide to meet the minimum requirements of several stakeholderobjectives, rather than say owners objective of profit maximisation

Who decides objectives?The aim of a business is decided by the dominant stakeholder(s) taking intoaccount legal constraints such as regulations and competition laws. In companies there is the potentialagent-principal problem. Directors may opt to avoid maximising any one objective and satisfice.

Barriers to entry

Define barriers to entry?Obstacles preventing or restricting firms entering a market

What is an incumbent firm?An incumbent is a business already operating in a market.

What is an entrant? An entrant is a firm seeking to join a market and compete with incumbents

What is the significance of barriers to entry?They limit the ability of new firms to join an industryand so restrict competition allowing incumbents to sustain any supernormal profits in the long run

List barriers to entrypreventing restricting firms entering a market

Legal: incumbents may have a legal monopoly over supply, or government regulations mayrequire firms to meet health and safety regulations before granting an operating licence

High start-up costsof hiring new staff, buying/leasing capital assets (eg planes and IT systems)and marketing to establish a brand image act as a deterrent to entrants

Incumbents generally enjoyeconomies of scaleunavailable to new entrants ie lower unit costs.Incumbents can use this cost advantage for limit pricingand set a price which covers their ownunit costs but which entrants find hard to match and still make a profit.

Define limit pricing.When firms set a low price to discourage ie limit rivals entering into a market

Define barriers to exit? Obstacles that restrict existing firms from leaving a market

Define sunk costs. Costs that cannot be recovered if a firm leaves an industry

List barriers to exit preventing or restricting firms leaving a market

Unrecoverablesunk costswhen exiting an industry. These include marketing costs incurredcreating a brand image, and any losses from reselling capital items eg planes and IT systems

Penalty clauses in contracts: eg payments needed to quit a franchise agreement to supply railservices, or to break an office lease. Staff are entitled to redundancy payments

Can firms recover any costs on exiting an industry?Some costs eg marketing are irretrievable.Equipment can often be sold for an alternative use eg train operators who lose their franchise canrecover some costs by selling eg IT systems to new entrants

How do barriers to exit affect competition?Potential entrants are deterred if barriers to exit arehigh. Profits may not be sufficiently high to justify the risks associated with entering new markets.


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| Market structure 11

Market structure

Define an industry. An industry is made up of all those firms producing the same product

What is a market?A market is the place where buyers and sellers meet to exchange a product.Markets require consumers (buyers) producers or firms (sellers) and products to trade.

What is a sub market?Transport market can be broken down into sub markets eg the market for airtravel can be domestic or international, short or long haul, business, etc

What is meant by market structure?Market structure is the characteristics of a market eg numbersize and strength of firms and buyers and barriers to entry and exit

State the main criteria used to distinguish between different market structures:

the number and size of producers and how differentiated each firms output is

the degree of competition between firms and whether or not firms act independently barriers to entry and exit and so firms ability to earn long run supernormal profits

Characteristic Perfect

competition

Monopolistic

competition

Oligopoly Monopoly

# & size of firms very many small many small a few large dominant one large

Product type identical differentiated identical or differentiated differentiated

Long run profits normal normal supernormal supernormal

Barriers to entry none low high very high

Concentration ratio very low low high very high

Interdependence none none significant n/a

Concentration ratios

Define market share. The proportion of total market sales held by a firm expressed as a percentage

Define concentration ratios.Concentration ratios measure the total market share held by the nlargest firms in the industry eg the top 4. Concentration ratios range from 0 to 100 %.

Give an example of a concentration ratio.If a four firm concentration ratio is 80 then 80 per cent ofindustry output is produced by the four largest firms. Sometimes shown as 4:80

Link concentration ratios with market structure.Low concentration ratios 50% or less indicatesmonopolistic competition; ratios in excess of 80% indicate oligopoly. Monopolies have a ratio of 100%

What is market power? Market power is the ability of the firm to influence market price. The extentof market power is indicated by the concentration ratio

What are the limitations of concentration ratios?Concentration ratios do not distinguish betweenthe relative sizes of the largest firms eg if the market share of the four largest firms is:

Firm A: 20%, Firm B: 20%, Firm C: 20%, Firm D: 20%. Concentration ratio: 4:80

Firm A: 10%, Firm B: 10%, Firm C: 10%, Firm D: 50%. Concentration ratio: 4:80

Concentration ratios require an agreed definition of the market so that market share can be calculatedthis can be problematic. Concentration ratios are meaningless if a market is not accurately defined

What does an increase in the concentration ratio imply?Higher concentration rations means anincrease in the market share of the largest firms in the industry. Economic theory suggests this mayresult in less competition, depending on the number and size of firms remaining in the industry.

How does the government define a monopoly? UKCompetition law presumes firms with a 25% or

more market share have the market power to act like monopolists. Firms with a 40% plus marketshare are defined as dominant monopolists


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12 Competitive markets |

Competitive markets

What is competition? Competition is when rival firms contend for customers

What is a competitive market?A market made up of many firms each contending for customers.

