Railways

MANAGERIAL ECONOMICS

MARKET STRUCTURE INDIAN RAILWAYS

AJINKYA KATE KAVITA MOHIT KHATRI KINJAL TOLWANI KRISHAN SHARMA 9/26/2011

Contents Introduction…………………………………………………………………………………………..4 Capacity enhancement……………………………………………………………………………….4 Capacity Utilization ............................................................................................................................ 5 Dynamic Pricing Policy .................................................................................................................. 5 Tariff Rationalization ..................................................................................................................... 5 Non-peak Season Incremental Freight Discount Scheme ............................................................... 5 Long term freight discount scheme ................................................................................................. 5 Revenue Enhancement ........................................................................................................................ 5 Marketing Indian Railways to the Masses .............................................................................................. 6 Proposed Strategy ............................................................................................................................... 7 Marketing based on Income based Segmentation ................................................................................... 8 Lower Class ........................................................................................................................................ 9 Middle Class ....................................................................................................................................... 9 MONOPOLY OF INDIAN RAILWAYS............................................................................................. 10 Demand Curve .................................................................................................................................. 11 Firm Elasticity and Cross Elasticity of Demand ............................................................................... 11 Pricing ............................................................................................................................................... 11 Second Degree Price Discrimination: Block Pricing .................................................................... 11 Third-Degree price discrimination ................................................................................................ 11 Concentration Ratio .......................................................................................................................... 11 Quantitative Analysis of Elasticity and revenue ............................................................................... 11 . .Pricing norms .................................................................................................................................... 12 Elasticity analysis.............................................................................................................................. 13 concentration ratio ............................................................................................................................ 13 Cost pricing ....................................................................................................................................... 14 conclusion ......................................................................................... Error! Bookmark not defined.

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INTRODUCTION TO RAILWAYS Indian Railways (IR) was the largest railway network under a single management in the world. IR was often called the 'lifeline of India', because it provided a source of livelihood to a large number of people and brought long-distance travel within the reach of the average Indian. IR was also the largest employer in the world, directly employing about 1.6 million people (as in 2003). In addition to this, it was estimated that it provided indirect employment to over seven million people. One survey in the early-2000s revealed that one in every ten Indians depended on IR, for his livelihood, directly or indirectly. IR carried, on an average, 13 million people across the country everyday. Indian Railways (IR) is the state-owned railway company of India. Indian Railways had, until very recently, a monopoly on the country’s rail transport. It is one of the largest and busiest rail networks in the world, transporting just over six billion passengers and almost 750 million tonnes of freight annually. IR is the world’s largest commercial or utility employer, with more than 1.6 million employees. The railways traverse through the length and width of the country; the routes cover a total length of 63,940 km (39,230 miles). As of 2005 IR owns a total of 216,717 wagons, 39,936 coaches and 7,339 locomotives and runs a total of 14,244 trains daily, including about 8,002 passenger trains. However, by the late-1990s, IR was at the crossroads. An inability to reconcile its social and economic objectives, a growing number of accidents and the burgeoning importance of airlines and roadways that ate into its market share, burdened the operations of IR and caused a decline in revenues. Analysts felt that it was time for a system-wide overhaul of the faltering organization, which had experienced relatively little change from the time it came into existence in the late-19th century. It was felt that privatization, partial or complete, would be the best solution to IR's problems. However, privatization had some inherent difficulties which made it an unviable option for a government department of the size of IR.

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Capacity Enhancement The Indian Railways has a massive infrastructure in place and the costs incurred are predominantly fixed and independent of the operations. The challenge was therefore to achieve enhanced capacity while not incurring additional capital expenditure. Following are some key innovative and erective measures that led to this: Productivity Improvement - It is done by increasing wagon loading capacity and significantly reducing wagon turnaround time. In the past, loading/unloading was done only during day time (10 hours a day on an average) and trains used to lie idle at customer sites overnight. The Indian Railways provided incentives to customers to undertake loading/unloading 24 hours a day. Consequently, the average time taken for loading came down from 30hrs to 16hrs and for unloading from 34hrs to 18hrs, reducing the turnaround time by over a day.

