Chapter 2

Transportation
Economics

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Contents
z The Scope of Transportation Economics
z Transportation Demand
z Demand, Supply, and Equilibrium
z Sensitivity of Travel Demand
z Factors Affecting Elasticities
z Kraft Demand Model
z Direct and Cross Elasticities
z Consumer Surplus
z Costs
z Pricing and Subsidy Policies

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1. The Scope of Transportation
Economics
z “Economics is the study of how people and
society end up choosing, with or without the use
of money, to employ scarce productive resources
that could have alternative uses to produce
various commodities and distribute them for
consumption, now and in the future, among
various persons and groups in society. It
analyzes the costs and benefits of improving
patterns of resource allocation”(Samuelson,
1976).
z Economics is divided into two main streams: 1)
Microeconomics; and 2) Macroeconomics.
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z Transportation economics is a branch of
applied microeconomics, yet simple laws of
market economics cannot be applied to
transportation economics due to a number of
specific problems and characteristics:
z The demand for transportation is derived instead of a
demand for its own sake
z Each trip is unique in time and space
z Technological differences among different modes and
economies of scale tend to create problems in
dealing with transportation economics
z Government intervention in transportation also
creates problems in analyzing issues
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2. Transportation Demand
z The demand for goods and services, in general,
depends largely on consumers’ income and the
price of the particular good or service relative to
other prices.
z A demand function for a particular product
represents the willingness of consumers to
purchase the product at alternative prices.
z The term “price” stands for all outlays perceived
by the traveler for a given trip. Most of the
components of the perceived price for travel can
be measured and expressed in monetary units.
This synthetic “price” is sometimes called a
“generalized price”.
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z A linear demand function:
z It assumes a particular level and distribution income,
population, and socioeconomic characteristic.
z It is an aggregate demand curve, representing the volume
of trips demanded at different prices by a group of travelers.
z Functionally represented by: q = α-βp, where q is the
quantity of trips demanded, and αandβare constant
demand parameters.
z A negative slope expresses a familiar situation where a
decrease in perceived price usually results in an increase
in travel, although this is not always true.

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Typical demand function
z Linear demand function for
a given pair of origin-
destination (OD), at a
specific time of day and for
a particular purpose.
z It is an aggregate demand
curve, representing the
volume of trips demanded
at different prices by a
group of travelers.
z Functionally represented by:
q=α-βp

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Shifted demand curves
z The shifted demand curves
represent changes in the
quantity of demand due to
variables other than the
perceived price.
z This is long-run changes
due to activity or behavioral
variables as opposed to
short-run changes in the
quantity of travel due to
price changes, represented
by movement along a single
demand curve.

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3. Demand, Supply, and Equilibrium
z The supply function (or service function) represents
the quantity of goods a producer is willing to offer at
a given price. If the demand and supply functions for
a transportation facility are known, then it is possible
to deal with the concept of equilibrium.
z Equilibrium is said to be attained when factors that
affect the quantity demanded and those that
determine the quantity supplied result in being
statically equal (or converging toward equilibrium).

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Static equilibrium of demand
and supply
z Example 2 (pp. 34)
z Supply (service)
function: t=15+0.02v
z Demand function:
v=4000-120t

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4. Sensitivity of Travel Demand
z Elasticity of demand (ep): percentage change
in quantity of trips demanded that
accompanies a 1% change in price
z Price elasticity:
z Point elasticity: e = δq / q = δq × p
δp / p δp q
p

z Arc elasticity: δq p Q1 − Q0 ( P1 + P0 ) / 2
ep = × = ×
δp q P1 − P0 (Q1 + Q0 ) / 2

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General case of a linear demand
function showing elasticities
z Demand function:
q=α-βp
z Perfectly elastic=-∞
z Unit elastic point=-1
z Perfectly inelastic=0

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 5. Factors Affecting Elasticities
z Income elasticity (ei): percentage change in
quantity of good demanded that accompanies
a 1% change in income
z Normal good: the demand for a good goes up
when a consumer’s income increases
ei > 0
z Superior good ei > 1
z Inferior good ei < 0

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z Factors affect price elasticity:
z The more percentage of income spent on a specific
good or service, the more willing will a customer be to
search hard for a substitute if the price of the good or
service goes up.
z The narrower the definition of a good, the more
substitutes the good is likely to have, and thus the more
elastic its demand will be.
z If consumers find out that the price and availability of
substitutes are easy, the more elastic the demand will
be.
z Those goods that consumers consider to be
“necessities” usually have inelastic demands, whereas
goods considered by consumers to be “luxuries”
usually have elastic demands.
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z Elasticity and total revenue
z e=% change in quantity demanded / % change in price
z If e>1, price and total revenue are negatively related:
an increase in price will reduce total revenue, vice versa.
z If e<1, price and total revenue are positively related:
an increase in price will increase total revenue, vice versa.
z If e=1, then:
total revenue will remain the same whether the price goes
up or down.

