# A-level Economics/OCR/2885

## Transport, Trends and the Economy

### Transport

#### Measuring Transport Output

• people/passenger transport - passenger-kilometres (number of passengers \times distance travelled in kilometres)
• goods/freight transport - tonne-kilometres (weight in tonnes \times distance travelled in kilometres)

#### Characteristics of Transport

• Transport is a unique product
• Demand for transport is largely derived.
• As a service, it is perishable
• Transport decisions recognise two key dimensions:
• distance
• time
• Transport generates significant externalities not recognised in the price (Private Costs are not equal to Social Costs) therefore market fails
• Journeys are indivisible
• Loading is the % capacity used on a journey
• Peaking: Demand > Supply, leading to congestion

### Transport Infrastructure

Two components:

• Network
• Terminals/Nodes

Infrastructure critical to economic success because it affects:

• transport costs and prices \therefore choice of mode
• patterns of land use
• operation of labour markets
• location of business activity

Can deliver:

• improved labour mobility\therefore greater efficiency
• positive externalities through regional development
• improved competitiveness

• Built up over time through investment:
• replacement investment (maintenance)
• net investment (additional capacity)
• Under-investment since the war leading to relatively poor quality infrastructure
• Investment:
• significant lead times (5-30 years)
• significant amounts of money (billions) from tax, borrowing and private funds
• long payback (decades)

### Transport Modes

• Methods of moving goods and passengers
• Often several mode options per situation:
• car, lorry, van, taxi, bus, coach, motorcycle, bicycle, walking
• Rail
• Air
• Sea
• Pipelines

Key issues in deciding between modes:

• Relative cost
• Distance
• Speed
• Bulk
• Urgency (perishable goods)
• Capacity
• Convenience
• Reliability
• Network extent
• Risk of delay/accident
• Pollution
• Traffic congestion

### Demand for transport

• Derived from economic activity
• Changes in economic relationships lead to immediate changes in demand for transport
• In UK, steady rise in demand
• Increasing domination of road transport

#### Price and demand for travel

• Travel can be priced and is demanded like any other product
• The price of a journey includes the full cost to a passenger, expressed in £ (e.g. car: fuel, delay, risk)
• Demand expressed through:
• number of passenger-kilometres
• number of vehicles
• Supply is fixed (inflexible service) Although there are more services in peak times of demand.
• Demand varies hugely (e.g. 8:30am vs 3:00am)
• Gross under-usage or peaking/congestion
• Off-peak travel is price elastic
• Peak travel is price inelastic
• Low positive cross elasticity of demand

#### Income and demand

• Changes in:
• Rates of economic growth
lead to large changes in demand for transport
• Road, rail and air have a high YED and are sustainable
• Buses have low YEDs, may even be inferior goods

## Theories of market structure and competitive behaviour in transport markets

### Markets Overview

Emphasis is to:

• understand theoretical models of markets (at A2 level)
• explain, analyse and evaluate behaviour in transport industries and markets

In market (capitalist) economies:

• Entrepreneurs/firms:
• invest their own capital
• take risks
• hire/buy resources/factors of production
• produce goods and services which they judge the consumers want in order to make at least a normal level of profit
• always make decisions with competition in mind
• the nature/extent of competition can be defined in terms of the number and power of firms in a market
• a core factor which defines the power of firms in a market is barriers to entry/exit
• where there are low barriers, profits tend to be normal
• where there are high barriers, profits tend to be supernormal

With new entrants to a market:

• the supply curve shifts right (an increase)
• the price decreases
• the quantity demanded expands
• the consumer surplus increases
• the producer surplus decreases

### Perfect Competition

#### Characteristics

• Infinite independent firms
• Homogeneous product, so no advertising
• Perfect information
• No market power, so all firms are price-takers
• No barriers to entry/exit
• Perfect resource mobility
• Firms are all profit-maximisers
• Normal profits in LR, although losses or supernormal profits are still possible in SR
• Theoretical model
• Benchmark to assess all imperfectly competitive markets
• e.g. window cleaners

#### Notes

• Would deliver best economic outcome:
• Allocative efficiency
• products which consumers want the most
• Productive efficiency
• output at lowest AC
• Yardstick to judge other markets/market structures
• Framework for developing government policies in order to make markets more competitive (e.g. transport)

