Basic economic principles .1 Marginal Cost Pricing

The marginal cost²¹ pricing principle was first formulated by Hotelling (1938) in its now classical work “The general welfare in relation to problems of taxation and of railways and utility rates”, in which he proved that marginal cost pricing is sufficient for welfare

21 Marginal costs are specific variable costs related to the provision of a service or use of infrastructure.

Marginal cost is the extra cost that is incurred by increasing output by one unit, and therefore can be expressed as the variation of the total costs with the production level.

optimality. Accordingly, marginal cost pricing should be adopted as principle in order to maximize social welfare, constituting the first best solution to the pricing problem.

In the short run²², the marginal costs of rail infrastructure are the operation, maintenance and renewal costs that arise when an additional train runs in the network. Pricing railway infrastructure according to them minimizes the exclusion of railway operators, as every train able to pay its marginal costs will be admitted in the network.

Fig. 20: Evolution of short run marginal costs with the quantity of output

Note: MCuncongested – marginal costs in uncongested conditions; Q uncongested – maximum quantity of output in uncongested conditions; Q _max – maximum quantity of output for the available capacity.

Source: NERA et al. 1998, p.24

However, due to the economies of scale existing in the rail infrastructure, the incomes generated by this principle will not be able to cover the fixed costs of operation, maintenance and renewal or the costs of upgrading and enlarging the network, resulting in deficit for the infrastructure manager. This deficit could be covered by general taxes, but at the cost of introducing distortive effects in the market. Another difficulty comes from the volatile nature of short run marginal costs when demand is approaching or even rising above the available capacity of the infrastructure (Fig. 20). In this case, the marginal costs should include disruption costs generated to other users or even scarcity costs (opportunity cost of the circulations priced off from the market).

Other drawbacks of short run marginal cost pricing have been referred by Rothengatter (2003, p.124), who remarked the following points: 1) The practical measurement of SRMC is complex; 2) Equity is ignored, as general taxes must be used to cover the deficit; 3) Dynamic effects are ignored, as welfare maximization is achieved for the

22 Depending on the period of time considered for the definition of marginal costs, it is possible to differentiate between: 1) Short run marginal costs (SRMC), calculated on the assumption that some production costs are fixed in the short term (e.g. infrastructure); and 2) Long run marginal costs (LRMC), obtained on the basis that all costs may be deemed variable with the output on the long run.

existing network without considering future investments or technology changes; 4) Financing issues are ignored; 5) Institutional issues are ignored; 6) Price distortions elsewhere in the economy are ignored; and 7) Implementing marginal social cost pricing may involve substantial administrative costs which may not always be justified by the benefits it brings.

Nash (2003, p.348) replying to the previous assertions, admitted most of the criticisms raised, but also pointed out that this does not mean that a totally different theoretical approach to pricing policy needs to be adopted. He stated that “considerations such as budget constraints, equity, institutional issues, simplicity and price distortions elsewhere in the economy lead to a need to depart from pure marginal social cost pricing but do not change the position that the measurement of marginal social cost is the correct starting point in the development [of] any efficient pricing policy”.

In the long run, the marginal costs of rail infrastructure also include the capital costs of expanding capacity to accommodate an increase in output. Pricing rail infrastructure according to them sets a price that is equal to the value of the resources that must be used to produce the transport performance in the future, ensuring the financial equilibrium of the infrastructure manager. Nevertheless, this approach finds difficulties because of the indivisibility of infrastructure assets, which imposes a long term forecast of which capacity enhancements will be carried in the future and at what cost.

Fig. 21: Pigouvian taxation

Note: In order to introduce marginal external costs in the charge and avoid the deadweight loss DWL, the price must include a tax t* able to shift the equilibrium from the private marginal cost curve AC ( ^p,

^q) to the social marginal cost curve SRMC (p*, q*). The application of such a tax will generate extra revenues equal to the shaded area OR.

Source: Rothengatter, 2003, p.124

In addition to the selection of the time horizon in which to calculate marginal costs, the marginal cost pricing principle may choose to include or not external costs, derived from

price

quantity

effects on society such as ecological damage, congestion, noise, accidents, etc. In this case, externalities are included in the charge in the form of pigouvian taxation able to reflect social marginal costs. These taxes should be set equal to the difference between the marginal social cost (curve SRMC in Fig. 21) and the marginal private cost (curve AC) at the equilibrium between the marginal social cost and demand.

