Executive Summary - The paper aims at identifying the various options available in the pricing of transportation services, with

specific reference to the railway services in India. The Railways in India is still in the form of a natural monopoly and it is an implicit assumption that government intervention is a must in order to maximize welfare. The current modal mix for the passenger movement in India is Road: Railways: Airlines = 86%:12.9%:0.4% while for Freight Movement is Road: Railways: Airline: Water = 61.2%:38.6%:0.022%:0.2% (Planning Commission, 2007). Indians currently consume 2330 Km of Inter-city passenger transport per year. For USA in 1988, with a purchasing power adjusted per capita GDP about nineteen times that of Indian level, the figure was 12,774 Km per capita, about six times that of the average Indian. At about the same time in Korea, personal mobility was about 1400 Km per capita, while in Brazil it was about 3700 Km. It thus appears that Indians consume more intercity passenger transport that other nationalities at comparable income levels. Natural growth rates and rural to urban migration are expected to raise the urban population of India to 42 percent of the total by 2010. The economic activity in urban areas would also increase to about 63 percent of the GDP in 2010. However, with the favorable experience of the public, in terms of the getting out of the government from telecom services and allowing the entry of private players, with the government playing merely the role of the regulator, there is a growing section of people who are of the feeling that similar shift from rowing to steering on part of the government in the railways will bring in competitiveness of pricing as well as improvements in service quality levels. The great advantage that India has at this stage is the plethora of successful models of transport sector reform that now exist worldwide. There is no longer a need to proceed into the unknown for the most of the required initiatives. The factor, plus the steady pressure of the long-term forces identified in this paper, could conceivably make the process in India more orderly and less painful that has been the case elsewhere. Drawing on the trend towards greater differentiation of infrastructure and service component of pricing for Infrastructure worldwide in other railway systems as well as in other public utilities of a comparable nature, the paper aims to evolve an approach based on existing theoretical paradigms. While

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beginning with the identification of the unique nature of the railways as a multiinput, multi-output system and it’s unique dynamics, including the deficiencies of statistical reports and previous studies undertaken in this area, the paper identifies the typical barriers to Efficient Cost Pricing which exist in a developing country scenario, where rail infrastructure is largely still under Governmental control and the acceptability issues involving the public at large remain. The paper therefore aims to end with a suitable roadmap for basing future development initiatives, in light of economic pricing models available for use on the Indian Railways. Historical Perspective: 1.1 The traditional railroad model During the past fifty years, the most common market structure in many countries’ rail sectors was a single, state-owned firm, entrusted with the unified management of both infrastructure and services. Despite some differences in their degree of commercial autonomy, the traditional methods of regulation and control of this sort of company have been relatively homogeneous. In general, it was assumed that the monopoly power of the national company required price and service regulation to protect the general interest. In addition, there was an obligation on the part of the companies to meet any demand at those prices. The closure of existing lines or the opening of new services required government approval. Thus, competition was rare and often discouraged, and the preservation of the national character of the industry was considered the key factor governing the overall regulatory system. Under this protective environment, most national rail companies incurred growing trade deficits during the 1970s and 1980s. Furthermore, social obligations to their staff made it nearly impossible to reach any agreement on redundancies or even wage adjustments. In some countries, the companies were forced to finance their deficits by borrowing, so their accounts lost all resemblance to reality. The main problems associated with the traditional policies for railways were: (i) (ii) (iii) increasing losses, which were usually financed by public subsidies; high degrees of managerial inefficiency; and business activities oriented exclusively toward production targets rather than commercial and market targets.

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These distortions did not come from any artificial reduction in the range of services provided, nor from excessively high fares, but more commonly, from an unjustified increase in the supply of services (and hence, of costs). Such behaviour implied larger public subsidies. In many cases, the lack of commercially-oriented tariffs and investment policies explained many of the difficulties faced by the companies. Together with the burden imposed by the technical characteristics of the sector, this placed most railways in a very weak position to compete against alternative transport modes. Thus, it became necessary to adopt measures affecting the internal behaviour and structure of the sector itself. Thus various initiatives were targeted at addressing these issues on an ongoing basis. Despite all these changes, the most salient characteristic of the restructuring process of the rail industry in the last decades has been the consolidation of different and alternative organizational structures for the industry as a whole. These structures differ along three main features to be analyzed in detail separately: how are access and infrastructure and multimodal competition considered, what is the extent of vertical separation introduced after the change, and what is the amount of private participation allowed in the industry after the reform. These are discussed separately below: 1.2. The access issue: The separation of infrastructure from services in the Industry implies that the new models should focus on the issue of access, which is particularly relevant in the case of highly integrated trans-national networks (as in Europe) or privately or publicly managed dense networks (as in the United States, Canada and some Asian countries) but not so much in the case of railways in India which continues to be in the form of a state owned monopoly. In summary, the general rule should be to promote open access as widely as possible once the separation between the natural monopoly infrastructure and train operations has been effectively achieved. However, this process must depend upon a detailed analysis of infrastructure costs and the prices charged to cover them. Barriers to entry are also related with intermodal competition. As already mentioned, modal choices can be heavily distorted due to different cost coverage ratios and the use of different cost input bases. A solution is to follow an integrated, multi-modal approach. Basic principles

