A2 ECONOMICS OCR

F584 TRANPORT ECONOMICS

2013 EDITION

RAPID REVISION HANDBOOK

Step by step guide to key concepts
Question and Answer format
Glossary

Q&A

Richard Young

A2 Transport Economics
Contents
Introduction to Transport.................................. 2

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Resource allocation and Government

Transport Policy ............................................. 36

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

Natural monopoly........................................... 15
Oligopoly ............................................................ 16
Contestable markets ...................................... 17
Franchising ........................................................ 18
Deregulation ..................................................... 19

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

COBA.................................................................... 38
Integrated transport policy........................ 39
International road schemes ....................... 40
A2 Transport Economics Glossary .............. 41

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

Richard Young All rights reserved. First edition 2011. This edition 2013. The right of Richard
Young to be identified as the author of this Work has been asserted in accordance with the
Copyright, Designs and Patents Act 1988.

| 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 transport is the movement of people from one place to
another. Freight transport is 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 rail
networks, airports that facilitate transport operations.
What are transport operations? Transport operations are decisions about the type of transport
mode to use (demand) or provide (supply). Demand side decisions are made by consumers and firms
eg what journey to make, by what mode, and at what time. Supply side decisions are mainly made by
private 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 freight
from 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 factor is 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 when people 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.

Transport and transport modes |

Demand for transport

Define the demand for transport. The demand for transport is the number of journeys consumers or
firms 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 depends
on the demand for another product or activity
Why is the demand for transport a derived demand? Transport is rarely demanded for its own
sake, 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 own
sake, the journey, but for what the journey enables eg economic growth leads to more
Commuting as a rise in GDP increases employment hence the number of commuters
Leisure as households higher incomes to take more holidays raising the demand for eg air flights
Distribution: eg firms hire lorries to transport products to customers. An increase in GDP or
international 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 or
population 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 place
at a given time. Shopping or social journeys are less time sensitive. This means the price elasticity of
demand for commuters is more inelastic than for leisure journeys
How does a fall in the bus fares affect bus use? A fall in
the price of bus fares from P1 to P2 results in an extension
in demand. Lower fares cause an increase the number of
journeys undertaken from Q1 to Q2
Explain the substitution effect. A price fall encourages
consumers to buy more of a relatively lower priced
product and less of a higher priced substitute
Explain the income effect. A price fall leaves consumers
with income left over after buying the same amount of the
product. Extra income may be spent buying more of this
item 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 a
price change also depends on own price elasticity of demand. Given few close and available substitutes
demand 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 car prices or 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 eg
rail to using their car more often
Increases in in real GDP have increased income increasing the demand for cars and causing a
rightward shift of the demand curve. Given the demand for cars has a high and positive income
elasticity of demand, a rise in incomes leads to a proportionately larger increase in demand
The price of substitutes eg bus and rail fares have risen in real terms resulting in some users
switching to the relatively cheaper alternative, cars, increasing demand and shifting the
demand curve for cars to the right. Given cars and buses/rail have a high and positive cross
elasticity of demand, a rise in the price of public transport leads to a proportionately larger rise
in car demand.

| Demand for 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 the
price 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 change
in the price of another product.
How can transport operators make use of price elasticity of demand (PED)? Operators can use
PED estimates in transport to predict a) the effect of a change in fares, indirect tax or road charging on
quantity demanded and b) the effect of a change in fares on total revenue
Why do elasticity values vary with
time? The longer consumers have to
adjust to a price change the better
able they are to find substitutes

Variable

With respect to

Short run

Long run

Petrol consumption

Petrol price

-0.3

-0.6 to 0.8

Car traffic

Petrol price

-0.15

-0.3

How does PED affect road pricing?

Petrol consumption Income
0.35 to 0.55
1.1 to 1.3
Glaister and Graham (2000) find
Car traffic
Income
1.1 to 1.8
petrol consumption and car traffic is
highly 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 a
proportionately smaller change in demand
If YED is positive and greater than 1, demand is income elastic. A change in income results in a
proportionately larger change in demand. This is a characteristic of superior goods eg 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 growth
eg 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 item

Negative 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.

Buses exhibit low, even negative YED. Road and public transport are weak substitutes for
commuters. Indicator: a low, positive, cross elasticity value.
Income elasticity of demand estimate is +1.4 for business and leisure air travel is +1.5 with
higher 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

Elasticity and transport |

Structure of transport operations

What is a mixed economy? In mixed economies, some resources are owned by the public sector
(government) and some resources are owned by the private sector (households). Public ownership
refers to state owned companies eg nationalised industries.
Explain the term organisation of transport. Organisation of transport is the structure of transport
operations in terms of private or public sector ownership and responsibilities
Define nationalisation. The transfer of ownership of a firm from the private to public sector
Define 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? Extensive privatisation since the
1990s 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 by
government. 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 BAA
invests 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 for
local 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 and
leads to greater allocative inefficiency

Recent trends in transport demand

For latest transport statistics and trends visit the Transport page published by UK National Statistics
How is passenger transport usage measured? Passenger transport is measured in term of either the
number of kilometres travelled by passengers usually expressed as billion passenger kilometres or the
number of kilometres travelled by vehicles ie billion vehicle kilometres.
What is a vehicle kilometre? A vehicle kilometre is equivalent to one vehicle times one kilometre
travelled. Vehicle kilometres are estimated by multiplying roadside traffic counts estimates of average
daily 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 and
finished 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. One
tonne 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 are
being transported.
Sustained under investment in infrastructure over 20 years means air rail and road networks
are operating beyond capacity, in peak times, at current levels of demand.
The duration of peak time periods is increasing. Projected increases in demand for car
transport are unsustainable.

| Structure of transport operations

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 transport eg expected number of journeys
value of costs and benefits as part of investment appraisal eg a cost benefit analysis
How is transport forecasts conducted? Analysts
identify factors affecting demand eg price, GDP, income, price of substitutes and complements
assess the relationship between variables eg how population changes affect demand
predict the strength of relationships between variables eg income and demand (YED)
make assumptions about the future value of variables eg fuel prices, GDP and population levels
predict central, high and low trends for future levels of demand
Identify problems in making transport forecasts.
Value judgements must be made as to which factors to include or exclude in the forecast and
the weighting to give each factor
Forecasts require estimates of future levels of GDP and populations size which are uncertain
Data collection may be difficult or costly
Inaccurate data may be collected eg by using biased surveys
unforeseen events may 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, a
projected 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 projected
10% 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 resources
between alternative uses. By forecasting likely future demand resources can be allocated to networks
experiencing 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 match
projected future passenger and freight levels to avoid future congestion.
Are forecasts always accurate? Forecasts give a broad indication of behaviour based on past trends
and 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 the
immediate future. Forecasts become increasingly unreliable overtime as predictions are more likely to
be 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 had
accurate information resulting in a misallocation of resources.
How are forecasts used in cost benefit analysis? See the section on CBA

Transport forecasts |

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 number
of 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 extra unit of a product
How is marginal revenue calculated? Marginal revenue (MR) is found by dividing the change in
total revenue (TR) by the change in output (Q). MR= TR/ Q
What is profit? Economists talk about two types of profit:
Normal profit is 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 curves
include an element of payment to the entrepreneur required for organising production.
Supernormal profit is any extra profit made in excess of normal profit. Firms earn supernormal
profits () 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 of
normal 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 finance
for 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 operation
and 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 the
level 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 variable
transport 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 have
to be paid out even transport operations cease. Fixed costs include car insurance and vehicle excise
duty (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 costs
examples 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 found
by 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 by
dividing 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 of
passenger kilometres or journeys. Freight output is measured in tonne kilometres

| Revenue and profit

Economies of scale
Define the long run. The time period when firms can adjust all factors used in production, ie both
labour 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 of
lower prices thereby improving consumer welfare.
State the two categories of economies of scale. Internal EoS lowers a firms unit costs because the
firm 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 production
process itself. Eg as airlines grow and invest in bigger airplanes they find capacity increases by a larger
percentage than operating costs so LAC fall the law of increased dimensions. The fixed cost of an IT
system 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 LAC
Explain purchasing economies of scale. Purchasing EOS arise when firms gain discounts from bulk
buying 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 run
average cost curve (LAC) shows the firms minimum
unit cost of producing each level of output for each
scale of operation.
Each scale (size) of operation has its own short run
average cost curve eg SAC1. Using more capital and
labour shifts the SAC curve outwards and downwards
if the firm experiences internal economies of scale.
The LAC curve shift outwards and upwards if firms
experience diseconomies of scale from growth.
What is minimum efficient scale? (MES) is the
lowest level of output needed to produce at lowest
unit cost. The firm has grown to the point where there
are no internal EoS left to exploit.
Define diseconomies of scale diseconomies of scale are the disadvantages to the firm, in the form of
higher 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 eg
staff may misunderstand a task resulting in productivity falls and LAC increases
Control: as firms grow it becomes more difficult to coordinate the 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. Lost
productivity results in in higher LAC

Explain external economies of scale. External EoS is the benefit, in the form of lower unit costs, from
an 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 close
together, transport costs fall. A pool of skilled labour reduces recruitment costs.

Economies of scale |

As the industry grows, government may improve local roads which cut the cost of delivering supplies
therefore lowering LAC.
Give examples of external economies of scale in
transport. Support services such as catering, couriers,
and airplane servicing companies tend to locate near
airports lowering the LAC for all firms in the industry
eg from LAC1 to LAC2 in the diagram.
Illustrate external economies of scale. Growth of the
entire industry reduces the LAC of all firms in the
industry. Eg the LAC for firm Y in the diagram opposite
shifts downwards at all levels of output. This means the
LAC 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 sole
trading 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 maximisation Traditional theory
assume firms aim to make as big a profit as possible ie
they are profit maximisers
Illustrate profit maximising. Profit maximisation
occurs by setting output where marginal cost = marginal
revenue: MC=MR at Q1.
Note that Q1 includes an element of normal profit in the
MC curve. Producing beyond Q1 means MC>MR: a loss is
made on each extra unit made. Making less than Q1
means forgone profit
Identify issues with MC=MR pricing. Firms can find it
hard to identify marginal costs and revenues and instead
add a profit margin to long run average costs. Not all firms are profit maximisers eg they may be keen
to avoid attracting the attention of rivals or regulators by setting profit maximising prices.
Illustrate other objectives.

Revenue maximising level of Q: where MR = 0.

Firms aim to maximise TR rather than profit

Sales maximisation level of Q: where AC = AR. Firms

want to maximise market share rather than profits

Distinguish between limit and predatory pricing. In limit pricing monopolists set a price to earn
normal profits and so deter (limit) potential entrants. Predatory pricing occurs after the arrival of a
new firm. The incumbent sets a low price trying to force the exit of competitors

| Firms and their objectives

Explain the term stakeholders. Stakeholders are groups who have an interest in the activity of a firm
eg 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 in
companies. Shareholders (the principal) elect directors (the agent) to act on their behalf and to
maximise shareholder value. Managers may instead take decisions that meet their own objectives eg
hiring extra staff to reduce manager workloads. The result is organisational slack and x-inefficiency.
How can the agent-principal problem be resolved? By linking managers pay to share prices eg by
offering 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 stakeholder
objectives, rather than say owners objective of profit maximisation
Who decides objectives? The aim of a business is decided by the dominant stakeholder(s) taking into
account legal constraints such as regulations and competition laws. In companies there is the potential
agent-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 industry
and so restrict competition allowing incumbents to sustain any supernormal profits in the long run
List barriers to entry preventing restricting firms entering a market
Legal: incumbents may have a legal monopoly over supply, or government regulations may
require firms to meet health and safety regulations before granting an operating licence
High start-up costs of 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 enjoy economies of scale unavailable to new entrants ie lower unit costs.
Incumbents can use this cost advantage for limit pricing and set a price which covers their own
unit 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
Unrecoverable sunk costs when exiting an industry. These include marketing costs incurred
creating 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 rail
services, 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 can
recover 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 are
high. Profits may not be sufficiently high to justify the risks associated with entering new markets.

