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An ode to demand-based transport pricing

As you read this I’ll probably be sitting on a flight from Brisbane to Auckland that cost me $750. Sounds like a lot of money, and it is, but I’m happy nonetheless.

Why? Well, at late notice I had the opportunity of working for 2 months in Brisbane. This presented something of a conundrum, because I wanted to be home in NZ to spend the holidays with my Mum and a whole bunch of my favourite people. I therefore had to weigh up the price of the ticket against the benefits of what I could achieve while here (both in terms of financial and professional returns).

Obviously plane tickets around Christmas are expensive because many other want to travel at the same time, which signals to the airlines that they should put their prices up. This ensures 1) the airlines make more money and 2) there are seats available for people who really need them, like me. So despite the high price I’m more thankful I had the opportunity to both get to Brisbane and get back to NZ for holidays.

This got me wondering about what would happen if airfares were not priced this way; that is if the price of the ticket was set at the average price needed for the airline to do business. In this situation one would expect many planes to fly empty during off-peak times and sell-out over Christmas. There’d usually be either too many or too few seats and, in the case of the latter, you simply would not be able to get where you want to.

In this situation, I would have been faced with an even harder decision: Do I take the job in Brisbane and risk missing Christmas in NZ, or stay home but miss out on the work? Thankfully that’s not a choice I had to make because airlines price their seats in response to demand, or more specifically what economists refer to as “willingness-to-pay”. Willingness-to-pay describes what you are prepared to pay for goods and services.

From a layman’s perspective it means making economic hay while the sun shines. At this point people frequently assume that someone with high willingness-to-pay must be rich and vice versa. Well no, not exactly. In fact, detailed empirical studies of my purchasing behaviour over 31 years proves that willingness-to-pay has less to do with income than it has to do with my own personal preferences.

For example, on the same day as I booked my flight home from Brisbane I also booked a $150 return flight from Auckland to Christchurch. In this instance if the ticket had been more than, say, $300 I probably would not have traveled at all. The difference in what I was willing-to-pay for these tickets reflects that when travelling for work I’m prepared to pay a lot, whereas I’m more frugal when travelling for pleasure.

That frugality does not mean that I never travel at busy times, but it does mean that when I do I’m more flexible about when/where I travel (e.g. later at night). It’s ultimately got very little to do with how much money I have or don’t have. So it seems intuitive to me that willingness-to-pay to travel varies considerably for factors that are not related to our income, but instead depend on personal preferences.

Moreover, the fact that airlines use a demand-based pricing system tends to mean that the available capacity is allocated to the people who really want them. Of course that’s not why airlines price this way; they do it to make money. But in a competitive environment (such as trans-Tasman air travel) the ability of airlines to “price gouge” is of course limited by how other companies respond.

That’s why demand-based pricing makes so much sense. But despite it’s enormous advantages, we do not price parts of our transport system in response to demand. From what I can tell the debate about demand-based transport pricing often gets distracted by the following issues:

  1. “Alternatives” - i.e. we have to invest in public transport before we can price road capacity. In response I point out that even if we had no other transport options would it not still be in our interest to implement a demand-based pricing system to ensure road space was allocated to those who needed it most? Also, cities that have implemented demand-based pricing schemes, such as Stockholm, have not observed major increases in PT patronage, at least compared to the reduction in vehicle trips.
  2. “Social equity” - i.e. low-income people will be priced off the road. But low-income households a) tend to drive less, especially at peak times in metropolitan areas. So why not implement an efficient pricing system and then compensate those (few households) that are adversely affected? That way we provide the right signals to everyone, while supporting those affected who are unable to change (although that support should be tagged to people adversely affect at the time of implementation).
  3. “The devil’s in the details” – i.e. we need to flesh out the details before we sign up to demand-based transport pricing. I understand the sentiment but think we need to split the “strategic” and “operational” factors. Can we not as a society decide to support demand-based transport  pricing “in principle” and then undertake research to flesh out the details? And then put the result to a public referendum? Indeed, if way back in 2005 if Auckland had not made a strategic commitment (through the RLTS) to support public transport, then we probably would not have seen the gains we have seen – simply because the operational details had not all been worked through at the time.

The first objection is the most common and deserves more attention than I can give it here because my flight is now boarding.

But very quickly, I will say that the disappearance of “traffic” in the presence of demand-based pricing has two interesting implications. First that there are many people on the roads at peak times that are not  willing-to-pay very much, i.e. they’re just there because the price is low. Second, people have many more options open to them than public transport, i.e. PT is not an all-encompassing transport panacea.

And with that said this economic scrooge would like to wish you all a very merry and safe summer holiday.