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will have to apply to all transport operators, irrespective of the mode in which they operate. In case of Indian Railways, the competition with the Highways is significant as the latter have the cost of way provided by the state whereas the former have to pay for their “Right of Way” as well. 1.3 The Imperative for Pricing Policy in the context of the Indian Railways: 1.3.1 The multi-product nature of the rail activity Rail companies are, in most cases, multi-product firms that provide different types of freight and passenger transport services. In the case of transport of bulk freight, freight, along with the usual rail operators also supply complete cargo wagons or trains,

parcel and postal services, as well as other services of inter-modal transport. In the case of passenger transport, long-distance traffic usually co-exists with local services (suburban and commuter trains), regional services, and in certain cases, even with highspeed trains. These elements are the multi-product nature of the activity, the particular cost structure of railroad companies, the role of infrastructure and networks, the evidence of rail system as a whole. The multi-product nature of railways has different implications. In accounting, for example, it is often difficult to allocate total operating costs among services. Many of the costs of running a longdistance train (including not only infrastructure costs but instance, the common costs also variable costs) are shared by different types of traffic and these joint costs co-exist with other costs not affected by changes in output. For of signal maintenance along a line section usually do not increase if the proportions attributable to a particular traffic (for example, passengers), most of them (wagons, energy, staff, etc.) are not. Thus, cost interdependence requires simultaneous decisions on prices and services, harder. At the cost level, another important aspect to consider in the multi-product setup of the rail industry is the sub-additivity of the cost function faced by a railroad. This idea conveys two relevant implications for the rail industry. First, is it more efficient for a which, in practice, makes any regulatory task much indivisibility of inputs and outputs, the organization of transport as public service, and the existence of externalities in the transport

of traffic of the different services change. Although some cost elements may be

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single firm, rather than two separate firms, to supply both infrastructure and transport services? Second, if the infrastructure and more firms participate? 1.3.2 The pervasive structure of railway costs Waters (1985) broadly distinguishes four railway cost categories: (i) (ii) (iii) (iv) train working costs, including the cost of providing transport services (fuel, crew, maintenance and depreciation of rolling stock); track and signalling costs (including operation, maintenance and depreciation of infrastructures); terminal and station costs; and administration costs. services are separated, is the supply of such services more efficient within the context of a monopoly, or should two or

The first two categories are prevalent in most companies and change according to several factors. Among train working costs, for example, rolling stock costs depend on both their number and the distance they run. Fuel costs depend on carkilometres run for each type of vehicle, while train crew costs vary according to train-kilometres run. Track and signalling costs usually rely on the length of the route (since they typically request a single, standard-quality track). The amount of track and signalling needed, however, changes with the number of trains requiring paths, although this relationship is not constant. Terminal and station costs depend upon the number of staff, but vary considerably across seasons with the changing volumes of traffic. Like for e.g., long distance passengers require more services (ticketing, reservations, luggage, etc.) than short distance users. Administration costs, finally, fluctuate depending on the overall size of the firm, although the precise nature of this dependence is generally difficult to determine. Allocating all of these costs to the multiple outputs or inputs it produces is complex. It often involves a degree of arbitrariness that demands, from a regulatory point of view, a clear distinction between avoidable and unavoidable costs. The avoidable costs are uniquely associated with a particular output: were this output not produced, no cost would be incurred. Avoidable costs may

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therefore be considered as a regulatory price floor (if any), since charging less would be equivalent to operating at an economic loss. 1.3.3 The role of rail infrastructure Since the birth of the rail industry in the last century, mainstream economists have always considered that the larger the size of a railway company, the greater its efficiency. The existence of substantial fixed costs (particularly, those associated with infrastructure) traditionally led economists to assume the presence of important economies of scale, and thus to regard rail transport service as a textbook example of a natural monopoly. However, this notion has been heavily challenged in recent decades by the introduction of new ideas into the industry’s economic analysis. Particularly, the upheaval of the theory of contestable markets (Baumol, Panzar and Willig, 1982) contributed to clarifying the proper definition of the natural monopoly concept, in terms of the sub-additive cost function 1This concept implies that duplicating rail infrastructure is generally inefficient (and therefore is subject to natural monopoly conditions), but once the network has been deployed, the cost of operating rail transport services and rolling stock can be efficiently covered by more than one company, either as actual or potential competitors. Therefore, from the regulatory point of view, the conclusion is that infrastructure and services can be dealt with in different ways: the former, as a natural monopoly, but also as a potential provider of adequate access to any willing-to-serve operator; the latter, as any other competitive economic activity that could be provided by multiple competing operators or by a single firm under some sort of concession or license arrangement. In this regard, the typical issue of asset indivisibility which needs to be accounted for is discussed below in greater detail. 1.3.4 The implications of asset indivisibilities

