Transport economics and management

Cost functions

Eric Pels apels@feweb.vu.nl

Volkskrant, 21/2/2013

Privatiseren spoor is kapitaalvernietiging op kosten van belastingbetaler Rail privatisation is capital destruction at the expense of the tax payer. EU wants to privatise EU rail market by 2019; members have to partition national network and tender the parts regularly. Members have to facilitate equipment of winning companies. Cost aspects?

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This lecture

Cost functions.

Theory of cost. Scale effects Empirics Examples Understand assumptions underlying cost functions Understand how cost functions are applied in transport related studies

Learning objective:

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Introduction

Factors of production Land (raw materials) Labor Capital (man-made resources)

for bus company: e.g. fuel e.g. drivers e.g. buses

Machines Computer systems Financial capital

Entrepreneurship

e.g. ownership/ management?

Risk-taking; organization of other factors

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Cost function

Choose production factors so that costs are minimized Produce output Q (e.g. Q=LK ) Use e.g. production factors:

Labour L at price w Capital K at price r

Minimize: C=w*L+r*K Subject to: target level Q can be produced from (K,L) Cost function C=C(Q,r,k): mimimum cost of producing Q given input prices, using optimal levels of (K,L).
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Cost function
labour Production: Q=f(L,K) Isoquant: L=f(Q,K) Same cost, lower output

L*
Iso-cost: L=(C-r*K)/w

K*
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capital

Cost function

Cost minimization: slope iso-cost = slope isoquant r/w=L/K Can be solved explicitly when f(K,L) is specified. C=C(Q,w,r)

Increasing in Q Non-decreasing in w,r C(Q,x*w,x*r)=x*C(Q,w,r)

Application of C=C(Q,w,r) (implicitly) assumes cost minimization!

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Costs

Fixed costs

Fixed costs for transport company? Outsourcing transforms fixed into variable costs.

Variable costs

Marginal costs: change in TC (VC) resulting from a unit change in output.

TC/Q; TC=total cost, Q=output

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Economies of scale

Cost function: C(Q,w,r) Average cost (AC): C/Q Marginal cost (MC): C/Q Elasticity of cost with respect to output:

(C/Q)*Q/C

(C/Q)/(C/Q)

= MC/AC

MC < AC: economies of scale or increasing returns MC > AC: diseconomies of scale or decreasing returns MC=AC: No economies of scale (constant returns to scale)

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Average costs

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Output
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Sources of economies of scale

Technical economies of scale

E.g. aircraft size. Producers with good reputation attract expensive but efficient management. Fewer workers necessary, large output. Large producers can negotiate favorable contracts with suppliers Marketing effort spread over large output

Managerial economies of scale

Marketing economies of scale

Financial economies of scale

Large producers perceived to have lower risk

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Sources of diseconomies of scale

Red tape

Paper work and coordination effort increases with size of producer. Chain of command becomes longer as producer grows.

Communication problems

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Economies of size in (transport) networks

Transport companies have networks Measures of size of company

Outputs (passengers, seats, tons of freight, passengerkilometers, seatkilometers, tonkilometers, trainkilometers etc.) Network size (e.g. points served)

Two measures are used in the empirical literature to analyze economies of size for network companies:

economies of scale economies of density

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Economies of density

Economies of density:

average costs are reduced when output is increased by using existing capital more extensively (M+G, p. 76). the reciprocal of the elasticity of total cost with respect to output, with all other variables (including points served, average load factor and input prices) held fixed (Gillen et al., 1990, Caves et al., 1984).

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Economies of density

Empirical literature may be confusing

Economies of density estimated using (C/Q)*Q/C = MC/AC

Theoretical definition of economies of scale but this uses the elasticity of cost with respect to output!

RTD

where y

C Q MC Q C AC

Economies of scale focuses on physical network size (e.g. number of points served in network)

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Economies of scale

In applied transport literature, economies of scale focuses on physical network size defined as the reciprocal of the sum of the cost elasticities of the output and points served, with all other variables, including average load factor, held fixed.
RTS 1 , Q p where p C P (P points served) P C

Easy interpretation: When we increase the number of passengers and destinations in our network, the average cost per passenger decreases.
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But

Can we keep average load factor constant?

B 150 pax A 150 pax +1 station B

150 pax 100 A pax 150 pax

C 300 pax, 3 stations

C 400 pax, 4 stations

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Applications of cost functions

Description of production technology (economics)

E.g. scale economies

Cost minimization Firm with lowest cost is peer. Add trend variable t to C; C/t is technological change

Efficiency analysis

Technological change

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Specifications

Cobb-Douglas specification: C=Qwr lnC=ln+lnQ+lnw+lnr

Economies of scale parameter:

Marginal cost: C/Q=Q-1wr Average cost: C/Q=Q-1wr MC/AC=C/Q*Q/C=

(lnC/lnQ=)

<1: economies of scale >1: diseconomies of scale

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Specifications

Short-run Cobb-Douglas specification: Assume capital is fixed: lnC=ln+lnQ+lnw+lnK

Amount of fixed capital is explanatory variable! (Rather than price of capital)

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Specifications

Translog specification: lnC=0+*(lnQ-lnQ*)+*(lnw-lnw*)+*(lnr-lnr*)+ (1/2)**(lnQ-lnQ*)*(lnQ-lnQ*)+ (1/2)**(lnw-lnw*)*(lnw-lnw*)+ (1/2)**(lnr-lnr*)*(lnr-lnr*)+ *(lnQ-lnQ*)*(lnw-lnw*)+*(lnQ-lnQ*)*(lnr-lnr*)

Often used in literature. Standardization.

