Freight Data Cost Elements (2013)

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A-1 A p p e n d i x A Basic Cost Concepts, Definitions, and Glossary Appendix A A-1 Appendix A: Basic Cost Concepts, Definitions, and Glossary Economic vs. Market Costs Economists study two related—though different—concepts: market or private costs, and economic or resource costs. As the name implies, market or private costs refer to the price an individual or private sector firm pays for a good or service in a marketplace. The market cost is equal to the cost of the resources required to produce the good/service, plus other items such as taxes, duties, and fees that are internal transfers in the economy. If the market cost is denoted by M, the cost of the resources by R, and the transfers by T, then M = R + T. Of great importance for public sector economic analysis are the resource costs, R, which represent the costs to the economy. (Resource costs are also called economic costs). Market costs represent the actual expenditures that a private venture or individual incur when purchasing a good or service. These costs are of great importance for private sector decision making. Public decision making, on the other hand, has a different set of needs that requires the use of both market and economic costs. For instance, when developing a freight demand model, market costs ought to be used as they reflect the actual costs to the industry and influence private sector behavior. However, for public sector cost-benefit analyses, using economic costs is the best practice because they are the ones that measure the cost to the economy. Figure A.1 represents an economy with one consumer that spends an amount, M, in transportation-related expenses. (For simplicity, value of time is disregarded.) These expenses include the cost of the resources used (e.g., gasoline, deterioration of the vehicle), as well as other transfers such as taxes, T. As shown, while the transfer T is a cost to the consumer, it is at the same time a revenue source for the government. However, from the standpoint of the entire economic system, the transactions involving the transfers cancel out. As a result, the only thing that matters is the economic cost of the resources, R, used by the consumer. This concept is important because the benefits produced by transportation projects are the difference between the resource costs before and after the project, which cannot be computed using the market costs before and after because the transfers introduce a distortion. Figure A.1. Illustration of economic (resource), transfer, and market costs. Cost to consumer: -R-T Government revenue: +T T

A-2 Appendix A A-2 Social Costs = Private Costs + External Costs Public sector decision making concerning freight transportation must consider the impacts that the different alternatives have on all stakeholders. Some of these impacts (e.g., the direct costs associated with making a delivery), are internalized by the participants in the transaction, while others (e.g., the pollution or noise generated by the truck) are not. The former costs are referred to as “private” and the latter as “external.” The summation of private and external costs are the social costs of that particular economic activity (Varian 1992). Since a fundamental tenet of public sector decision making is to maximize the net social benefits of its actions, planners should have a solid knowledge of all components of social costs. This is a challenge because of the inherent difficulties associated with getting access to data about the private costs of freight activity and with valuating the externalities produced by freight. It is important to mention that in some cases the distinction between private and external costs is quite nuanced. A good example is accident costs. One could argue that at least part of the accident costs are internalized by the freight industry via the insurance rates. At the same time, the accident costs associated with the congestion produced by freight traffic remains external. Market Rates (Prices) vs. Costs Market rates (prices) and costs are two interrelated concepts that provide different pieces of information about the functioning of an economic system. Taken together, they play a key role in explaining freight industry behavior. For that reason, it is important to discuss them in some detail. Costs capture the value of the resources and transfers used to produce a given amount of a product or service. Costs are usually represented using a function that captures the relationship between the output of the process and the corresponding inputs. Costs can be classified in different ways. In terms of the relationship to the output unit, costs can be classified as either fixed (not dependent on output level) or variable (dependent on the output). As a result, the total cost is equal to the fixed cost plus the variable cost associated with producing an output, Q. An important concept is that of marginal cost, which equals the cost of producing one additional unit of output. On the basis of the planning horizon, costs may be considered short term (if some input factors, such as facility costs, cannot be changed), or long term (if all input factors are variable). Most analyses concerning freight are based on short-term principles. Figure A.2 shows the cost components involved with both economies and diseconomies of scale, as represented by the unit costs as a function of output Q. The figure illustrates that (1) the unit fixed cost gets smaller as the output increases; (2) the variable cost increases with output and, once in the diseconomies range, it increases even faster; and (3) the marginal cost intersects the average cost at its minimum value, which also takes place at the intersection of fixed and variable costs. Figure A.2 also shows two distinct regions: (1) scale economies, where increasing output reduces average costs, and (2) diseconomies of scale, where increasing output increases average costs. In scale economies, the average costs are larger than marginal costs (something of great significance to the study of freight in a deregulated market like that in the United States); while in regions that feature diseconomies of scale the opposite happens as marginal costs exceed average costs. This means that companies operating in the efficient range of scale economies are not likely to make money, as the marginal cost is lower than the amount they need to recoup the costs (i.e., average cost). There is clear evidence that this is the case in some segments of the freight industry.