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According to Baumol (1977), a cost function is sub-additive when the provision of services by a single

firm is more efficient (in terms of a lower unit cost) than the same production carried out by two or more companies

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Even though this potential vertical separation alleviates some of the natural monopoly problems, the rail industry remains very capital-intensive, with several other indivisibilities within its productive process. Specifically, the capital units (rolling stock, tracks and stations) can only be expanded in discrete, indivisible increments (the addition of a train or wagon, for example), while demand fluctuates in much smaller units. Consequently, increases (decreases) in supply can exceed increases (decreases) in demand, resulting in excess capacity. This lumpiness has several important implications for investment and pricing. For example, the transportation costs of an additional unit of traffic (freight or passengers) may be insignificant when there is idle capacity, but may become substantial when the capital is being used to its fullest. Firms can also be forced to employ fixed assets with differing economic lives, whose reliability spans over a large time horizon and heterogeneously affects the cost items described above, modifying investment decisions, and requiring a complete accounting and management information system. Therefore, dynamic price and output considerations become crucial in order to recover the real costs associated with each period of activity. A final implication of the indivisibilities in the rail industry’s capital assets is that innovation and infrastructure improvement projects are usually deferred and only carried out in small, discrete amounts. Railway firms seldom change the entire definition of their existing network, which in most countries corresponds to an inherited burden from past decades when the traffic structure was very different than today. Instead, they opt for partial renovations that often introduce technical asymmetries between tracks within a country or region, and accentuate indivisibilities and inflexibilities. 1.3.5 The role of rail transport as a public service Although not derived from historical and organizational reasons and not from technical characteristics, the concept of rail transportation as a public or social service, irrespective of profitability, is another defining element that has determined the industry’s organization and performance around the world. The low rolling resistance of steel wheels on steel rails made railroad transportation extremely fuel efficient and relatively cheap. This allowed railroads to rapidly

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grow as the first mass transportation system, particularly for passengers, beginning in the years of the industrial revolution (for European countries). Public control over the rail industry occurred both with and without accompanying subsidies, public service obligations to transport providers in the form of compulsory (often unprofitable) routes, organized timetables or particular services for strategic products or areas. The ultimate reason behind this control, which remains the same today, is that this industry is regarded as an integral mechanism to overcome geographical barriers in certain areas, aid in the economic development of undeveloped zones, and even as a guarantee of minimum transport services for a particular segment of the population. Several theories exist that provide adequate mandates for the role envisaged for a public utility. One of them is discussed below. Garfield and Lovejoy (1964) have highlighted major rights and duties of a public utility. The rights include: a) Entitlement to charge “reasonable rates” for its services, under prudent management, allow to collect revenues sufficient to cover all proper operating expenses and a return on net valuation of its property adequate to provide debt interest ,dividends on its capital stock and a contribution to earned surplus; b) Entitled to get protection from competition. At the same time major duties are: a) Obligation to serve all those who are ready to pay; b) Obligation to provide adequate services to customers: c) The services should be priced at reasonable rates; and d) Maintain public safety, in particular. 1.3.6 Externalities and the rail system The policy goal of public service obligation is often supported by the idea that rail transportation contributes less to negative externalities than other transport modes, especially roads. There is abundant empirical evidence showing that under high demand conditions, the external costs of traffic congestion, accidents and environmental impact (noise, visual impact, pollution, etc.) could be reduced by transferring a substantial part of road traffic to rail. The current inter-modal misallocation (more road users than rail users) arises from the fact

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that road transport does not fully internalize all of the social costs that it generates. Economists often recommend the use of congestion and/or pollution rates to account for this. However, when these mechanisms are not feasible or politically viable, it might be preferable to decrease railway fares to improve the overall inter-modal balance, which is an additional consideration for rail regulation. In summary, all of the above-mentioned characteristics suggest that an analysis of the regulation of railway transport should be carried out within a general context, taking into account the industry’s technological and organizational features, beginning with a detailed evaluation of recent performance.
The economy’s real GDP grew by a 9% each year. Over the same period, traffic units transported by rail grew by 9.4 % for freight and 13% for passengers.

Thus we may see that the Indian Railways has effectively tried to capture available markets in both the Passenger as well as in the Freight sector and has shown consistent growth in synch with the growth of the economy during the last year.

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Most of the complaints about rail services concern the lack of competitive pressure.

