PROJECT

Prepared for: Microeconomics Prepared by: Tudose Ana-Maria, Ungureanu Magda, Scarlat Aurelia-Stefania Date: 03.01.2011

Expensive Way Home

Analyzing the Natural Monopoly Of Railway China

Table of Contents
Table of Contents..............................................................3 Introduction......................................................................3 Railway China: natural monopoly and managerial limitation ........................................................................................4 Railway China: analysis on price rise..................................9 Recommendations...........................................................13 Conclusion......................................................................15 Reference ......................................................................16

Introduction
Every Chinese New Year brings mixed feeling to every Chinese family and their traveling members, those who are busy preparing for this momentous festival and those who cant wait to be on their

way home for a family reunion. However, they all find out the homecoming has become more and more difficult and unaffordable beyond their expectation. Jan 4th 2004, as the supervisor, as well as the sole carrier, of railway transportation of China, the Department of China Railway (Railway China) promulgated the temporary scheme for the price rise of train tickets during the Chinese New Year period, with a markup of 20% in average. However, even in China, a country used to be so economically centralized, it is rare to find business with such high monopolization both in resources and in pricing. Apparently, each time the price adjustment was announced, it has caused more argument than it should have. Following the aftermath of the rocketing of the plane ticket price at the end of the year 2003, the price jump of train ticket threw a huge argument among consumers. The intention of this paper is to analyze the reasoning and economics behind those expensive trips Railway China made for its consumers.

Railway China: natural monopoly and managerial limitation

The term economies of scale refers to a situation where the cost of producing a good or service decreases as the volume of production increases. The converse situation in which the cost of producing a good or service increases, as the volume of production increases is known as diseconomies of scale. Economies of scale tend to occur in industries with high capital costs in which those costs can be distributed across a large number of units of production. In such industries, marginal cost is usually low when compared with their high capital costs. As we can notice that in some industries, plentiful participants are often more efficient than just a few (e.g. many consumer goods such as garment and apparel) while in other industries, the market simply becomes inefficient with many players (e.g. utility such as gas, electricity). The exploitation of economies of scale helps us explain these phenomenon and answer questions such as why companies grow large in some industries and how a natural monopoly can often occur. A monopoly is a situation where there is only one seller in the market. A firm under perfect competition is often regarded as a price taker because it has no effect on the market demand and price by making decision. It takes the market prevailing price as given and can only decide on what quantity to produce. However, a monopolist's demand is in fact the market demand, and hence the monopolist can set its own price. Monopolies can be considered inefficient because they produce a lower output and charge a higher price than competitive firms would and that they incur deadweight loss. Therefore, from consumers point of view, their welfare is not maximized as they pay higher price for goods (if they can get any since the quantity is reduced). This gives room for government to step in. Government regulates monopolies mainly for: (a) to make the monopoly more efficient (b) to maximize consumer welfare. It can achieve these by requiring the firm to produce more efficiently and to produce more output so that price is equal to MC. A natural monopoly is a company that becomes the only supplier of a product or service because the nature of that product or service makes a single supplier more efficient than competing ones. This firm can produce and meet the entire market demand at a lower cost than with more suppliers when economies of scale exist over a wide range of output. As Hal Varian defined, the etymologic meaning for Monopoly is the exclusive right to sales. Nowadays, however, it is used mostly to describe the exclusive control of a commodity or service by one or more sellers, within a given market. The term Natural Monopoly

describes a situation where one firm can produce a given level of output at a lower total cost than can any combination of multiple firms. If such subadditivity exists in a certain industry, then we consider that natural monopoly exists, with or without economy of scale. According to this definition, Railway China is a typical natural monopolistically industry, whose long life-spanned fixed assets are hard to transform to other use and thus have great sedimentation. This characteristic makes the construction of railways within a certain region highly uneconomical and thus catalyzes the regional natural monopoly of railway industry. To be more specific, the sedimentary fixed assets have become high entry barriers for this monopolistic market. However, theoretically and practically speaking, as a naturally monopolistically department, Railway China has the below stated defects. 1. Managerial deficiency

From a pure economic perspective, every producer, if aiming at maximizing their profit, will have to lower their cost as much as possible, no matter if they are in a fully competitive or a highly monopolistic market. In reality, however, Railway China doesnt have to experience severe competition to earn its huge profit. Therefore, it lacks of motivation of lowering its cost as much as possible and, thus, expresses extremely low efficiency. According to relevant statistics drawn from 1000 residents from Beijing, Wuhan and Xian, three of the most populated city in China, 29.3% of them think there are great difficulty in purchasing a ticket without paying a too high price; 36.3% of them maintain that the establishments and facility of Railway China are outdated and its service not fulfilling; while 57.3% of them think the overall environment on the train is far from satisfying. Lack of motivation for managerial innovation is the biggest problem. 2. Unconcerned about R&D.