10

Barriers to entry |

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 air
travel 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 number
size 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 n
largest 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 of
industry 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 indicates
monopolistic 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 extent
of market power is indicated by the concentration ratio
What are the limitations of concentration ratios? Concentration ratios do not distinguish between
the 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 calculated
this 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 an
increase in the market share of the largest firms in the industry. Economic theory suggests this may
result in less competition, depending on the number and size of firms remaining in the industry.
How does the government define a monopoly? UK Competition law presumes firms with a 25% or
more market share have the market power to act like monopolists. Firms with a 40% plus market
share are defined as dominant monopolists

| Market structure

11

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 entry
where many firms produce identical products
Can competitive firms earn supernormal profits? Competitive firms can earn supernormal profits
only in the short run. In the long run, supernormal profits attract competition. Zero barriers to entry
allow 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, their
lack 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 free
markets 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 small
firms 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 to
entry and are highly competitive.
Why is the monopolistically competitive firms demand
curve downward sloping? Product differentiation means
each firm has its own demand curve which is downward
sloping because firms must reduce price to increase
quantity demanded. The large number of close substitutes
means demand is highly price elastic: a small price rise
results in a proportionately much larger fall in quantity
demanded
Assess barriers to entry and exit in monopolistic
competition. Low start-up costs mean barriers to entry are low which means firms can enter the
market easily. Sunk costs such as advertising are low so barriers to exit are minimal which encourages
entry as firms know they can recoup most costs on exit.

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Competitive markets |

Do monopolistically competitive firms have market power? The large number of firms in the
market means firms face intense competition and so have limited market power.
Can monopolistically competitive firms earn supernormal profits? Monopolistically competitive
firms earning supernormal profit attract competition. Low barriers to entry make it easy for new
entrants 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 attract
new entrants. This means supernormal profits can only be earned in the short run.
Are monopolistically competitive firms allocatively
efficient? Profit maximising firms in monopolistically
competitive set output where MC=MR. Price exceeds
marginal cost causing allocative inefficiency. The area
of deadweight loss is JKL made up of lost consumer
and producer surplus.
Are monopolistically competitive firms
productively efficient? Productive efficiency is
achieved where firms are producing at minimum unit
cost. Profit maximising monopolistically competitive
firms produce at an output level above lowest average
and 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 intersection
of MC with MR gives the profit maximising level of
output 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 Q1
In competitive markets supernormal profits attract
new firms and the resultant increase in supply lowers
price until normal profits are earned. However the
existence of barriers to entry allows the monopolist to
continue earning supernormal profits in the long run
Use a graph to compare priced and output in
monopoly and competitive markets. Assume the
MC curve is also the supply curve for the industry. In a
competitive markets price is set by the intersection of
the supply and demand curve. Price is PC and output is
QC. Note P=MC ie allocative efficiency is achieved.
A profit maximising monopolist use their market
power to set output at QM where MC = MR. Price is
higher and output is lower in monopoly compared
with a more competitive market
How can market dominance result in market
failure? Profit maximising monopolies are allocatively
and productively inefficient. Allocative efficiency
occurs at QC where P=MC. Monopolies set output at QM where MC=MR.. Market failure from over
production 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 in
lost staff motivation and management coordination and communication issues. LAC rise with output.

| Monopoly

13

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 exploit economies of scale which 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 unit
costs. 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 sub
markets, 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 off
peak 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 increase
profits 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 demand
is 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 price
discrimination = (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&D
leading 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 consumer
surplus from buyers and increasing their profits, so consumer welfare falls

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Price Discrimination |

Natural monopoly
What is a natural monopoly? A natural monopoly occurs when economies of scale are so substantial
that 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 an
overwhelming 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 a
lower 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 productive
efficiency. 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 natural
monopoly is a capital intensive industry where very
large fixed costs create significant economies of scale.
This means LAC continue to fall as the scale of
production increases because fixed costs are spread
over higher and higher levels of output.
Why is it inefficient to have more than one
supplier in a natural monopoly? Multiple suppliers
cannot access the economies of scale enjoyed by a
monopolist. Competition results in higher unit costs
Illustrate equilibrium in a natural monopoly
industry. A profit maximising monopolist sets output
where MC=MR ie at Q1. (P1-P2) x Q1 supernormal
profit 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 efficiency requires monopoly provision.
Allocative efficiency occurs at Q2 where P=MC. Profit
maximising output is at Q1, resulting in market failure
from under production.
Use a diagram to show arguments for natural
monopoly subsides. Allocative efficiency occurs
where LMC = P ie output level Q2 and price P3.
However, marginal cost pricing leads to a loss = (P4P3) x Q2. Only a subsidy will persuade a profit
maximising monopolists to provide the socially
efficient level of output, Q2.
How can the state prevent monopolies abusing
their market power? Options include:

Nationalisation state owned firms decide

socially appropriate levels of output and price
Using regulations to set standards and control prices eg establishing an industry regulator to
monitor performance; approve pricing decisions; ensure sufficient investment for dynamic
efficiencies; and enforce consumer protection law. Eg Office of Rail Regulation
Franchising: if creating competition within a market is inappropriate, create competition for
the market. Invite firms to tender for the right to run the monopoly for a limited period of time.
Introduce yardstick competition. The natural monopoly is broken up into regions. A regulator
then compares the performance of each region to identify underperforming areas.

| Natural monopoly

15

Oligopoly
Define oligopoly. A market structure dominated by a few large firms
Describe the characteristics of an oligopolistic market. A few large interdependent firms dominate
a market characterised by high barriers to entry. Prices are rigid and incumbents use non-price
competition 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. High
sunk 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 concentration
ratio (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 to
entry 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 the
price 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, and
are influenced by, the decisions of competitors. This means oligopoly behaviour is reactive. Firms
factor 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. Assume
the initial market price is P1. If an oligopoly
increases price above P1, rival firms do not follow.
Consumers switch to substitutes. This means the
firms 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 demand
curve price inelastic below point B. The firms
demand curve becomes ABC. The kinked demand
curve creates a discontinuity (gap) in the marginal
revenue 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 - the
behaviour of its rivals. In the kinked demand curve model prices are rigid because price cuts are
usually matched by competitors and rivals generally fail to match any price rise made by the firm
causing 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 agreement to avoid
competitive 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, market
share or exchange information on costs
Give examples of formal and informal collusion? A cartel is an example of formal collusion and is
illegal in most countries including the UK. Price leadership is an example of informal collusion where,
without official agreement, rivals charge the same price as that set by the market leader and so avoid
price competition. Collusion restricts competition.

16

Oligopoly |

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 contestable
given no barriers to entry or exit and identical unit costs for incumbents and potential entrants
Describe the implications of contestable markets. In contestable markets incumbents (existing
firms) face the threat of competition from potential entrants. Incumbents take into account the likely
response of rivals when setting price. If firms set a price yielding supernormal profits, incumbents face
a threat of increased competition from new entrants threatening market share and future profit levels.
Identify factors that determine contestability. The size of the pool of potential entrants and extent
of barriers to entry and exit determine the degree of market contestability.
Give examples of contestable markets in action. Given low barriers to entry, any bus company
earning 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 it
easier for new firms to join a market and challenge incumbents.
Draw a diagram to show the impact of
contestability. Profit maximsing output occurs
where MC=MR. If Q1 is produced at P1, supernormal
profits of (P1-P2) x Q1 are earned.
However, supernormal profits encourage rivals to
enter the industury provided barriers to entry and
exit are low. Firms wanting to avoid the threat of
competition may use limit pricing and set output at
Q2 and charge P2 where P=AC. Earning normal profits
leaves no incentive for entry by rivals. Incumbent
pricing 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 now
operate 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 identical
products. In a contestable market potential competition exists between any number of firms whose
output may be homogenous or differentiated
Why do governments take measures to improve contestability? By increasing the threat of
competition monopolists and oligopolies act as if they were in competitive markets. Increased
completion increases supply and lowers price. Allocative efficiency improves.
List government policies to improve contestability.

Deregulation removes legal barriers to entry making it easier for firms to join a market
Short franchise periods mean incumbents face potential competition in the near future
Creating leasing companies eg ROCOs in the rail industry reduces sunk costs.

| Contestable markets

17

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 making
the 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 to
operate 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 competition
lowers 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 government if 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 adjust
supply 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 of
competition for the contract to operate a service thereby improving contestability but also creating
uncertainty 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 to
introduce competition: Transport for London (TfL) invites bids for 5 year franchises to operate a given
route 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 train
operating 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 will
be limited competition.
how long the franchise runs for. Short periods discourage bidders due to the limited time to
recoup investment. Long period franchise encourage investment but reduce contestability

18

Franchising |

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 to
entry 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 to
entry and makes it easier for firms to enter the
market. Competition increases; new entrants
increase supply
Use a supply and demand diagram to show the
impact of deregulation on a market. S1 is initial
supply in a regulated market. Deregulation reducing
legal barriers to entry makes it easier for new firms
to join the industry. Supply increases shifting the
supply curve to S2. Price falls to P2 with Q2 Q1
more journeys undertaken. Consumer surplus
increases by (P1,J,K,P2)
How does deregulation affect contestability? Deregulation removes legal barriers to entry and
makes 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 output
at QM where MC=MR. Deregulation removes legal
barriers to entry and so encourages competition. The
entry 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 an
incentive to cut unit costs so as to be able to cut prices
and remain competitive. Eg eliminating organisational
slack reduces x inefficiencies and improves productive
efficiency. Lower unit costs means incumbents can
match the price of new entrants
What are the drawbacks of deregulation? Deregulation increases 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 now
operate 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 joining
an 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

| Deregulation

19

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 firms
to 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 efficiency improves
competition moves market price closer to MC. Allocative efficiency improves
firms invest in greater research and development to develop innovative products which
increase sales, or improved production techniques that cut costs. Dynamic efficiency improves
Identify arguments for privatisation. Advocates argue private sector firms have an incentive to

Eliminate x-inefficiencies associated with state owned corporations which, if passed on, result
in lower prices or lower subsidy requirements
Improve quality eg reliability leading to increased use of public transport
Increased use of public transport generates positive externalities eg a switch from cars to trains
Private sector investment is introduced overcoming decades of public sector under investment
Government borrowing is 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 of
competition means economic inefficiency remain and fares 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 eg
socially necessary but loss making services are closed
Profit maximising private firms may cut costs to improve profits which may reduce service
provision 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 then
there will be limited competition.
Identify arguments for nationalisation. Advocates argue natural monopolies are best owned and
run by the state control to avoid abuse of market power. Transport is a strategic industry best
coordinated by government which unlike the private sector takes account of external benefits.
Identify arguments against nationalisation. Privatised natural monopolies can be regulated to
avoid abuse of market power. Overall transport strategy can be coordinated by the state. Subsides can
be used to ensure private sector firms maintain socially necessary services. State run organisations
have no incentive to be productively efficient.