Policy Objectives The pricing strategy to be followed in case of transport services would be determined by the object to be achieved and the optimal prices for each case maybe different. One possible policy objective in the scenario of the Indian Railways could be maximizing revenue while obtaining a satisfactory level of welfare with a profit. Profit Maximization under Perfect Competition vs. that under Perfect Monopoly:

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Profit Maximization is the traditional motivation of private enterprise undertakings. The actual price level in this case depends upon the degree of competition in the market. Where the competition is considerable, no single supplier has any control over the price and must charge that determined by the interaction of the supply and demand in the market as a whole. In the long run, Price will be equated with marginal costs of each supplier, since the supplier will produce an additional unit if the revenue from that unit exceeds the incremental cost of producing it. With this perfectly competitive environment, it is impossible for any supplier to make super normal profits in the long run as such profits would act as incentive for new entrants to the market who would then enter the market and increase supply to the point where prices fall to levels dictated by marginal costs. In contrast, a true monopoly supplier has no fear of new entrants increasing the aggregate supply of transport services and has the freedom either to set the price or to stipulate the level of services he is prepared to offer. The effective constraint on the monopolist is the countervailing power of demand, which prevents the joint determination of both output and price. However, given the absence of competition and the degree of freedom enjoyed by the Monopolist, it is almost certain that a profit maximizing price will result in charges above the Marginal and average cost (the only exception being the most unlikely exception of a perfectly elastic market demand curve). This is one reason why governments all over the world have tended to regulate railways, ports and other transport undertakings with Monopoly characteristics. Revenue maximization: Even in the private sector, however, pure and unbridled profit maximization is rarely the policy objective as managers may not have incentives for maximizing the profits. It is likely that growth of revenue and size of operations may offer more security and chances of promotion whereas profit maximization may lead to retrenchment of staff. Here, we need to note the difference between profit maximization and revenue maximization since the price at which the revenue is maximized, is not necessarily the same as that at which maximum profit is obtained. The time frame of the policy also effects the decisions since in the short term maximization of profits may in fact damage the long term market potential as consumers

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shift to and get used to other products. Alternatively, in case the barriers to entry are not very high, the profit potential created may encourage new entrants to enter the market. If we look at the Indian transport scenario, we find that in the case of road transport, where almost perfect competition exists, freight rates are only slightly above the costs of provision of the service. However, in the case of rail freight the freight rates are well above the costs of providing the services and we have already come to a situation where many potential customers are abandoning rail services. Welfare maximization: Social Welfare is maximized when price is equated to the marginal cost. What marginal cost pricing does, in effect, is to result in transport services being provided unto the point where the benefit for the marginal unit is equated with the costs of providing that unit. Traditional theory also tells us that such a condition prevails in the long term when perfect competition exists, despite the fact that each firm is attempting to maximize its own profit. The ability to exercise any degree of monopoly power, however, permits a firm to price above marginal cost so that it can achieve a decent profit at the expense of reduced output and higher costs to the consumer. Welfare Economics looks upon price as a method of the resource allocations which maximizes social welfare rather than simply the welfare of the supplier. Setting prices equal to marginal social costs, leads to allocational efficiency since the Price equals the cost to society of producing that good. Marginal Social Cost= Short Run Marginal Production Cost+ any external costs or benefits. In case services are priced above this, then we have two possible effects: a) Customers shift to other modes which may actually impose higher costs to the economy such as higher environmental effects, higher imports coupled with lower basic energy efficiency (as is the case with road transportation). b) Production facilities far from production centers may become uneconomic due to high costs of transport involved leading to establishment of facilities in and around areas of high consumption thus distorting the pattern of economic development and population growth.

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However In case, the objective of the firm cost recovery automatically takes place by following the above strategy. It would be usual (other than in the case of some non-profit organizations) to add small profit percentage to this average price as well. Public utilities and other public sector organizations are likely to follow this strategy in the absence of profit motive. The determination of the actual costs of providing a service is entirely different issue and will not be discussed here in view of the complications involved. Price Discrimination: Price Discrimination is the process of selling different units of essentially the same product to different customers at different prices. There are basically three degrees of price discrimination. First Degree: Different units of a product are sold at different prices to different users or what is compendiously referred to as “Perfect Price Discrimination”. Evidence of this can be found change in fares for the same class of rail passenger fare varying over time. Typically, in the Indian Railways advance booking is done 90 days in advance, as per the extant policy. This is to enable differential pricing for the different units of the passenger traffic product like various berths, within a class of travel and based on other factors. Second Degree: This type occurs where although different prices are charged for different units of output but each user who buys the same amount of goods pays the same price. Evidence of this can be sampled from fare within a class of travel. However, the comparability ends with the number of such “same amount of goods” like side berths, lower side berths in different classes like AC three tier and AC two Tier within the transport product. Third Degree: This type of discrimination occurs where different users are charged different rates for the same product. Evidence of this negative discrimination can be seen partly within passenger classes especially for women, senior citizens in the form of fare discounts. Positive discrimination of this degree is however not implemented within the Indian Railways passenger traffic segment till date. In addition, an analysis of the multi product nature of the Indian Railways serves to understand the pricing discrimination model better. Examples of this differentiation are student or senior "discounts". For example, a student or a senior consumer will have a different willingness

