Pricing of Transportation Services:

Theory and Practice II

Moshe Ben-Akiva

1.201 / 11.545 / ESD.210

Transportation Systems Analysis: Demand & Economics

Fall 2008

Review and Outline

Review of Previous Lecture:

Review of cost and demand concepts
Public sector pricing in theory
Issues with marginal cost pricing
Congestion pricing in theory
Outline of this Lecture:
Public sector pricing in practice:
Congestion pricing
Pricing vehicle emissions
Public Transportation
Private sector pricing in theory and in practice
Appendix: Examples of congestion pricing

2
Congestion Pricing in Practice

Characteristics of the congestion problem

Severity
Avg. speed: Manhattan: 6 mph (Traffic Congestion Mitigation Commission of NYS DOT,
Interim Report for Public Comment, 2007); London: 9 mph (Transport for London Congestion
Charging Group, Impacts Monitoring First Annual Report, 2003)

Magnitude: between Lyon and Paris on 16 Feb 1980, a traffic jam

(queue) of 109 miles (176 km) (Guinness Book of World Records, 2007)
Economic cost
Urban Mobility Report (TTI, 2004): 2002 cost of congestion in U.S. (lost
time, excess fuel, increased VOC) was US$63.5 billion
Unpredictability
Its estimated that over half the delays on freeways in the U.S. are due to
non-recurrent events (accidents, breakdowns, etc.)

3
Congestion Pricing in Practice (cont.)

Concerns over congestion pricing

Driving should be free
Equity
Use of revenues
Privacy/Confidentiality

4
Congestion Pricing in Practice (cont.)

Ideal features of a congestion pricing scheme

Sensitivity to true marginal costs of auto use
By level of congestion
By time of day
By direction of travel
By area of travel
Transparency
Predictability

5
Congestion Pricing in Practice (cont.)

Short-term reactions to congestion pricing

Suppress trips
Change departure time
Change mode
Change destination/chain trips
Change route
Carpool (share costs, exploit exemptions)

Long-term reactions to congestion pricing

Land use / activity system change

6
Examples of Congestion Pricing

Singapore Area Licensing Scheme (ALS)

and Electronic Road Pricing (ERP)
Trondheim toll ring
Autoroute A1 (Paris Lille)
California SR-91 (value pricing)
London congestion charging scheme
Stockholm Congestion Charge
New York City: tried but defeated politically

7
Examples of Congestion Pricing (cont.)

Lessons learned:
Pricing does cause travelers to change their behavior
But wide variety of price levels / system impacts
Almost all pricing schemes to date are blunt
(not very sensitive to congestion costs or levels)
Cordon or individual facility based
Limited variation by time of day (e.g. peak/off-peak)
Public acceptance is key to success
Perception of current traffic problems
Promise to use proceeds to fund local improvements
or perception of choice options
Addressing confidentiality concerns
Political leadership

8
Outline
Public sector pricing in practice:
Congestion pricing
Pricing vehicle emissions
Public Transportation
Private sector pricing in theory
Private sector pricing in practice:
Amtrak
Airlines
Appendix: Examples of congestion pricing

9
Pricing Vehicle Emissions
Increasing concerns over the externalities associated with the
automobile:
Noise
Accidents
Petroleum Usage
Emissions
CO2
NOx
Particulates

10
Pricing Vehicle Emissions (cont.)

Governments are looking for ways to reduce output of CO2

and toxic emissions
How to make these reductions while minimizing the overall
welfare cost?
Many available policy options:
Regulation/Standards (forcing technology)
Pricing
Taxes
Other rule-based approaches

11
Pricing Vehicle Emissions (cont.)

Amount of emissions depends on

Amount of driving
Type of driving
Physical characteristics of vehicles and fuels
Vehicle maintenance
Effect of changes will not be instantaneous need a
dynamic model
Because drivers respond both to speeds and costs, should
be considered simultaneously with congestion

12
Pricing Vehicle Emissions: EU Study*

Reducing CO2 emissions

Dominated by transport emissions
Projected to rise 40% in EU from 1990 to 2010
Most cost-effective instrument would be tax on carbon

content of fuel

Affects all behavioral leverage points

Allow consumers to equalize marginal costs appropriately
Buttaxes already high, and alternatives often limited, so is
quite difficult politically

*: Jansen, Heinz and C. Denis (1999), A welfare cost assessment of various policy measures to reduce pollutant emissions from passenger
road vehicles, Transportation Research D, Vol. 4, pp379-396.