Capacity Utilization

Dynamic Pricing Policy Till recently, IR had a price policy, irrespective of demand scenario and competition. In order to be able to effectively face the challenges posed by stiff competition, a Dynamic Pricing Policy was introduced for freight as well as passenger, for peak and non-peak seasons, premium and non-premium services, and for busy and non-busy routes. As per this policy the rates for non-peak season, non-premium service and empty row directions would be less than the general rates and the rates for peak season and premium services could be higher than normal.

Tariff Rationalization To simplify and rationalize goods tariff, the classification of items was reduced from over 4000 to a mere 28 groups of commodities. In 2005-06, the total number of classes in the freight tariff schedule was reduced from 27 to 19. The highest class - 250 for charging freight was lowered to 220 in 2006-07. This was a very clever policy as more classes were put in the higher price category. Thus even though the maximum cost was lower in new tariff rates, the net revenue weighted over the traffic in all the classes was larger.

Non-peak Season Incremental Freight Discount Scheme The demand for freight transportation typically dips from 1 July to 31 October on account of monsoon. It was estimated that over 400 trains remain idle in this period due to lack of 4

demand. Hence, during this period, freight rebate of 15% was offered for incremental freight revenues of over Rs. 5 Crore in a month and 10% for incremental earning of less than Rs. 5 Crore.

Long term freight discount scheme Merchants want to make transportation arrangement for goods on a long-term basis. Hence, long- term freight discounts were offered to attract new customers and new freight traffic. Under this scheme, zonal railway administrations were able to offer a discount of up to 20% during non-peak season and up to 10% in the peak season for a period of three years. For loading in empty flow direction, the discount was up to 20% and 30% during peak season and non-peak season respectively. Many other schemes have been launched by the IR over the past few years the details of which are available at the Official IR website.

Revenue Enhancement The incentives to ramp up volume were complemented by a two-pronged revenue enhancement strategy, which capitalized on opportunities and reduced losses by exiting noncore operations. The strategy in freight operations was to recognize low-cost high volume operations where the Railways enjoyed significant comparative advantage vis-a-vis road and air transport and achieve higher realizations on these operations. For example, the tariff on ore has been increased by 70% (virtually no competition) at a time when rate on iron and steel has been reduced 30%. The strategy to focus on capacity utilization resulted in high volumes and compensated for the discounts and the lowered tariffs. Some of the innovative measures adopted in the passenger segment included increasing the number of coaches in popular trains and encouraging occupancy in the profitable upper classes. The passenger tariff was rationalized such that the fares of AC First and AC Second Class were 11.5 times and 6.5 times the Second Class fare respectively. This, coupled with the innovative automatic upgradation scheme, enabled higher occupancy in the profitable upper classes. The Railways also exited from the loss-making parcel and catering services and offered it to private players on a bidding basis. There was also a significant thrust on non fare income streams such as advertising and allied services including land-use rights at railway stations.

Marketing Indian Railways to the Masses The turnaround of the Indian Railways has largely been due to volume of its freight services. Hence, to sustain its current level of growth, it needs to focus on the other services that it offers - passenger travel and other earnings from parcel, catering etc. In this study, we would focus on the steps that have been and need to be taken to increase its volume in passenger traffic.

The situation then The Indian Railways has been largely functioning according to the Supply concept which states that supply of the product/ service ensures demand. This concept held in the older days, where rail was the only mode of cheap long distance transport and hence people had to depend on it for all their travel needs. Therefore, by simply ensuring that rail routes existed 5

and trains were being run, the railways was ensured of demand for its services and hence assured earnings.

The situation now The scenario has altered drastically in the past decade with the onset of alternative cheaper and faster modes of travel i.e. the airplanes. This trend is clearly visible in the growth of number of passengers travelling by the airlines in comparison to railways as shown in Figure The main areas where air travels scores over railways are: Time of travel This is one aspect which the railways cannot change because of its inherent dependence on transport on land. Air travel reduces the time of traveling by more than 75% in most cases when compared to railways. Hence, railways are always at a disadvantage when it comes to the corporate sector of the consumers. Prices With the onset of low cost airlines with rates comparable or even lesser than the rail fares for the corresponding routes, railways have been hard hit. On most of the domestic routes, the airlines are actually offering prices lesser than AC 2 tier on express trains like Rajdhani. This, coupled with the fact that the per capita income in the country has steadily been rising over the years, implying that the disposable income per person has been on the rise, has lessened the rail traffic even further.