### Imperfect Competition

#### Characteristics

Imperfect competition displays at least one of the following to some extent:

• Finite firms, allowing an individual firm to affect the market
• Some market power, so all firms are price-makers
• Differentiated products
• Barriers to entry
• Non-price competition
• Supernormal profits in LR

### Monopolistic Competition

#### Characteristics

• Many firms (all independent)
• Differentiated product
• Price-makers to an extent
• Downward-sloping demand curve
• Many close substitutes
• Relatively price elastic
• No barriers to entry/exit
• In LR, only normal profits
• In SR, abnormal profits/losses can occur

### Oligopoly

#### Characteristics

• Few firms
• Interdependant
• actions take account of reactions
• High degree of sales concentration - sales concentrated among a few firms
• Firms are significant price-makers
• Differentiated, branded products
• Non-price competition - advertising/promotion to increase market share
• Significant barriers to entry/exit
• Abnormal profits in the LR possible - invested into advertising/R&D
• economic efficiency is not attainable in the oligopoly

#### Pricing Characteristics

• Generally stable prices
• Loathe to start a price war
• Uncertain outcomes when changing price:
• Prices cut:
• Competitors follow suit
• Volume gain insignificant (price inelastic)
• Leads to a loss of revenue
• Prices raised:
• Competitors may not follow suit
• Large decrease in volume (price elastic)
• Leads to a loss of revenue

### Collusive Oligopoly

• Firms agree to act together to restrict competition on:
• price
• location allocation
• Price is likely to be higher than the market clearing price meaning output/sales are likely to be lower than they might otherwise be
• May not maximise profits, in order to create a more secure environment
• Most efficient firms will be tempted to break ranks by cutting prices, leading to increased market share
• Inherently unstable
• Illegal

### Monopoly

• Either a single or dominant (>25\% market share) firm in the market
• Insurmountable barriers to entry
• Price-maker - they can set either output or price
• Abnormal profits in the long run
• Potential barriers to entry
• High sunk costs
• Some legal monopolies (e.g. TOCs)
• Economies of scale
• new firms cannot use EoS
• Predatory pricing
• Natural monopoly
• best for consumer if there is a monopoly

### Comparing perfect competition and monopoly

• Perfect competition is productively and allocatively efficient
• Monopolies are not
• Monopolies are most appropriate where:
• there is a natural monopoly
• there are very significant economies of scale
• abnormal profits are invested in R&D or to reduce costs
• it would enable a domestic firm to compete internationally

### Natural Monopoly

Occurs because:

• One firm can operate more efficiently that two or more
• There are high fixed costs \rightarrow significant EoS
• More likely to be productively efficient
• Minimum Efficient Scale leading to a high % of market volume/value
• Cannot be threatened by more efficient new entrants
• Regulation needed to protect captive consumers (e.g. railways)

### Market Comparison Summary

 Type of competition Number of firms Product differentiation Barriers to entry/exit Abnormal Profits Transport Example Perfect Competition Infinite None None Only in SR Taxi driver Monopolistic Competition Finite Marginal None Only in SR Taxi firms Oligopoly Few, all price-makers Great High Possible in LR TOCs, Airlines Monopoly One major price-maker None Insurmountable Yes London Underground

### Contestable Markets

Recent government intervention:

• Focus on increasing market competitiveness:
• More customer-oriented, leading to better products
• Greater efficiency, leading to lower costs
• Lower prices
• Profits

Three policy approaches:

• Deregulation (e.g. buses, taxis)
• Privatisation (e.g. rail)
• Contestability

#### Barriers to entry

• Can be technical or economic
• Determine the degree of competition in a market
• Lead to LR abnormal profits for monopolists
• Transport examples:
• British Rail - pre 1997 (legal monopoly)
• Laker Skytrain - no-frills airline (predatory pricing)
• Railways, cross-channel ferries (sunk costs)
• Economies of scale
• British Airways (branding)

#### Theory of contestable markets

• The threat of entry leads to competitive behaviour:
• make normal profits
• productive efficiency
• allocative efficiency
• The number of firms is largely irrelevant
• Contestable markets have:
• one or few firms
• minimal barriers to entry
• minimal sunk costs
• differentiated product

#### TOC franchise

• Lump sum for franchise (contract)
• Legal right to operate service for a limited period (initially 7 years, now 15 years)
• Invest own money (which may not be returned upon within the time period)
• Termination when period ends (loss of sunk costs)

### Deregulation

Not appropriate for natural monopolies such as:

• National Air Traffic Control
• Network Rail

#### Bus Deregulation

Up to 1980:

• Many companies nationalised in 1947
• Licensing system
• Local route monopolies
• Price controls
• Government subsidies
• Cross subsidisation

Private hire coaches always privately owned.