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to pay than an average consumer, where the WTP is presumably lower because of budget constraints. Thus, the supplier sets a lower price for that consumer because the student or senior has a more elastic price elasticity of demand (see the discussion of price elasticity of demand as it applies to revenues from the first degree price discrimination, above). The supplier is once again capable of capturing more market surplus than would be possible without price discrimination. 2. Economic Analysis of the Railway Services Market
An economic analysis of the emerging railway services market has to begin with a proper understanding of three main characteristics: a. the multi-service / multi-purpose nature of railway, giving rise to significant economies of scale and scope; b. railway service provision is depending on the existence of a fixed cost and very specific infrastructure giving rise to natural monopoly, because these costs are largely sunk; c. the existence of numerous technical and legal barriers to entry. These features discourage cost transparency and efficient allocation of resources, imply huge economies of scale and scope, put a premium on coordination based on vertical integration while greatly reducing the room for competition in the sector. We shall explain each characteristic briefly. 2.1 Economies of scope, and intermodality Railway service provision is characterized by its multi-product nature. The major Business lines for the railways are sub-divided in two categories: a. Freight b. Passengers with a number of specific services. The demarcation is often clear, although modest degrees of substitutability or complementarity can be found in the business lines listed in Table 3. In the freight domain, major business lines include the traditional transportation of bulky products (coal, raw materials, oil, chemicals, wood and derivatives, steel and metal profiles, cars and heavy machines). Originally the core of railway services, increasing competition and substitutability from other modes (pipelines, waterways, road) have gradually reduced profit margins and market share. Possible inter-modal complementarity still exists and is encouraged.

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However, without proper business plans inter-modal competition or complementarity failed to deliver efficiency. Thus far, railways have, more often than not, failed to respond to such customer demands. Thus, a broad consensus has emerged that in such railway markets, the introduction of intra-modal competition (between different railway competitors) might prove useful to increase efficiency and customer satisfaction. In the passenger area, two major markets can be distinguished. On the one hand the longdistance services (intercity and high-speed services) with a degree of substitutability (hence competition) with other modes (road-air) and with some possibility to host degrees of intramodal competition depending on the scale and density of the market. On the other hand, commuter line markets (urban and regional services) where a better complementarity with other modes of transport might result in sustainable solutions, but where intra-modal competition is likely to produce diseconomies of scale and scope. As we shall see, the fact that a complex bundle of services can be offered over the same network and potentially by the same companies has substantial implications for costaccountancy, transparency and efficient functioning of the railways.

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Source: The Economics if EU Railway Reform, Pietrantonio,L.D, Pelkmans, J. The imperative for pricing mechanisms to be employed on the Indian Railways Freight and Costs of Transportation- The General Principle of determining: Freight that is charged for moving a commodity between two places, is normally expected to cover the cost of its transportation and, except when it is carried at a concessional rate keeping in view of the importance of the commodity to the society, a small profit for the operating railway system. However, without going into all the factors that go into the Pricing of Railway services in the words of Prof. Jackson of University of Toronto we can sum up the basic principles as thus: While the great fundamental principle underlying the practical determination of the rates is to charge according to what the traffic can bear, yet, there are occasions when that principle maybe used as a basis for securing unduly high rates by the railways and other occasions when it maybe invoked by shippers as a reason for rates to be so low as to be wholly unreasonable from the point of view of the railways. In these circumstances, it becomes necessary to check the rates by performing the service, wherever this can be obtained. There are however, difficulties in this. In the first place, a large share of the cost of operation is jointly incurred for the service as a whole and cannot be allocated among the multitude of services for which rates are charges. In the second place, if the rates were made strictly on the basis of the cost of service, low grade, heavy, bulky commodities could be moved only a short distance, if at all, from the point of origin and this would restrict greatly the development of many communities, in fact large areas of the country. In the third place, rates based entirely upon costs would ignore one of the most important factors which should influence rates viz. the value of the commodity. If rates were made by a rigid adherence to the cost basis, the difference between the rates on some manufactured articles and high priced goods and the rates on other low priced articles would be much less than the present difference in such rates. The rates of low grade commodities maybe so high as to preclude the movement of some of the essentials of life and of development of industry, thus preventing industrial and social welfare, while the rates on the highest grade goods would be unduly low. “

