Pricing



Railway Pricing

According to pure economic theory, to maximize overall economic welfare for the whole community, the most economically efficient pricing approach would be for prices to equal the marginal social costs of railway services. As a practical matter, no railway in the world does this for the following reasons.

  • In economic theory, the concept of ‘margin’ is a very small unit of output, such as a single passenger seat-km, or wagon-km of freight. In practice, the increments of output in which prices can realistically be set are much greater, i.e. for a class of service, a class of trains, a regular commodity movement, or a particular freight shipper;
  • Railway costs that are variable, particularly in the short term, are less than total costs, so that pure marginal cost pricing will lead to financial losses. Even long-run marginal cost pricing is insufficient to recover all railway running costs when all fixed common and joint costs are included.
  • In virtually all countries, railways’ main transport competitors do not include external costs in their prices. This negates the assumption underlying the economic theory—to charge social costs only in the rail sector would create perverse outcomes.
Therefore, the pure economic theory has little practical application in railway management. In practice, there is no prescribed or standard form of market-based pricing for railways. Good railway managements adapt pricing practices to their markets, customers, institutional arrangements, pricing regulations, and the social and economic norms in which they operate.

Nevertheless, the economic concepts are important in guiding workable principles that can contribute to railway financial sustainability in freight and passenger markets.

Freight pricing
Competition should be the primary determinant of rail freight pricing strategies, not costs. As indicated in , most railway infrastructure costs are fixed in relation to an individual traffic movement during the currency of rail freight contracts, so any infrastructure cost allocation to individual customers is largely technically arbitrary. More than a century ago, railway economist William Acworth observed:

‘Volumes have been written to show that railway rates ought to be based on the costs of carriage...such a basis is impossible, as no one knows, or can know, what the cost of carriage is. Cost of carriage of a particular item may mean the additional cost of carrying that item; this is normally so small as to be negligible. It may mean the additional cost plus a fair share of the standing costs of the organization... an arbitrarily estimated proportion of a sum that can only be ascertained very roughly.’ 28


Basic principles of commercially efficient rail freight tariff setting are well established and have been used by competent railway managers since the nineteenth century. The rate set should be the highest that the market will bear, taking account of prices charged by actual or potential competitors, except under special circumstances, such as the need to nurture a new service. This rate should at least cover a price-floor of the long-run variable costs of carrying specific traffic for the duration anticipated. 29

The economic formulation of this practical and already established approach to railway pricing was provided in 1927 by mathematician Frank Ramsey. 30 To paraphrase, the railway should mark up its long run variable costs to individual customers in inverse proportion to their price elasticity of demand.31 So customers with a low elasticity of demand (such as coal producers) will be charged a higher markup than the customers with high elasticity of demand (such as container shippers).

Railway marketing managers cannot know the precise elasticity of demand for each customer, but railway marketing staff should have sufficient information on customers and competition to estimate the effect of prices on customer volumes. The general principle of commercial pricing is to establish a price that will maximize the service’s contribution to railway fixed costs; the corollary is that the railway should not price below long-run variable costs.

By contrast, ‘average cost pricing’32 in rail freight distributes fixed common and joint costs over all traffic. However, average cost pricing can depress demand in some traffic segments, thereby reducing overall traffic and creating higher fixed cost burdens for remaining traffic. In (exceptional) cases, where the railway does have significant market power, the ‘market’ may be a regulatory body. The railway freight provider’s general market-based pricing philosophy should still prevail. Typically, the railway will attempt to allocate as many costs as possible, but ultimately, the regulatory body decides on which costs the user industries will bear.

Passenger service pricing
The so-called ‘Ramsey pricing’ matched to individual customers or commodity groups has practical application in most freight markets, which comprise an identifiable and limited number of customers. However, in passenger markets, railway market pricing aggregates customers by pricing options based on individual features such as service class, travel times, or ticket purchase restrictions, and passengers select for the cheapest prices that fit their traveling needs. Railways can set price offerings by considering load factors for each train and station pair-sometimes using airline-style yield management software—and conducting extensive market research to respond to customer demand levels with desirable ticketing packages that maximize revenues from seat sales. Thus, most passenger pricing is highly centralized by the service provider and service offerings are analyzed intensely to determine overall revenue and ridership impacts.

However, underlying this very pragmatic system of continuous adjustment, the economic concepts that support financial sustainability in passenger services remain the same: pricing above long run variable costs should be inversely related to demand elasticity, and price-service packages should be tailored to meet customer needs more effectively than competing alternatives. Therefore, railway passenger marketing managers must fully understand the competitive environment and the demand elasticity of passenger sub-markets within market segments. Tariff structures should be designed to maximize overall revenue yield from the seat capacity on offer.

Typically, railway passenger services can be divided into major segments for service planning and management-inter-city, regional (sometimes segmented by sub-region) and suburban services (sometimes segmented by city). Each segment may have a different tariff structure, and within each segment, individual trains may carry passengers travelling at first class premium fares and those travelling in more basic accommodation or with less flexible ticket types at discount or concession fares. To be financially sustainable, the schedule of services for major service segment should aim to recover their long-run variable costs, and collectively, all the segments must recover overall fixed costs allocated to the passenger sector.

If this were always feasible, it would be convenient. However, railway passenger financial modelling indicates that it is rare for passenger train services to operate without long-term budgetary support, even at efficient input-cost levels and with optimal pricing circumstances. 33 Inter-city railway passenger services often fail to recover their long-run variable costs (a negative financial contribution) and rarely cover their FAC from the fare-box alone, except on the densest inter-city rail corridors. The cost-recovery challenge is even greater for heavily ‘peaked’ suburban services or less heavily utilized regional services. In many countries, it is impossible for a single passenger railway route to make a positive contribution above long-run variable costs and many barely cover short-run costs.

As a result, for most passenger and mixed-use railways in the world, financial sustainability depends on receiving some budgetary support. of this toolkit discusses effective implementation of government support that is justified or politically necessary for social or other reasons.

    


28 W. Acworth, The Elements of Railway Economics, (Oxford University Press, 1905).
29 Avoidable cost for an existing traffic, incremental cost for a new traffic.
30 F. P. Ramsey F.P., “A Contribution to the Theory of Taxation,” Economic Journal, (Vol. 37, No 145, 1927) 47-61.
31 Elasticity of demand is measured as the percent change in the quantity of demand divided by the percent change in the price. A customer that is sensitive to the price and will reduce the quantity demanded by more than the change in price has an elasticity of demand greater than 1. A customer that will reduce the quantity demanded by less than the change in price has an elasticity of demand less than 1.
32 Also known as fully distributed or fully allocated cost pricing.
33 Amos and Bullock, The financial performance of non-urban passenger rail services, (World Bank, 2007).
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