Pricing Policy

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What are the options available with Indian Railways By Rahul Gosain MA(PP&SD) 2008-’10

Indian Railways-At the Cross Roads
 Indian

Railways has recently shown a profit of more than Rs.25,000 Crores.  Today it’s the second largest profit making PSE in India after ONGC.  Indian Railways was said to be “Heading for bankruptcy in 2001” as per the Expert Group on Railways (July 2001, NCAER).  What does this now mean for IR?  Lets view these facts in perspective!

Few e.g. of the Cost Overruns The impact of failure to execute projects within time

Konkan Railway Corporation- 760 Km- 7 Years
– –

Sanctioned cost Rs 800 Cr Completion Cost Rs 3200 Cr Sanctioned cost Rs 1800 cr Anticipated cost Rs 11,000 cr Sanctioned cost Rs 4800 cr Actual cost Rs 10,000 cr

J&K Line- 290 Km- 7/14 years
– –

Delhi Metro Phase I- 5 years
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Cross subsidization between Freight & Passenger Services
Year Cost per Pass Km 25.18 25.78 26.57 28.72 33.62 Rate per Pass Km 16.52 17.10 17.89 18.55 19.90 Ratio Cost Rate Ratio per per NTKm NTKm 49.75 54.77 56.53 60.05 68.89 140.9% 140.4% 142.8% 138.7% 136.5%

93-94 94-95 95-96 96-97 97-98

65.6% 35.31 66.3% 39.02 67.3% 39.60 64.6% 43.28 59.2% 59.20

Planning for the Future

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Total Investment planned for the next 8 year period (20072015) is Rs.350,000 Crores for the DFC project ALONE which WILL ALSO SPILL OVER TO THE NEXT PLAN. Rs.350,000 Crores( Sanctioned Investments on IR’s most ambitious project yet, the DFC.) The planned investments for the Xth FYP was Rs.60,000 Crore( Actual expenditure has crossed Rs.80,000 Crore). Every 1000 cr increase in cost will mean need to generate 10 Million TKms of additional traffic every year for the next 20 years to service additional debt. At present the Freight Services market is 481 BTKms growing at a rate of 12%.

The XI FYP at a Glance
 Total

Plan Size (XI FYP)-Rs.250,000 Cr.  Mobilization targetted through PPP-Rs. 1lakh Crores.  Total Outlay(2008-09)-Rs.35,000 Crores.  80% of funding to be through Internal Generation & Budgetary Support.

The current modal mix
Passenger movement in India • Road:Railways:Airlines= 86%:12.9%:0.4% • Freight Movement in India • Road:Railways:Airline:Water= 61.2%:38.6%:0.022%:0.2% (Planning Commission, 2007).

High levels of Intercity Transport Consumption
 Current

Indian per capita passenger Intercity Transport Consumption levels is 2330Km per capita per year.  The most obvious long term impact of urbanization- Rapid Growth in Demand for Urban Goods & Passenger movement.  This will translate into increased pressure on infrastructure of city streets and suburban rail systems.

The Present Scenario at a glance

Current Performance in Freight

The Present Scenario Contd. Present Performance Passenger

The Rate ofduring the previous year Growth Growth in Freight

The GrowthPassenger Business Contd. The Growth in the

The Traditional Railway Model

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.

The Traditional Railway Model Contd.

  

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: 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.

Unique nature of transportation services

Transport services cannot be stored and are perishable. The capacity going empty on a plane/train is lost forever once a plane/train departs. The person/cargo becomes a part of the process and it becomes necessary to ensure comfort/safety of the same. Tpt is a derived demand. The services are consumed as a part of the production & distribution process.

Unique nature of Transportation Services Contd.
 Provision

of these services requires a very high expenditure on infrastructure/rolling stock etc.  Tpt is a network industry which gives it its inherently monopolistic character which leads to a power imbalance between the buyer and the seller. There is a need for regulatory controls to help protect the interests of the consumer.

Unique nature of transportation services contd.
 The

output is lumpy , whereas demand is likely to change only in a linear fashion.  It has very high externalities such as pollution, environmental impact, accidents costs etc.  In the case of Railway tpt ( much like other tpt) it is a multi-input, multi-output kind of services system.

What are our Policy Objectives?
Policy Objective for IR -Profit Maximization -Revenue Maximization -Cost Recovery - Welfare Maximization - Obtaining a satisfactory level of profit All these objectives listed above maybe summarized in the form of a comprehensive Policy Prescription as under :Revenue Maximization( while obtaining a satisfactory Profit level) with achievement of an acceptable level of Welfare (with full Cost Recovery).

Profit Maximization
  

It is the traditional Policy Objective in Private Organizations. Actual Price level depends upon the Degree of Competition in the Market. With PM in perfectly competitive environment, it is impossible for any supplier to make super normal profits in the long run. 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.

Profit Maximization Contd.

The effective constraint on the monopolist is the counterveiling power of demand, which prevents the joint determination of both output and price. It is certain that 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.

Revenue Maximization

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Basis: Price at which the revenue is maximized, is not necessarily the same as that at which maximum profit is obtained. Even in the private sector, pure and unbridled profit maximization is rarely the policy objective. 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 staff reduction and layoffs.

Revenue Maximization Contd.
 

The Objective also depends upon the time frame of the policy. In the short term steps taken towards PM may in fact damage the market potential during the long termalthough the yield per mt has increased to Rs.62 Crore (from Rs.55 Crore per MT just 3 yrs back) but the sounds of dissent are already beginning to be heard from vital stakeholders like the Steel Industry. Alternately, in case the barriers to entry are not high, the potential of profits may lure newer entrants into the markets.