23 comments to An ode to demand-based transport pricing

  • Peter M

    Indeed I guess you are right. I think the key point is that road pricing needs to replace existing transport revenue, rather than be an “add on” to increase revenue. Ultimately the pricing is not there to generate much revenue but to even out demand and create a more efficient outcome. Just a pity that it seems the current push for road pricing is based primarily around revenue generation and therefore will fail to get past public opposition.

  • The problem I have with demand-based pricing is that it restricts those on low incomes far more and is therefore an extremely regressive charge.

    You address the point at number 2, but you still continue to equate “need” with “ability to pay”. this is the problem. someone earning $35k a year very greatly “needs” to be able to get to work every day while someone on $200k doesn’t need to get to the casino quite so urgently and yet demand-based pricing is going to affect the former (“Great, now I have to ride a bus and a train for 2 hours to get from South Auckland to West Auckland”) vastly more than the latter (“Great, now that the motorways are clear I can drive my porsche to the Marina at 8:30am on a Monday”).

    Your assumption “there are many people on the roads at peak times that are not willing-to-pay very much, i.e. they’re just there because the price is low” may in fact be “there are many people who can afford to commute to their low-wage jobs by car because the price is low” but as soon as the price is high they face a much longer and more inconvenient commute by public transport.

    So especially when it comes to peak traffic times I don’t think it’s safe to assume there are a high number of commuters who don’t “need” to be on the roads (does anyone ride the motorway at peak times because they enjoy wasting petrol and crawling along at 10km/h?). Just that they choose car because it is convenient and they can afford it. Pricing them off the roads doesn’t help low-income workers and it doesn’t really impact high income workers except by making their commute easier and raising more revenue.

    The question then become how to mitigate the negative effects of the policy using this increased revenue, and I don’t think this is a very simple question…

    • Stu Donovan

      I guess I put mitigation of adversely affected low-income households in the “operational” section. You’re right in that it’s an important consideration, but it’s not one that should stop the show in my opinion. That’s why I’d suggest we commit in principle and then undertake research into how the scheme might be best designed.

      At the moment we’re doing nothing and that’s hugely frustrating and wasteful, because every day more people are making more bad decisions because of the absence of these price signals. In fact I’d argue that the longer we leave it the worse it gets.

      • Simon C

        Stu, I work in airline reservations and you are almost completely wrong and I need to a bit of myth-busting of my own. The airlines do not put their prices up apart from NZ-UK/Europe where the normal two or so lowest fares are unavailable through the Xmas and New Year season. That is definitely not the case for 99% of destinations and fares though. The reason the prices may seem higher are the fact that being a peak season the airline does not do sale fares which so many people are so used to getting these days and therefore take for granted. Heck, I’ve had customers ring up this year and spew because they would have to pay the 2nd lowest regular price (Still bloodly low in my opinion) on a trans-tasman flight(s) when the last two-three times they always got a bargain. Also Xmas flights anywhere and everywhere are now often snapped up yonks ahead of what normal flights are booked up. My airline opens bookings up for flights up to 350 days ahead, So almost a year. Some people probably think they are booking well in advance 3-4 months out but the truth is these days most Xmas/New Year flights are already heavily booked by April!!! I can guarantee that Xmas and New Year will hardly be over and a significant number of people will, already be booking flights for next Xmas. That means when the likes of yourself Stu come to book a couple of months out you are left with the higher priced fares. Therefore it’s wrong of you to suggest there weren’t the same lowest regular fares as usual and that the airlines actually put the fares up. The fact is the airline still offered those fares – you just didn’t book early enough to get one. The fare you’ve paid will be the same as a fare that is offered throughout the year. The difference is you’re just not used to having to take that fare.

        • Simon C

          Stu, if you’re going to use airlines fares in any comparisons about PT I suggest you be very careful as most people have assumptions about them which are completely wrong due to not actually knowing stuff all about them!

          • Bryce P

            The assumption isn’t far off, just the wrong way around. Road pricing can be exactly the same ie. the road has a ‘full fare’ price and then discounts for less busy times :-).

          • Bryce P

            Although Simon, I think it’s fair to say the airlines and their grabaseat and similar promotions have given the image of discount pricing being the norm to most people.

          • Stu Donovan

            Note that the comparison is not to PT – but to transport in general. Actually primary application would be to road pricing, but PT fares should also be higher in peak periods.

        • Stu Donovan

          Simon C, if I may split hairs: Discounting during off-peak periods is almost financially/economically equivalent to charging higher fares in peak periods. Think about it – the airline is trying to maximise revenue by setting prices in response to elasticity of demand of different groups of people. That means charging more in peak periods than in offpeak – whether that price differential is called an “offpeak discount” or a “peak surcharge” is simply semantics.