Use a graph to show equilibrium in a perfectly competitive market

An equilibrium market price of P1 for a perfectly

competitive industry set by the interaction of supply

and demand curves. The supply curve is the

horizontal addition of each firms marginal cost curve

Each firm within the industry is a price taker ie they

accept the price P1 set by the market and set output

where MC=MR ie at Q1. Note the firm is making

normal profit only

Define perfect competition. Perfect competition is a market structure with no barriers to entrywhere many firms produce identical products

Can competitive firms earn supernormal profits?Competitive firms can earn supernormal profitsonly in the short run. In the long run, supernormal profits attract competition. Zero barriers to entryallow new entrants to increase supply. Price falls back to a level where normal profits are restored.How does competition encourage productive efficiency? Productively inefficient firms have higher

unit costs than their rivals. Unless they make better use of their resources and reduce unit costs, theirlack of price competitiveness means they lose market sales and are forced out of the industry.

Is competition allocatively efficient?The interaction of supply and demand in competitive freemarkets results in an equilibrium price and output where P=MC, the condition for allocative efficiency.

Monopolistic competition

What is monopolistic competition?It is a market structure with a large number of relatively smallfirms each producing slightly different products. The industry has a low concentration ratio.

Give examples of monopolistically competitive

transport markets. Local taxi services have few barriers toentry and are highly competitive.

Why is the monopolistically competitive firms demand

curve downward sloping?Product differentiation meanseach firm has its own demand curve which is downwardsloping because firms must reduce price to increasequantity demanded. The large number of close substitutesmeans demand is highly price elastic: a small price riseresults in a proportionately much larger fall in quantitydemanded

Assess barriers to entry and exit in monopolistic

competition.Low start-up costs mean barriers to entry are low which means firms can enter themarket easily. Sunk costs such as advertising are low so barriers to exit are minimal which encouragesentry as firms know they can recoup most costs on exit.


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| Monopoly 13

Do monopolistically competitive firms have market power?The large number of firms in themarket means firms face intense competition and so have limited market power.

Canmonopolistically competitive firms earn supernormal profits? Monopolistically competitivefirms earning supernormal profit attract competition. Low barriers to entry make it easy for newentrants to join the industry causing incumbents to lose sales to new rivals. Incumbents demand

curve shifts to left reducing supernormal profits until they are eliminated. Supernormal profits attractnew entrants. This means supernormal profits can only be earned in the short run.

Are monopolistically competitive firms allocativelyefficient? Profit maximisingfirms in monopolisticallycompetitiveset output where MC=MR.Price exceedsmarginal cost causing allocative inefficiency. The areaof deadweight loss is JKL made up of lost consumerand producer surplus.

Are monopolistically competitive firms

productively efficient? Productive efficiency isachieved where firms are producing at minimum unitcost. Profit maximising monopolistically competitivefirms produce at an output level above lowest averageand so are productively inefficient.

Monopoly

Define a monopoly.A pure monopoly is a single seller of a product in a given market.

How can monopolists exclude competition?Monopolies exist as a result of barriers to entry

Illustrate monopolists earning supernormal

profits. Assume profit maximisation. The intersectionof MC with MR gives the profit maximising level ofoutput of Q1. Consumers are willing to pay P1 for Q1.Unit costs are only P2 so the firm is making an

abnormal profit of (P1-P2) x Q1In competitive markets supernormal profits attractnew firms and the resultant increase in supply lowersprice until normal profits are earned. However theexistence of barriers to entry allows the monopolist tocontinue earning supernormal profits in the long run

Use a graph to compare priced and output in

monopoly and competitive markets. Assume theMC curve is also the supply curve for the industry. In acompetitive marketsprice is set by the intersection ofthe supply and demand curve. Price is PC and output is

QC. Note P=MC ie allocative efficiency is achieved.

A profit maximising monopolistuse their marketpower to set output at QM where MC = MR. Price ishigher and output is lower in monopoly comparedwith a more competitive market

How can market dominance result in market

failure? Profit maximising monopolies are allocativelyand productively inefficient. Allocative efficiencyoccurs at QC where P=MC. Monopolies set output at QM where MC=MR.. Market failure from overproduction of QC-QM results in allocative inefficiency. A lack of competition means monopolists have

few incentives to minimise AC to remain price competitive and so can be productively inefficient.How can diseconomies of scale affect monopolies? Monopolists may operate on scale that results inlost staff motivation and management coordination and communication issues. LAC rise with output.


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14 Price Discrimination |

Identify factors that identify the extent of market failure from monopoly. Factors include

the level of contestability and threat of competition rather than the size and number of incumbents

the firms objective eg a nationalised industry can set output where P=MC to maximise allocative

efficiency rather than where MC=MR to maximise profit

the extent to which monopolies are regulated and can set price eg the state restricts rail fare rises

Outline potential benefits of monopoly. Monopolists can

produce on a large scale and exploiteconomies of scalewhich results in lower unit costs.

Consumers benefit if monopolists pass on the benefits of EoS by lowering price. use any supernormal profits to finance research and development. R&D can result in new

products. R&D can also lead to improved processes that raise productivity and so lower unitcosts. Consumers benefit if these dynamic efficiencies are passed on as price cuts

Price Discrimination

What is price discrimination?A firm sell the same product at different prices in different submarkets, even though costs are identical

List the conditions needed for price discrimination. Price discrimination requires:

the firm is a price maker ie it operates in an imperfectly competitive market

Firms can create sub markets and prevent customers in on sub market reselling to others Price elasticity of demand is different in in each sub market

Give examples of price discrimination.Train operators charge peak time users a higher fare than offpeak users for the same seat on a given journey. Airlines sell discounted tickets to students

How do monopolists benefit from price discrimination?Assume constant MC. Firms can increaseprofits by breaking down a whole market into two submarkets and charging different prices in each.