Figure 3: Number of passengers (in millions) travelling through Railways and Airlines (source: Ministry of Civil Aviation, [4])

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Figure 4: Distribution of Income in India

Proposed Strategy To counter these factors, the railways need to adopt the following strategy: Focus on grabbing the portion of the consumer segment that has time to spare i.e. is not averse to spending 12-18 hours in travel. Additionally, since railways scores over airways in terms of penetration into the country, in large parts of the country it enjoys better reach ability. In such areas, it needs to ensure that people prefer the railways for low distance travel over roadways. The price points should be significantly lesser than the low cost airlines. To achieve this, it has to adopt every avenue of cost reduction feasible. It should take steps to recover its market share through a combination of tariff re-balancing and quality enhancement measures.

Figure 5: Services offered by Railways to various income Segments

Marketing based on Income based Segmentation It would be beneficial if the Indian Railways (IR) follows an income based segmentation strategy and follows a separate promotion strategy for each. Broadly classifying the consumer segment into 3 categories on the basis of income: 1. The Lower Class (< Rs. 3 lakh p.a.) 7

2. The Middle Class ( Rs. 3 - 10 lakh p.a.) 3. The Upper Class (> 10 lakh p.a.) The broad categorization of services that the IR can offer to each segment is seen in Figure 5.The lower class would be more inclined to use railways as a medium of travel rather than for tourism purposes. The opposite holds true for the upper class which has significant amount of disposable income and might not want to compromise on the time factor for travel. Thus the only way to woo the upper class is through tourism. The middle class is the most potential profitable segment from the point of IR and hence it should focus on promoting Railways both as a means of cheap travel and enjoyable tourism. Railways is banking a lot on the tourism factor which is also a good source of foreign revenue. Many luxury trains such as Palace on Wheel, The Deccan Odyssey, The Fairy Queen etc. These trains have packaged tours over many cities and such luxury packages are becoming very popular today among the rich and foreign tourists. Besides this, many measures have been taken by the IR to woo the other two classes. Some of these from the Railway Budget 2007 [7] are:

Lower Class Unreserved compartments in newer trains will be increased from four to six. Simultaneously, efforts will be made to increase the number in existing trains as well. To provide a more comfortable journey, the wooden seats in ordinary class passenger trains will be replaced by cushioned ones. Eight new Garib Raths (subsidized Air Conditioned trains with enhanced passenger capacity) and 32 pairs of new trains to be introduced in the coming year.

Middle Class  

200 trains to be made superfast Dynamic pricing: Differential discounts in peak and o®-peak seasons. AC first class rates slashed by 6% in the lean season and 3% in the peak season  Sleeper class fares slashed by four per cent  Reduction of super fast charge on second-class tickets by 20 per cent from Rs 10 to Rs eight  Rs 5,000 crore set apart for local trains  Women & senior citizens to get priority lower berth  Cyber cafes and ATMs to be opened at major stations  6000 automatic ticket vending machines to be set up in next two years  E-tickets made cheaper and to be made available for all mail and express trains Besides this, there are many other strategies which can enhance the passengers' train travel experience. These if implemented will add to the “delight" of customer and hence help positioning the railway brand higher in the minds of people.

Discounted tickets are available for senior citizen (above sixty years) and some other categories of passengers including the disabled, students, sportspersons, persons afflicted by serious diseases, or persons appearing for competitive examinations. One compartment of the lowest class of accommodation is earmarked for ladies in every passenger carrying train. Some berths or seats in sleeper class and second class are also earmarked for ladies. Season 8

tickets permitting unlimited travel on specific sections or specific trains for a specific time period may also be available. Foreign tourists can buy an Indrail Pass which is modeled on the Eurail Pass, permitting unlimited travel in India for a specific time period.