1985/1980:

• Price controls abolished
• Prices reflected route costs
• Social, non-profitable routes - out to tender
• Offered (by local authority) to bid, requiring least subsidy
• Limited subsidy funds
• Licensing process abolished
• Safety regulations remain
• Any operator free to operate
• Must notify Traffic Commissioner of closures/alterations of routes

Results:

• Initial increase in competition
• More entrants
• More buses
• More frequent services
• Lower fares
• Buses operated below capacity
• More congestion and pollution
• Prompted mergers and acquisitions:
• Arriva
• Stagecoach
• First Group
• National Express
• Nationally, an oligopolistic market
• Locally a monopolistic market

• Higher fares
• Lower levels of service
• Withdrawal of most marginally commercial routes
• Some small competitors operate with low margins
• Large operators cannot entirely neglect the market

#### Air Transport Deregulation

Air travel has distinctive characteristics:

• Significant externalities:
• noise
• climate change
• diminished air quality
• Short-haul particularly polluting
• To internalise externalities:
• Short haul: £3
• Long haul: £20
• Airports need land leading to urbanisation
• Airspace and landing slots ('supply') limited
• Capacity insufficient to accommodate projected demand

Operators:

• Private (e.g. BA)
• State-owned (e.g. Iberia)
• Low-cost (e.g. easyJet)
• Charter

Market segments:

• 1st class vs. economy/low-cost
• Domestic vs. short-haul vs. long-haul
• Business vs. leisure vs. holiday

Leisure is, for example, a long weekend whereas holiday is, for example, two weeks.

Infrastructure:

• Airports
• Air Traffic Control

Core regulation:

• Flight worthiness
• Air space security

Deregulation of air services:

• USA: 1978
• UK: 1987
• Europe: 1993

Pre-deregulation:

• Bilateral agreements between 'flag-carriers'
• No competitive pressure
• High fares

Post-deregulation:

• Replication of US experience
• Explosion of low-cost operators
• 'Flag-carriers' under immediate threat
• EU "Open Skies Policy" under a common regulatory framework
• 50% new/unused slots allocated to market newcomers

Impact of deregulation:

• Newcomers had a precarious existence
• Rising profits for established low-cost operators
• Losing passengers
• Cutting prices
• Experiencing falls in profit
• Struggling to differentiate
• Avoiding competition

Future:

• Air travel has increased threefold since 1975
• Freight increased twofold since 1990
• UK economy depends increasingly on air transport:
• Consumption
• Investment
• Tourism employment
• Competitiveness
• Airport demand, on current trends, will double by 2030
• New capacity being constructed at:
• Stansted
• Birmingham
• Heathrow
• Edinburgh

### Privatisation

• Applied to buses and trains amongst others (e.g. utilities)
• Operational decisions based on the needs of shareholders

More recently, two types of quasi-privatisation have been used:

#### Public Private Partnership

• Partnership of public sector and private sector
• Shared funding of a project
• Shared revenues
• e.g. London Underground:
• Track, signals and stations are privately owned (for 30 years)
• Operations stay in the public sector

#### Private Finance Initiative

• Private company finances, builds and operates the infrastructure
• Government pays fee for its use
• State ownership in due course
• Considered suitable for Air Traffic Control

#### Transport Infrastructure Ownership

• Quasi-public good
• Largely non-rival
• Partially non-excludable (to an extent)
• Owned by the state
• Funded from general taxation
• Built/maintained by private sector, under tender
• Rail:
• Significant change since 1996
• Network Rail:
• not-for-profit private company
• Railtrack plc replaced in 2002
• Rail regulator (government body)
• TOCs (private sector)
• Air:
• Airports and air service operators in the private sector
• Air Traffic Control partially privatised (PFI to ensure adequate investment funds)