Output is set in each submarket where MC=MR. Price is higher in peak travel markets because demandis price inelastic. Price is lower in off peak market because demand is price elastic.

Single pricing generates P1-AC x Q1 supernormal profits less than the amount of profit from pricediscrimination = (P2-AC) x Q2 in the peak market plus (P3-AC) x Q3 in the off peak market

Outline arguments for price discrimination.Price discrimination

is a method for reducing demand at peak time and so avoiding overcrowding on trains, etc

Output is higher than with single pricing.

Some consumers pay lower prices than with single pricing, increasing their consumer surplus

The firm may use higher profits to fund investment in improved planes, trains, etc or in R&Dleading to potential dynamic efficiencies in the long run

Outline arguments against price discrimination. Price discrimination means

Some consumers pay higher prices than with single pricing, decreasing their consumer surplus

Monopolists increase prices in markets where demand is inelastic, extracting consumersurplus from buyers and increasing their profits, so consumer welfare falls


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| Natural monopoly 15

Natural monopoly

What is a natural monopoly? A natural monopoly occurs when economies of scale are so substantialthat a single firm can produce output at lower unit cost than two or more firms. Eg Network Rail.

Why are some industries a natural monopoly?In capital intensive industries, fixed costs form anoverwhelming proportion of total costs. Significant economies of scale mean long run average costs(LAC) falls continuously at all levels of output likely to be demanded.

What are the implications of a natural monopoly?As one firm can supply the entire market at alower unit cost than two or more firms, productive efficiency is increased by monopoly provision.Introducing competition leads to lost economies of scale, hence higher unit costs and lower productiveefficiency.Incumbents have an overwhelming cost advantage creating a major barrier to entry.

Use a diagram to show the cost and revenue

curves facing a natural monopoly. A naturalmonopoly is a capital intensive industry where verylarge fixed costs create significant economies of scale.

This means LAC continue to fall as the scale ofproduction increases because fixed costs are spreadover higher and higher levels of output.

Why is it inefficient to have more than one

supplier in a natural monopoly?Multiple supplierscannot access the economies of scale enjoyed by amonopolist. Competition results in higher unit costs

Illustrate equilibrium in a natural monopoly

industry. A profit maximising monopolist sets outputwhere MC=MR ie at Q1. (P1-P2) x Q1 supernormalprofit is made

Comment on economic efficiency in natural

monopoly. As one firm can supply the entire market

at a lower unit cost than two or more firms,productive efficiencyrequires monopoly provision.Allocative efficiency occurs at Q2 where P=MC. Profitmaximising output is at Q1, resulting in market failurefrom under production.

Use a diagram to show arguments for natural

monopoly subsides. Allocative efficiency occurswhere LMC = P ie output level Q2 and price P3.However, marginal cost pricing leads to a loss = (P4-P3) x Q2. Only a subsidy will persuade a profitmaximising monopolists to provide the socially

efficient level of output, Q2.How can the state prevent monopolies abusing

their market power? Options include:

Nationalisationstate owned firms decidesocially appropriate levels of output and price

Using regulationsto set standards and control prices eg establishing an industry regulator tomonitor performance; approve pricing decisions; ensure sufficient investment for dynamicefficiencies; and enforce consumer protection law. Eg Office of Rail Regulation

Franchising: if creating competition withina market is inappropriate, create competitionforthe market. Invite firms to tender for the right to run the monopoly for a limited period of time.

Introduceyardstick competition. The natural monopoly is broken up into regions. A regulator

then compares the performance of each region to identify underperforming areas.


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16 Oligopoly |

Oligopoly

Define oligopoly. A market structure dominated by a few large firms

Describe the characteristics of an oligopolistic market.A few large interdependentfirms dominatea market characterised by high barriers to entry. Prices are rigid and incumbents use non-pricecompetition to try to gain market share.

Why are there high barriers to entry in oligopolistic markets? Incumbents enjoy economies of

scale unavailable to new entrants whose higher unit costs mean they cannot compete on price. Highsunk costs also deter competition so that the industry remains dominated by a few large firms

How is the market power of oligopolists measured?Oligopoly industries have a high concentrationratio (80%+). This means a few large firms account for the majority of industry output.

Can oligopolists earn long run supernormal profits? Oligopoly industries have high barriers toentry which restrict the ability of new firms to join and so compete away supernormal profits

What is interdependence? Firms consider the likely response of their rivals to eg price changes

Give an example of interdependent oligopolists acting interpedently. If an oligopolist cuts theprice of its products, rival B is likely to react by cutting its own prices to maintain market share.

Why are oligopolists interdependent?Oligopolists are aware that decisions about pricing,promotion, R&D, etc are likely to trigger a reaction from rivals. The actions of one firm influence, andare influenced by, the decisions of competitors. This means oligopoly behaviour is reactive. Firmsfactor in the likely responses of competitors, eg a potential price war, when setting price or output.

Use the kinked demand curve to illustrate

interdependent oligopolist behaviour. Assumethe initial market price is P1. If an oligopolyincreases price above P1, rival firms do not follow.Consumers switch to substitutes. This means thefirms demand curve is price elastic above point B.

If rival firms match, or better any price cut below P1

demand is unresponsive making the firms demandcurve price inelastic below point B. The firmsdemand curve becomes ABC. The kinked demandcurve creates a discontinuity (gap) in the marginalrevenue curve between R and C.

Why are prices usually rigid in oligopoly?

