Pricing Policy -

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
 J&K Line- 290 Km- 7/14 years
– Sanctioned cost Rs 1800 cr
– Anticipated cost Rs 11,000 cr
 Delhi Metro Phase I- 5 years
– Sanctioned cost Rs 4800 cr
– Actual cost Rs 10,000 cr
Cross subsidization between Freight &
Passenger Services

Year Cost Rate Ratio Cost Rate Ratio

per per per per
Pass Pass NTKm NTKm
Km Km
93-94 25.18 16.52 65.6% 35.31 49.75 140.9%

94-95 25.78 17.10 66.3% 39.02 54.77 140.4%

95-96 26.57 17.89 67.3% 39.60 56.53 142.8%

96-97 28.72 18.55 64.6% 43.28 60.05 138.7%

97-98 33.62 19.90 59.2% 59.20 68.89 136.5%

Planning for the Future
 Total Investment planned for the next 8 year period (2007-
2015) 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
Present Performance Passenger
Contd.

The Rate of Growth
Growth in Freight during the previous year

The Growth Contd.
The Growth in the Passenger Business
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
 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 term-
although 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
 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 monopoly-
power.
 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.
 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
 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
 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.
 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.