3.5.1.2 Ramsey Pricing

The basics of Ramsey pricing were set by Frank Ramsey (1927), who proposed it in the field of taxation after studying how to minimize the negative effects of indirect taxes.

Ramsey pricing aims to maximize social welfare under the constraint of deficit coverage.

It considers rail infrastructure as a multi-product natural monopoly and tries to find mark-ups for each of the products in order to cover the deficit that results from SRMC pricing. This involves varying charges reciprocal according to the elasticity of demand of each user or group of users. Ramsey prices are a second best solution as they deviate from unconstrained welfare maximization.

Pricing railway infrastructure according to the Ramsey principle achieves static allocative efficiency under the constraint of deficit coverage, thus allowing the recuperation of a given cost target. As negative aspects it is to be noticed that it is a second best solution involving large information requirements (elasticities of the demand – e.g. willingness to pay of railway undertakings) and that it provides no incentives for the infrastructure manager investment once his deficit is covered (Peter, 2003, p.7).

3.5.1.3 Non-linear pricing and two-part tariffs

A non-linear tariff consists of various components, where each term is obtained by multiplying a basic cost parameter, such as tonne-km or type of train, by corresponding coefficients.

More precisely, a two-part tariff consists of an access charge independent from the quantity consumed and a variable charge set as a price for every unit consumed. When applied to railway infrastructure, the fixed charge is generally aimed at recovering fixed costs, while the variable charge usually reflects marginal or variable costs.

Two-part tariffs may be compulsory or optional (with self selection). In the first case, the operator must accept the payment of the fixed charge in order to access the network, while in the second he will be able to choose between the two-part tariff and a linear tariff. The operator will select one or another charging option depending on the total quantity of output consumed. The economic theory proves that in the particular case of a two-part tariff with self-selection there is an improvement with respect to a compulsory two-part tariff (De Rus et al. 2003, pp.202-204).

The main inconvenient linked to the use of two-part tariffs comes from the decreasing behaviour of unitary costs with respect to output, which may favours larger operators and penalize small ones, increasing the risk of exclusion of the latter from the market.

Graphically, this fact is represented by the steeper slope that corresponds to a quantity of output q1 lower than q2 in a price – quantity graph (Fig. 22).

Fig. 22: Discrimination between operators induced by two-part tariffs

Note: A- level of the access charge; q1 – quantity demanded by operator 1; p1 – unitary charge paid by operator 1; q2 – quantity demanded by operator 2; p2 – unitary charge paid by operator 2.

Source: adapted from García Álvarez et al. 2007, p.30

3.5.1.4 Fully distributed costs pricing

The fully distributed costs pricing principle takes as a starting point the level of short run marginal costs and then seeks to cover the financial deficit of the infrastructure manager by allocating the remaining costs according to selected parameters such as train-km, revenues or the level of SRMC.

As major strength, this system achieves the complete coverage of the deficit, thus avoiding distortions in the market through general taxation, but it does it at the expenses of efficiency. In fact, under this principle neither static nor dynamic allocative efficiencies are reached, as demand elasticities are not taken into account. Furthermore, if it is applied on a network-based approach, it can cause negative chain reactions in secondary parts of the network, which may become too expensive, pricing off some operators with the consequent increase in costs in other lines (Peter, 2003, p.8).

Another limitations may result from the potential absence of equilibrium under this principle (it requires at least an intersection point between the demand curve and the average cost curve) and the difficulty of measuring total costs of providing the infrastructure.

price

quantity A

p1 p2

q1 q2

3.5.1.5 Average cost pricing

The average cost pricing principle argues for setting prices equal to the average cost of provision of infrastructure services, so that prices cover both marginal costs and fixed overhead costs incurred through past investments. This approach involves the sometimes arbitrary apportionment of fixed costs to the trains running on the network.

Average costs can be calculated in the short run by dividing the total costs of delivering all infrastructure services, given current capacity, by the number of services delivered. In the long run approach they will also include investment costs for capacity enhancement and enlargement.

The average cost pricing principle is equivalent in most respects to fully distributed cost pricing, with which shares its main advantage (cost recovery) and important limitations like efficiency losses, potential absence of equilibrium or cost measurement difficulties.

Moreover, the absence of relation between the cost drivers of infrastructure provision and the charges is more accused in this case, hindering the transmission of adequate incentives to the operators.