As one of the Crown companies who enjoy governmental allowance, even if Railway China doesnt practice any systematic reform, or make any effort on lowering its cost, it wont suffer from any noticeable loss. In other words, it lacks the motivation as well as the pressure to lower its cost in order to create efficiency. Unless the below listed situation emerges, there would be no major change for Railway Chinas policy: 1) Competition from its substitute, such as highway and airway transportation, force Railway China to react with more active and economically healthy strategies;

2) What Railway China is doing damages the majority interest of China, shrinking the collective well-being so much that it negatively impacts the Chinese economic growth. Then, outside pressure necessitates its reform or innovation. However, the characteristic of the population of China (large population), combined with the fact that the highway and airway networks are less developed, makes railway transportation relatively the cheapest and the most feasible method, so the above described situation and the kick for Railway China to practice any reform (managerial and technological) become less likely to happen. 3. Artificially increase the price to confine the amount of service rendered. In natural monopoly, the technical characteristic of digressive cost eliminates fully competition. For Railway China, its marginal cost is digressive, and it is below its average cost. Therefore, when its price is equal to its marginal cost, this price will be lower than its average cost, a situation that will make its profit negative and make it incur a loss. This is shown in the graph, Pricing in Nature Monopoly. As shown in this graph, the shaded part is the loss. Obviously, Railway China would not produce at the point where price equals it marginal cost. What it applies is the principle of marginal cost equals marginal revenue, and produce Q2 with the price of P2. This action, however, has already jeopardized the collective well-being. As shown in the graph, since Q1 is the social efficient production, with the production of Q2, the total value for Railway China to render its service to its consumers is bigger than the its marginal cost, thus to increase the amount of service will increase the total surplus.

P P 2

P 1 Q2 MR

AT C MC DEMAN Q1 D Q

Pricing in Nature Monopoly

Theoretically speaking, in order to decrease the total loss of collective well-being due to a natural monopoly like this, government should practice price regulation, according to its Marginal cost pricing or Average cost pricing principle and then, if necessary, give Railway China an appropriate subsidy. However, the regulated price is made based on historical data of the cost provided by Railway China itself. Obviously, this price-setting method gives competition-free Railway China great opportunity to add either all its high cost, mainly from its low efficiency, or the artificially exaggerated part of cost (in order to obtain monopoly rent) into the price of train ticket. Consequently, such bidding up leads to the price of train tickets largely exceeding the normal cost. On the one hand, this unavoidably creates production inefficiency and resource misallocation. On the other hand, if government wants to lower price by offering subsidy in order to avoid economical convulsions, as it did all these years, it has to do so by taxation. Obviously, the increase in tax will increase other economic cost and lead to further shrinking of the total well-being. Simply put, even before Chinese New Year price rise, the monopolistic and competition-free position of Railway China has put its consumers in a disadvantageous situation and caused huge deadweight loss.

Railway China: analysis on price rise

The supervisor of an industry, Railway China uses its monopolistic advantage to raise the price of train ticket. Nevertheless, this is not handled according to market rules and couldnt be further from a market behavior. Ideally, if the capacity of carriage is below demand, price rise should give no fair cause to criticism. However, a price that only increases and never decreases is unendurable. Meanwhile, the legality of price rise during Chinese New Year is fishy. Since this is price rise of public service, it is necessary to hold a hearing of witness to request different opinions from consumers and operators in order to argue its necessity and feasibility. Furthermore, if, by any chance, the price rise is manipulated in the light of the market rules, then after Chinese New Years Day, when everybody stays home and there are only few people to take the train, Railway China should depreciate its ticket price. Nonetheless, this is never the case.

Analyzing from the relationship of monopolistic marginal revenue and monopolistic marginal cost, the graph shows The Cause of Formation for Price Discrimination.

P A P

K1

M D K2 F

O D MR Q C B Q

The Cause of Formation for Price Discrimination

Suppose the Demand Curve AB is linear, AC is the marginal revenue curve, this graph draws us a monopolistic industry, like in our case, Railway China. If we take P for price and Ed for price elasticity of demand: Since Ed=BM/MA=OP/PA, and APDMFD AP=MF Ed=OP/PA=OP/(OP-FQ). OP=P, FQ=MR Ed=OP/(OP-FQ) MR=P*(1-1/Ed) Assume a given market (with a given MR) consisted of K1 and K2, which have different Ed, and then we have: K1: MR1=P1*(1-1/Ed1); K2: MR2=P2*(1-1/Ed2) and MR1=MR2

When Ed1<Ed2: (-1/Ed1) < (-1/Ed2) 1-1/Ed1<1-1/Ed2. P1>P2 In other words, when Ed differs, Railway China, without any improvement of its performance, can easily ask for a higher price to a less elastic market (K1) and increase its monopolistic revenue with the discrimination price. In Chinese New Year period, when a large number of people floods the transportation centers, the utility in homecoming for reunion is skyrocketing, thus, the price elasticity of demand of this floating population is very low, or we can even say it is rigid and with huge demand.

P B P
2

M N MC

P
1

A MR Q
2

DEMAN D Q
1

Inefficiency in Monopoly
Before the price rise, Railway China has already increased its producer surplus by its monopolistic price. Suppose MC is constant, then NBCM is the lost consumer surplus, MAN is the deadweight loss. During Chinese New Year, student passengers, labor passengers and other tourism passengers entwine with each other and consist of a continuant passenger flow with low elasticity of demand. Railway China, therefore, applies price discrimination to transfer its high cost caused by its low efficiency to the passengers by the price rise and, thus, create an even more disadvantageous situation.