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6. Kraft Demand Model

z Characteristics of the Kraft demand model: the

elasticity of demand for travel with respect to
its price is essentially constant.
z The functional form of the Kraft demand model:

β
Q = α (P)

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The derivation of a constant
elasticity of the Kraft demand
model
β
Since,Q = α ( P )
dQ β −1
then, = αβ P
dP
dQ P β −1
therefore, e p = = αβ P PQ = β
−1

dP Q
Thus, β, the exponent of price, is the price elasticity.
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 7. Direct and Cross
Elasticities
z Direct elasticity: the effect of change in the price of a good
on the demand for the same good.
z Cross elasticity: the measure of responsiveness of the
demand for a good to the price of another good.
z Substitute: consumers buy more of good A when B’s price
goes up, we say that good A is a substitute for good B (and
good B is a substitute for good A).
z Complement: consumers buy less of good A when good
B’s price goes up, we say that good A is a complement to
good B.

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 8. Consumer Surplus
z Consumer surplus: a measure of the monetary value made
available to consumers by the existence of a facility,
defined as the difference between what consumers might
be willing to pay for a service and what they actually pay.
z Latent demand: travelers between Q and the point of
intersection of the demand function and the abscissa do not
currently make trips, but would do so if the price per trip
were lower than the equilibrium price, the number of such
potential travelers is popularly called latent demand.

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Consumer Surplus Concept

z The area ABC

represents the total
consumer surplus.
z The area AOQB is
equal to the total
community benefit,
BCOQ is equal to
the market value,
and ACB is equal to
the consumer
surplus or net
community benefit. 962R561200 20
Change in Consumer Surplus

z A transportation
improvement can be
measured in terms of
the change in
consumer surplus.
z The change in
consumer surplus can
be quantified as the
area of trapezoid
P1P2E2E1, or
(P1-P2)(Q1+Q2)/2
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9. Costs
z Cost: fixed cost, variable cost, and total
cost
z Fixed cost: inescapable costs and do not
change with use
z Variable cost: increase with output or
production
z Total cost: the sum of fixed and variable
costs and will increase with production
z Average cost: monetary cost per unit of
production 962R561200 22
z Laws related to costs:
z The law of diminishing returns: although an increase in
input of one factor of production may cause an increase in
output, eventually a point will be reached beyond which
increasing units of input will cause progressively less
increase in output.
z The law of increasing returns to scale: in practice, the
production of units is often likely to increase at a faster rate
than the increase of factors of production, this
phenomenon may be due to any number of factors, such
as technological features or the effects of specialization.

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z Average cost
z The mathematical relationship connecting the total cost
(C) of a product to the unit cost (c) and magnitude of
the output (q) can be written as: C=cq=α+β(q), where
parameter α equals the fixed cost of production, and
the function β(q) equals the variable cost of production.
z The average cost (c’) of each item produced is equal to:
C cq α + β (q) α β (q)
c' = = = = +
q q q q q
z Economy of scale: a decrease in average cost as
output increases.
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Relationship between Total
Cost and Average Cost
z As output q increases, the
average cost of production
decreases, and then
increases at higher levels of
production, with a minimum
average cost at production
level of q’.
z There is an economy of
scale for production levels
between 0 and q’; beyond q’,
there is no economy of
scale.

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z Marginal cost
z The marginal cost of a product is the additional cost
associated with the production of an additional unit of
output.
z Total cost=TC(q) TC (q) FC VC (q)
= +
z Average cost=AC(q)= q q q
z Marginal cost=MC(q)=TC(q)-TC(q-1)
z When the output is a continuous function, the differential
form of the marginal cost is used, in which the marginal
cost is the rate of change of total cost with respect to a
change in output:
dTC (q ) dVC (q )
MC (q ) = =
dq dq
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Relationships among Total Cost,
Average Cost, and Marginal Cost
z The point of minimum cost
occurs at the intersection of
the average cost (AC) and
marginal cost (MC) curves.
z The projection of this point
to Figure 2-5(a)
corresponds to the point
where the gradient of the
tangent drawn from the
origin has the minimum
slope.

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z Cost and production
z Net profit (P): is equal to the total revenue (R)
minus the total cost (C), or P=R-C=pq-cq
z The necessary condition for the maximization
of net profit:
dP dR dC dP d ( pq ) d (cq)
= − = 0 or = − =0
dq dq dq dq dq dq
Thus, d ( pq) = d (cq)
dq dq
Therefore, when MR=MC, the goal of
maximizing net profit is achieved.
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10. Pricing and Subsidy Policies
z The choices facing society to deal with traffic
congestion are:
z To do nothing
z To reduce the inconvenience by adding additional
lanes
z To restrict road use in the central business district
(CBD)
z The pursuit of the first two courses is likely to
result in further congestion and therefore greater
inefficiency, while the third choice offers the
possible opportunity to solve the problem through
reallocation of resources, including: 1) taxes on
suburban, 2) dispersed living, 3) subsidies to
public transportation.
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z Means of increasing the costs of motoring:
road pricing and car parking charges.
z It has long been accepted that introducing an
element of marginal cost pricing may be the
answer to the problem of congestion.

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Congestion Pricing

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