The Implications of Economies of Scale, Scope and Network Integrity on the Privatisation of Transport Services

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1. INTRODUCTION

Since the privatisation and deregulation of domestic transport markets, the involved industries have witnessed major changes in their structural organisation. In general it could be observed that the average firm size as well as industry concentration have increased considerably. Bankruptcies, mergers and takeovers are common place in those transport industries (Oum and Zhang 1997). Whether the driving force behind the firms becoming larger is an evidence for the existence of economies of scale, or the sole motivation can be found in gaining market power has very important implications for competition policy planning and implementation.

Policy-makers appear to believe that in such deregulated environments a larger company size may have advantages in productive efficiency (Oum and Zhang 1997). The objective of this paper is to explore the implications of the development of scale economies to service integrity economies for the economic perception of market structure. The new insight into the existence of natural monopolies bears important lessons for decision making process concerned with privatisation in the transport industry.

2. MARKET STRUCTURE AND NATURAL MONOPOLY

As mentioned above already, the interest of analysing returns to scale, scope or service integrity lies in the fact that they indicate the existence of a natural monopoly. Availability of such information is important to the policy-maker to devise effective regulatory or antitrust measures, which guarantee an efficient market structure and maximum (constrained) social welfare after privatisation. Therefore this section is devoted to very briefly outline the basics of market structure and natural monopoly.

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The two extreme cases of market structure are the ‘naturally competitive’ market, where a large number of small operators have reached a competitive equilibrium, and a ‘natural monopoly’, where it is always cheaper for a single firm to produce the relevant output than for two or more firms to produce it. A case in between is a ‘natural oligopoly’ wherein a small number of efficient firms will fit into the market (Keeler 1997). A natural monopoly exists if either economies of scale, economies of scope or economies of service integrity can be found (Hensher 1993). In the economic sense a competitive market can or will provide an economically efficient solution. For these markets deregulation is the appropriate means of privatisation. A natural monopoly requires intervention or regulation, unless there is competition ‘for the market’. In this case the threat of market entry will discipline the monopolist in terms of costs minimisation, price control, however, is shown to be necessary. Otherwise the monopolist will be able to earn above-normal profits. If there is no competition for the market regulation also need to control production efficiency. Such above-normal profits are not compatible with governments’ objective of maximising the welfare of the community.

3. FROM ECONOMIES OF SCALE TO SERVICE INTEGRITY

The concepts of economies to scale through to economies of network integrity basically indicate that a single firm can supply output(s) more efficiently than two or more firms are able to due to varying factors of production (see table 1, next page). The discussion of the development of those factors used in economic analysis to determine the existence of a natural monopoly is the scope of this section.

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Table 1. The concepts of economies of scale, scope and service integrity

source: Caves et al 1984, Button 1986

3.1 Economies of scale

In the strict economic definition economies of scale exist were the average costs of output expand and this output is homogeneous. Oum and Zhang (1997) state that empirical studies of the transport industry could not provide enough evidence for the presence of scale economies in the transport sectors analysed, as there were generally constant returns of scale observed. These results on economies of scale seem to indicate that any attempt to expand the output without significantly altering the nature of the network or the output mix would not improve scale efficiency (Bailey and Friedlaender 1982, Oum and Zhang 1997, Gillen et al 1985).

The resulting difficulty to explain the expansive behaviour of transport companies led to re-examine the economic methods for measuring economies of scale. A first step of improvement was to distinguish between returns to density and returns to scale (Caves et al 1984).

But even when taking output and network size into account, constant returns to scale seem to prevail in the transport industry. This is a consequence of traditional measures overlooking the role of operating characteristics, other than network size, which have

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