20

Privatisation |

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 allocative
and productive efficiency are achieved.
Explain allocative efficiency. Allocative efficiency occurs at the level of output where price equals
marginal 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 of
production 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 at
a level where selling price = marginal cost of production ie P=MC
What is productive efficiency? Productive efficiency occurs when firms are maximising output from
given inputs and thus producing output at lowest possible unit cost.
What is the condition for productive efficiency? Productive efficiency occurs when firms are
producing 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 are
maximising output from given resources and are producing at lowest unit cost
How does competition encourage productive efficiency? Competition energises firms to seek
productive efficiency gains and produce at lowest unit costs to avoid losing sales to more efficient
rivals. Unit cost reductions are passed onto consumers in the form of lower prices.
Explain X-inefficiency. X-inefficiency means a firm is
using more inputs than is needed for a given level of
output. Actual unit costs (AC1) exceed lowest
attainable unit cost (AC2).
What causes x-inefficiency? X-inefficiency is caused
by organisational slack where firms opt to employ
more resources than are needed to produce a given
level of output. Staff and capacity are under used
Why are firms x-inefficient? Managers in firm
operating in uncompetitive markets have little
incentive 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 ideas
into a) new processes that 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 new
scientific and technological ideas to improve products and processes ie innovation
Why is R&D important? Successful R&D results in dynamic efficiency gains from improved
production 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 use super normal profits
to 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 or
distribute profits to owners. In the absence of competition is there any incentive to finance R&D?

| Economic Efficiency

21

Market failure
Define a free market. In a free market, the forces of supply and demand alone determine price and
output without any government intervention. Free markets are totally unregulated.
What is market failure? Market failure occurs when free markets make an inefficient use of scarce
resources 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 not
being used in a way that maximises consumer satisfaction. Factors of production can be put to better
use making products consumers value more highly, given their cost.
Why can transport markets fail? Reasons why transport markets can fail include:
the impact of externalities such as pollution is overlooked by producers and consumers
roads are a quasi-public good. The free rider problem means private sector firms will not
supply an allocatively efficient amount of road space
monopolies may use their market power to set a price that maximises profits , not efficiency
transport markets can generate inequity and social exclusion eg when inability to pay means
low income households are denied access to transport
What is government failure? Government failure occurs when state intervention increases economic
inefficiency - 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 made
conditional 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 provide
socially 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 the
characteristics 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 by
construction 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 and
maintain the socially optimum amount of roads is required to ensure allocative efficiency. UK
highways are financed from taxation eg petrol duty and VED
How do highway improvements affect consumer
surplus? A road improvement scheme reduces price of
a journey from P1 to P2 causing an extension in demand
of (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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Market failure |

Negative externalities
Define positive externalities. Positive externalities exist when third parties receive benefits from the
spill 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 benefits
of 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 consumption
imposes costs on third parties who receive no compensation
Why do negative externalities cause market failure? If economic agents ignore the external costs of
their actions, over-consumption of a product causes market failure, hence allocative inefficiency
List negative externalities associated with transport. Increased transport often means more
Noise pollution affecting people living near roads or under flight paths
Air pollution eg 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.
Blight where 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 journey
include air pollution from emissions. Infrastructure projects such as a new motorway link result in loss
of 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 of
hours lost by the average wage eg 1m lost working hours x 12 average hourly wage = 12m
Compensation: estimate the cost of putting right an externality eg include the cost of installing
double glazing in houses affected by increased road noise from a new motorway. If 200 houses
are 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 200
householders 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 private
cost of production (MPC) S= MPC.
Given negative externalities such as pollution, an
estimate of marginal external cost (MEC) is added to
the MPC curve to give the marginal social cost (MSC)
curve: MSC = MPC + MEC.
The demand curve is a measure of private marginal
benefit. If no positive externalities exist then D
shows social marginal benefit: D = PMB = MSB.
The equilibrium level of output delivered by a free
market, Q1, is allocatively inefficient. SMB = SMC at Q2. The market has overproduced by (Q2Q2). The
welfare loss triangle JKL gives the amount of welfare loss from overproduction and is equal to the
amount 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 on
geography, time of day and type of vehicle.
| Negative externalities

23

Indirect taxes
Outline the problems in using environmental taxes. The aim of an indirect tax is to make the
polluter pay and so internalise the externality. However implementing taxes is problematic
Setting the right tax rate if 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 not
pollute and international competitiveness if 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 Excise
Duty (VED) is an annual indirect tax on car ownership which varies by type of car based on CO2
emission 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 than
low polluting car owners. However VED is an annual payment the amount of VED paid does not vary
according to the number of miles travelled

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

External costs of road

transport bn ( ASI 1999)

Explain hypothecation Revenues raised from one area of economic activity

are ring fenced ie only used by government.

Congestion

18bn

Accidents

3bn

Air Pollution

3bn

Noise Pollution

1bn

Total

25bn

In 2000 The Adam Smith Institute reported road users pay 32bn in tax
revenues each year but receive back only 6bBn in road investment - a
shortfall of 26bn. However the same reportii valued negative externalities
generated by road traffic at 25bn an argument against hypothecation

24

Indirect taxes |

Congestion and Road Pricing

Define congestion. Congestion is when demand exceeds supply on a given network at a given period
in time eg bank holiday on holiday routes.
How does congestion affect costs? It increases private costs to users: increased vehicle operating
costs 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 pricing
Can congestion be corrected by building more roads? Cet par, more supply reduces congestion, if
current levels of demand are maintained. In the long run, new roads typically generate extra traffic so
that 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 of
negative externality according to the time of day, place and vehicle used
Summarise the London Congestion Charge (LCC). Most motorists pay a daily 10 charge for
entering parts of central London in peak times. The LCC is linked to VED bands and so mildly reflects
the 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 eg
bus services. The estimated PED with respect to the number of journeys is -0.58iii ie price inelastic
Define road pricing. A direct charge to road users for their 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 space
on a particular journey and is an indirect tax. Road pricing increases private cost, reduces supply and
shifts 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 the
private costs of car journeys shown by the MPC
curve rise because congestion causes time delays
and higher fuel costs for users.
Consumers ignore external costs of their actions and
beyond J1 extra road use imposes spillover effects
on others. The vertical distance between the MPC
and MSC is a monetary estimate of the value on
negative externalities including increased air and
noise pollution ie MEC.
Without state intervention J3 journeys occur. The
socially optimum level is J2 resulting in market
failure from over consumption. The overall loss to
society is given by the area of welfare loss: JKL.
How can indirect taxes correct market failure from
congestion? Motorists ignore the impact on third
parties of negative externalities created by their road
use eg air pollution and congestion. Overconsumption
of J3-J2 results in an inefficient use of scare resources
and market failure
Road pricing can correct market failure. An indirect tax
such as a toll increases private costs, reduces supply
and 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
| Congestion and Road Pricing

25

What is the effective level of road pricing? Road pricing corrects market failure if it is set equal to
the external cost of a journey. Ideally tolls vary according to time, distance, place, the level of vehicle
emissions and number of passengers.
How effective is indirect taxation in reducing market failure from car transport? The bigger the
indirect tax rise the greater the fall in car use. Effectiveness depends on whether it is one policy used
as 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 they
drive. Each journey has its own road price equal to its external cost, say,43p per kilometre in a city
centre 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 to
satellites to set tolls for lories.
Why are GPS road pricing systems not used in private cars? Using sensors to monitor journeys
does 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 be
undertaken at a given time of day on a given route eg city centre commuting before 9 00am. The
convenience and flexibility of cars, and poor quality of public transport substitutes, means there are
few close available substitutes commuting by car making demand highly price inelastic
Set out arguments for road pricing Congestion is caused by demand exceeding capacity on given
networks at given times eg mid-week peak times. Road pricing:
forces polluters to internalise their externalities and include the estimated cost of their
negative externalities in their decision making. Users pay for the social cost of their actions
generates revenue for hypothecation eg subsidies for public transport substitutes
encourages modal shift: higher prices encourage commuters switch to the now relatively
cheaper 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 underconsumption results; too low and over-consumption continues ie government failure occurs
requires alternative modes of transport to enable modal shift and allow motorists to switch
from cars to close, available substitute public transport eg trains and buses
has minimal impact 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 reduce car usage unless the scheme is comprehensive covering all
road networks
has high set up, maintenance, monitoring and enforcement costs
increase costs of production which is inflationary and reduces competitiveness of local firms if
rivals in other regions have free road access. International competitiveness is reduced
is a regressive tax raising equity and social inclusion issues if low income groups are priced
out of 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 the
demand for road travel. If there is no alternative bus or rail services, the lack of close substitutes
makes demand highly price inelastic. High tolls are required to reduce demand to socially optimum
levels. This means road user charging is more likely to be effective if introduced alongside other
policies eg subsidies for substitute public transport and integration policies which allow modal shift
over parts of a journey eg park and ride schemes

26

Congestion and Road Pricing |

Subsidies
What is a subsidy? A subsidy is a payment made by the government to producers or consumers to
encourage production or consumption.
How are subsidies used in public transport? Subsidies can be given by the state to reduce operating
costs and so allow operators to lower fares or the cost of capital and infrastructure improvements eg
for new buses and bus lanes
How do subsidies affect price? A producer subsidy lowers costs of production. Firms increase supply
resulting in a lower price and higher output.
How do subsidies affect modal shift? Subsides for
public transport reduces their price and encourages
car user to switch to relatively cheaper alternative
modes of transport.
Draw a diagram to illustrate producer subsidy. A
subsidy = Su reduces firms costs of production. Firms
increase supply at all market prices causing an
outward shift in the supply curve to S2. Equilibrium
market price falls from P1 to P2 and output rises to Q2
What is the cost of the subsidy? Consumers use to
pay P1 but now pay P2. Firms use to receive P2 but
now get P3. The subsidy costs the govt (P3-P2) x Q2
How are subsidies financed? State subsidises are financed from general taxation or by borrowing
Why subsidise public transport? Advocates argue effective state subsidies
move output away from the market to social optimum level so improving allocative efficiency
encourages a modal shift away from private cars and so create positive externalities and
improves sustainability
improve social equity and reduce social exclusion as low income households who cannot afford
cars now have access to transport
How effective are subsidies in encouraging commuters to switch from road to rail? Road and rail
are substitutes. A rail subsidy makes tickets cheaper and encourages car commuters to switch from
cars, depending on the cross elasticity of demand value between cars and trains. The easier it is for
commuters to switch easily from cars to rail, the more effective subsidies are in reducing road travel.
Outline arguments against state subsidies. Critics argue state transport subsidies
may encourage x-inefficiency as firms can use subsidies to cover the cost of organisational
slack
are ineffective if the demand for public transport is price inelastic. Very large subsidies are
required to increase the number of travellers using public transport
affect only one factor determining demand: price. Non price factors such as poor reliability and
comfort may mean consumers do not use public transport even after a price fall from subsidy
may be absorbed by firms as profit rather than passed onto consumers as lower prices
are expensive and represent an opportunity cost
Comment of the effectiveness of subsidies. The impact of subsides depends on the size of the
subsidy and whether or not demand is price elastic. Subsides used in isolation are less effective than if
part of strategic integrated solution eg in combination with a road pricing scheme.
Effectiveness also depends on how the subsidy is used: capital subsidies improve the quality of public
transport and so improve consumer perceptions increasing demand and making income elasticity of
demand for public transport positive and more elastic.