Welfare Maximization

Welfare is maxmized when Price= Marginal Cost Such a condition exists in the long term when there is Perfect Competition. Price= Marginal Social Cost leads to Allocational Efficiency. Marginal Social Cost= Short Run Marginal Cost+ any external costs or benefits In case services are priced above this then the following consequences can ensue: Customers may shift to other modes( which may impose higher costs to the economy, such as higher environmental effects, higher imports and lower basic energy efficiencies as is seen in the case of shifts from rail to road transport). Production facilities developed far from the Production centers may become uneconomical because of the high cost of transport which in turn distorts the economic and demographic growth adversely.

Cost Recovery (with an acceptable level of profit)
 Basic

strategy of Cost plus pricing is followed.  This is very popular among public utilities and power sector organizations.  Price= Average cost of providing service (plus an acceptable level of profit as the case maybe).

Pricing Policy Options?
 Price

Discrimination Degrees of Price Discrimination & Examples of First, Second & Third Degree Price Discrimination. Ramsey Pricing Yield Management Block Rates, Non linear or Multi Part Tariffs

Price Discrimination

PD is selling of different units of same product to different customers at diff. prices. There are three degrees of PD: First Degree also known as Perfect PD: In this different units of a product are sold at different prices to different customers. Eg. Yield Management systems used by Airlines. Second Degree: Different units of output are sold at different prices but every user who buys the same amount of good pays the same. For eg. Systems where quantity discounts are given.

Price Discrimination Contd.

 Third

Degree: When different rates are charged from different users for the same product. However, every unit sold to a given user is sold at the same price. Eg. Negotiated rates where different organizations are able to negotiate different preferential rates for transport services.

Ramsey Pricing

This is also known as the Inverse Elasticty Rule- In the case of a multi product firm where the cross elasticty between the various services is negligible then Price = Short Run Marginal Cost + a markup that is inversely proportional to the service’s price elasticity of demand. This can be used for push up revenues above marginal cost to target levels without adversely distorting the allocation between services.

Ramsey Pricing Contd.
Is not always possible on account of: High Administrative Costs of system Lack of Knowledge regarding demand & elasticities. Also comes under criticism on account of Equity considerations as well as because of distributional consequences. Eg. Passengers with low elasticity maybe from poor sections of the community and maybe unable to transfer to alternative means of transport.

Yield Management
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Seats are a perishable resource and represent a net loss once the train/ship/ airline has departed. The policy followed by airlines is by offering seats at different prices to different people has been named Yield Management. It was defined by American Airlines as,”Selling the right seats to the right customers at the right price”. Formally it is a combination of Dynamic price discrimination and Product differentiation in order to maxmize revenue from a pre-defined activity.

Yield Management Contd.
The Supply of service must exhibit the following characteristics:  Scheduled services  The supplier has correct and exact information on what the “market will bear” i.e. there exist good forecasting & market research models.  The supplier enjoys a good degree of monopolypower.  It is possible to product differentiate.  There is information assymetry (the customers have less information about the options available to them than the supplier has about the availabilty of capacity.

Efficiency Considerations in Yield Management
 Seats

are allocated to passengers who have the highest value of being on the flight (or the highest opportunity cost of not being on the flight).  The process of allocation of discounted seats results in less fixed cost per seat. Thus, it results in either reduced fares or higher service frequencies- both of which are beneficial to passengers.

Eg. of Yield Management as applied in Rail Freight in America
 Offering

two classes of services- a high price, high speed and a low price, low speed service. Trains schedules planned so as to meet the demand on the high price service say 99% of the time and the excess capacity available on the train is then used for running the low price service.

Block Rate or Multi- part Tariffs

We use the quantity consumed as a signal indicating a consumers underlying taste for the good, and design 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. Block rate tariffs require decisions about the number of blocks, the threshold between block and the tariff in each block

Block Rate Tariffs Contd.
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The optimal prices for the blocks 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. Thus 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.

Policy Strategies Available
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MCP Ramsey Pricing Yield Management Cost based pricing Cost plus pricing Value Based Pricing Capacity Pricing Bundling (and likewise Unbundling) Peak Pricing Dynamic Pricing

Conclusion

Policy will depend largely on policy objectives required to be met. Indian Economy & also Indian Railways is in a state of flux. Once the tone is set which decides the management model that the railways will follow in India and the framework in which the services are to be provided then the policy to followed can be decided accordingly.

THANK YOU
The views expressed are my personal views and are not necessarily those of the Indian Railways.

Acknowledgements

Dr. Surender Kumar for his valuable guidance on the various issues involved in this subject.

References & Bibliography
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White Peter 1995: Public Transport- Its planning, management and operation, Third Edition, UCLpress. Botimer T.C(1996): Efficiency Considerations in Airline Pricing and Yield Management, Transport Reviews- July ‘1996. Abe.M.A.:Skytrains(1979): Competitive Pricing, Quality of Service and the Deregulation of the Airline Industry, International Journal of Transport Economics. 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.

References Contd.

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Laffont, J-J., 2005, Regulation and Development, Frederico Caffe Lectures, New York, USA and Cambridge, UK: Cambridge University Press. 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, Leeds University, United Kingdom and adpC, Belgium: Barriers to Efficient Cost-based Pricing of Rail, Air, and Water Transport Infrastructure in Europe. Pietrantonio,L.D, Pelkmans, J.: The Economics if EU Railway Reform.