An Indian Railway Ticket from Chennai toVijaywada by Howrah Mail.

For long-distance travel, reservation of a berth can be done for comfortable travel up to 90 days prior to the date of intended travel. Details such as the name, age and concession (if eligible) are required and are recorded on the ticket. The ticket price usually includes the base fare, which depends on the classification of the train (example: super-fast surcharge if the train is classified as a super-fast), the class in which one wishes to travel and the reservation charge for overnight journeys. If a seat is not available, then the ticket is given a wait listed number; else the ticket is confirmed, and a berth number is printed on the ticket. A person receiving a wait listed ticket must wait until there are enough cancellations to enable him to move up the list and obtain a confirmed ticket. If his ticket is not confirmed on the day of departure, he may not board the train. Some of the tickets are assigned to the RAC or Reservation Against Cancellation, which is between the waiting list and the confirmed list.

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MONOPOLY OF INDIAN RAILWAYS Demand Curve

Costs and Revenue

Monopoly pric e Preg Average total cost

Pcom

Marginal cost Marginal revenue 0

QMAX

Firm Elasticity and Cross Elasticity of Demand    

Elasticity of market demand – Single Player – Monopoly Number of firm in the market – Natural Monopoly – Govt. Regulated Interaction among firms – Not applicable Impact on passenger and freight volume with Low cost carriers and road and waterways

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Pricing A

B 1. The intersection of the marginal-revenue curve and the marginal-cost curve

Second Degree Price Discrimination: Block Pricing  Prices for single ticket  Prices for monthly pass  Prices for quarterly pass  Bulk Booking discount for seasonal trains Third-Degree price discrimination Consumers groups  First class, second class, third class, sleeper, AC  Prices are charged accordingly. Intertemporal Pricing  Tatkal reservation  No two part tariff or peak load pricing strategies are implemented

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Quantitative analysis of elasticity and revenue impact:Referring to p as price and q as demand, let us consider two states; state ‘i’ (with demand qi and price pi) and state ‘j’ (with demand qj and price pj). If we go from state ‘i’ to state ‘j’, dq is the change in demand and dp is the change in price. The Elasticity E(i,j) can be defined as, E(I,j)=(dq/qi)/(dp/pi) It can be observed that while going from state ‘j’ to state ‘i’ (i.e. in the reverse direction) the elasticity value will be different. To avoid any confusion and computational errors and to reduce the complications in any mathematical model, the use of arc elasticity (Eilon, 1983) is more commonly used, where the percentage change is taken with respect to the average price and the average demand (usually presented as absolute numbers, thus negative signs of dq or dp are not considered). E(arc I,j)=(dq/dqavg)/(dp/dpavg)=E(arc j,i)………………………..1 where qavg = (qi+ qj)/2 and pavg = (pi + pj)/2……………………..2 Pricing norms:Discussions with railway personnel reveal that not much experimentation is done to feel the pulse of the competitive market. The major check is only to see if the revenues are higher than the money spent, in any initiative. One parameter considered to analyze the pricing is unsatisfied demand, where IR assumes as a rule of thumb that 50% of the cancellations are due to the unavailable seats (non-confirmed reservation). Thus unsatisfied demand is usually estimated as Unsatisfied demand = W+C/2 where W is the number of waitlisted passengers and C is the number of tickets cancelled. We ignore the impact of passenger switching to other modes and to other trains. We neglect the fact that there is an overbooking capacity that is arbitrarily decided by IR. The waiting list is allowed to get large whenever it happens, because the railways sometimes use options of providing additional capacity (additional coaches and even special trains). In this sense the waitlist is viewed as an indication of the desired demand. Therefore, for our quantitative analysis, we consider only the price changes at different time periods (across the 60 day reservation period) to start off with the calculation of elasticity values. As elasticity is a complicated term and can be calculated in various ways, we calculate the cumulative demand for the first 6 weeks for all the three classes to remain consistent with our strategy of formulating a new fare structure with discounted ticketing in the first 6 weeks (as it is a period with very little variation in booking/cancellation trends. Tables 1 and 2 show the demand through booking and cancellations in all the 9 weeks.