| Subsidies

27

Regulation
Define regulation. Laws that ban or restrict specified activities.
What are standards? Government standards set out legal requirements for a given economic activity
eg the allowable level of C02 emissions above which a car fails its MOT
Why use regulation? Governments can use the law to change the behaviour of economic agents in
ways which the state believes will improve the use of scare resources. Compliance with regulation and
standards moves market output towards the social optimum level
Give examples of transport regulations. MOTs, the London Emissions Zone and restrictions on car
usage in city centres
How can regulation correct market failure? In a free market, the forces of supply and demand
determine the level of output. Regulation overrules market forces and sets a standard for desired
consumer and producer behaviour. Compliance moves market output towards, or ideally to, the social
optimum where marginal social cost equals marginal social benefit.
Describe the regulation process. Regulation uses two-step process: command and control
command: regulation sets a standard for a given activity defining what is and is not legal
behaviour eg the maximum level of C02 emissions above which a car fails its MOT
control: regulations are enforced using sanctions. Economic agents must comply with a
regulation or risk fines or imprisonment thus giving an incentives to change behaviour
Explain the role of monitoring and enforcement. Regulation corrects market failure only if it causes
economic agents to change their behaviour in desired ways. Some consumers and producers may
chose to ignore regulations. Effective regulation requires
monitoring by police to check economic agents are complying with the law
enforcement using fines or imprisonment to compel observance of the law
Describe various forms of regulation. The government can pass and enforce laws that:
ban activities leading to market failure eg price fixing by cartels
limit a given activity eg cap allowable noise levels airplanes; introduce output quotas
require a given activity from eg compulsory wearing of seatbelts
How can regulation affect costs of production? Costs may increase if firms have to change
production processes or hire staff to meet legal standards. Firms cut supply at all market prices and
the supply curve shifts to the left. Price rises and output falls
Use a diagram to show how regulation can affect supply. In each diagram P1 and Q1 is the
equilibrium price and output in free markets. Q2 is the social optimum level. Regulation can:
aim to increase firms costs of production so
shifting the supply curve shifts to the left. The
price increase to P2 leads to a contraction in
demand with output at Q2 the optimal level

28

Regulation |

set a quota, ie a legal limit on the amount that

can be produced, equal to the optimum level Q2.
The supply curve shifts to S2 and become
perfectly price inelastic

Give examples of regulations used to solve market failures arising from negative externalities
Set legally enforced standards for eg maximum level of air and noise pollution from planes
restrictions over landing slots and number of flights allowed at night
Give examples of regulations used to solve market failures from abuse of market power

Price controls: use a RPI X% formula. If the RPI is 3% and the inflation rate is 2%, then firms
must reduce prices by 1% every year through increased efficiency or lower profit margins.

Define a regulator? A government agency that monitors the performance of firms in an industry
Give an example of a transport regulator. The Office of Rail Regulation (ORR) ensure Network Rail
complies with standards on eg punctuality, productivity, investment for dynamic efficiencies
Explain yardstick competition. Regulators assess the performance of a firm against other similar
firms. Eg he McNulty Report found UK rail industry costs are 30% higher than European railways.
Yardstick competition can introduce comparative competition eg the ORR has set Network Rail a
target of closing this efficiency gap by 2019 to match the performance of European railways.
Describe the benefits of regulation. Regulations

set clear standards for activities to avoid market failure, and the costs of non-compliance
can be introduced quickly and at little cost to the state. Laws can have an instant impact.
Fines give economic agents an incentive to comply and can finance enforcement costs

Describe the difficulties in using regulation to correct market failure. Regulations

incur monitoring and enforcement costs depending on the level of public support
require externalities be easily identified and valued so the optimum level of output can be set.
Does government have accurate and complete information?
needs to set the right standard to change behaviour to optimum levels: difficult to assess
may have unintended consequences eg encourage illegal activity in the shadow economy
may export harmful economic activity to other countries with less stringent regulations
offer no incentive for improvement once standards have been set
may be too expensive, ineffective or lead to unintended consequences causing government
failure ie state intervention increases economic inefficiency in a market
Identify factors that determine the effectiveness of regulations. Regulations work better if
standards are simple and the costs of non-compliance are known, certain and high risk
externalities are easily identified and valued so the optimum level of output can be set
monitoring and enforcement costs are low
measures command public support so reducing enforcement costs
there are no harmful unintended consequences eg black markets
Does regulation always work? Government intervention can lead to government failure if the costs
of regulation are high or regulators act on the basis of imperfect information or forecasts.
What if economic agents ignore regulations? Regulations are legally enforced rules that override
economic agents own preferences. Offenders risk legal action, fines and imprisonment
Why is monitoring important? Monitoring helps ensure compliance ie consumers and firms observe
regulations and meet standards. Law breakers can be prosecuted.
What are the drawbacks of regulations? New laws, regulations or standards usually
increase costs of production causing higher prices or lower profit margins
impose monitoring and enforcement costs and restrict consumer and producer choice
Comment on the London Emission Zone (LEZ). The LEZ covers most of greater London. HGVs are
regulated to help reduce air pollution. To avoid a daily 200 charge, lorries must meet exhaust
emissions standard - Euro IV from 2012. HGV owners register their vehicles. Camera, automatic
number plate recognition and databases are used for monitoring and enforcement

| Regulation

29

Sustainability
What is sustainable development? Sustainable development meets the needs of the present without
compromising the ability of future generations to meet their own needsiv.
How does transport threaten sustainability? Travel generates negative externalities eg pollution
which damages ecosystems and depletes non-renewable resources, eg oil, so reducing the ability of
future generations to meet their own needs
Are all modes of transport equally unsustainable? Car journeys generally generate more negative
externalities per passenger kilometre travelled than public transport by rail and bus. Road freight
transport results in more negative externalities per tonne kilometre than rail. Air travel creates
negative externalities eg noise and air pollution and contributions to climate change
Are all planes, trains or buses equally unsustainable? There is a significant variation in the levels
of sustainability within a given mode eg latest planes Boeing Dreamliner are more fuel efficient and
generate lower emissions than older model planes. This means each flight generates fewer negative
externalities and uses up less non-renewable resources on a given journey.
How can transport infrastructure projects threaten sustainability? A new road means visual
intrusion and the loss of countryside that is now no longer available for present and future
generations to enjoy. Where new roads generate extra traffic, extra negative externalities result
Why is road transport unsustainable? Cars and HGVs burn fuel and so produce CO2 emissions that
damage ecosystems so reducing the ability of future generations to meet their own needs.
Is public transport more sustainable than private car journeys? The mass transit nature of public
transport means lower negative externalities per passenger than the same journey by car assuming
the bus or train has a high loading. This means public transport reduces market failure arising from
over consumption and so improves allocative efficiency. Better use is made of scarce resources.
Are all flights equally polluting? Planes burn most fuel during take-off. Therefore short flights are
disproportionately polluting. Modern planes are more fuel efficient than older models
Do buses generate negative externalities? Buses and coaches are mainly powered by diesel engines
and so contribute to air pollution, particularly in busy city centres. Where privatisation or
deregulation results in more bus services with lower loading, extra negative externalities result
How can integrated transport contribute to sustainability? Convenience affects the demand for a
given mode of transport. Improving the ease with which users can switch between modes, promotes
more use of low polluting public transport over part of a journey previously undertaken solely by car.
What is the aim of integrated transport policy? Integrated transport policy aims to shift travel
from less to more sustainable modes of transport eg a modal switch from road to rail.
List factors blocking a modal shift from private cars to public transport. Modal shift occurs only
where public transport is a close and available substitute for a given journey. The unavailability or
relatively high cost of public transport and poor quality and reliability also inhibits modal shift
What are sustainable transport policies? There are three types: policies which

achieve modal switch eg passengers (or freight) traffic moves away from road to rail
reduce demand for unsustainable modes eg indirect taxes on cars (congestion charging) or air
travel (APD) raise price and so contract demand leading to less use of scarce resources
use policies to reduce negative externalities eg regulations

List potential sustainable transport policy measures. Potential government measures include
indirect taxes equal to external costs eg road pricing and APD. Higher prices reduce quantity
demanded and overconsumption leading to a more allocatively efficient use of resources
public transport subsidies reduces the relative price of trains, etc encouraging modal shift away
from high polluting private cars. Lower pollution improves allocative efficiency
regulations such as higher emission standards reduces output and overconsumption so
improving allocative efficiency
Tradeable permits for CO2 emissions from planes gives high polluting firms an incentive to
reduce emissions. Lower pollution improves allocative efficiency.
30

Sustainability |

UK Transport Industries
Bus Industry
What is the UK bus industry? The UK bus industry has two main submarkets: local bus services and
national services from city to city.
Is the bus industry deregulated? In the 1985 the bus industry outside of London was privatised and
deregulated. Any operator meeting health and safety regulations can now provide a bus route.
Are some routes subsidised? Local governments invite firms tender to run a socially necessary but
unprofitable route and award the contract to the operator requiring the least subsidy.
Outline the main findings of the Competition Commission report on Local Bus Services 2011

There is a high concentration ratio of 69% five firm for local bus services in urban areas
Most urban areas have just one or two operators but this varies in different areas and routes.
The level of demand on many routes is not sufficient to support multiple operators
In many local markets there is limited head-to-head ie direct competition
Passengers take the first bus that arrives so firms compete by varying service levels, not price
In the short run, non-price competition increases supply but results in losses. In the long run
sustained losses force firms to exit the market generally resulting in a monopoly
Incumbent local bus operator may respond to the threat of potential competition by lowering
the prices of network tickets and increasing the quality of their network. Contestability falls.
there are substantial sunk costs in entering the bus market for a given route

What is the likely income elasticity of demand for buses? Many consumers view buses as
unreliable, poor quality inferior good. This means the income elasticity of demand value is negative. If
the YED value for buses is say -2 and 10% rise in income results in a -2x10% = -20% fall in demand
Outline sustainability issues in local buses. A bus service involves mass transport. By moving
passengers out of cars, buses reduce overall negative externalities.
How is franchising used in the bus industry? The regulated London bus market using franchising to
introduce competition: Transport for London (TfL) invites bids for 5 year franchises to operate a given
route with a 2 year extension if performance targets are met.
Summarise the impact of deregulating local buses
Initially deregulation made markets more competitive and contestable
The initial increase in competition led to more frequent services, lower fares and more buses
operating below full capacity increasing air pollution levels in crowded city centres
To cut costs and raise productive efficiency operators introduced small hopper style buses
In the long run, competition results in losses leading to the exit of one operator and a local
monopoly on those routes where demand is insufficient to support more than one operator
Operators with significant economies of scale can use limit pricing to inhibit competition
Outline the factors determining the impact of deregulation. The impact of deregulation

varies from area to area. In some regions the bus market is monopolistically competitive; more
typically the local market is a monopoly
depends on the extent to which other barriers to entry remain eg high set up costs such as a bus
fleet, marketing to establish their brand and ticketing arrangements
the type of bus market eg local or national