Oligopolists are interdependent: the behaviour of one firm will influence and be influenced by - thebehaviour of its rivals. In the kinked demand curve model prices are rigid because price cuts areusually matched by competitors and rivals generally fail to match any price rise made by the firmcausing lost sales and market share.

How do oligopolists compete if not on price?Non-price competition is a feature of oligopoly.

Oligopolies compete on quality and customer service ie product differentiation

What is collusion? Collusion occurs when rival producers decide to act together rather than compete.Collusion is illegal. However tacit collusion may occur where there is an unspoken agreementto avoidcompetitive behaviour eg all firms match the price set by the market leader

Give an example of collusion. In 2007 some airlines colluded and all set high fuel surcharges

Define a cartel.A cartel is a group set up by rival firms to take common action eg agree prices, marketshare or exchange information on costs

Give examples of formal and informal collusion?A cartel is an example of formal collusion and isillegal in most countries including the UK. Price leadershipis an example of informal collusion where,

without official agreement, rivals charge the same price as that set by the market leader and so avoidprice competition. Collusion restricts competition.


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| Contestable markets 17

Contestable markets

What is a contestable market?A market which can be entered without cost and left without loss

Define contestability.The extent to which firms can enter or leave a market without cost

State conditions needed for a perfectly contestable market. Markets are a perfectly contestablegiven no barriers to entry or exit and identical unit costs for incumbents and potential entrants

Describe the implications of contestable markets. In contestable marketsincumbents (existing

firms) face the threat of competition from potential entrants. Incumbents take into account the likelyresponse of rivals when setting price. If firms set a price yielding supernormal profits, incumbents facea threat of increased competition from new entrants threatening market share and future profit levels.

Identify factors that determine contestability.The size of thepool of potential entrants and extentof barriers to entryand exitdetermine the degree of market contestability.

Give examples of contestable markets in action.Given low barriers to entry, any bus companyearning supernormal profit on any one route, faces the threat of competition from new entrants.

How can deregulation lead to greater contestability?Removing legal barriers to entry makes iteasier for new firms to join a market and challenge incumbents.

Draw a diagram to show the impact of

contestability. Profit maximsing output occurswhere MC=MR. If Q1 is produced at P1, supernormalprofits of (P1-P2) x Q1 are earned.

However, supernormal profits encourage rivals toenter the industury provided barriers to entry andexit are low. Firms wanting to avoid the threat ofcompetition may use limit pricing and set output atQ2 and charge P2 where P=AC. Earning normal profitsleaves no incentive for entry by rivals. Incumbentpricing choices is shaped by the threat of competion

What are the benefits of contestability?The threat of competition gives incumbents an incentive to: cut price, earn normal profits and avoid new competition. Lower prices raise consumer surplus

eliminate x-inefficiencies to cut AC so as to be able to cut price and so deter potential entrants

finance R&D in an attempt to improve products and productivity and so remain competitive

What are the drawbacks of contestability?A rise in contestability increases completion:

lower supernormal profits reduces funds available for R&D leading to lost dynamic efficiency

more firms in the industry mean lost economies of scale hence higher LAC and so higher prices

more services on existing routes generate extra negative externalities eg if two buses nowoperate half full there is a waste of scarce resources and allocative inefficiency

Explain the difference between a perfectly competitive and contestable market.In perfectly

competitive markets actual competition exists between a large numbers of firms making identicalproducts. In a contestable marketpotentialcompetition exists between any number of firms whoseoutput may be homogenous or differentiated

Why do governments take measures to improve contestability? By increasingthe threatofcompetition monopolists and oligopolies act as if they were in competitive markets. Increasedcompletion increases supply and lowers price. Allocative efficiency improves.

List government policies to improve contestability.

Deregulationremoves legal barriers to entry making it easier for firms to join a market

Short franchise periodsmean incumbents face potential competition in the near future

Creating leasing companies eg ROCOs in the rail industry reduces sunk costs.


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18 Franchising |

Franchising

What is a franchise? In transport,a franchise is the right to operate a given service on a given route,to a given standard, for given period of time

Give examples of franchising.Firms have won contracts to run train services and London bus routes

How are franchises awarded?Franchises are awarded following a competitive tendering process.

Explain the competitive tendering process. Firms bid for a contract to operate a service on a given

route for a given number of years to a standard defined by the franchisor. Generally, the firm makingthe highest bid is awarded the franchise.

Explain the benefits of franchising. Franchising

introduces competition: the tendering process means firms to compete to win the contract tooperate a route. Competition means firms strive for productive efficiency as, by reducing costs,they can increase their bid and still make sufficient profit if successful. Increased competitionlowers fares and so increases consumer surplus

increases contestability: there is the threat of competition when the contract is up for renewal transfers some supernormal profit to governmentif bidders use profit to increase their bid

Explain the drawbacks of franchising. Franchising

means govt defines service levels over the franchise period so limiting firms ability to adjustsupply to match future changes in demand. Contracts, not market forces, allocate resources.

may cut the amount of profit available to finance innovation hence reducing dynamic efficiency

results in a fragmentation of services introducing barriers to an integrated transport policy

Why is the contract period important?Short franchise periods increase the frequency ofcompetition for the contract to operate a service thereby improving contestability but also creatinguncertainty which may deter long term investment and so limit potential dynamic efficiencies.

