Mass Transit Fares, Subsidies and Elasticity

Luis F. Dumlao, Ph.D., is Associate Professor of the Department of Economics, School of Social Sciences, Ateneo de Manila University. This piece was published in the March 14, 2011 edition of the BusinessWorld, pages S1/4 to S1/5.

 

 

The most important thing in economics is supply and demand. The second most important thing is elasticity. Just about anything in economics depends on supply and demand and elasticity. One difference between the two is that most people know supply and demand, while most do not understand elasticity. Back in my days as a doctoral student at Fordham, Professor Dominick Salvatore would joke. He would say that if in the middle of debate you ran out of arguments to say, just say “the answer to that depends on elasticity.” Chances are you are correct and that your counterpart does not understand elasticity.

True enough, the answer to the question of whether the government should decrease its subsidy and allow fares to increase in the mass transport system depends on elasticity. Certainly, the reason for this is a mystery for many. In general, elasticity measures the responsiveness of one thing as a result of another thing changing. For example, “price elasticity of demand” or “elasticity” hereafter measures the responsiveness of demand as a result of a change in price.

Consider a simplified stylized example. Suppose the cost of building and operating our train systems is PhP100 and the build-operate-transfer (BOT) scheme promises to pay back investors PhP120. Suppose that the initial government subsidy is PhP60, the initial fare is PhP10 and that there are six daily commuters. This makes up PhP60 + (PhP10 X 6) = PhP120. Now the government claims that the PhP60 subsidy is too big and that the subsidy prevents it from spending on other social and anti-poverty projects. Hence, it claims the need to reduce subsidy, which will require the public to shoulder more of the PhP120 promised to investors, which will require a raise in the fare.

Suppose the government allows the fare to increase from PhP10 to PhP15. The naïve outcome is that the six daily commuters will now pay PhP15 each. The revenue from commuters will be PhP15 X 6 = PhP90. To complete the P120, the government will need to shell out PhP30 as opposed to PhP60. This saves the government PhP30, which it can now spend more on other social and anti-poverty projects.

However, the law of demand says that when price goes up, demand goes down. How much demand goes down depends on elasticity or demand’s responsiveness to change in price. Suppose that demand is inelastic or not responsive. An increase of fare from PhP10 to PhP15 will decrease the demand from six to five daily commuters—a response reduction of only one. The five daily commuters will now pay PhP15 each. The revenue from commuters will be PhP15 X 5 = PhP75. To complete the PhP120, the government will need to shell out PhP45 as opposed to PhP60. This saves the government P15, which it can now spend on other social and anti-poverty projects.

But suppose that demand is elastic or responsive. An increase of fare from PhP10 to PhP15 will decrease the demand from six to three daily commuters—a reduction of three. The three daily commuters will now pay PhP15 each. The revenue from commuters will be PhP15 X 3 = PhP45. To complete the PhP120, the government will need to shell out PhP75 as opposed to P60. Two undesired things come out of this. First, less commuters benefit from the mass transit infrastructure, and they have to pay more. Second and more importantly, government ends up subsidizing more, which forces it to spend less on other social and anti-poverty projects!

As of now, the increase in fare has been delayed on the basis of the need for further study and consultation. The main starting point of further study and consultation with the public should be elasticity.

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