Is the bus industry contestable? Deregulation means entrants can challenge incumbents on
individual routes. However barriers to entry and exit have emerged:
Cost: incumbents enjoy economies of scale not open to new entrants. Set up costs are reduced
by leasing, operating older vehicles or small hooper style buses
Branding: Advertising may be necessary to persuade customer to switch loyalty from branded
rivals a significant sunk cost

| Bus Industry

31

Rail Industry
Outline the history of the rail industry. In 1946 the UK rail industry was nationalised and operated
as an integrated public corporation. British Rail owned and run infrastructure and operations.
In 1996 the UK rail industry was privatised and split up into four sections
Infrastructure: Network Rail (NR), owns and operates track, signalling and stations. Revenue
comes from charging TOCs for use of the lines and government subsidies. NR is a natural
monopoly: economies of scale are so substantial that a single firm can produce at lower unit
cost than two or more firms. The McNulty Report 2011 identified an efficiency gap of 30%
between NR and top performing European rail infrastructure firms ie NR unit costs are higher
Passenger Operations: Train Operating Companies (TOCs) are private sector firms that run rail
passenger services, leasing and managing stations from NR. They have typically won a time
limited franchise to supply rail services over given routes to a given standard. TOCs revenue
comes from ticket sales and subsidies. They normally lease trains from ROSCOs. Franchising
introduces periodic competition to join or remain in the industry. The McNulty Report finds
that since privatisation unit costs have shown relatively little improvement and that passenger
fares per passenger-kilometre on average are around 30% higher in GB than in Europe.
Freight Operations: Freight Operating Companies are privatised firms that use the rail network
to transport goods eg coal. They operate without subsidy in a highly competitive market with
intermodal competition from road haulage. The McNulty Report 2011 finds freight unit costs
have fallen by some 30% since privatisation indicating productive efficiency gains
Rolling stock companies (ROSCOs) lease out train carriages thereby lowering set up and sunk
costs and improving contestability
How is franchising used in the rail industry? The Department for Transport (DfT) invites rival train
operating 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.
Why are some rail services subsidised? TOCs require payment if they are to run loss making but
socially necessary services eg on rural routes or late at night
Who regulates the rail industry? The Office of Rail Regulation (ORR) monitors Network Rail to
ensure it manages track efficiently and does not exploit its monopoly power.
Can TOCs set their own fares? TOCs set around half of fares according to market conditions.
Regulated fares, eg season tickets, are set by government using the formula the RPI + 1%.
What is a public service obligation? A public service obligation is the subsidy given to TOCs to
ensure loss making but socially essential services operate eg rural lines and late night services
Does data suggest the UK rail industry is efficient? The McNulty Report (2011) benchmarked the
UK rail industry against their European counterparts and found that states UK rail industry costs are
30 per cent higher than comparable railways elsewhere in Europe.
What are Open Access Operators (OAOs)? Open Access Operators run train services on routes not
served by a franchise. OAOs purchase a slot on the network eg London-Heathrow Express
Is the rail passenger market competitive? TOCs have monopoly rights to supply rail services over
given routes for a period of 15 years. If a potential entrant identifies a new market for train services
not currently served by a franchise, they can apply for open access rights to run those trains.
What is smart ticketing? A single ticket is valid on many modes of transport run by many operators
by more than one operator and, ideally, for more than one mode of transport. Smart ticketing
improves integration and encourages modal shift

32

Rail Industry |

Aviation industry
Outline various airline
submarkets. The aviation
industry is made up of a
number of submarkets.
Each submarket has its own
characterisitcs eg the
factors affecting the
demand for budget airlines
is very different to schedule
flag carriers such as BA.
Outline the main feature of the aviation infrastructure. UK airports are owned and operated by a
private sector companies eg BAA. Air traffic control is provided by National Air Traffic Services (NATS),
a company owned by the government and a group of UK airlines who are the controlling shareholders.
Distinguish between hub and secondary airports. A hub airport is a major airport offering a large
number direct flights to many other airports eg Heathrow. A secondary airport is a minor airport
offering a limited number of direct flights to a small number of other airports eg Luton
Who regulates the aviation industry? In the UK, the Civil Aviation Authority (CAA) responsible for:
Economic regulation eg setting the maximum landing fee airports can charge airlines and
charges per passenger for the use of a terminal.
Airspace policy eg the CAA issues operating licences to airlines to operate a route
Safety regulation and consumer protection.
What are the main challenges facing UK aviation.
Air travel demand at UK airports is forecast to more than double from 228 million passengers
per annum (mppa) in 2005 to 495mppa in 2030 Source: DfT v threatening sustainability
Aviation infrastructure has insufficient capacity to meet the forecasted growth in air flights,
leading to calls for new runways
Air travel generates significant noise and air pollution. Increasing negative externalities means
the government is expecting polluters to pay with higher taxes of flights
Sustainability: CO2 emissions mean more air flights contribute to faster climate change
Why is demand for air travel rising? The demand for flights is a derived demand. Increasing world
economic growth and economic integration means more international passenger travel and movement
of freight. 25% of the UK's visible trade is carried by airvi.
Explain the rapid growth of air travel. Factors include

Increased disposable income from growth means consumers travel more often (short break
holidays) and further (long haul holidays) - especially as air travel is highly income elastic
Falling price of complements eg falling hotel prices and rising price of substitutes eg rail fares
Low cost airlines have emerged increasing supply and so extending demand
Globalisation results in more business trips and air freight

Who dominated air passenger transport in the 1990s? Nations negotiate bilateral (two way
agreement) landing rights for a fixed number of flights by flag carriers creating legal barriers to entry
Distinguish between budget and premium carriers. Premium carriers eg BA operates scheduled
flights from hub airports charging premium prices. Budget airlines such as easyJet are called low cost
carrier (LCC) or no-frills carrier and operate from regional airports
State the characteristics of LCCs. LCCS offer an undifferentiated service on-board ie one standard
class; high density seating; no frills eg free drinks; frequent yer schemes
Outline the impact of deregulated air travel. Deregulation of the EU airline market in the 1990s has
removed a legal barrier to entry. Any carriers from any member State can y on any route throughout
the EU and set its own deregulated prices.
How have LCCs affected competition? LCCs have increased competition in the short haul, budget and
leisure segments resulting in lower fares, new destinations and greater frequency on popular routes.
| Aviation industry

33

Explain open skies policy. An open skies policy deregulates international air travel. In its ideal form
legal restrictions on routes, prices and frequencies, capacity, or types of aircraft are abolished. An open
skies policy increases contestability and competition between airlines, resulting in lower fares, new
destinations and more flight frequency
What are airline alliances? Alliances are an agreement between two or more airlines to cooperate.
How do airline alliances affect costs? Shared operations and maintenance result in economies of
scale which if passed on to consumers lead to lower fares. Productive efficiency improves.
How do airline alliances affect competition? Alliances create barriers to entry. The convenience of
airline alliances encourages consumers to use the members rather than competitors. Rival airlines
cooperate rather than compete of routes leading to potentially higher fares and less frequent services.
Is aviation a contestable market? This depends on the route and sub market. Barriers include
Government regulations eg bilateral treaties (Air Services Agreements) can restrict entry
The high entry cost of acquiring a fleet of planes, landing slots and promotion costs to establish
market brand are deterrents to entry.
Significant economies of scale enjoyed by incumbents
Increasing alliances between national flag carriers restrict non-member new entrants
On exit firms may not recover fees paid for landing slots. Marketing costs are irrecoverable.
These high sunk costs reduces contestability on the given route
How can operators reduce the impact of air flights on the environment? Airlines can
Use larger planes to carry the same number of passengers in fewer flights
Introduce latest aircraft utilising fuel conserving and noise reducing green technologies while
phasing out old fuel inefficient planes
Improve air traffic control management so fewer planes are in holding stacks waiting to land
What is Air Passenger Duty? Air Passenger Duty (APD) is an indirect tax paid by consumers. The aim
is to make polluters pay and force passengers to internalise their externalities
How can Air Passenger Duty reduce negative externalities from air transport? Air Passenger
Duty (APD) is an indirect tax on passengers flying from UK airports, based on distance travelled.
Critics argue APD takes no account of the efficiency of planes passengers using latest aircraft with
green technologies are taxed at the same rate those using older planes for identical trips.
Why is aviation infrastructure stretched? In the UK and Europe, the supply of airspace and landing
slots at major cities is limited. Increased demand means hub airports lack the capacity to handle the
projected number of flights. Eg in 2013 Heathrow is operating at 98% capacity. The current Coalition
Government has ruled out a third runway or any further increase in capacity in the South East
How can government mange restricted airport capacity?

building new runways especially around London eg at Stansted and/or Heathrow

making better use of existing capacity eg allowing night flights for stretched airports
reducing demand eg by taxing flights eg Air Passenger Duty

Outline the trade-off between growth and sustainability. Heathrow is the worlds largest airport in
terms of passenger number. Its role as a major international hub generates income, employment and
tax revenues but also significant negative externalities eg noise and air pollution.

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Aviation industry |

Freight industry
Define freight transport. The carriage of goods between an origin and a destination
What are the main modes of transport for freight? The freight industry is made up of privately
owned rail freight operating companies and road hauliers.
List the characteristics of freight transport
The demand for freight is a derived demand. Customer demand can vary at short notice.
Road haulage dominates freight transport in terms of volumes and value carried
International freight passes through UK ports, airports, or the Channel Tunnel
The fixed route rail network means the XED for rail transport with respect to the price of road
haulage is usually low and positive ie they are weak substitutes
Outline the characteristics of UK road haulage industry. Barriers to entry for local road haulage
are low. Small firms can enter local markets that are competitive with low profit margins.
At a national level, economies of scale mean road haulage is oligopolistic. Firms like DHL and TLT
maintain a fleet of lorries and depots carrying out contract logistics for manufacturers. High set up
costs for fleets of lorries and IT systems mean high barriers to entry
Define contract logistics. Manufacturers outsource of transport and distribution activities
Why move goods by rail? Moving bulk goods such as coal by rail also generates less negative
externalities than by road, especially over long distances
List the challenges facing rail freight operators. The Dept for Transport has responsibility for rail
freight in England. Network Rail decides which services can operate on a given route.
Freight and passenger trains operate on the same lines. Growth in both freight and passenger
markets has put increased pressure on network capacity resulting in peaking
Restricted rail capacity over some core UK freight routes causes peaking, If Network Rail
denies FOCs access to track, they are unable to deliver goods for its customers.
What are the likely effects on freight operators of a rise in operating costs? Increased operating
costs leads to a fall in supply. These cost increases may be passed on to other firms who may increase
the price of their products to customers or accept lower profits generating inflationary pressure.
How can government make freight transport more sustainable? Measures include:
improving information eg the DTIs Freight Best Practice web site
encouraging a switch from road to rail transport for the carriage of goods
allowing larger lorries to operate resulting in fewer journeys. One large lorry can carry more
freight than several small lorries. The amount of journeys, congestion and C02 emissions falls.
improving loading by reducing the numbers of partially laden vehicles Eg encourage firms to
make better use of spare capacity on the return leg of a delivery.
Offering advice on reducing fuel consumption by using routing software, driver training, etc
Tax incentives for using more environment friendly lorries eg lower VED
Has freight privatisation benefited the economy? Freight operators operate without subsidy in a
highly competitive market with intermodal competition from road haulage. The McNulty Report finds
freight unit costs fell by some 30% since privatisation denoting productive efficiency gains

| Freight industry

35

Transport policies
Resource allocation and Government Transport Policy
What is a transport policy? A transport policy is a plan of action to achieve set objectives eg reducing
road congestion, encouraging sustainable transport; improving the economic efficiency of rail
How is the success of policy assessed? Policies such as road pricing, bus subsidies, franchising,
deregulation and privatisation are effective if the lead to
improved productive, allocative and dynamic efficiency
lower fares, increased in passengers and freight increasing consumer surplus
improved safety, punctuality, and sustainability eg reduced levels of negative externalities
How are resources allocated in transport? Privatisation means most transport operation resource
decisions are taken by the private sector. Infrastructure investment decisions are mainly taken by state
What is the impact of infrastructure projects? New roads, airports, etc
alter the relative cost of travel and so influences modal choices, traffic volumes, patterns of
land use, business location and the operation of labour markets.
Generate positive externalities eg new roads open up market and employment opportunities to
the benefit of third parties such as local businesses and workers.
Create regional multiplier effect: Investment in local transport infrastructure can be an initial
stimulus to regional economic development and generate a multiplier effect.
Give examples of transport investment. Capital items such as roads and rail networks, airports and
buses, rolling stock (trains) and aircraft are examples of transport investment
What are Public Private Partnerships? Public Private Partnerships (PPPs) are joint ventures
between private sector firms and government to finance build and operate infrastructure projects.
Give an example of a PPP in transport. A private sector firm financed, built and now operates the
M6 Toll motorway in return for the right to collect tolls from users until 2054.
What are the arguments for the PPP investment schemes? Private sector involvement means

Extra infrastructure is built. PPP schemes mean new transport infrastructure without state
borrowing or diverting expenditure from other areas of public spending such as education.

better use of scare resources. Profit maximising private sector firms have more
incentive to eliminate x-inefficiency than the public sector Eg penalty clauses act as an
incentive for firms to finish projects on time and within budget.

