Transport summary chapter 2

Market structure & competitive behaviour in transport

Goods and services are produced by firms, this firm takes the risk by employing land, labour and capital to produce and sell goods and services. The reward for the risk is the profit(difference between revenue and costs) they make.
As long as there is profit to be made in an industry (all firms together selling a particular product in a given market) new competitors will try to enter the market and get some market share. Not always are firms free to enter an industry, sometimes there are barriers to entry(like high start-up costs in the metal-industry)
More firms in a market leads to more supply, the supply curve shifts to the left.( S to S1)



Note: Consumer surplus increases as new suppliers enter the market.

Perfect & imperfect competition:



Firms in an oligopolistic or monopolistic environment have a lot of market power. They can influence price by varying their output because consumers have limited choice of rival products. Market power is measured in the concentration ratio, this is the proportion of output accounted for by the five largest firms.
Assume a firm want to make more output, and there are just two resources employed: labour and capital. Firms can use both to higher their output. However their behaviour in constrained by time:
- In the short run, the amount of capital in a firm is fixed, so the company will only be able to increase production levels by hiring more workers.
- In the long run , production levels can be increased using both labour and capital.
Diminishing returns.

Let’s look at a bicycle factory in the short run, so capital is fixed and the bicycle factory is only capable of increasing output by hiring more workers.


The marginal product of labour is the addition to output made by each extra worker. In the beginning each worker is adding more to total product than their predecessor, (Marginal product is rising so increasing returns occur) however, eventually the addition to total product made by the extra worker is less than the previous worker.
This is known as the law of diminishing returns.

Cost & Revenues:



Now we know this we can look at the bicycle factory also looking at costs. The fixed cost is capital.We assume every machine costs the firm GBP 200 each month in interest charges and each worker earns GBP 100 each month.(making total fixed costs always GBP 1000 and variable costs GBP 100 per worker)


Note: The factory is most profitable with 6 employees.
If we would plat the Marginal Cost and the Average Cost curves it would look like this:



A firm uses the marginal cost curve to decide how much of a product to make at different prices. The upward shape of the supply curve is determined by the law of diminishing returns.

We’ve looked at the bicycle company for the short run. Now let’s have a look at the long run for a taxi company. What happens if we are able to increase the amount of capital employed?
There are mainly three potential outcomes:
1) Constant economies of scale, this happens if unit costs are identical after buying the second taxi then the new SAC curve shifts horizontally to the right. The Long run Avarage Cost curve (LAC) is horizontal. In this case capacity has doubled and the costs stay the same.


2) Economies of scale, this happens if unit costs fall with the introduction of the second taxi. The SAC curve shifts downwards to the right. Capacity doubled but costs have fallen. The firms experiences economies of scale and the LAC curve slopes downwards.
Economies of scale refer to the cost advantages that a firm can enjoy when the volume of production increases, in the long run.


There can be two kinds of economies of scale:

1) Internal economies of scale: Lower long run unit costs are achieved within a firm with higher levels of output. As the firm produces more, so long run average cost fall because of various factors. For example:

- Technical economies E.G. Large firms can use expensive vehicles, intensively. Train operators van make intensive use of expensive IT systems to manage the deployment of drivers and vehicles. Large-scale production allows the gains from division to labour to be exploited.
- Managerial economies. Big fixed costs are spread across a larger output. Average fixed costs go down.
- Financial economies made by borrowing money at lower rates than smaller firms.
- Marketing economies made by spreading the high cost of advertising on E.G. television across a large level of output.
- Purchasing economies made when buying supplies in bulk and therefore gaining a larger discount.
- Research and Development economies by spreading the high cost of developing new and better products.

Mostly the average cost can internally be cut because of spreading the fixed costs across a higher level of output.

2) External economies of scale: Long run unit cost reductions made outside the firm as a result of it’s location and occur when:
- A local skilled labour force is available
- Specialist local back-up firms can supply parts or services.
- An area has a good transport network
External economies arise from a growing local economy and industry rather than through an individual firm.