#### Rationale for privatisation

• Profit incentive
• No operational subsidies (money can be spent elsewhere)
• Investment in latest technology
• Introduce a business culture (competitive approach)
• Operate more efficiently:
• Lower LRAC
• Lower prices
• Be more customer-oriented leading to improved service
• Significant source of funding, after decades of state neglect
• More contestable market

#### Criticisms of privatisation

• Assumes competitive environment in LR (e.g. buses)
• Greater neglect of negative externalities
• Reduced pay/conditions\rightarrow
• demotivation
• transfer of welfare to shareholders and consumers
• Profit maximisation (investors want quick return)
• Profit vs. performance vs. safety (conflicting stakeholder objectives)
• Natural monopoly
• Regulator needed to achieve economic efficiency
• Private firms ignore equity issues

### Price Discrimination

Charging different prices to different customer groups for the same product for reasons unrelated to cost in order to increase profits

Examples:

• (Off-)Peak Pricing - not price discrimination, the products are different
• Different Classes - not price discrimination, the products are different
• Discounts - tend to be price discrimination, as the price is different for the same product

Price discrimination requires:

• Different price elasticities of demand in each sub-market (e.g. OAP vs. business traveller)
• No market seepage (i.e. reselling between sub-markets is impossible)
• Firms are price-makers (i.e. operate in an imperfectly competitive market)

There are three types of price discrimination:

#### First Degree Price Discrimination

• Must know how much each customer is willing to pay
• Not very likely
• e.g. Allocation of limited seats to the highest bidder first
• All consumer surplus transferred to the firm:

#### Second Degree Price Discrimination

• Selling off excess capacity at lower prices than previously charged
• e.g. Airlines after 9/11
• Used when a firm is:
• left with huge amounts of capacity
• desperate to maintain cash flow
• need to increase occupancy rate
• A firm sells at a price initially, but clears at the marginal cost of each unit
• Employed by European low-cost airlines:
• Attempt to fill all seats
• Increase price progressively as seats are sold
• Flight revenue and profits are maximised
• Strategy explains strong sales growth over recent years

#### Third Degree Price Discrimination

• Allows firms to increase revenue and profit by charging different prices for the same product to different market segments
• e.g. rail travel:
• For students, the fare is a higher % of income meaning student demand is price elastic
• For commuters, the fare is a lower % of income meaning commuter demand is more price inelastic
• For business travellers, the fare is almost irrelevant meaning business traveller demand is extremely price inelastic

### Costs

• Most business decision made in SR
• Businesses will initially experience "increasing returns"
• Eventually, "diminishing returns" will be experienced

In SR:

• Output increases at an increasing rate initially, then at a decreasing rate
• Fixed costs stay the same
• Variable costs increase with output
• Total costs will increase with output
• MC falls initially

In LR:

• Businesses typically benefit from economies of scale
• This leads to a lower AC in LR
• At a certain point, AC plateaus (productive efficiency)
• Beyond the plateau, a business experiences diseconomies of scale

Economies of scale are important because they motivate businesses to develop. There are two types of economy of scale and two matching types of diseconomies of scale:

#### Internal Economies of Scale

Those economies of scale accrued within a business (business-specific). For example:

• Technical: Improved use of technology/machinery
• Financial: More, cheaper sources of finance available
• Marketing Budget: need not increase proportionally
• Purchasing: Bulk-purchase discounts
• Research & Development: Budget need not increase proportionally
• Managerial: Cost of management become more dissipated

#### External Economies of Scale

Those economies of scale that a market can exploit. For example:

• A readily available skilled workforce
• Locally accessible specialist suppliers
• Good transport network

#### Internal Diseconomies of Scale

These diseconomies of scale may be caused by:

• Division of labour benefits fully exploited
• Management out of touch
• Slower decision-making
• Poorer communication
• Worsening labour relationships

#### External Diseconomies of Scale

These diseconomies of scale may arise when:

• Resources are scarce
• There is congestion on the transport network

### Revenues

Revenue patterns depend on the type of market. For example:

• In a perfectly competitive market, MR doesn't change.
• In an imperfectly competitive market, ${\displaystyle MR={\frac {1}{2}}D={\frac {1}{2}}AR}$

#### Profit

• Profit = TR - TC
• Reward for risk-taking
• Cost of entrepreneurship

Two types of profit:

• Normal: The minimum profit needed to continue trading
• Abnormal: Anything above normal profit

Economics assumes that firms are profit-maximisers.