What are arguments against PPP investment schemes? Critics argue private sector firms in PPP:
make excessive supernormal profits operating infrastructure for each year of long contracts
can cease trading leaving government ultimate responsibility for operating projects
What is investment appraisal? Investment appraisal is the process of assessing the appropriateness
of a project eg a new road
How do private sector firms assess investment projects? Firms compare expected revenue with
expected costs. Generally, projects with the highest profitability are prioritised for investment. Unlike
public sector decisions, impacts on third parties are not considered in the appraisal process.
How does the public sector assess investment projects? By using investment appraisal techniques
which take account of externalities to identify social costs and benefits eg a Cost Benefit CBA, COBA
and new techniques such as Appraisal Summary Tables
Give an example of a failed PPP. Metronet won a 15.7Bn contract in 2003 to upgrade most of the
London Underground Tube network. Unexpected cost overruns saw Metronet go into administration
in 2007. A public sector corporation, Transport for London, now operates the tube. This means PPP do
not always transfer risk from government to the public sector.

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Resource allocation and Government Transport Policy |

Cost benefit analysis

What is Cost Benefit Analysis (CBA)? CBA is a decision making tool which compares the social costs
and social benefits of a project, over time, to establish a net present value.
Outline the steps economists take when producing a CBA. Analysts
identify private and external costs and benefits created by the project
make value judgments and decide which externalities to include or exclude.
attach a monetary value to selected costs and benefits
but attaching money values to a projects costs and benefits is difficult eg how can economists:
o value externalities (eg noise) which have no market? Shadow pricing, revealed
preference or compensation can be used to value spillover effects on third parties
o place a present value on future costs and benefits generated by the project over its
working life? Solution: economists select a discount rate which they use to discount
(value) the present value of future net social benefits. This process is called discounting
o account for uncertainty in forecasted future usage? Solution: sensitivity analysis
The outcome of a CBA is a single monetary value for the net social benefit (NSB) of a project ie
its net present value (NPV). A positive NPV means that the overall social benefits of the
project exceed its social costs and the project is worthwhile
A CBA states a road project has a present net value of 25m. What does this mean? The value
today of all future benefits, less costs, over the life of the road (say 60 years) is 25m
How do analysts decide which externalities to include in a CBA? Economists use value judgments
to decide which external costs and benefits to include or exclude in the CBA
How are externalities valued in a CBA? Value judgments are made about which method to adopt (eg
compensation) or what shadow price to use eg is the average wage for valuing congestion 12 or 10
How are forecasts used in CBA? Forecasts of future usage are used to value future costs and benefits
What is discounting? A statistical technique to establish the present value of a future benefit or cost.
What is a discount rate? A discount rate is the interest rate used to establish the current present
value of future stream of costs or benefits generated over time by a project eg 60 years for a road.
What is net present value? Net present value is the value, today, of a stream of future benefits or
costs over the life of the project, discounted at a given interest rate (the discount rate).
Why is the discount rate important? The discount rate chosen affects present value. Eg the present
value of 100 in 10 years time is 55.84 if discounted at 6% but only 38.55 if discounted at 10%
What is sensitivity analysis? CBA are based on forecasts. Future economic conditions are uncertain.
Sensitivity analysis involves creating a range of NPV values based on likely, best-case and worst case
assumptions and forecasts eg by how much NPV change if 10,000 or 50,000 cars use a new road
How can CBA help government allocate resources? Decision makers can use CBA to identify
projects with a positive NPV which are worth undertaking because social benefits exceed social costs.
CBA can also help prioritise projects - undertake those with the highest NPV. Eg if the PDV for a new
bridge is +20m and a new tunnel is +30m, then the tunnel is selected because it has a higher NPV.
What is a benefit cost ratio (BCR)? BCR is the ratio of a projects present value benefits to its present
value costs. Eg a BCR of 7:1 means every 1 invested in this project yields 7 of net social benefit. BCRs
can be used to prioritise projects undertake those projects with the highest positive BCR.
Explain problems in undertaking a CBA. Analysts must make a value judgement and decide eg
which benefits and costs to include or exclude; what shadow price to attach to externalities; what
discount rate to use: increasing the discount rate lowers the PDV for a given future net benefit.
Forecasts of future costs and benefits for a project need up-to-date and reliable data

| Cost benefit analysis

37

COBA
What is COBA? COBA (COst Benefit Analysis) is a decision making tool used by central government to
establish the net present value of a new road or road improvement scheme ie a type of CBA
Outline COBA methodology.
assumes a proposed road scheme has a working life
of 60 years
estimate the difference between what the situation
in the study area would be with (Do Something) and
without (Do Minimum) the road scheme.
estimates the monetary value of benefits (called
user cost changes) of the road scheme
estimates the total costs ie initial construction costs
and annual maintenance costs.
Uses discounting to establish present values of
benefits and costs
60 years of net benefits are discounted at a 6%
discount rate to establish net present value
What are user cost changes in COBA. COBA uses the
term user cost changes to describe the user benefits of a
road improvement scheme. User cost changes are the
monetary savings enjoyed by users of the improved highway eg from reduced journey times
List the benefits measured by COBA. A new or improved road usually causes:
time cost savings from reduced travel times for commuters, freight operators, etc.
vehicle operating cost savings as less congestion means less fuel consumption
accident costs savings from a reduction in the number and severity of accidents and lower damage
to property, insurance administration, and police time costs involved
How does COBA value time savings? COBA estimates an average money value of time for travelling
for work, commuting or non-work purposes. Average wages value work time while a lower figure is
used those commuting or travelling for non-work reasons. Eg for COBA the value of time per occupant
of a car, in working time, is 2.18 per hourvii.
How are vehicle operating cost savings calculated? COBA places an estimated monetary value on
the cost savings to users from the scheme eg using less fuel because of less congestion.
What are the issues involved in valuing accidents? The total cost of accidents on a road network is
calculated by multiplying the number of predicted accidents on the network by the cost per accident.
Not all accidents are equally serious. Accidents can result in damage to property, slight injury or death.
How can COBA be used to decide between competing projects? Given limited resources road
improvements with the highest positive net present value are undertaken first.
What is an appraisal? An appraisal is an assessment of a project undertaken at the planning stage
Outline New Approach to Road Appraisal (NARA) NARA is a decision making tool which estimates a
projects economic and environmental impact using an Appraisal Summary Table (AST)
What are Appraisal Summary Tables? An Appraisal Summary Tables (AST) is a one page tabular
summary assessing the impacts of a given transport project on five areas: the environment, safety,
economy, accessibility and integration. COBA is just one an element in a broader AST appraisal
process. AST assesse environmental impacts qualitatively eg a new road
Why is NARA needed? COBA is a narrowly focussed form of CBA which only assesses the safety and
economic impacts of projects to direct users of a road scheme. NARA is more comprehensive taking
into account other impacts eg environmental. COBA monetary valuations are used in ASTs alongside
qualitative indicators eg impact on biodiversity are summarised as moderate/slight/large; adverse or
beneficial or neutral

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COBA |

Integrated transport policy

What is integrated transport? Journeys often involve switching from one mode of transport and
another. Integrated transport occurs when where passengers and freight can easily switch between
different modes of transport over a given journey.
Define integrated transport. Integrated transport occurs when different modes of transport work
increasingly more effectively and efficiently together. Inter-modal travel is encouraged
How are transport modes interlinked? Transport modes are interlinked eg motorists arriving at a
park-and-ride need a bus to continue their journey to a town centre or railway station.
Give an example of integration. A car driver arrives at an out of town park-and-ride and quickly
catches a bus to the city centre rail station in time for a waiting train. Taxis are readily available for
journeys to and from rail stations.
What is an integrated transport policy? A government action plan to link two modes of transport.
What are the benefits of integrated transport? Coordinated intermodal journeys:

reduces journey times and lowers the cost of travelling for households and firms
switches demand from private transport to mass public transport so there will be less negative
externalities

How can transport be made more integrated? Integrating modes of transport requires better
coordination of the transport network through
better information systems eg signs at bus stops stating expected arrival time
coordinated timetables eg trains leave after and not before a scheduled bus arrival
improved ticketing arrangements eg the ability to buy one ticket, online, for a train journey
using several train operators
better interchanges well situated park and ride schemes with large enough car parks to meet
demand, cafes and covered bus stops
give public transport priority access to roads in urban areas at peak times eg bus lanes
How does smart ticketing enable integrated transport? Smart ticketing makes it easier for
consumers to switch between different modes of transport, eg bus rail and tube, for one journey.
Simplifying the purchase of tickets increases the demand for public transport.
Why does integrated transport require government action? Only the government has the ability to
ensure transport services are coordinated by
passing legislation requiring train and bus operators to coordinate their timetables
investing in infrastructure eg park and ride and roadside information screens.

| Integrated transport policy

39

International road schemes

Outline the Singapore experience Singapore is a small island that uses coordinated transport polices
to reduce congestion:
A 10-year license permits to own a car is sold at monthly auctions in limited numbers at up to
$75,000. Sales tax and import duty are double the price of a car. The fixed cost of putting a car
on the road is almost $200,000
Introduced in 1997 electronic road pricing (ERP) charges motorists a variable toll by time of
day and type of vehicle according to the level of congestion and to maintain traffic speeds.
Cars are fitted with a radio unit holding a pre-paid debit card. Cars pass under overhead
gantries that deduct charges direct from the motorist. As tolls vary with congestion levels,
tariffs more accurately reflect the marginal external costs of a trip.
Subsidised buses and extensive railway network that covers much of the 25-mile-long island
offers substitutes for cars.
Traffic control: police use closed-circuit television to coordinate traffic lights and manage
traffic flows
Outline the Greece experience. Athens has tried:
Closing the city centre to cars for 2 1/2 hours to encourage Greeks to try public transport. The
resulting traffic jams increased carbon monoxide level by 50%.
Alternate-plate driving days, whereby cars are allowed in every other day depending on the
last digit of their license number. Car ownership actually rose: drivers bought a second car
with different plates so that they could drive every day.
Outline the Melbourne experience Melbourne, Australia's opened a 22 kilometre privatelyoperated, electronic City Link toll road in 2002. Toll booths have overhead cameras gantries reading
pre-paid e-tags fixed to windscreen. The system uses similar vehicle identification technology to the
London scheme.
What is the Germany Lorry Toll Scheme? Germany has successfully introduced a distance-based
road GPS toll scheme for lorries. In 2005 lorries over 12 tonnes began to pay between 0.09 and 0.14
for each kilometre of road travelled on Germany's autobahn (motorway) network. The tax charged
depends on the lorrys emission levels and number of axles. The charge is calculated via an on board
unit and satellite tracking system.
The German governments objective in introducing the lorry road pricing scheme is
make the user pay - road wear from a 40 tonne HGV is up to 60,000 times higher than a car.
To introduce fairer competition for freight encourage operators to move traffic from road to
rail or inland waterway.
To generate additional revenue for upgrading of transport infrastructure in Germany.
Early results show an improvement in haulage load per vehicle and the number of empty trips is down
by six per cent. There has been a six per cent shift to rail from freight transport. Some lorries are
diverting off autobahns onto other roads to avoid paying the charge.