Hence, the graph of Inefficiency in Monopoly changes as follows. Using J as the axes, demand curve D1 shifts outward and becomes steeper to intersect with the axis of price at point E, and thus forms D2. We can also draw the marginal revenue curve before the price rise MR1 and after the price rise MR2. We, then, assume that MC, compared to D, is constant. Therefore, facing us is the K1 market situation described above: Railway China raises its unfair price again from P1 to P2, and thus the curve shifts from D1 to D2 as shown in the graph, Monopolistic Profit and Well-being shrinkage after Price Rise. Because of the low elasticity of demand, the price rise earns Railway China huge easy money. Consumer loss increased by ABCD+ BCJ, with BCJ being the deadweight loss. The consumer loss of ABCD doesnt consist of total loss of collective well-being, because its just income transfer. However, it fosters the desire of Railway China for squeezing excess profit by keeping its low-efficiency status as it is, which is detrimental to the economic growth of China. P E

MR2 P 2 D C D2 P 1 A MR1 B D1 MC J Q1 Q

Monopolistic Profit and Well-being shrinkage after Price Rise

Furthermore, monopoly like this creates resource using inefficiency as well as inequality of income distribution. Namely, the income Railway China earns through price rise during Chinese New Year can hardly be translated into productivity that benefits the society as a whole. From the point of view of the passengers, they have no control over this higher price (because of the homecoming enhanced low elasticity). From the point of view of society, the unjustified price

rise of Railway China may seemingly look like a market-driven behavior. However, not only cant it solve any managerial problems inherited within Railway China, but it also causes deadweight loss for the collective well-being. With such price rise, the shameful profit collected tries to emphasize the quality of service provided and management becomes less remunerative, thus, inessential, under which circumstances, the lack of pressure and motivation becomes inevasible.

Recommendations
For those natural monopolistic crown industries that specialize in public establishment or services, such as transportation, medical care and electricity, focus on the social benefits as well as economic interest should be well balanced and thoroughly considered. Oversimplified price rise can solve no radical problem but worsen the stability of the society.

Therefore, the following two recommendations are offered for reference: 1. Implementing Franchise Bidding competitive mechanism. to encourage internal

Logically speaking, price regulation and allowance to monopolistic industries should be put into practice, thus, making such industries to utilize marginal cost pricing that could improve efficiency in allocating resources. However, in China, because of the comprehensive existence of information asymmetry, in addition to the severe absence of motivating mechanism to increase efficiency, this method might not be as helpful to reach what is called Pareto improvement. Therefore, by implementing Franchise Bidding, government auctions the franchise of one or several districts among a given period to a number of inter-competing enterprises and, then, authorizes the franchise to whoever bids the lowest price. Obviously, this bidding can help to avoid the potential malpractice in price regulation by establishing a healthy motivating mechanism and, therefore, effectively and economically restrict the monopolization of Railway China. Accordingly, train ticket price will drop to the level of efficient average cost and Pareto improvement can be achieved in this win-win game. This proposal has remarkable feasibility. Firstly, bidding enterprises possess only the operatorship, so theres no fuss for asset transfer; secondly, the franchise contracts contains fairly simple listed terms, including maintenance of railway facilities, pricing for the services rendered and the service standards the franchisees must meet, so that the governmental supervision and administration can be easily implemented with the asset value intact or even reasonably appreciated. 2. Further developing the highway and airway transportation systems. Government should put more effort in energetically developing alternative transportation systems, such as highway and airway, by lowering their costs, to distribute passengers. Doing so not only would it ease the flux of passengers in each transportation center, but it would also give the whole industry healthy pressure for its efficiency improvement.

Conclusion
The price rise during Chinese New Year does not help Railway China in distributing the passengers, instead, it, again, grabs for its designer even more excess profit for covering the high cost due to the inefficient management and operation. Once again, this happy ending defuses the driving force for any innovation and reform, shrinks the collective well-being and, furthermore, hinders the high growth of Chinas economy. The above analysis is established in studying the natural monopolistic position of Railway China, about its short run consequence only. By denying what Railway China has been unfairly practicing all these years, I offer recommendations and feasible solutions in order to beget more sophisticated and penetrating considerations.

Reference
1. ESTRIN, S., LAIDER, D., (1995), Introduction Microeconomics, 4th Edition, New Jersey: Prentice-Hall, Inc. to

2. LEIBENSTEIN, H., (1980), Inflation, Income Distribution and Xefficiency Theory, Barnes & Noble Books-Imports 3. MILLER, R.L., (2000), Economics Today, 10th Edition, New York: Addison-Wesley Publishing Company Inc. 4. PINDYCK, R.S., RUBINFELD, D.L., (2001) Microeconomics, 5th Edition, New Jersey: Prentice-Hall, Inc. 5. 6. www.economist.com www.wikipedia.org