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Specifications

Translog specification: lnC/lnQ= + 2**(lnQ-lnQ*)+*(lnw-lnw*)+*(lnr-lnr*)

Flexible functional form: no a-priori restrictions on parameters

economies of scale dependent on output level

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Estimation

Cobb-Douglas: OLS Translog: OLS or more complicated (SUR)

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Example

The cost of air service fragmentation (Tolofari, Ashford and Caves, 1995) Different airports around London

Capacity problem: congestion Other airports have surplus capacity

Cost implication of moving flights from large airport to small

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Example

Sample:

7 airports controlled by BAA 1 company; same accounting principles 12 years (1975/76-1986/87): trend variable necessary Standardization: mean
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Translog

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Example

Variables:

Output: WLU ( person = 100kg freight) Input prices:

Labour: labour cost / #employees Equipment: equipment cost / net value of airport property (value depreciation sales of asset) Residual: (operational cost labour equipment) / net value of airport property

Operating characteristics: passengers per ATM, % international traffic, capital stock, capacity utilisation Heathrow dummy
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Example of results table

coefficient y LP EP RP YY R2adjusted: 0.99 Variable Output Labour Equipment Residual factors *output2 Parameter value 0.4459 0.4984 0.1543 0.3474 0.2153 t-value 11.09 34.36 31.177 35.3970 8.1634

50 other coefficients

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Example

Some results

0.2153 2 ln Cv ... 0.4459 ln y ln 7.2922 ln y ln 7.2922 ... 2 ln Cv 0.4459: Economies of scale for average airport ln y y 7.2922

Airport specific values: LHR: 0.47; LGW: 0.51; STAN: 0.27 What is the cost implication of moving flights from large airport (LHR) to small (STAN or LGW)?
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Efficiency analysis, benchmarking

Cost minimization: minimize cost to produce given output level. Benchmarking: comparing business (performance metrics) to industry bests. Various tools

Partial indicators (e.g. labour productivity) Frontier analysis

Cost frontier Production frontier

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Applied literature, scale effects, summary.

Economies of scale (density) Rail Yes Focus U.S. (freight) Europe (passengers) U.S. Asia U.S. Most popular specification Translog Remarks Popular topic Policy oriented Deregulation Often public Small companies eos? 1 study

Airlines Buses/Urban transport Motor carriers/trucking companies Airports

Yes Yes Mixed results

Translog Translog Translog

Yes

U.K.

Translog

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Rail

Economies of density found in literature What is a potential effect of partitioning a rail network on cost per passenger?

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Regression - OLS
observations regression line: lnC=K+a*ln(X) errors (v) Determine K and a such that (v)2 is minimized

ln(C)

ln(X)

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Regression - COLS
OLS curve ln(C) COLS curve

Most efficient observation (firm)

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ln(X) Corrected OLS; error term gives deviation from minimum cost.
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Frontier analysis

OLS: ln(C)=K+a*ln(X)+v v has normal distribution Stochastic frontier: ln(C)=K+a*ln(X)+u+v v has normal distribution u is non-negative error term v+u: compound error term (composed error model)

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Frontier analysis

ln(C)=K+a*ln(X)+u+v C=K*Xa*eU+V Efficiency coefficient: EC = CMIN/C = K*Xa*ev/K*Xa*eu+v =e-u Same output can be obtained at fraction EC of costs Estimation of cost frontier:

Maximum likelihood (freeware: FRONTIER) Interpretation: coefficients as with OLS; efficiency coefficients

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Example

Efficiency of European railways (Cantos and Maudos, 2001) Cost inefficiency of regulated railway companies in Europe, 1970-1990

1991: change in accounting principles

Method: translog, stochastic frontier Data: 16 companies, 21 years

Some missing values

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Example

Variables:

Outputs: passengerkilometers, tonkilometers Price of labour Price of energy Price of materials

1970 1975 0.91 0.87 1980 0.94 0.89
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Average levels of cost efficiency

1985 0.93 0.90 1990 0.93 0.87 19701990 0.92 0.87

NS Average

0.95 0.88

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Summary

Cost function: assumes cost minimization Economies of scale/density: average costs decrease as output increases Applications: Cost function estimation

Scale effects important in transport sector

Pricing, mergers

Benchmarking

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