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International road schemes |

A2 Transport Economics Glossary

Agent-principal: the relationship between a
principal (owners) and an agent of the principal
(eg managers)
Airline alliances: An agreement between two
or more airlines to cooperate. Used by scheduled
airlines to increase their reach eg codesharing
Allocative efficiency: scarce resources are used
in a way that maximises consumer satisfaction
Allocatively efficient output: the level of
output where MSB = MSC ie the socially
optimum output level
Appraisal: an assessment ofa project
undertaken at the planning stage
Average cost: The cost of making one item
sometimes called unit cost; cost per unit of
output
Average fixed cost: total fixed costs of
production divided by the quantity produced;
unit fixed cost
Average revenue: the amount a firm receives
per unit sold - another name for price
Barriers to entry: obstacles preventing or
restricting firms entering a market
Barriers to exit: obstacles that restrict existing
firms from leaving a market eg sunk costs
Behavioural economics: a branch of economics
that studies the impact of psychological and
social factors on economic decision making.
Benefit cost ratio (BCR): the ratio of the
benefits of a project expressed in monetary
terms, relative to its costs
Billion: billion denotes 1,000 million ie
1,000,000,000
Capacity utilisation: the proportion of current
resources used; the extent to which resources
are used: eg operating at 80% capacity means
20% of resources are unused
Carbotage: the transport of passengers or
freight within country by a means of transport
eg plane registered in another country
Cartel: when a group of rival firms join together
to take common action eg agree prices, market
share or exchange information on costs
Ceterus paribus: a Latin phrase meaning 'all
other things (influences) being equal'
Civil Aviation Authority (CAA): the UK's
aviation regulator
COBA: a decision making tool used by central
government to establish the net present value of
a new road or road improvement scheme
Codesharing: two airlines share the same flight
and sell tickets in their own name

Collusion: when rival producers decide to act

together rather than compete
Competition: when rival firms contend for
customers
Competition Commission: an independent
public body which investigates situations where
firms may exploit market power
Competition policy: government action to
promote rivalry between firms and reduce
abuse of market power eg banning cartels or
blocking mergers
Competitive market: a market made up of
many rival firms who are free to enter or leave
the industry
Concentration ratio: measures the percentage
of total market held by of the largest firms in the
industry eg the top 4
Congestion: when demand exceeds supply on a
given network at a given period in time eg bank
holiday on holiday routes
Congestion charging: A direct charge for use of
roads in a defined zone eg central London
Consumer sovereignty: buyers ultimately
determine what is produced and how scarce
resources are used by means of their purchases
Contestability: the extent to which firms can
enter or leave a market without cost
Contestable market: a market that has no
barriers to entry or exit and a pool of potential
entrants
Contract logistics: manufacturers outsource of
transport and distribution activities
Cost benefit analysis: a decision making tool
which compares the social costs and social
benefits of a project over time
Costs: expenses of production; a payment
incurred by a firm in producing a good or a
service; monetary value of inputs used in
production
Cross elasticity of demand: the responsiveness
of demand for one product to a change in the
price of another product
Cross-subsidisation: an internal subsidy where
a firm uses profits from one activity to reduce
the price of another product
Deadweight loss: an estimate of allocative
inefficiency from market failure
Demand for transport: the number of journeys
consumers or firms are willing and able to
purchase at various prices in a given time period
Demerit good: products that have less private
benefits than consumers may recognise because
of imperfect information
| International road schemes

41

Deregulation: the removal of legally enforced

rules that restrict or ban specified activities.
Derived: got from or obtained from something
else
Derived demand: demand for a particular
product depends on the demand for another
product or activity
Discounting: a mathematical technique that
establishes the present value of a future cost or
benefit
Diseconomies of scale: higher unit costs from
increasing the size of operation; a rise in long
run average costs from increases in the scale of
production
Disequilibrium: a situation where there is a
state of imbalance and so a tendency for change
Distribution: (1) the share of (eg total income)
received by different groups (2) the methods
used to get products from the manufacturer to
the end consumer
Dominant monopoly: A firm with 40% or
higher market share
Dynamic efficiency: improved economic
efficiency over time
Economic activity: the production or
consumption of goods and services
Economic agents: decision makers eg
consumers and producers
Economic efficiency: occurs when best use is
made of scarce resources; when both productive
and allocative efficiency are achieved
Economic inefficiency: when resources are not
being put to best possible because either
allocative or productive efficiency is not
achieved
Economies of scale: benefits, in the form of
lower unit costs, from increasing the size of
operation; a fall in long run average costs from
increases in the scale of production
Efficiency: making the best use of scarce
resources
Efficiency maximisation: when a firm selects
the level of output and price that delivers
allocative efficiency by producing where P=MC
(marginal cost pricing)
Elastic: a variable (eg demand) is responsive to
a change in a second variable (eg price)
Elasticity: a measure of the extent to which one
variable (eg demand) responds to a change in a
second variable (eg price)
Enterprise: the willingness to take business
risks and organise production
Entrant firm: a business seeking to join a
market and compete with incumbents

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International road schemes |

Entrepreneur: the individual who bears the

risk of business by organising land labour and
capital to produce output
Equilibrium: a state of balance
Equity: fairness; a view on the rightness of an
issue based on opinion rather than fact requires a value judgement
Evaluation: a retrospective (ex post)
assessment after a scheme has started to
operate
External benefits: the gain a consumer or
producers economic activity creates for others
External costs: the cost a consumer or
producers economic activity imposes on others
External diseconomies of scale: the
disadvantages to a firm, in the form of higher
unit costs, from being part of a growing industry
Externality: the spill over effects of economic
activity on others not directly involved in
production or consumption of the product
Extrapolation: taking existing trends and
projecting into the future
Firm: an organisation that hires and manages
resources to make products; a decision making
business unit
Fixed costs: expenses of production
independent of the level of output; costs that do
not change in the short run as output levels are
varied
Flexible pricing: a firm varies price by
customer to maximise revenue. Used in first
degree price discrimination.
Forecast: a statement of what is expected to
happen in the future
Franchise (transport): a firm wins a contract
to operate a service on a given route, to a given
standard, for given period of time
Freight transport: the carriage of goods
between an origin and a destination
Fundamentals: the main or most important
features
Game theory: a theory that predicts decision
making in situations where economic agents are
influenced by the actions and reactions of others
Globalisation: the process of creating ever
closer links between national economies
Goods: tangible, physical products eg cars and
computers
Government: the body that passes, monitors
and enforces laws, collects taxes to finance
public expenditure, and intervenes in markets to
influence the behaviour of economic agents
Government failure: state intervention
increases economic inefficiency in a market

Gross Domestic Product (GDP): the total value

of goods and services produced in an economy
in a time period
Growth maximisation: the firm's objective to
increase its size
HGV: heavy goods vehicle; a lorry
Hit and run competition: firms enter a market
offering supernormal profits and withdraw if
profits disappear
Holding stacks: aircraft circling until space is
available at an airport for them to land
Hub airport: a major airport offering a large
number of direct flights to many other airports
eg Heathrow
Hypothecation: the ring fencing of taxes to
finance spending in a particular area taxed eg
the use of congestion charges to subsidise public
transport
Income elasticity of demand: the
responsiveness of demand to a change in income
Incumbent firm: a business already operating
in a market
Independent goods: two products that have no
price-quantity demanded relationship: XED=0
Indirect tax: a compulsory charge imposed by
the government on the sale of goods or services
ie taxes on spending.
Industry: all those firms producing the same
product
Inefficiency: when the best use of resources is
not being made
Inelastic: a variable (eg demand) is
unresponsive to a change in a second variable
(eg price)
Inferior good: products for which an increase in
income leads to a decrease in the demand for
that item
Information failure: occurs when limited data
means consumers or producers make different
decisions than if they had full information
Infrastructure: the stock of physical capital
used to support the economic system eg
transport and telecommunications networks;
energy, power and water supplies networks
Innovation: technology advances lead to new or
improved products, or processes that raise
productivity ans so reduce unit cost
Integrated transport: when different modes of
transport work increasingly more effectively
and efficiently together to create an easier
travelling experience for the traveller
Integrated transport policy: a government
action plan to link two modes of transport
Interchange: the location where different
modes of transport meet

Interdependent: when economic agents are

interlinked eg trading partners become mutually
dependent on one another for products
Intermediate output: items sold to firms and
used to make products eg components and raw
materials
Internal diseconomies of scale: the
disadvantages to the firm, in the form of higher
unit costs, from increasing the size of operation
Internal economies of scale: the benefits to the
firm, in the form of lower unit costs, from
increasing their size of operation
International competitiveness: the ability of
firms in an economy to match the price and
quality of other nations output
Kaldor-Hicks criterion: a project is worth
undertaking if winners could, in theory,
compensate losers
Labour: the quantity and quality of human
resources available in an economy
Laissez faire: a view opposing state
intervention in free markets beyond protecting
property rights and ensuring law and order
Land: the quantity and quality of natural
resources available in an economy
Limit pricing: when firms set a low price to
discourage rivals entering a market
Load factor: the percentage of capacity utilised
in a journey. Eg a loading factor of 80% means
20% of seats or space is unused in a journey
Logistics: the management of the flow and
storage of materials from point of origin to point
of consumption
Long run: the time period when firms can adjust
all factors used in production, ie both labour and
capital, and enter or leave an industry
Long run average cost curve: shows the
minimum unit cost of producing each level of
output for each scale of operation of the firm
Loss: when total revenue fails to cover total
costs
Marginal: the extra one or the next unit
Marginal benefit: the gain from consuming one
extra item
Marginal cost: the expense of making one extra
item
Marginal private benefit: the additional
benefits received by those consuming or
producing one extra product
Marginal returns: the extra output from a one
unit increase in a variable inputs (eg labour)
while other inputs (eg capital) are held constant
Marginal revenue: the income earned from
selling one extra item