Profit-maximising output is where MC = MR

Profit-maximising price is AR above MC = MR

Economics does recognise other objectives:

• Survival
• Growth
• Profit
• Meeting needs of stakeholders

## Definitions

• Allocative efficiency: the efficiency with which markets are allocating resources. A market will be allocatively efficient if it is producing the right goods for the right people at the right price. Alternatively, you cannot make anyone better off without making someone else worse off.
• Average revenue (AR): the TR divided by the level of output. It is equivalent to the price because it is the revenue the firm receives for each unit.
• Barriers to entry/exit: barriers that prevent the entry of new firms into a market. Barriers to entry may be technical barriers, legal barriers, cost (or investment) barriers or barriers that arise from strong branding of the product.
• Bilateral: affecting or undertaken by two sides equally, binding on both parties.
• Business cycle: the tendency of economies to move, over time, through periods of boom and slump. In other words, the fluctuations in the rate of economic growth that take place in the economy. (aka trade cycle)
• Captive consumers: consumers who do not have any choice as to how they access a service/product. Often occurs within a monopoly.
• Congestion: over-crowding of a particular service/resource.
• Consumer surplus: when people are able to buy a good for less than they would have been willing to pay. In other words they are receiving an effective benefit from buying the good. The consumer surplus is shown as the area between the equilibrium price and the demand curve.
• Contestable market: a market in which there is always a threat or possibility of competition. This will still have the effect of making firms in the industry behave as if it is competitive as they will be concerned about the threat of other firms entering the market.
• Cross elasticity of demand (XED): a measure of the responsiveness of demand for one good to a change in the price of another. ${\displaystyle XED={\frac {\%\Delta P_{A}}{\%\Delta P_{B}}}}$. If the value is positive then the goods are substitutes, and if the value is negative then the goods are complements.
• Cross subsidisation: where one group pays a relatively high price and thus enables another group to pay a relatively low price.
• Deregulation: the removal of regulation or the removal of controls on a particular market.
• Derived demand: where the demand for one thing depends on the demand for another. In other words the amount of demand for good A depends in turn on the amount of demand for good B.
• Diminishing returns: a situation where the addition of a variable factor of production results in a fall in marginal product. The firm may be trying to expand by using more of its variable factors, but finds that the extra output they get each time they add more of the variable factor gradually falls.
• Diseconomies of scale: a situation where average costs increase as production increases. This is the opposite to economies of scale and often happens where there are communication problems in larger organisations. They are also known as decreasing returns to scale.
• Economic growth: an increase in a country's total output of goods and services. It is measured by changes in real GDP.
• Economies of scale: where average cost falls as production increases. They are happening because larger firms are able to lower their unit costs. This may happen for a variety of reasons. A larger firm may be able to buy in bulk, it may be able to organise production more effectively, it may be able to organise cheaper loans and so on. They are also known as returns to scale.
• Equity: a situation where the distribution of income is considered to be 'fair' or 'just'. An equitable distribution will not be the same as an equal distribution of income.
• Externalities: spillover effects from production or consumption for which no payment is made. Externalities can be positive or negative.
• Government intervention: when the government intervenes in a particular market. This may mean the introduction of price controls or it may mean intervention buying and selling in an attempt to stabilise the market.
• Homogeneous product: all products are perceived to be of the same nature and value by the consumer.
• Income elasticity of demand (YED) a measure of the responsiveness of demand to a change in income. ${\displaystyle YED={\frac {\%\Delta D}{\%\Delta Y}}}$. A positive figure means that the good is a normal good whilst a negative figure means that the good is an inferior good.
• Increasing returns: a situation where increasing the quantity-variable factor of production causes marginal product to rise.
• Inferior goods: goods where an increase in income leads to a fall in the quantity consumed. They will have a negative income elasticity of demand.
• Infrastructure:7 the basic underlying networks necessary to support economic activity. This includes roads, bridges, ports, sewers, hospitals and schools.
• Interdependence: when the actions of one firm has an effect on its competitors. It is common in oligopolistic market structures where there are only small numbers of firms.