13
Pricing Vehicle Emissions: EU Study (cont.)

Also consumers appear to have high discount rate on

purchasing fuel efficiency
Found that to achieve 10% reduction in CO2 emissions
compared to baseline required 26% increase in fuel prices
Despite myopia, more than half came from technical
improvements in vehicle fuel consumption
Modest reduction in mileage and car ownership
Moderate increase in speeds

14
Pricing Vehicle Emissions: EU Study (cont.)

What about other options?

Standards
Feebate (taxes and subsidies on certain cars)
Feebate and fuel tax
Road pricing
Best result appears to be combination of fuel taxes with
differentiated purchase taxes (subsidies)

15
Outline
Public sector pricing in practice:
Congestion pricing
Pricing vehicle emissions
Public Transportation pricing
Private sector pricing in theory
Private sector pricing in practice:
Amtrak
Airlines
Appendix: Examples of congestion pricing

16
Public Transportation Pricing

Current state:
Low fares cover under 50% of operating expenses. No
contribution to capital expenses
High level of subsidy

17
Arguments for Low Fares

The vicious cycle

Economies of scale
Second best pricing
Equity considerations

18
The Vicious Cycle

Fare Reduced
increase ridership

Increase
deficit

Assumes that after multiple fare increase the demand is elastic,

|E| > 1
Estimated elasticities ~(-0.4)

Source: Goodwin, P (1992) Review of New Demand Elasticities With Special Reference to Short and Long
Run Effects of Price Changes, Journal of Transport Economics, Vol. 26, No. 2, pp. 155-171.

19
Outline
Public sector pricing in practice
Private sector pricing in theory
Basic idea
Relation to marginal cost pricing
Price discrimination
Segmented pricing
Revenue-maximizing Price
Private sector pricing in practice:
Amtrak
Airlines
Appendix: Examples of congestion pricing

20
Private Sector Pricing

Private firms maximize profit

Profit = Total Revenue Total Cost
Max (R(Q) C(Q))

Firms should set prices such that

MR(Q) = MC(Q)

21
Profit-Maximizing Price

Total revenue
R(Q) = p Q = D -1(Q) Q
Marginal revenue
p D 1 (Q)
MR(Q) = p + Q = p+Q
Q Q
Therefore
D 1 (Q)
p = MR(Q) Q MC(Q)
Q
p MC(Q) Q D 1 (Q) 1 1
=- = =
p p Q Q p E Q|p
1

D (Q) Q

22
Profit-Maximizing Price (cont.)

Under competition
D 1 (Q)
Q 0

because the firm is a price-taker (its output does not affect

market prices); hence:
p = MC(Q)

i.e., in a competitive market prices are likely to be close to

marginal costs social optimum

23
Price Discrimination

In a fully competitive market, if a firm tries to charge prices

higher than marginal cost, it will be undercut
In a less competitive market, firms maximize profits by
charging different prices ( > MC) to different customers
Price

P1
P2

MC

Quantity
Q1 Q2 Q*

24
Price Discrimination (cont.)

First buyer willing to pay p1 for Q1, the firm charges p1 and the
revenue is p1Q1

Second buyer: p2 for (Q2-Q1), the firm charges p2

Second buyer cannot sell his/her parts to the first buyer

Monopolistic firm will produce Q* where the marginal buyer is not

willing to pay above the MC

Price discrimination is economically efficient,

but all the consumer surplus is extracted by the monopolist

25
Segmented Pricing
Market for travel can be subdivided into different segments with different
price sensitivities

Various strategies of segmented pricing can increase revenue (e.g.

regular commuters vs. business travelers)

Revenue potential can be increased if price increases can be

implemented for inelastic segments (i.e. business travelers) and vice
versa

26
Segmented Pricing: Example
Determination of the level of toll for a tunnel
Separate price sensitivity for occasional travelers and commuters
Offer discounts to commuters and charge high toll for occasional
travelers
More potential for profit maximization by attracting price-sensitive drivers
without reducing the price for less price sensitive ones
Concern for exceeding available capacity due to number of drivers paying
the lowest toll

27
Revenue-Maximizing Price

Often used when price changes have a negligible effect on cost

Pricing changes to maximize revenue should be aimed at
achieving and maintaining a price elasticity of -1
Appropriate when marginal or variable cost is small compared
to average cost
Cost structures of most transportation services include some
variable component