3) Diseconomies of scale, this happens if unit costs increase with the introduction of the second taxi. The SAC curve shifts upwards to the right. Capacity doubled but costs have risen. The firms experiences diseconomies of scale and the LAC curve slopes upwards.



There can also be two kinds of diseconomies of scale.

1) Internal diseconomies of scale occurs when the firm had become too large and inefficient. As the firm increases production, eventually average costs begin to rise because:

- The disadvantages of the division of labour take effect.
- Management becomes out of touch with the workforce and some machinery vehicles become over-manned
- Decisions are not taken quickly and there is too much bureaucracy e.g. form filling.
- Lack of communication in a large firm means that management tasks sometimes get done twice
- Poor labour relations may develop in large companies.

2) External diseconomies of scale are long run unit cost reductions made outside the firm as a result of its location and occur when:
- Local labour becomes scarce and firms now have to offer higher wages to attrackt new workers.
- Land and factories become scarce and tents begin to rise.
- Local roads become congested and so transport costs begin to rise.

Over time, changes from economies of scale to diseconomies of scale are made. (En visa versa)



If as a result of increasing both labour and capital in the long run, the firm experiences a fall in long run average total cost, it is experiencing economies of scale. Conversely, if long run average unit cost rises as the firm expands, diseconomies of scale are occurring.
The table above shows a simple example of the long run average cost of a firm that experiences economies of scale up to output level 1000. The minimum efficient scale (MES) is the scale of production where internal economies of scale have been fully exploited. It corresponds to the lowest point on the long run average cost curve, the MES. Between 1000 and 1400 we speak of constant economies of scale and beyond 1400 we speak of diseconomies of scale.

Short run revenues. There are three types of revenues:


We must stress the difference between the marginal revenue in a perfectly competitive market and the marginal revenue in a monopoly market.
Lets look at the taxi company again, now suppose it operates in a perfectly competitive market.

Note that the marginal revenue is always equal to the fare, the price is set by the market so the fare doesn’t change.
Because of the taxi company being in a perfectly competitive market they are price takers and accept the price set by the market. The firm faces a perfectly elastic demand curve.


Now assume the taxi company operated in a monopolistic market.

Note that the taxi company can set the prices, the marginal revenue is no longer constant but declines with output.
Because of the taxi company having a monopoly they can set the prices and output. The firm has a diverging average and marginal revenue curve.



There are two types of profit(π):
- Normal profits: the minimum the amount of money a firm must receive to carry on production of a given good. Normal profit is included as a cost.
- Abnormal profits occur when revenue exceeds costs so the profit is greater than 0 (so actual profit is made) so also when TR is greater than TC.

So: Even if no abnormal profits are made, normal profits are earned – the firm is still rewarded for managing resources.

Profit maximising output. (Maximising profits)

For the perfect competition market profits are being maximised at the point where MC = MR



In the chart you see that after around 25 trips diminishing returns set in and after 50 trips the marginal cost is already higher than the marginal revenue.
However, in a pure monopoly market a monopolist has market power and so can set his price.



A profit maximiser increases output until MC=MR at Q1. The intersection of MC with MR gives the profit maximising level of output. The intersection of MC with MR gives the profit maximising level of output. To find the market price one must project up from Q1 to the demand curve and across the vertical price axis, P1. Consumers are willing to pay P1 for Q1. Unit costs are only P2 so the firm is making an abnormal profit of (P1-P2)*Q1

The objectives of a firm.

The main objective of a firm is growth. Growth often allows firms to enjoy the benefits of:
- Economies of scale and the competitive advantage that comes from the resultant lower unit costs.
- market leadership and the enhanced ability to set a price that meets objectives.
- higher profits which mean higher salaries for managers and higher share price for owners.
stakeholders are groups who have an interest in the activity of a business eg shareholders, managers, employees, suppliers, costumers, government and local communities. Different stakeholders have different objectives eg owners want maximum profits.
stakeholder conflict occurs when different stakeholders have different objectives. Firms have to choose between maximising one objective or satisfactorily meeting several stakeholder objectives, so called satisficing.
In public limited companies, ownership and control are separate . Owners seek profits; managers may seek sales maximisation as these increase bonuses.