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While charging according to what the traffic will bear, will determine the upper limit of the rate, the cost of the service, so far as this is ascertainable, should be the basis of the minimum charge for the service”. Pricing Policy Constraints Pricing Policy constraints imposed by the government, lead to under-recovery costs in some streams of traffic, whereas substantial over-recovery takes streams. There is thus a substantial element of cross-subsidization on the Indian Railways, which cannot be justified on the basis of economic principles. The passenger services as a whole lead to losses, mainly on account of below-cost pricing of railway services, while the freight rates, with the exception of those for a few commodities, bring in substantial revenues, were neutralizing the losses, not only in respect of the low-priced commodities, but also the subsidy element in the passenger services as a whole. The following table will indicate the magnitude of the cross- subsidization: Proportion of Cost Recovery by the two main streams of profit Year Coaching Service Cost Rate Ratio per 1993-94 1994-95 1995-96 1996-97 1997-98 PKm 25.18 25.78 26.57 28.72 33.62 per PKm 16.52 17.10 17.89 18.55 19.90 65.6% 66.3% 67.3% 64.6% 59.2% Cost per NTKm 35.31 39.02 39.60 43.28 51.21 Goods Service Rate per Ratio NTKm 49.75 54.77 56.53 60.05 68.89 140.9% 140.4% 142.8% 138.7% 136.5% of place in other

Pointed attention to the heavy cost subsidization has been drawn by The Comptroller and Auditor General of India also, who in his report on the Railways for the year ended March 1998 has brought out that in 1996-97, while passenger traffic caused a loss of Rs.2695.25 Crores, Goods Traffic earned a profit of Rs.4726.78 Crores. According to that report: “about 26.66% of expenses on passenger services during 1996-97 were left uncovered by actual receipts from passenger services. About 16.17% of receipts from Goods services during 1996-97 went to makeup the loss in the Operation of passenger services.” Further, cross subsidization in Indian Railways has already reached alarming proportions of Rs. 4875 Crore during 2000-01 as per the Status Paper on Indian

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Railways,(2002). The extent of cross subsidy is as much as 46% of revenue from passenger traffic2. Such high level of cross-subsidization has driven away freight traffic from the railways. This feature of cross-subsidization involving under-recovery of cost from passenger services and over recovery from goods services has been in existence on the Indian Railways, from the very early times, but it started affecting the interests of the railway adversely only when they started facing intense competition from other modes of transport (A.V.Poulose, Subsidies in the Transport Sector). Freight rates increased by around 12 per cent in 1997-98, 4 per cent in 1999-2000 and further by 5 per cent in 200001. The passenger fares have hardly increased during the Ninth Plan period. As a result, the cross subsidization has actually increased. However over the years the market share of freight has actually gone down. As per the Railway Fare and Freight Committee (1993)’s (referred to as RFFC) estimates, the railways have lost nearly 35 per cent of the bulk and long distance goods traffic to the roads. Thus, the Railways could not have afforded to continue with the historical rate of growth of 3-4 per cent in freight traffic movement, and needed to pursue a much higher growth rate. Otherwise, the Indian Railways would have most certainly got marginalized and this would have also lead to an economic slowdown due to infrastructural bottlenecks. Ramsey Pricing: In many cases a transport undertaking provides a number of different types of services (for e.g., first and second class railway services) and is also under constraints to make a prescribed level of profit, or to break even, rather than to profit maximize alone. Given these conditions and assuming that cross elasticity of demand for different services is negligible, it has been demonstrated that the price of any service should be set equal to its short run marginal cost plus a mark-up inversely proportional to the service’s Price elasticity of demand. Hence, where the demand for a service is highly inelastic a substantial addition should be added to the Marginal Cost. When the demand is perfectly elastic, short run marginal cost pricing is applied. In this way the revenues
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“Pricing Issues in Urban Transport with specific reference to Indian Railways” by A.K Jain, IRTS, IIT Mumbai, July- September 2004, available online at http://www.rscbrc.ac.in/July-September2004/04A04_Pricing%20Issues%20In%20Urban%20Transportation%20by%20AK%20Jain.doc

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above the marginal cost can be obtained to meet the financial targets without distorting the allocation of traffic between services. This is called Ramsay Pricing. It is not always possible, for practical reasons, to discriminate perfectly: the administrative cost of operating the system maybe too high or exact knowledge of the demand curves and elasticity may not be available. In other cases, it maybe felt socially undesirable to charge “what the user will bear” because of the distributional consequences. Passengers with low elasticity of demand may be from poor sections of the community and unable to transfer to alternative modes of transport. It may still be justified, even in these circumstances to provide service even if not all the costs are recovered by the operator by providing that the potential revenue if discrimination is adopted exceeds the costs of the service. If this is the case, a subsidy is required to bring actual revenue up to potential revenue. Yield Management: In the case of other transport industries, capacity going empty represents a net loss of revenue once the plane/train has departed. The policy followed by various other modes of transport for maximizing revenue by offering seats at different rates to different people, has been named as Yield Management. Formally, Yield Management has been described as “the ability of management to maximize the revenue from a pre-defined activity (e.g. a scheduled flight or sailing) by a combination of dynamic price discrimination and product differentiation”. This has also been practiced in other parts of the transport industry as well as in the Hotel industry. In the transport industry it has been practiced with varying degrees of sophistication in different transport markets where the supply of the service exhibits the following characteristics: 1. The service is to be provided with a fixed commitment (i.e. scheduled services). 2. The supplier has information on what charges ‘the market will bear’ i.e. good market research and forecasting models exist. 3. The supplier enjoys good degree of monopoly power. 4. It is possible (in the eyes of potential customers) to product differentiate.