28
Revenue-Maximizing Price (cont.)
So, a price increase that causes a demand decrease is
generally associated with decreasing total cost and vice versa
A price reduction is profitable only if the increase in revenue is
greater than the increase in total variable cost
If the cost structure includes a relatively small variable cost,
revenue maximizing price should be set to maintain demand in
the range where price elasticity is slightly smaller that -1

29
Revenue-Maximizing Price (cont.)
If demand is highly elastic, a price reduction should be
implemented to keep the price elasticity in the elastic range and
bring it closer to 1
But large price reductions may increase demand well beyond
capacity
Adding capacity would require significant incremental costs that
may be infeasible
So, pricing strategy should be to raise prices in inelastic
markets and vice versa if there is enough capacity available

30
Profit Maximizing Price, Competition,
and Price Discrimination
In an imperfectly competitive market
The firm will set the price above marginal cost
Its extent will depend on the price sensitivity
In case of segmented pricing (or price discrimination)
If the price charged to one customer does not affect the quantities
purchased by others then this pricing rule applies to each individual
customer or segment
The less sensitive the customer is to price, the more he/she will pay
relative to others

31
Profit Maximizing Price, Competition,
and Price Discrimination (cont.)
Perfect competition makes price discrimination difficult
As competitors will undercut any firm charging more than
the marginal cost
Price discrimination is a sign that competition is imperfect
In a perfectly competitive market, the prices all firms charge to
all customers should be the same

32
Outline
Public sector pricing in practice
Private sector pricing in theory
Basic idea
Relation to marginal cost pricing
Price discrimination
Segmented pricing
Revenue maximizing
Private sector pricing in practice:
Amtrak
Airlines
Appendix: Examples of congestion pricing

33
Example: Pricing at Amtrak
Strategy
Objective is to maximize revenue
- Consistent with a fixed cost structure

To achieve the objective, Amtrak must have knowledge of

passenger price sensitivity and competition

Amtraks pricing strategy

- To raise prices in inelastic markets and to lower prices in
elastic market with excess capacity to meet increased
demand
- Else extra demand will need excess capacity

34
Example: Pricing at Amtrak
Competition
Main alternatives are travel by car, air or bus

Monitor changes in the price of gasoline and air travel and

respond accordingly
For example, Amtrak will follow an airline fare increase by a
corresponding fare increase for its service

Revenue gains by changing fares in a competitive market, i.e.

travel between end points, may be offset by revenue losses in
less competitive markets, i.e. travel involving intermediate points
along the same route

35
Example: Pricing at Amtrak
Segmented Pricing and Yield Management
Pleasure travelers vs. business travelers
Offer discounts to early purchasers of tickets
The danger of segmented pricing
Lower fare passengers may largely take the available

inventory (if it is fixed)

So, yield management system is used to adjust seat inventory

(seat allocation among different price levels based on expected
demand)
Yield management can only be applied to reserved trains (as it
depends on advance bookings)

36
Example: Pricing at Amtrak
Effectiveness of Pricing Decisions
Measuring price elasticities based on two sources
Previous price changes and their effect on demand and
revenue
Explicit experiments designed to investigate price

sensitivities

Pricing experiments can only be conducted in certain markets

characterized by
Relatively low demand with excess capacity even at
minimal train frequency

37
Example: Airline Pricing

Deregulation in the industry since 1978

Successful experience
Average lower fares
Increase in air travel
More variation in fares across segments
Due to differences in airline costs and to price

discrimination

Much more on this in Prof. Belobabas upcoming lectures

38
Conclusions
Pricing and investment policies for transportation services are often far
from optimal
Marginal cost pricing difficult in transportation sector
Dissatisfaction with the outcome of public transportation services
Increasing use of price discrimination (segmented pricing)
Knowledge of demand and price sensitivities is critical

39
 Appendix

Examples of congestion pricing

Applied Examples of Congestion Pricing

Singapore Area Licensing Scheme (ALS) and Electronic Road

Pricing (ERP)
Trondheim (Norway) Toll Ring
Autoroute A-1, Paris Lille, France
California SR91 Value Pricing
London Congestion Charging Scheme
Stockohlm Congestion Tax
New York City (tried, but failed)
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1.201J / 11.545J / ESD.210J Transportation Systems Analysis: Demand and Economics

Fall 2008

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