In perfectly competitive markets:
- No individual customer receives preferential treatment
- There are no barriers to entry or exit
- Consumers and producers have perfect market knowledge
- There is perfect mobility of factors of production
- Each firm is price taker.



Note: Q1 is also the point where MC=MR, so on this point it is maximising profits.

The perfectly competitive industry will self-correct itself to P1 equilibrium price. If we look at the next graphs:

At first, demand increases which makes the demand line shift from D1 to D2. Demand increases and therefore the price shifts upwards to P2. As soon as this extra demand is noticed new suppliers will enter the market making the supply line shift from S1 to S2.
This brings the equilibrium price back to P1. The market is self-correcting


An imperfect competitive firm produces differentiated products to rival firms and so has the ability to set price or output. It faces a downwardly sloping demand curve.

Categories of imperfectly competitive firm are:
- Monopolistically competitive
- Oligopoly
- Pure monopoly

Monopolistic competition.

Monopolistic competition is a market structure with:
1) A large number of firms producing slightly differentiated products.
2) Each firm selling a differentiated (non-identical) product ie a firm is price maker and its demand curve is downward sloping
3) The large number of close substitutes means demand is relatively price elastic
4) No barriers to entry or exit mean normal profits are earned in the long run.




Oligopoly

An Oligopolistic market has these characteristics:
- A high concentration ratio(relatively high market share by top-5 companies) and each firm is price maker
- Firms produce differentiated, branded products supported by intensive advertising and marketing
- There are significant barriers to entry & exit
- Firms are interdependent. The behaviour of one firm will influence – and be influenced by – the behaviour of its rivals E.G. oligopolists take into account likely reactions of rivals to price changes.
- Generally stable prices as firms fear a price war where firms cut prices and rivals respond. Price wars are only initiated if a firm feels it has a cost advantage and its objective is to increase long term market share/growth at the expense of short term profits.
- Firms wishing to increase sales use non-price competition such as promotion campaigns.
- Abnormal profits It can be argued profits are not distributed to shareholder but retained to fund R&D into new products.
The key characteristic of oligopoly is interdependence - there are so few firms that each one has to anticipate on actions on the rivals. “What will rivals do?” is an important question.
Within the oligopoly there can occur a collusive oligopoly. This occurs when firms within an industry agree to act together to restrict competition. E.G. they set up a price fixing cartel where each firm restricts output.
The oligopolistic kinked demand curve model is an illustration of interdependence between firms. Under the price of P1 it isn’t profitable anymore to decrease prices because the demand will become inelastic. That’s why price wars are so infrequent and short lived.



Pure monopoly.

A pure monopoly is a firm that has 100% of market share. Not all monopolies are pure monopolies, monopolies is a firm that holds more than 25% of market share.
Characteristics of a pure monopoly are:
- Significant barriers to entry and exit. E.G. high costs of entry or legal restraints.
- Monopolists are price makers an can set price or output for their own product.
- Monopolists are usually assumed to be profit makers and can set price or output for their own product.
- Monopolists are likely to earn abnormal profits in the long run.
A monopolist can only sustain abnormal profits by erecting barriers to entry:
- legal monopolies E.G. TOCs run exclusive train services.
- Natural monopoly argument E.G. NATS
- High sunk costs - expenditure that cannot be recovered if an unsuccessful entrant leaves an industry – deters competition.
- predatory pricing( Price war) where monopolists lower prices to a level that forces new entrants to operate at a loss.
- Because of the economies of scale the established market leaders have the new entrants cannot compete on cost and price.
Transports are known for being relatively monopolistic, the government mainly three tools to remove the monopolistic character of transport.
1) Privatisation by moving ownership and control of state owned firms such as british rail into the private sector
2) Deregulation , removing barriers to entry and allowing new firms into previously closed markets. (E.G. busses)
3) Make markets contestable

Negatives to deregulation (=‘opening up’) bus-industry in the UK.

In the beginning the competition increased resulting in more frequent bus rides and lower prices. However: because of the more frequent busses the loading is less(busses are not full) adding to existing congestion.
Also, trough mergers the companies created an oligopoly market meaning many regions now have a monopoly local bus company, resulting in higher fares, lower levels of service and withdrawal of marginally commercial routes.