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Table 3: Fare structure at different times as of 15 march 2006

Table 4: Statistics of tatkal booking schemes in AcII class(total capacity=24)

Table 5:Statistics of Tatkal booking scheme in AC III class (total capacity = 56),

Elasticity analysis:It is difficult to estimate pure elasticity with respect to price in a situation where multiple products or services are offered at the same time. In such a situation, customers would choose to enter the market not just on price valuation for a standard commodity, but based on a more detailed price value trade-off for each variant. Earlier studies on elasticity highlight the common fact that with a large number of parameters involved (price, income, preference, class of travel, type of travel; business or leisure etc.) it is difficult to make or validate a perfect model. Each study makes some appropriate approximations and assumptions to present the results/data in a manner which is mathematically interpretable and that can be implemented practically. Some examples are discussed here. Fridström and Larsen (1989) take the average cost and demand values for all travel classes to estimate elasticity. Brons et al. (2002) take two or more parameters for modeling. Greene (2000) defines a bias factor to take into account the overestimation, and Uysal and McLellan (1991) solve the model for two parameters at a time using techniques like SURE.The booking system followed by IR allows for a substantial waitlist for each class of travel. Although this study, like other studies, also 13

identifies the presence of numerous parameters affecting the evaluation of elasticity for the use of different classes, we conjecture that the total booking for each class is an expression of the true demand for each class. Eg:-For the Rajdhani service on IR, at least compared to other rail services and road, it would seem that the basic service element of fast, reliable and premium service per se would be the most important factors influencing travelers. Within this, the demand expressed for each class does capture the elasticity with respect to price. This may need to be deflated a bit to account for the fact that the service element in each class is actually differentiated. Using the same terminology, we can write (for a situation where price decreases and demand increases) pavg = (p - dp/2) and qavg = (q + dq/2); where dq and dp are both positive numbers and ‘p’ and ‘q’ are the initial values of price and demand respectively. Now using Eq.2, we get the final equation as p/dp=[Earc *(q/dq)]+[(Earc+1)/2] where q is the demand for 6 weeks. If we define E(I,II) = Elasticity between two state points – AC I and AC II, from Eq 2 its value now becomes =[dq(I,II)/q(avg,I,II))/(dp(I,II)/p(avg,I,II)]. From the data given in Tables 1 and 3, we can calculate the price elasticity of demand as, E(I/II)=(123/7.96)/(1925/3172.5)=2.83 Similarly, we get E(II/III) =2.85 As above, analyzing the Tatkal booking data and fares from Table 3, 4 and 5 we infer Tatkal elasticity= 2.86 Studies on price elasticity for air travel in the UK and the US are estimated to be between 1 and 2 and sometimes as highas between 2.7 and 3.2 (Brons et al., 2002). From above points we should expect the elasticity levels of rail travel in India to be in the higher range. We see that, in fact, the computed elasticity of 2.86 for Rajdhani lies within the range suggested by Brons et al.

Concentration Ratio The Concentration Ratio is the percentage of market share held by the largest firms (m) in an industry. CRm= Σni=I xi Therefore CRm = s1 + s2 + .... + sm where si is the market share and m defines the ith firm As the Indian Railways has a monopoly on the rail transport, the concentration ratio is given by,  The Four Firm Concentration ratio is 100%  Herfindahl -Hirschman index is 10,000

Cost pricing:Railways unlike other industries have a very large common cost (joint cost). Characteristics of railways with relevance to pricing:-