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43

Market: any place where buyers and sellers get

together to trade and exchange products eg a
shop or the internet
Market clearing price: the one price which
leaves neither unsold products nor unsatisfied
demand ie equilibrium price
Market failure: when free markets make an
inefficient use of scarce resources by failing to
deliver allocative or productive efficiency
Market mechanism: price movements act as a
signal to consumers and producers to change
their economic activity
Market power: the ability of the firm to
influence market price by varying its own output
Market share: the proportion of total market
sales held by a firm expressed as a percentage
Market structure: the characteristics of a
market eg number size and strength of firms and
buyers and barriers to entry and exit
Maximum price: when government sets a price
ceiling market price cannot exceed
Merger: two businesses combine to form one
new organisation
Microeconomics: studies how individual firms
and consumers behave in individual markets
Minimum efficient scale: the level of output
where all potential internal economies of scale
have been exploited. The firm is producing at
lowest possible long run unit cost
Mixed goods: products that have the
characteristics of both private and public goods
Modal shift: when passengers or freight switch
from one form of transport to another for a
particular journey eg from car to train
Mode of transport: a method of transferring
passengers and freight from one destination to
another
Model: a simplified view of complex
relationships and processes, used to explain
economic activity and predict behaviour
Monopolistic competition: a market structure
with few barriers to entry where many firms
produce differentiated products
Monopoly: a single firm in an industry
Nationalisation: the transfer of ownership of a
firm from the private to public sector
Natural monopoly: occurs when economies of
scale are so substantial that a single firm can
produce output at lower unit cost than two or
more firms
Negative externalities: occurs when
production or consumption imposes costs on
third parties; when the social cost on an
economic activity is greater than the private cost

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Net present value: the value today of a stream

of future benefits or costs over the life of the
project, discounted at a given interest rate (the
discount rate)
Normal profit: the minimum amount that must
be received to keep a firm in its current industry.
A cost of production
Normative statements: statements of opinion
which cannot be proved or disproved through
testing
Objective: the aim of an economic agent eg
firms can aim to maximise profits
Off peak pricing: charging lower prices outside
periods of intensive use
Office of Fair Trading: a government agency
responsible UK competition policy ie making
markets work well for consumers
Oligopoly: a market structure dominated by a
few large firms
Open skies policy: an agreement between two
countries to extend unrestricted landing rights
at each other's airports to each other's airlines
Opportunity cost: the best alternative
sacrificed when a choice is made
Optimum output: an efficient level of output
which delivers both productive and allocative
efficiency
Pareto efficiency: when resources cannot be
reallocated without making someone else worse
off
Passenger kilometre: found by multiplying the
distance travelled by the number of people in
the vehicle
Pay off matrix: a table summarising the impact
on two firms profit of a pricing decision
Peaking: occurs when demand exceeds supply
on a given network at a given time causing
congestion eg rush hours and bank holidays
Perfect competition: a market structure with
no barriers to entry where many firms produce
identical products
Policy: a plan of action designed to achieve set
objectives
Polluter pays principle: economic agents
creating negative externality should pay for
damage done
Positive externalities: occur when production
or consumption create external benefits for
third parties; when the social benefit of on an
economic activity exceeds the private benefit
Positive statements: statements of fact which
can be proved or disproved through testing
Predict and build: Traffic levels are forecast
and new capacity is added to match projected

future passenger and freight levels to avoid

future congestion
Price discrimination: firm sell the same
product at different prices in different sub
markets, even though costs are identical
Price elasticity of demand: the responsiveness
of quantity demand to a change in the price of
the product
Price elasticity of supply: the responsiveness
of supply to a change in the price of the product
Price leadership: a dominant firm sets market
price and rivals follow its price changes
Price mechanism: the means by which
decisions of consumers and producers interact
to determine the allocation of resources through
the forces of supply and demand
Price rigidity: the situation where the price of a
product rarely changes
Price system: the means by which decisions of
consumers and producers interact to determine
the allocation of resources through the forces of
supply and demand
Private benefits: the benefits received by those
consuming or producing a product
Private costs: the costs incurred by those
consuming or producing a product
Private finance initiative: a method of
financing public private partnerships (PPP)
Private goods: products which are both rival
and excludable
Private sector: that part of the economy made
up of households and firms controlled by private
individuals
Private transport: when people use their own
vehicles to travel
Privatisation: the transfer of ownership of a
firm from the public to private sector
Producer surplus: the difference between the
market price and the price that producers are
willing to accept
Product differentiation: the processes of
making a firms product look distinct from the
output of competitors. Usually achieved through
branding and advertising
Productive efficiency: when output is
maximised from given inputs. This means
products are made a lowest possible unit cost.
MC = AC
Productivity: the amount of output created per
unit input of used
Products: goods or services
Profit: the surplus left over from total revenue
once a firm's total costs are paid

Profit maximisation: when a firm selects the

level of output and price to gain the most profit
possible by producing where MC=MR
Public goods: products which are both nonrival and non-excludable
Public private partnerships: joint ventures
between private sector firms and government to
finance build and operate infrastructure
projects.
Public sector: that part of the economy made
up central government local government, and
public corporations
Public transport: any form of transport not
owned by the traveller eg trains and buses
Quasi-public good: goods which are nearly but
not fully public ie almost non-rival and almost
non-excludable
Red tape: official rules and procedures causing
time delay and increased transaction costs
Regulation: laws that ban or restrict specified
activities
Regulatory barriers: government regulations
that restrict the ability of firms to enter a market
eg an operating licence
Renewable resources: natural resources such
as wind power which automatically replace
themselves
Research and development (R&D): the
process of applying new scientific and
technological ideas to improve products and
processes
Resources: items used to produce goods and
services eg land, labour and capital
Revenue: the amount of money a firm receives
from the sale of its output; receipts from sales
Risk: the possibility of difficulty or loss from a
business activity
Road pricing: a direct charge to road users for
their use of a particular road eg a motorway toll
Royal Commission of Environmental
Pollution: an independent standing body that
advises the Government and the public on
environmental issues including transport
Satisficing: In setting objectives managers
balance the conflicting views of stakeholders
and seek acceptable compromise outcomes. No
one target is maximised.
Scale of production: the level of output
achieved by a firm - determined by the amount
of capital and labour employed
Secondary airport: a minor airport offering a
limited number of direct flights to a small
number of other airports eg Luton

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45

Semi fixed costs: costs that are fixed for a given

level of activity but increase if an operator
decides to supply an additional service
Services: non-physical, intangible products such
as banking and education
Shadow price: an estimated monetary value on
outcomes that have no market price eg
externalities
Shadow prices: The estimated price of a
product which has no market and so no market
price eg noise pollution
Short run: the period of time when the quantity
of one factor of production, usually labour, is
fixed
Social benefits: the total gain to society of a
given economic activity taking account of both
private benefits and positive externalities
Social costs: the total cost to society of a given
economic activity
Social exclusion: low income groups are denied
access to goods and services normally available
to members of society eg healthcare
Social optimal output: the level of output
which is allocatively efficient
Social responsibility: the obligation a business
has to consider the interests of its stakeholders
Sovereign default: when a government misses
interest or principal payments due on its
national debt
Stakeholder: a group who have an interest in
the activity of a firm eg shareholders, managers,
staff, customers, government and local
communities
Stakeholder conflict: when different
stakeholders have conflicting objectives
Standards: required levels of behaviour from
economic agents enforced by law eg a ban on flytipping; minimum legal requirements for a given
economic activity
State provision: governments directly supply
goods and services eg state run schools and
hosptials
Static efficiency: best use of scarce resources at
a given moment in time
Static efficiency: efficiency occurring in a single
time period ie efficiency now
Stock: stored goods held ready for future use or
sale ie inventory; an amount at a given moment
in time
Sub market: a market segment (part of the
market) made up of customers with similar
wants eg the computer market has desktop and
notebook submarkets
Subsidy: a direct payment from the government
to encourage production or consumption
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International road schemes |

Substitutes: alternative products consumers

can buy to satisfy a given need eg butter or
margarine. Products in competitive demand.
Substitution effect: A price fall encourages
consumers to buy more of a relatively lower
priced product and less of a higher priced
substitute.
Sunk costs: costs that cannot be recovered if a
firm leaves an industry
Supernormal profit: any extra profit made in
excess of normal profit. Firms earn supernormal
profits when total revenue exceeds total cost.
Supplier: a firm which sells products
Supply: the amount of a product firms are
willing and able to provide at different market
prices in a given time period, eg one month
Supply chain: the network of manufacturers,
distributors and retailers involved in the
production, delivery and sale of products to
consumers
Sustainability: meeting the needs of the present
without compromising the ability of future
generations to meet their own needs ie capacity
for continuance
Tacit collusion: An unspoken agreement to
avoid competitive behaviour eg all firms match
the price set by the market leader
Takeover: the purchase of one business by
another. Also called an acquisition
Technology: the application of knowledge to
production
Tertiary sector: the part of the economy that
creates services eg transport, tourism, banking,
insurance and retail
Tonne kilometre: the weight of freight lifted
multiplied by the distance carried. One tonne
kilometre means one tonne of freight travels one
kilometre.
Total Costs: a payment incurred by a firm in
producing a good or a service; expenses of
production
Total Revenue: total amount a firm receives
from selling a given level of output
Tradable permits: government issued licences
allowing firms to emit a specified amount of
pollutant eg C02. Firms can buy and sell permits
in a market.
Trade off: the process of making a choice
between alternatives eg deciding if is worth
sacrificing a new car for a holiday in Hawaii
Traffic forecasts: estimates of how many
passengers, vehicle and freight are likely to
travel by a given mode in the future.

Train Operating Companies (TOCs): has a

time limited franchise to run rail services over
given routes eg Virgin Trains
Transport: the movement of people and goods
between destinations
Transport infrastructure: capital items such as
roads and rail networks, airports that facilitate
the movement of goods and people
Transport operations: decisions about the type
of transport mode to use (demand) or provide
(supply) to move goods
Transport organisation: the structure of
transport operations in terms of private or
public sector ownership and responsibilities
Trend growth rate: The average annual
increase in potential GDP over time, expressed
as a percentage
Turnarounds: the process of preparing a flight
for the next departure and landing
Unit cost: the cost on average of producing one
item; average cost
User cost changes: the user benefits from a
road improvement scheme
Value: the amount of money received given by
price x quantity
Value added tax (VAT): a percentage is added
onto price as an indirect tax on the sale of most
products in the UK eg 20%
Value judgement: an evaluation of an issue
based on attitudes and beliefs; a statement of
how things 'ought to be'
Variable costs: costs directly related to the level
of output
VED: Vehicle excise duty is a tax paid for a
licence for a car to use public roads - tax discs
Vehicle kilometre: equivalent to one vehicle
times one kilometre travelled
Volatile: unstable; changing or changeable
Welfare loss: a monetary measure of lost
efficiency; the amount by which consumer
surplus is reduced when output is not a the
socially optimum level
White paper: An official report outlining
government policy in a certain area eg transport
X-inefficiency: a firm uses more inputs than are
necessary for a given level of output. Actual
costs exceed attainable costs.

Brundtland Commission 1987

DfT UK Air Passenger Demand
and CO2 Forecasts p4
vi Air Transport White Paper Progress Report 2006
iv
v

vii

http://www.dft.gov.uk/pgr/economics/software/cob
a11usermanual/part2thevalofcostsandb3154.pdf

Demand for Outbound Leisure Air Travel and its Key

Drivers CAA pviii and UK Air Passenger Demand
Forecasts P2
ii The Road from Inequity Adam Smith Institute 2000
iii Demand Elasticities for Car Trips to Central London
Transport for London p2
i

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