Pure monopoly vs Perfect competition


Profit maximising monopolists set their output where MC=MR. In perfect competition MC gives the supply curve S. Perfectly competitive industries result in lower price and higher output.

Monopoly isn’t always an inappropriate market structure. It may be the best market structure where:
- Only monopolies can generate sufficient profits to enable large-scale high cost Research & development (R&D)
- Domestic monopolies can compete internationally more easily than small firms.
- There is the potential for significant economies of scale ie one large firm can produce at lower unit cost than many small firms. The natural monopoly argument.
Price discrimination in imperfectly competitive transport modes.
One of the advantages of being a price maker is being able to use price discrimination ie they don’t have to charge the same price for the good to everyone. (E.G. peak and off-peak travel)
So for price discrimination we require:
- That firms who apply price discrimination are price makers.
- No market seepage (reselling between sub markets)
- Different price elasticities of demand (PEDs) in each sub market. (sub markets like peak and off peak travel)
Price discrimination is a very good tool for extracting all consumer surplus. For example:



Imagine this is an airline company and customers are invited to bid for a limited number of seats. The first customer is willing to pay more so he will get Q1st. And so on until the plane is full.
The only negative is that the company will have to know how much the customers are willing to pay for their flight. (starting bid prices)
So what most flight companies do is: they set their price at MC=MR (profit maximising), at the price of P1. The spare capacity (only up to Q1 will be sold) will be sold in a last-minute for the P2 price.

Another way of extracting consumer surplus is by charging different prices in sub-markets. For example peak and off-peak fares.


The firm basically picks the MR=MC level for the entire market and applies it in the sub-markets.

Despite government tries to deregulate (remove entry barriers) the transport industry there still are some significant barriers like:
- Legal monopoly eg the Train operating companies have been given regional monopolies with a time-limited franchise by law.
- Vertical integration: Where by acquiring suppliers or distributors a firm can exclude rivals from a producing a product or supplying a market.
- Predatory pricing where established firms lower price to force competitors into losses and so force their withdrawal from industry.
- Economies of scale Initially, new entrants with low output cannot enjoy the same economies of scale and low unit costs of established firms.
- Large potential sunk costs deter new entrants from risking entry.
- Branding establishes products as unique. New entrants require expensive advertising to establish sales deters entrants.

Contestable markets.

Contestability theory states the mere threat of new firms entering a market impels existing firms to act competitively ie earn normal profits and deliver allocative and productive efficiency.
Contestable market theory is based around four concepts:
- Barriers to entry: the technical or economic factors preventing firms from entering an industry and competing with existing firms
- Sunk costs are the costs associated with leaving an industry. E.G. R&D costs.
- A franchise is the legal right to operate a given service for a given period of time.
- Hit& Run Rival firms attracted by abnormal profits ‘hit’ ie enter an industry. As increased supply forces down prices, then they ‘run’ ie leave.
Note: The contestability theory does not require firms to enter the market; it is about the threat of potential competition.
A contestable market has:
- One or only a few firms in the industry ie a pure monopoly or oligopoly structure
- No or minimal barriers to entry
- Minimal sunk costs.

But do not confuse perfect competition with contestable markets!



In the UK the government tried to privatise the transport sector. The main arguments for privatisation are:
- As ‘efficient’ private sector firms now has the profit that encourages technical efficiency ie assets in private hands have higher productivity. Higher productivity leads to lower unit costs so the average cost curve shifts down.



- Losses turn into profits and a reduced government subsidy is needed which allows public expenditure elsewhere eg in education and lower government borrowing.
- Privatisation raises standards increase usage of public transport and associated positive externalities.
- Contestable market argument. Privatisation introduces competition.
The main arguments against privatisation are:
- Public sector monopolies become private sector monopolies. (Government attempts to create contestable markets do not work)
- Private sector firms ignore significant externalities generated by transport causing market failure.
- The services in rural areas will reduce drastically because the private companies want to acquire maximised profit.