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5. There is asymmetrical information i.e. the customers have less information regarding the options available to them than the supplier has about the availability of capacity. Efficiency Considerations in Yield Management: The Yield Management system has been examined from the economic efficiency perspective by Botimer (1994) who has concluded that this system achieves efficiency in allocation since seats are allocated to passengers who have the highest value of being on the transport mode. The process of allocation of discounted seats results in reduction in fixed costs per seat (and corresponding fare) by increasing the occupancy levels or it can result in increased service frequencies- both of which are beneficial to the passengers. This allocative efficiency is, however, achieved at the cost of shifting the economic rents (surplus) from the consumers to the producer. Yield Management in Rail Freight: The concept of Yield Management has been applied to rail freight by some of the Railroads for providing regular, scheduled services. This is done by offering two classes of service- a high price high speed service and a low price low speed service. Train schedules and loads are planned for ensuring that demand on the high price service can be met most of the time and the excess capacity available on the train is then used for running the low price service. However no such Yield management example is available within the natural monopoly model of the Indian Railways, particularly freight. Block Rates or Multi-part tariffs Price structures can be setup to vary prices not only between markets, but also between consumers in the same market. The regulated firm cannot identify individual consumers by type and charge each consumer a different price. Instead the firm uses quantity consumed as a signal indicating a consumers underlying taste for the good, and designs a non-uniform price schedule so as to price consumers differently according to the amount that they buy. The tariff structure consists of an access fee and different usage charges for different blocks of consumption. This scheme is, therefore, also known as block-rate tariffs. Block rate tariffs require decisions about the number of blocks, the threshold between block and the tariff in each block. Given the threshold the optimal prices for the blocks

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are Ramsay prices. Usually the elasticity of demand for consumption in the lower blocks will be lower than the marginal elasticity of demand in the higher blocks. According to the inverse elasticity rule the mark-up over marginal cost will be higher in the lower blocks. If marginal cost is constant then it will result in a declining block rate tariff. Declining marginal costs, e.g., because of lower costs for servicing bulk consumers will further accentuate the decline in tariff with increasing consumption. Thus summarizing all the Responses available at hand for Pricing for the Indian Railways we arrive at the following options: 1. Marginal Cost Pricing with Subsidies- The perfect outcome of price equals the marginal cost. However with economies of scale and decreasing average costs, price equal to marginal cost will imply price less that average cost and the operator will not ‘break-even’. Therefore, marginal cost pricing is possible only if it is accompanied by subsidies to cover losses. However, this distorts the overall market structure and results in indiscriminate exploitation and wastage of resources and hence is undesirable. 2. Average Cost Pricing- While this achieves break even it is a second best solution as it represents a deviation from marginal cost pricing and, therefore, loss of welfare. 3. Optimal two-part or non-linear pricing- In this case there is a lump-sum access fee and a per unit usage charge. In some circumstances this may result in the first best but generally only the second best will be achievable. The above rudimentary approaches to pricing get further developed in multiproduct situation to Comprehensive Pricing Strategies are as follows: 1) Marginal cost pricing if the marginal costs if the different outputs could be identified, and if marginal cost pricing yielded sufficient revenue to cover total cost, including joint and other fixed costs. This is unlikely to be feasible in the presence of economies of scale and scope. 2) Ramsey Pricing also referred to as the inverse elasticity rule. In this case different products are priced at marginal cost plus a markup for each product which together are just sufficient to allow the firm to break- even. The markups are inversely related to the price-elasticity of demand for a

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product so that they result in the minimum loss of welfare. However, elasticity estimates are difficult to obtain and the resulting prices in many situations may appear unfair on grounds of social justice. 3) Perfectly contestable market pricing. These are the prices that would prevail in a market with no sunk costs and, free entry and exit. This establishes a floor and ceiling for the individual prices and a rate of return criterion for all prices taken together. It also provides a test for “cross subsidy”. 4) Cost based pricing involving allocation of joint and common costs. While the allocation rules are usually arbitrary and without any economic foundation this methodology has found favor with regulators because of perceived fairness. 5) Cost plus pricing where the services are priced on the basis of the Average Cost of producing the services (plus a profit element). 6) Value based pricing where the user is charged on the basis of the value of the service to him (in this case the price is not linked to the cost of providing the service). 7) Capacity Pricing which is used where the equipment costs constitute an important part of the total costs, the service may be priced at the level where the capacity is fully utilized and thus generates economies of scale. This was the typical policy followed by the Japanese auto manufacturers, which enabled them to capture large market shares in the international markets. 8) Bundling which involves providing a bundle of services. The prices are set for the bundle of services as a whole though individual prices may also be available. An example of this could be provision of tourist packages including train and road journeys as well as accommodation. The provision of all inclusive fares on Rajdhani’s (including food and linen charges) could be another example of bundling. 9) Peak Pricing in which a major determinant of cost is the level of provision. Not only are some of the vehicles only at peak times, but many crews