• Lead time: the time interval between the initiation and the completion of a production process.
• Legal monopoly: a market in which the government has allowed a particular firm to become a monopolist.
• Long run (LR): all factors of production are variable.
• Marginal cost (MC): the cost of producing one extra unit. It is the increase in total cost when one more unit is produced.
• Marginal revenue (MR): the revenue earned from selling one more unit of a good or service. It is the increase in total revenue that occurs when one more unit is sold.
• Market clearing price: the price at which equilibrium between supply and demand is reached.
• Market seepage: no reselling between sub-markets.
• Minimum Efficient Scale: lowest level of output at which the lowest AC occurs.
• Modes of transport: methods of moving goods and passengers.
• Natural monopoly: a situation where a single company tends to become the only supplier of a product or service over time because the nature of that product or service makes a single supplier more efficient than multiple, competing ones.
• Non-excludability: once the good is provided it is not possible to stop people benefiting from it.
• Non-rivalry: consumption by one person does not reduce the amount available for another.
• Normal profit: the level of profit required for a firm to keep the resources they are using in their current use. In other words it is enough profit to keep them in the industry. Anything in excess of normal profits is called abnormal or supernormal profits.
• Peaking: demand for a good is higher at a particular time.
• Perishable goods: goods which have a limited life-span from when they are produced.
• Predatory pricing: where a firm reduces price in the short run to try to force competitors out of the industry.
• Price elasticity of demand (PED): a measure of the responsiveness of demand to a change in price. ${\displaystyle PED={\frac {\%\Delta D}{\%\Delta P}}}$ If a good is elastic (a value for the elasticity of more than one), it is considered to be responsive to changes in price. If inelastic (a value below one) then it is unresponsive.
• Price makers: firms who are able to influence price as their output represents a significant share of the market. Firms in monopoly and oligopoly will tend to have a high level of price setting power.
• Price takers: firms whose output does not influence price.
• Private sector: the part of the economy privately owned and in the control of individuals and companies.
• Privatisation: the process of moving economic activity from the public sector to the private sector. The most common form of privatisation is the sale of government-owned shares in private sector companies or the sale of whole companies to private investors.
• Producer surplus: the difference between the minimum price a producer would accept to supply a given quantity of a good and the price actually received. It is the gap between the marginal cost curve (supply curve) and the equilibrium price.
• Productive efficiency: when a firm produces at the lowest unit cost. This will be at the minimum point of the average cost curve (where MC = AC).
• Profit maximisers: firms which aim to make the highest level of profit possible (the largest surplus of revenue over cost) as opposed to other objectives.
• Public goods: goods that would not be provided in a pure free-market system. This is because they display non-rivalry and non-excludability.
• Public sector: the section of the economy under government control. In the UK it includes the health and education services, the police, fire service and ambulance service.
• Quasi-privatisation: the use of private sector money within the public sector.
• Quasi-public good: a near-public good. It has many but not all the characteristics of a public good.
• Real: excluding the effects of inflation.
• Resource mobility: the ease with which resources can move between different uses and locations.
• Revenue: the money received from the sale of output.
• Short run (SR): at least one factor of production is fixed.
• Subsidies: payments made to firms or consumers designed to encourage an increase in output. A subsidy will shift the supply curve to the right and therefore lower the equilibrium price in a market.
• Sunk costs: unrecoverable past expenditure.
• Supernormal profit: when profit exceeds the amount a firm must receive to carry on production. If supernormal profits persist in an industry this will tend to attract new firms in, supply will increase, prices will fall and normal profits will be restored in the industry.
• Tender: companies bid for the lowest subsidy they would need to complete the work required.
• Total revenue (TR): the number of goods sold multiplied by the price charged for each one.
• Total cost (TC): the total amount spent by a firm on producing a given level of output. It is made up of the fixed costs and the variable costs of production.
• Transport: the movement of goods and passengers from one place to another.
• Urbanisation: the social process whereby cities grow and societies become more urban.