How is franchising used in the bus industry? The regulated London bus market using franchising tointroduce competition: Transport for London (TfL) invites bids for 5 year franchises to operate a givenroute with a 2 year extension if performance targets are met.

How is franchising used in the rail industry?The Department for Transport (DfT) invites rival trainoperating companies (TOCs) to bid for a franchise to run a given rail service for around 15 years.Franchises are awarded to the TOC bidder making the highest bid and requiring the lowest subsidy.

Comment on the effectiveness of franchising in the rail industry. Effectiveness depends upon how:

many firms are willing to bid for a given franchise. If few firms are willing to bid then there willbe limited competition.

how long the franchise runs for. Short periods discourage bidders due to the limited time torecoup investment. Long period franchise encourage investment but reduce contestability


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| Deregulation 19

Deregulation

What are regulations? Regulations are legally enforced rules that restrict or ban specified activities.

How can regulations affect competition?Laws establishing legal monopolies act as a barrier toentry restricting competition from entrants and reducing consumer choice.

Define deregulation. The removal of legally enforced rules that restrict or ban specified activities.

Outline the impact of deregulation.Impact depends on the type and extent of deregulation eg

removing legal barriers to entry and makes it easier for firms to enter the market.

How can deregulation affect competition?Deregulations reducing or removing legal barriers toentry and makes it easier for firms to enter themarket. Competition increases; new entrantsincrease supply

Use a supply and demand diagram to show the

impact of deregulation on a market. S1 is initialsupply in a regulated market. Deregulation reducinglegal barriers to entry makes it easier for new firmsto join the industry. Supply increases shifting thesupply curve to S2. Price falls to P2 with Q2 Q1more journeys undertaken. Consumer surplusincreases by (P1,J,K,P2)

How does deregulation affect contestability?Deregulation removes legal barriers to entry andmakes it easier for firms to enter the market. Lower barriers to entry make markets more contestable.

Analyse the impact of deregulation on allocative

efficiency. A profit maximising monopolist sets outputat QM where MC=MR. Deregulation removes legalbarriers to entry and so encourages competition. Theentry of new firms moves price and output towards

price and output set in perfect competition ie PC and QC.Allocative efficiency improves.

Analyse the impact of deregulation on productive

efficiency. Competition gives inefficient incumbents anincentive to cut unit costs so as to be able to cut pricesand remain competitive. Eg eliminating organisationalslack reduces x inefficiencies and improvesproductiveefficiency. Lower unit costs means incumbents canmatch the price of new entrants

What are the drawbacks of deregulation? Deregulationincreases competition which can mean

lower supernormal profits so less funds available for R&D leading to lost dynamic efficiency

more firms in the industry so lost economies of scale hence higher LAC and so higher prices

more services on existing routes leading to more negative externalities eg if two buses nowoperate half full there is a waste of scarce resources and allocative inefficiency

Does deregulation always increase competition and contestability?Impact depends on:

the extent of existing regulation and the type and scope of deregulation measures

whether or not other barriers remain: deregulation removes legal restrictions on firms joiningan industry but high start-up costs or incumbents cost advantage from EoS may deter entrants

may vary by region, industry and be different in the short and long run


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20 Privatisation |

Privatisation

Define privatisation.Privatisation is where state owned firms are sold to the private sector

How does privatisation affect competitiveness?In theory privatisation allows private sector firmsto join an industry so improving competitiveness.

How can privatisation impact on economic efficiency? Some argue that unlike nationalised firms:

private sector have incentives to eliminate x-inefficiencies to reduce unit costs to either lower

prices to retain or attract customers, or improve profits. Productive efficiencyimproves competition moves market price closer to MC.Allocative efficiencyimproves

firms invest in greater research and development to develop innovative products whichincrease sales, or improved production techniques that cut costs. Dynamic efficiencyimproves

Identify arguments for privatisation. Advocates argue private sector firms have an incentive to

Eliminate x-inefficienciesassociated with state owned corporations which, if passed on, resultin lower pricesor lower subsidy requirements

Improve quality eg reliability leading to increased use of public transport

Increased use of public transport generatespositive externalitieseg a switch from cars to trains

Private sector investmentis introducedovercoming decades of public sector under investment

Government borrowingis reduced if it is no longer required to support transport operators

Identify arguments against privatisation?Critics argue privatisation

public sector monopolies become private sector monopolies or oligopolies. A lack ofcompetitionmeans economic inefficiency remainandfares rise in real terms

Profits now go to shareholders rather than being reinvested eg in new infrastructure

Profit maximising private firms may ignore externalities so causing allocative inefficiency egsocially necessary but loss making services are closed

Profit maximising private firms may cut costs to improve profits which may reduce serviceprovision or compromise safety

Where privatisation breaks up a natural monopoly, eg Railtrack, economies of scale are lost

Consider factors that determine the effectiveness of privatisation. Effectiveness mainly depends

upon how many firms join the industry following privatisation. If few firms are willing to join thenthere will be limited competition.

Identify arguments for nationalisation. Advocates argue natural monopolies are best owned andrun by the state control to avoid abuse of market power. Transport is a strategic industry bestcoordinated by government which unlike the private sector takes account of external benefits.

Identify arguments against nationalisation.Privatised natural monopolies can be regulated toavoid abuse of market power. Overall transport strategy can be coordinated by the state. Subsides canbe used to ensure private sector firms maintain socially necessary services. State run organisationshave no incentive to be productively efficient.