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maybe needed for the peak and not fully utilized at other times. There are two main ways of looking at this – Either most costs are allocated to the days service as a whole, on a time and/or distance bases, with only the extra peak output costed wholly to the peak or alternatively the peak output can be seen as the raison d’etre of the service, with all the costs of providing it allocated initially to the peak( i.e. all vehicles, and a shift of crews), with the extension of service to the other parts of the day seen as an incremental cost. 10) Dynamic Pricing with Higher peak fares and discounted off peak fares which serves the following two purposes: a) It helps in leveling the demand as some users with high price elasticity shift to the off peak times/seasons( helps ease the problem of congestion for the other remaining users); and b) It helps attracting new customers during off peak times thus improving the capacity utilization in off peak times/seasons. Conclusion: Thus, we have seen that the policy prescription is determined by the objectives desired to be met by the policy. Since, the Indian Economy as a whole at large and the Indian Railways as an organization within it are both in a state of tremendous flux at this moment so the policy objectives are also undergoing big changes. The policy objectives could very from profit maximization, revenue maximization, and welfare maximization or cost recovery with minimal profits depending upon the market situation and the management model. An appropriate strategy can then be developed for meeting these objectives. References Anand,I.P.S and Shinghal, N- Pricing of Transport Services. Abe.M.A.:Skytrains(1979): Competitive Pricing, Quality of Service and the Deregulation of the Airline Industry, International Journal of Transport Economics. Brooks M, Button K.J.(1994): Yield Management: A phenomenon of the 1980s and the 1990s, International Journal of Transport Economics, June `1994.

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Botimer T.C(1996): Efficiency Considerations in Airline Pricing and Yield Management, Transport Reviews- July ‘1996. Button K.J(1993): Transport Economics; chapter 6. Hanna N,Dodge H.R.(1995): Pricing: Policies and Procedres, Macmillan. White Peter 1995: Public Transport- Its planning, management and operation, Thrid Edition, UCLpress. Tariff setting on Indian Railways- Principles, Practices and Propositions: Bhandari M.S. The Economics of Transportation Pricing, Taxation and Subsidy: Ray S.K. Subsidies in the Transport Sector: Poulose A.V. Price Regulation of Natural Monopolies: Sinha S. The Indian Transport Sector- Long Term Issues Executive Summary of the World Bank Report Smith, Leinkuhler & Darrow(1992): Yield Management at American Airlines, Interfaces, Jan-Feb’1992. IIR 2007 – Rural Infrastructure, (Eds.) P. Kalra and A.Rastogi, New Delhi: 3iNetwork and Oxford University Press, pp. 22-24. India Infrastructure Report 2004, Bringing about value for money in Infrastructure, Morris S. (ed.), New Delhi: 3iNetwork and Oxford University Press. India Infrastructure Report 2003, Public Expenditure Allocation and Accountability, Morris S. (ed.), New Delhi: 3iNetwork and Oxford University Press. McKinsey Quarterly, November, accessed on March 15, 2008, http://www.mckinseyquarterly.com/Economic_Studies Laffont, J-J., 2005, Regulation and Development, Frederico Caffe Lectures, New York, USA and Cambridge, UK: Cambridge University Press. Nagaraj, R., 2006, “Public Sector Performance since 1950: A fresh look”, Economic and Political Weekly, XLI, 25, June, 2551-2557. Sankhe, S., 2007, “Creating a modern Indian city: An interview with Delhi’s chief minister”, Sheifer, A. and R.W. Vishny, 1993, “Corruption”, Quarterly Journal of Economics,599-617. Wikipedia, 2008, http://en.wikipedia.org/wiki/Indian_Railways

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Sriraman, S., 1997, “Financing Transport Infrastructure and Services”, in D.M. Nachane and M.J.M. Rao (eds.). The Regulation Book of Knowledge: Glossary. Cantos, Pedro and Campos, Javier: Recent changes in the global rail industry: facing the challenge of increased flexibility. Nicole Adler, School of Business Administration, Hebrew University of Jerusalem, Israel, Chris Nash, Institute of Transport Studies, Leeds University, United Kingdom, Esko Nishkanen, Infrastructure in Europe. The Economics if EU Railway Reform, Pietrantonio,L.D, Pelkmans, J. Leeds University, United Kingdom and adpC, Belgium: Barriers to Efficient Cost-based Pricing of Rail, Air, and Water Transport

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