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1. Sunkness of cost:-utilized capacity has no alternative use in the short run and its economic value is zero. And railways can have no other use except to provide rail transport along road. 2. If demand fails to materialise or does not materialise to the extent expected, it would lead to idle capacity so Indian railways run the risk of idle capacity. Joint cost and by-product nature of railway services, on same railway track different types of railways run and heterogeneous products are manufactured e.g.:- locomotives, rails, wagons etc. making apportionment of costs of different products very difficult. 3. Decreasing cost with longer distance and successive blocks of output. The railways share other large-scale undertakings, economies of scale. 4. The railway capital can never be replaced completely. To meet additional demand it is necessary to add or modify existing capital stock. If track is maintained properly it could be a long lasting asset. This creates conceptual difficulties for defining cost. Full cost pricing:Total cost of railways is divides among all users. Where the costs differ from one railway to another, payment should in principle be related to individual railways, but in practice they are related to cost of railway system as a whole. Under this method users are subjected to uniform rates but two part tariff comprise a fixed and a variable levy while two portions are blended under one under the single plan tariff. When railway services provided at prices below their cost, there arises a conflict between the interest of an individual in his capacity as the user and in his capacity as a provider of the service. And when the same price is charged for all users it is bound to be inequitable. Under two part tariff, a railway user will pay a variable cost equal to the marginal cost and fixed charge to reflect benefit he derives from the facility. Since fixed cost is common to all users some will enjoy surplus over and above fixed cost and others would be excluded from using it. So on assumption of no divergence between costs and social cost on one hand and consumers preference as expressed in the market and social benefits on the other hand, profitability of railways under full cost pricing can serve as an indicator for future investment decision. Marginal cost pricing:Under this the price to be charged should be equal to only additional costs generates by one more unit of railway service. The basis of charging is the value of resources consumed by the additional user. A price which is equal to the real economic cost of using railway services brings about an optimal allocation of resources. Such a price ensures that a railway output would be expanded to the point and only up to a point at which the cost of producing the extra unit of railway services would equal price. Means price equals to marginal cost. 15

A firms costs are a function not only of the rate of output per period, but also of the number of periods during which production takes place, the total volume of the production and the period when output starts. So, there need not be only one marginal cost. In railways, as in other industries,2 marginal costs concepts are involved, 1. Short run marginal cost (SRMC):This pricing rule suggests price should equal only those costs which are immediately responsive to changes in the level of output. This means a price equal to variable maintenance cost, operating cost etc. This is advocated as the proportion of annual capital cost to variable maintenance cost is high; the difference between full cost and SRMC will be considerable. So it has a potential of greater efficiency. Also capital costs incurred infrequently because of long physical life of railway assets. This implies long periods during which main problem is one of getting the best use of existing resources and this is best achieved by SRMC pricing. 2. Long run marginal cost (LRMC):It includes all costs, fixed as well as variable. There are difficulties of determining LMRC. So a way of getting out of this is the method of treating capital expenditure in a given year as a current item. If this accepted LMRC pricing means a price equal to capital cost in any given year plus variable cost in that year, per unit of output. But this cannot be accepted. When in equilibrium SMRC and LMRC are equal then there need be no reduction in output. Optimal allocation:-Assumption behind marginal pricing that all goods are sold at marginal cost and all factors receive their marginal product Throughout the economy, it is negativated in most of the countries due to taxes, monopoly conditions. When this is so charging marginal cost would lead to its overutilization .so national income can be increases by shifting resources out of railway sector.

CONCLUSION In this case study we looked at the growth achieved by the Indian railways in the past few years and major strategies responsible for them. These include capacity enhancement, better utilization of the current capacity and also schemes to increase the existing sources of revenue. Today, IR is facing serious threats from the low cost airlines which offer a much quicker journey at comparable costs. Thus there is a need to position the railways brand higher in the mind of the Indian passengers. We have done an income based market segmentation and analysed possible strategies that could be used to lure different segments and ultimately increase the volume of the passenger revenue. Another question that has been lingering around for quite a while now is regarding the privatization. We do a comparative study with the British railways and come to a conclusion that complete break up into smaller 16

enterprises will not prove to be good. Due to the critical role played by the railways in India, total control of IR should not be transferred into private hands. Focus should be on commercialization rather than privatization where various smaller tasks are outsourced to private hands or are done in public-private partnerships. Steps are being taken to do such a restructuring of the operations today. Quoting: The turnaround over the past two years has demonstrated that IR is indeed a sunrise sector. With the right moves, nothing can hold it back from being world class.

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