A-3 Appendix A A-3 Figure A.2. Basic relations among cost components. As the name implies, market prices/rates reflect the results of the competition among the participants in a marketplace. It is widely acknowledged that the most efficient market (i.e., the one that maximizes economic welfare) is the one under perfect competition, which is referred to in the economic literature as the “competitive market.” For such a market to arise, the following conditions are needed: (1) there are many buyers and many sellers, making it so that no individual agent could exercise market power; (2) the products being transacted are homogeneous; (3) there are low entry and exit barriers that allow losers to exit the market, and new entrants to come in; (4) there is perfect information (i.e., all participants are aware of the market conditions); and (5) all firms are attempting to maximize their profits (Varian 1992). The existence of a competitive market is a matter of the degree to which these conditions are met. Of great importance is the number of agents that participate in the market. The focus will be on three key cases: monopolistic, oligopolistic, and competitive markets. It could be proven (Varian 1992) that the optimal prices/rates that a firm could charge in these markets follow well- established economic rules. A monopoly could charge a markup (an amount above production cost) that is bounded by the inverse of the demand elasticity. (The more inelastic the demand, the higher the markup.) In an oligopoly, the markup is constrained by the firm’s market share. (The larger the share, the larger the markup.) Finally, no markup is possible in a competitive market, as the price equals the marginal cost. Mathematically, these three cases are shown below. (Monopoly) (1) (Oligopoly) (2) (Competitive market) (3) η 1=− P mP η k k kk s P mP =− mP = Marginal cost, m(Q) Average cost, AC(Q) Unit variable cost, Cv(Q) Unit fixed cost, Cf(Q) Scale economies: Average costs > marginal costs Scale diseconomies: Average costs < marginal costs Unit of output (Q) Cost

A-4 Appendix A A-4 where P = the market rate, m = the marginal cost, = the elasticity of demand, and sk = the market share of producer k. As shown, equations (1) and (3) could be obtained from equation (2) by setting sk equal to 1 and 0, respectively. The term (P – m)/P is referred to as the markup. The fact that no markup is possible in a competitive market has major implications in freight transport. As illustrated in Figure A.2, the average costs of firms operating in the scale economies range are larger than their marginal costs. As a result, freight companies that participate in a competitive market and charge their clients at marginal costs will not be able to recoup their fixed costs. In the parlance of the trucking industry, these firms “eat their trucks.” Far from being a theoretical curiosity, ample evidence suggests that this condition exists in the freight industry. In the case of rail freight, “With excess capacity [and competition], railroads could ignore the cost of infrastructure and price at marginal cost; however, as volume grew [and competition for cargo decreased], excess capacity disappeared, and railroads needed to price at average costs—a higher threshold” (Prince 2008). Prince’s description indicates the role played by the economic conditions that prompted the rail industry to set rates at marginal costs, even when doing so led them to lose money. Something similar happens in the urban delivery industry, as evidenced by the fact that the data show that only 9% of the carriers could pass time-of-day tolls to their customers. Not surprisingly, these carriers belong to industry segments in which individual firms have market power, such as the construction industry, food, and electronics (Holguín-Veras 2008). The remaining 91% of carriers had major difficulties in passing the toll costs to their customers because their contracts are based on distance, and do not allow for the inclusion of tolls (i.e., the tolls are a fixed cost that do not depend on the unit of output) (Holguín-Veras 2008; Holguín-Veras 2009). Glossary Activity-based costing (ABC): Approaches that match costs with the activities that cause those costs. 1 Classification of the functions of government (COFOG): A United Nations database that describes the broad objectives of government. Cost: The amount of monetary resources required to produce a set amount of a good or service. Cost-benefit analysis (CBA): A formal procedure to estimate an indicator of economic performance that takes into account the costs and benefits brought about by a project during its economic life. Data cost elements: The various inputs that enter into total cost. Econometric cost estimation: Techniques that rely on the use of formal statistical procedures to estimate 1 Source: http://www.businessdictionary.com/definition/activity-based-costing-ABC.html η cost functions.