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| Economic Efficiency 21

Market Failure

Economic Efficiency

What is economic efficiency?Economic efficiency is making best use of scarce resources

How is economic efficiency achieved? Economic efficiency occurs in a market when both allocativeand productive efficiency are achieved.

Explain allocative efficiency. Allocative efficiency occurs at the level of output where price equalsmarginal cost. This means scarce resources are used in a way that maximises consumer satisfaction.

Why is allocative inefficiency a problem?It results in a misallocation of scarce resources. Factors ofproduction can be put to better use making products consumers value more highly, given their cost.

What is the condition for allocative efficiency?Allocative efficiency occurs when firms set output ata level where selling price = marginal cost of production ie P=MC

What is productive efficiency?Productive efficiency occurs when firms are maximising output fromgiven inputs and thus producing output at lowest possible unit cost.

What is the condition for productive efficiency?Productive efficiency occurs when firms areproducing at lowest possible unit cost on the lowest possible cost curve ie MC=AC

Why is it important to achieve productive efficiency?Productive efficiency means firms aremaximising output from given resources and are producing at lowest unit cost

How does competition encourage productive efficiency? Competition energises firms to seekproductive efficiency gains and produce at lowest unit costs to avoid losing sales to more efficientrivals. Unit cost reductions are passed onto consumers in the form of lower prices.

Explain X-inefficiency.X-inefficiency means a firm isusing more inputs than is needed for a given level ofoutput. Actual unit costs (AC1) exceed lowestattainable unit cost (AC2).

What causes x-inefficiency? X-inefficiency is causedby organisational slack where firms opt to employmore resources than are needed to produce a givenlevel of output. Staff and capacity are under used

Why are firms x-inefficient?Managers in firmoperating in uncompetitive markets have littleincentive to minimise unit costs.

Define dynamic efficiency.When firms make productive efficiency gains over a period of time

How is dynamic efficiency achieved?Dynamic efficiency gains occur over a period of time as a result

of successful research and development (R&D) which converts new scientific and technological ideasinto a) new processesthat raise productivity and lower unit costs and b) new, improved products

What is R&D. R&D is an abbreviation of research and development: the process of applying newscientific and technological ideas to improve products and processes ie innovation

Why is R&D important?Successful R&D results in dynamic efficiency gains from improvedproduction processes which lower long run average costs and so give firms a competitive advantage:

lower unit costs may be passed on as lower prices to gain price competitiveness.

firms can capture sales from rivals by offering new improved products.

Explain the link between profit and dynamic efficiency. Monopolists can usesuper normalprofitsto finance R&D. Firms in competitive markets earning normal profits may not be able to finance R&D

Do monopolists always use supernormal profits for R&D? Monopolists may opt to retain profits ordistribute profits to owners.In the absence of competition is there any incentive to finance R&D?


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22 Market failure |

Market failure

Define a free market. In a free market, the forces of supply and demand alone determine price andoutput without any government intervention. Free markets are totally unregulated.

What is market failure?Market failure occurs when free markets make an inefficient use of scarceresources by failing to deliver allocative or productive efficiency.

Why is market failure a problem?Productive inefficiency means firms are not maximising output

from given inputs. There is lost potential output. Allocative inefficiency means scarce resources are notbeing used in a way that maximises consumer satisfaction. Factors of production can be put to betteruse making products consumers value more highly, given their cost.

Why can transport markets fail?Reasons why transport markets can fail include:

the impact of externalitiessuch as pollution is overlooked by producers and consumers

roads are a quasi-public good. The free rider problem means private sector firms will notsupply an allocatively efficient amount of road space

monopolies may use their market powerto set a price that maximises profits , not efficiency transport markets can generate inequityand social exclusioneg when inability to pay means

low income households are denied access to transport

What is government failure?Government failure occurs when state intervention increases economicinefficiency - an even more inefficient use of resources than that made by free markets results.

Public goods

What is a public good?A public good is a product which is both

non-rival: individual's consumption does not reduce the satisfaction enjoyed by others, and

non-excludable: once provided users cannot always be excluded from consumption

Define free rider. A consumer who obtains benefit from a public good without paying for it directly.

What is the free rider problem?Non-excludability means use of public goods cannot be madeconditional on direct payment to firms. By avoiding payment, free riders reduce revenue making it

difficult if not impossible for firms to operate at a profit. This means free markets fail to providesocially optimum quantities of public goods such as roads.

What are quasi-public goods? A quasi-public good is a near public good ie it has many but not all thecharacteristics of a public good. Roads are an example of a quasi-public good

Semi non-rival: extra users do not initially reduce the amount of road space available to others.Finally extra drivers cause peaking, congestion and so reduce journey times for other users

Semi non-excludable: drivers can be excluded by regulation: only adults with a driver licence,insurance and VED disc can legally drive cars on UK roads. Non payers can be excluded byconstruction toll booths or using IT based satellite tracking although is a costly process

Justify direct provision of roads by the state. Roads are a quasi-public good. The free rider problem

means free markets under produce roads leading to market failure. State intervention to build andmaintain the socially optimum amount of roads is required to ensure allocative efficiency. UKhighways are financed from taxation eg petrol duty and VED

How do highway improvements affect consumer

surplus? A road improvement scheme reduces price ofa journey from P1 to P2 causing an extension in demandof (Q2-Q1), Extra journeys are generated

The benefit to existing users is P1 L N P2.

The benefit to generated traffic is L N M.