          Mind you, I can see definitely why the airlines themselves would couch it in terms of the latter – because lower offpeak prices make them out to sound benevolent. Don’t let them pull the wool over your eyes; myth-busting denied ;).

          • yes but Simon’s point is still valid in that the pricing structure of airline fares is not really analogous to congestion charging road traffic = in terms of regular fares, the premium applies to those who do not plan ahead, not those who choose to travel at peak times. in terms of the discounted fares, this is closer to your analogy: paying less during times of peak demand.

            it doesn’t really affect your core premise that charging more for something will lead to less demand

          • Stu Donovan

            Not true. The algorithms by which airlines set prices are very complex (i.e. not single variate.

            I am absolutely certain that they include variables for both 1) the time until you travel (as SimonC suggests) and 2) the available capacity at the time you want to travel (as I suggest). I understand that some of the cleverer airlines even charge higher prices during different times of day because they know different demographics book at different times, e.g. high-income people often book while at work on their lunchbreak.

          • Simon C

            Yes, that’s the problem Bryce P. Increasing numbers of customers somehow believe that they should be able to get a grabaseat or bargain basement fare anytime to anywhere. For some reason, people’s expectations around travel are not always on planet earth! That includes say someone who is booking only a couple of days out from the flight thinking they can still get the lowest or one of the lowest fares and then being horrified when they can’t! Of course my airline has now brought in domestic standby fares as well which helps to fill the plane at up last minute but as it gets better known will encourage people not to buy earlier and long-term will further skew customers expectations in my opinion.

            BTW anyone who has schoolkids on here and is looking at the end of term 1 school holidays for travel better get in soon. They are already getting well-booked up! That’s another one where people now book way ahead of time to get the best prices.

            Stu. It’s not splitting hairs because we aren’t offering a sale fare continuosly or for each and everyday even outside Xmas/New Year and other peak periods. As i said we still offer our normal lowest regular fares in those peak period that you could also get during the remainder of the year. It’s not like we have added 20 or 30% on top of those same fares – that would be putting up our prices. There are airlines overseas that I know of that do cut-out their lowest couple of regular fares so that the lead-off fare is indeed higher. With the one exception I mentioned in my original post my airline doesn’t. What you’re suggesting is the equivalent of say a menswear retailer hiking say their jeans prices all because the 30% discount you saw two weeks ago is now not available despite the jeans still being available for their original price. Our original prices, including the lowest normal lead-in prices are (or were) still available during the Xmas-New Year period. Sorry, but that’s not putting prices up. Yip, myth-busted!

          • Stu Donovan

            SimonC, your logic seems to miss the link between the volume of demand and fare levels. Yes you may have low price tickets available at Christmas time, but if demand is higher then these will sell out sooner, hence meaning that more people pay the higher fare levels.

            Of course you don’t change you fare structure – but the combination of fixed low price tickets and higher demand means that people effectively pay more. That’s the point!

      • Thanks,

        I agree it is an operational consideration, but I think a very important one that needs to be kept at the forefront of any policy development around congestion charging. and is especially endangered by a revenue gathering mindset

        What we want to create is a system where peak time public transport is a viable alternative chosen by a great majority of regular commuters – not a 2-tier system where some people happily joyride on clear motorways while thousands of people spend 10-20 hours grinding to work and back.

        the main thing is that any revenue gathered be used to enhance low-congestion alternatives to single-occupancy traffic hell, rather than helping balance books in other areas

  • Having said the above, I support demand-based pricing if it can be used to encourage more car-pooling (ie. targeting single-occupant commuters) and help to fund better PT alternatives, but I think that these things need to be at the forefront of any such policy. As Peter M said above, a lot of Polis will treat this as a means to gather revenue when in fact it will likely entail more expenditure in terms of the infrastructure/mechanisms to bring it into effect and public campaigns to try and shift behaviour…

    • Bryce P

      I don’t think its as hard as suggested. Instead of trying to make the charge match an income what it will do is encourage those on lower or even middle incomes to car pool or use pt. To try and somehow compensate will be very administration heavy and expensive to operate.

  • Periodical tickets, such as the Monthly pass on AT Hop, remove the ability to use pricing signals to get people to travel at more convenient times for the system.

  • Simon C

    Stu. Yes SOME people pay more because of demand.at Xmas. I never disputed that. I disputed your incorrect assertion that airlines actually put their prices up. Stu, due to demand. SOME people ALWAYS pay more on any given day, not just Xmas just like SOME people will end up paying more for that same pair of jeans than others did. I completely understand your logic and support your idea but working in airline reservations for a long time and knowing how it works I just think you used an anolgy where you got your facts slightly wrong ;)

  • Bob

    Does anybody review these articles before they are put up? They need to be researched a bit more and not based on smoko room discussion.

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