A-5 Appendix A A-5 Economic costs: The actual costs of each activity without internal markups, transfers, or profits. External costs: The costs that are not internalized by the participants in an economic transaction. Fixed costs: The costs that do not depend on the output produced. Freight planning activities: Activities related to the process by which freight issues and concerns are addressed in the statewide or metropolitan transportation planning activities and documents. Freight policy activities: Activities related to the development of specific policy guidance concerning freight movements. Freight policy activities are designed to help metropolitan planning organizations (MPOs) assess their roles in addressing freight issues, and help focus metropolitan freight planning efforts. Freight programming activities: Activities that involve the ways in which MPOs commit funds to freight specific projects. Function: A group of related actions that contribute to a larger purpose or objective. Inventory costs: The costs associated with storing and maintaining a stock of goods. Logistics costs: The summation of transportation and inventory costs. Long run: The period of time after which all input factors are variable. Market costs (rates): The costs actually paid by the consumers in the market, equal to the sum of economic costs, transfers, and profits. Markup: The additional amount a producer is able to extract from a consumer above and beyond the production cost. The profit associated with the rate charged to customers is generally considered part of the markup. Metropolitan freight planning programs: Programs that integrate freight planning activities, freight policy activities, and freight programming activities into a comprehensive, continuous process. Metropolitan planning organizations (MPOs): Federally mandated and federally funded transportation policy-making organizations made up of representatives from local governments and governmental transportation authorities. Operational costs: Those expenses incurred in the daily running of a business, which may also be referred to as operating expenses. Price: The amount of money expected, required, or given in payment for something. Private costs: The costs that are incurred internally within the organizations of the participants in a transaction. Safe Accountable Flexible Efficient Transportation Equity Act: A Legacy for Users (SAFETEA-LU): Federal legislation signed in 2005 to guarantee funding for highways, highway safety, and public transportation, with a total budget of $244.1 billion. SAFETEA-LU represents the largest surface transportation investment in the history of the United States. Short run: The period of time during which some input factors are fixed. Social costs: The summation of private and external costs.

A-6 Appendix A A-6 Short-run average costs: Short-run total cost divided by the total output. Short-run fixed costs: The summation of all fixed costs required to produce a set output. Short-run marginal costs: The increment in total costs associated with an increase in total output. At the limit it is equal to the first derivative of total costs. Short-run total (private) cost: The summation of fixed and variable costs. Short-run unit fixed costs: The total fixed costs divided by the total output. Short-run unit variable costs: The total variable costs divided by the total output. Short-run variable costs: The summation of all variable costs required to produce a set output. Unified planning work program (UPWP): A work program that lists the transportation studies and tasks to be performed by an MPO or one of the local jurisdictions. (Transportation) user costs: The monetary expenses associated with the use or provision of transportation service. Variable costs: The costs that depend on the unit of output produced by the firm. Willingness to accept (WTA): The amount of money a consumer is willing to accept in exchange for a deteriorated condition. Willingness to pay (WTP): The amount of money a consumer is willing to part with in exchange for an improved condition. _____________________________________________________________________________________