The total rise in consumer surplus is P1 L M P2


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| Negative externalities 23

Negative externalities

Define positive externalities. Positive externalities exist when third parties receive benefits from thespill over effects of production or consumption for which they do not pay

Why do positive externalities cause market failure? If economic agents ignore the external benefitsof their actions, under-consumption of a product causes market failure, hence allocative inefficiency

Give examples of positive externalities in transport. A new motorway generates third party

benefits including reduced transport cost for local firms and generates a regional multiplier effect.Define negative externalities.Negative externalities occur when production or consumptionimposes costs on third parties who receive no compensation

Why do negative externalities cause market failure? If economic agents ignore the external costs oftheir actions, over-consumption of a product causes market failure, hence allocative inefficiency

List negative externalities associated with transport. Increasedtransport often means more

Noise pollutionaffecting people living near roads or under flight paths

Air pollutioneg vehicle CO2 emissions affect local residents and sustainability

Congestion: as more vehicles join a traffic flow and increase journey times for others

Accidents causing increased loss of life and injuries

Visual intrusion: infrastructure impacts on the landscape or people's enjoyment of it. Blightwhere the threat of say, a new airport runway, creates uncertainty and lengthy planning

processes which adversely affect local economies eg it is hard to sell houses

Give examples of negative externalities in transport. The adverse spillover effects of a car journeyinclude air pollution from emissions. Infrastructure projects such as a new motorway link result in lossof rural land for current and future generations ie sustainability issues

Define shadow pricing.A monetary value is estimated for outcomes with no market price eg noise

Analyse how externalities are valued by economists. Methods include:

Shadow pricing:the external cost of congestion can be calculated by multiplying the number ofhours lost by the average wage eg 1m lost working hours x 12 average hourly wage = 12m

Compensation: estimate the cost of putting rightan externality eg include the cost of installingdouble glazing in houses affected by increased road noise from a new motorway. If 200 housesare affected each with 5,000 double glazing cost, increased road noise is estimated at 1m

Revealed preference: how much people are willing to pay to avoid an externality eg if 200householders are willing to pay 2,000 each to avoid noise, the externality is valued at 0.4m

Use a graph to show market failure from negative

externalities: over production

The supply curve S shows the firms marginal privatecost of production (MPC) S= MPC.

Given negative externalities such as pollution, an

estimate of marginal external cost (MEC) is added tothe MPC curve to give the marginal social cost (MSC)curve: MSC = MPC + MEC.

The demand curve is a measure of private marginalbenefit. If no positive externalities exist then Dshows social marginal benefit: D = PMB = MSB.

The equilibrium level of output delivered by a freemarket, Q1, is allocatively inefficient. SMB = SMC at Q2. The market has overproduced by (Q2Q2). Thewelfare loss triangle JKL gives the amount of welfare loss from overproduction and is equal to theamount of lost consumer and producer surplus.

Define deadweight loss.Deadweight loss is an estimate of allocative inefficiency from market failure

Are road user generated negative externalities uniform? The impact of road users depends ongeography, time of day and type of vehicle.


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24 Indirect taxes |

Indirect taxes

Outline the problems in using environmental taxes. The aim of an indirect tax is to make thepolluter pay and so internalise the externality. However implementing taxes is problematic

Setting the right tax rateif the monetary value of a negative externality is hard to measure

Cost of collection: road charging requires expensive infrastructure eg IT system of billing Inelastic demand: higher petrol prices via higher indirect taxes has little effect on demand

Redistribution effects: Indirect taxes are regressive and affect low-income household most.

Increased costs.Higher indirect taxes may cause inflation affecting consumers who did notpollute and international competitivenessif taxes are higher in one country than another.

What is VED?Vehicle excise duty is a tax paid for a licence for a car to use public roads ie tax discs

How can Vehicle Excise Duty reduce negative externalities from road transport?Vehicle ExciseDuty (VED) is an annual indirect tax on car ownership which varies by type of car based on CO2emission rates per kilometre. Low polluting cars pay no VED. High polluting cars pay higher VED.

Comment on the effectiveness of VED in addressing market failure form negative externalities.VED bands do reflects the level of pollution by car type: high polluting car owners pay more VED thanlow polluting car owners. However VED is an annual payment the amount of VED paid does not varyaccording to the number of miles travelled

Hypothecation

Define hypothecation.Hypothecation is the ring fencing of taxes to financespending solely within the area taxed eg the use of congestion charges tosubsidise public transport not health

Explain hypothecationRevenues raised from one area of economic activityare ring fenced ie only used by government.

In 2000 The Adam Smith Institute reported road users pay 32bn in taxrevenues each year but receive back only 6bBn in road investment - a

shortfall of 26bn. However the same reportii

valued negative externalitiesgenerated by road traffic at 25bn an argument against hypothecation

External costs of road

transport bn ( ASI 1999)

Congestion 18bn

Accidents 3bn

Air Pollution 3bn

Noise Pollution 1bn

Total 25bn


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| Congestion and Road Pricing 25

Congestion and Road Pricing

Define congestion. Congestion is when demand exceeds supply on a given network at a given periodin time eg bank holiday on holiday routes.

How does congestion affect costs?It increases private costs to users: increased vehicle operatingcosts and time delays to the driver and external costs to third parties: others time, air/noise pollution

How can congestion be reduced?By increasing supply eg improving or building new roads or by

reducing demand using road pricingCan congestion be corrected by building more roads? Cet par,more supply reduces congestion, ifcurrent levels of demand are maintained. In the long run, new roads typically generate extra traffic sothat congestion may well continue even after a new road is built or an existing highway is widended.

