EconFather Blog

On track for success?

May 20, 2021 - 5 min read

What do you do with a market that doesn’t lend itself to competition?

The issue of natural monopoly is back on the agenda with the announcement of major reforms to our rail system.

Natural monopoly on the railways is an obvious target for examiners, such as the AQA June 2019 Paper 1 Context 2 question.  An exemplar answer is available here https://economicsfactory.com/product/aqa-june-2019-paper-1-context-2/

Natural monopolies are markets in which only one firm can operate efficiently.  The infrastructure requirements are usually large, such as the network of track and stations on the railways, giving huge technical economies of scale if these fixed costs can be spread across more output (customers) to achieve lower unit costs.  The minimum efficient scale of production may not be reached, even by a single firm, and duplication of infrastructure would see average costs rise.  If there were competition in such markets we might expect to see firms attempting to merge.

So, what to do, given that monopolies tend to squeeze output and raise prices above marginal cost? The last unit of output is then valued by the consumer at more than its production cost, a source of allocative inefficiency. One option is to allow a private monopoly, such as enjoyed by the regional water companies, but to regulate prices in recognition of the potential market failure.  Another is full scale nationalisation (public ownership) a solution called for by many, including the Labour Party, in relation to the railways.  Worries here include the consequences of a lack of a profit motive under public ownership, although when parts of the rail network have been renationalised in recent years, performance has been widely praised. The East Coast mainline for five years from 2009 is an example.

A third solution is to introduce competition between private firms despite an industry’s natural monopoly characteristics.  This has been seen in energy markets.  For example, firms compete to sell electricity to households and simply have to supply the amount of electricity used by their customers to the national grid, which is under separate ownership.  In theory, this generates the benefits of private firms competing for business, both on the basis of price and quality of service.  To a degree this solution has worked with many households regularly switching energy suppliers, though consumer inertia is still a significant barrier to the efficient working of the market and price caps were reintroduced in 2019.

There are some markets where this response isn’t practical.  Water can’t be moved over long distances as easily as energy and a national water grid probably isn’t possible.  Which is a relief as the mixing of water and electricity worries me!

In rail too, the model is difficult to apply, though in essence this is what has happened since the mid-1990s.  One firm, currently Network Rail, is responsible for the track and stations, and are paid for their use by train operating companies, who provide passenger services.  Private train operating companies bid for franchises to run trains along particular routes.  This means monopoly power is still present along any given route and prices, especially along commuter routes at peak times, still have to be regulated.  Meanwhile, the system creates disputes about who is to blame when things go wrong – Network rail or the train operating company? Ticketing options have also been enormously complex with difficulties for passengers in finding the cheapest tickets.

The solution announced by the UK government on May 20th sees the management of track and trains brought under a single government body from 2023.  It is hoped that this will address the problems of the current model.  The government will still contract private firms to run trains on its behalf, with the profit motive of these firms providing an incentive to reduce waste and cut costs.

Among the expected benefits are “joined up” ticketing solutions, which will allow the use of smartphones and contactless debit cards to pay for transport.  Early indications are that the new model may look something like Transport for London where a customer can use their debit card to register each journey they undertake and there is a daily cap on the maximum amount customers are charged.  The model appears to have significant potential and changes will start to occur even before Great British Railways takes responsibility for both tracks and trains.  From June 21st, flexible season tickets will be available to reduce fares for those who now commute on only a few days each week having started to work from home during lockdown.

Critics are pointing towards the enormous growth in passenger numbers over the past decades to suggest that the railways are already working well, at least to some extent.   It has been suggested that this passenger growth is explained partly by investments and innovations that train operating companies have used to improve their services and attract customers.  Worries are expressed that such innovation may be lost under government ownership.

Overall, however, I’m hopeful for good outcomes from the new rail solution.  What could possibly go wrong?!

Oh….and please let me indulge myself while we’re on the topic of transport.  Customer: “Can I have a packet of helicopter flavour crisps please?” Retailer: “Don’t be silly, we only sell plane ones.”