Define congestion charging. A direct charge for use of roads in a defined zone eg central London

Why is a flat tax congestion charge inappropriate? Different users generate different amounts ofnegative externality according to the time of day, place and vehicle used

Summarise the London Congestion Charge (LCC). Most motorists pay a daily 10 charge forentering parts of central London in peak times. The LCC is linked to VED bands and so mildly reflectsthe level of pollution by car type. The LLC uses automatic number plate recognition to identify users

and non-payers. LCC revenue is hypothecated and used to subsidise public transport substitutes egbus services. The estimated PED with respect to the number of journeys is -0.58iiiie price inelastic

Define road pricing. A direct charge to road users fortheir use of a particular road eg a motorway toll

Can road pricing reduce the demand for car use?Road pricing charges users for use of road spaceon a particular journey and is an indirect tax. Road pricing increases private cost, reduces supply andshifts the supply curve for car use to the left resulting in a higher equilibrium price and lower quantity.

Use a diagram to show road traffic congestion causes resource misallocation. For simplicity,assume no external costs up to J1, the capacity of the road. Beyond J capacity is exhausted and theprivate costs of car journeys shown by the MPCcurve rise because congestion causes time delays

and higher fuel costsfor users.Consumers ignore external costs of their actions andbeyond J1 extra road use imposes spillover effectson others. The vertical distance between the MPCand MSC is a monetary estimate of the value onnegative externalities including increased air andnoise pollution ie MEC.

Without state intervention J3 journeys occur. Thesocially optimum level is J2 resulting in marketfailure from over consumption. The overall loss tosociety is given by the area of welfare loss: JKL.

How can indirect taxes correct market failure from

congestion? Motorists ignore the impact on thirdparties of negative externalities created by their roaduse eg air pollution and congestion. Overconsumptionof J3-J2 results in an inefficient use of scare resourcesand market failure

Road pricing can correct market failure. An indirect taxsuch as a toll increases private costs, reduces supplyand so shifts the supply curve inwards from S1 to, say,S2. The user cost of a journey rises from P1 to P2

causing a contraction in demand and less journeys, J2.The toll forces drivers to internalise their externalities.If the correct road price is set and J2 journeys occur,allocative efficiency is reached as at J2 MSC = MSB


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26 Congestion and Road Pricing |

What is the effective level of road pricing?Road pricing corrects market failure if it is set equal tothe external cost of a journey. Ideally tolls vary according to time, distance,place, the level of vehicleemissionsand number of passengers.

How effective is indirect taxation in reducing market failure from car transport?The bigger theindirect tax rise the greater the fall in car use. Effectiveness depends on whether it is one policy usedas part of an integrated strategy. If so, modal shift is more likely to occur.

How is flexible road pricing implemented? By fitting GPS sensors in cars that record the time,

distance and place of a journey. Motorists are charged based on when, where, and how much theydrive. Each journey has its own road price equal to its external cost, say,43p per kilometre in a citycentre at peak time and 0.8p on empty rural roads

Give an example of GPS based road pricing scheme. Germany uses sensors in lorries linked tosatellites to set tolls for lories.

Why are GPS road pricing systems not used in private cars?Using sensors to monitor journeysdoes not command public support and raises significant civil liberty issues.

Why is the demand for peak time road usage price inelastic? Certain journeys can only beundertaken at a given time of day on a given route eg city centre commuting before 9 00am. Theconvenience and flexibility of cars, and poor quality of public transport substitutes, means there arefew close available substitutes commuting by car making demand highly price inelastic

Set out arguments for road pricingCongestion is caused by demand exceeding capacity on givennetworks at given times eg mid-week peak times. Road pricing:

forces polluters to internalise their externalities and include the estimated cost of theirnegative externalities in their decision making. Users pay for the social cost of their actions

generates revenuefor hypothecation egsubsidies for public transport substitutes

encourages modal shift: higher prices encourage commuters switch to the now relativelycheaper substitutes: public transport.

Set out arguments against road pricing. Road pricing:

the tax must be set at a level that internalises the externality. Set too high and under-consumption results; too low and over-consumption continues ie government failure occurs

requires alternative modes of transport to enable modal shift and allow motorists to switchfrom cars to close, available substitute public transport eg trains and buses

has minimalimpact on road usage if demand is price inelastic eg peak time in urban areas.High charges are needed to cause significant falls in road usage

may displace rather than reducecar usage unless the scheme is comprehensive covering allroad networks

has high set up, maintenance, monitoring and enforcement costs increase costs of productionwhich is inflationary and reduces competitivenessof local firms if

rivals in other regions have free road access. International competitiveness is reduced is aregressive tax raising equity and social inclusion issues if low income groups are priced

outof using cars. High income groups are unlikely to be deterred as they can still afford to pay

What factors affect the success of road pricing or subsidies?Price is one factor affecting thedemand for road travel. If there is no alternative bus or rail services, the lack of close substitutesmakes demand highly price inelastic. High tolls are required to reduce demand to socially optimumlevels. This means road user charging is more likely to be effective if introduced alongside otherpolicies eg subsidies for substitute public transport and integration policies which allow modal shiftover parts of a journey eg park and ride schemes


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| Subsidies 27

Subsidies

What is a subsidy? A subsidy is a paym

qa f584 transport economics 2013

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