Railways flexi-fare policy rests on naive and unclear assumptions
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The ministry of railways has introduced a new pricing mechanism for the three premium trains—Rajdhani Express, Shatabdi Express and Duronto, numbering 142 in total, plying across India with a combined daily passenger load of about 1,50,000.
As per the new pricing scheme (dubbed flexi-fare system), which has come into effect from 9 September, fares for these trains are set to rise by a minimum of 10% to a maximum of 50% of the base fare, depending on the demand and class of travel. Specifically, the base fares for 2AC, 3 AC and chair cars in these trains will rise by 10% for every 10% of the tickets sold up to a maximum of 1.5 times the original base fare. For tatkal scheme, the rate will be 1.5 times the base fare for all classes, except first-class AC and economy in Shatabdi. Other supplementary charges like reservation charges, superfast charges, catering charges and service tax etc. as applicable, shall be levied additionally.
The basic motivation of rolling out this new scheme is to extract additional revenue from high-end passenger segment so that it can to some extent bridge the current losses of about Rs.33,000 crore in the passenger segment and meet its gross passenger revenue target of Rs.51,000 crore for this fiscal. However, some estimates suggest that the potential revenue gain from such a measure will be only around Rs.500 crore, or less than 1% of the revenue target. This, therefore, appears to be a futile exercise to meet revenue targets, unless the railways plans to effect such flexi-fare model to all other express trains in this fiscal. Indeed, it appears that Railways is testing waters with this new pricing system before it finally rolls out higher fares in other passenger segments in the near future.
While there is no disagreement on the philosophy that as a modern public sector organisation, Railways should generate profit to better serve its diverse stakeholders, the current plan of introducing a flexi-fare system, albeit in a limited way, rests on some naive and unclear assumptions. Basic microeconomic theory would suggest that the proposed pricing scheme, which does not capture the full essence of dynamic pricing, is likely to result in inefficiencies and deadweight losses for the society.
The new pricing strategy is premised on the assumption that the reservation prices (maximum willingness to pay) of high-end customers travelling in 2AC and 3AC is greater than the current price, implying an opportunity to extract additional consumer surplus from these segments. Another implicit assumption seems to be that being a monopoly in rail transport endowed with customers limited by choice and inelastic demand, it can charge a higher mark-up, thereby maximising its producer surplus. These assumptions may be erroneous as the targeted customer segment which has both a higher willingness and ability to pay may not necessarily be captive customers.
Further, availability of functional substitutes such as low-cost no-frills airlines and luxury road transport may make rail transport less lucrative, alter consumer preferences, thereby rendering this to be an ineffective step. In any case over the past few years, repeated price hikes in the upper class segments have made it less competitive, as consumers in such segments have begun to factor in the opportunity cost of time and convenience.
The flexi-fare scheme also does not reflect the true essence of dynamic pricing. Like a ratchet effect, prices in this case will only move up and not down. An implicit assumption here is that the demand will always exceed supply at all times. While this may be true for the non-premium trains, it might not hold for the premium trains barring the festive seasons. The probability of seats going unoccupied in such cases may accentuate given that in the off season, such trains do not run to full capacity. Under such circumstances, the purpose of dynamic pricing of rationalising demand will be defeated.
Also, such a system of dynamic pricing may be welcomed in a more competitive market when the consumers are not constrained by lack of choices or offer of value. In this case, neither are being satisfied as higher prices are not indexed to differentiated or value-added services. Moreover, a part of customer demand might be siphoned to other non-premium segment and thereby create excess demand for these trains, especially during the peak seasons, incentivizing proscribed transactions. Hence, it becomes evident that the aspect of customer utility is being totally ignored while designing such pricing schemes. All these will certainly lead to loss of consumer welfare. Even if the producer’s surplus for the Railways stands out to be positive, it will not always be able to outweigh the loss of consumer’s surplus, resulting in deadweight losses.
In defence of its new pricing scheme, the Railways has cited the prevalence of dynamic pricing internationally. But similar pricing mechanism elsewhere have economic and mathematical underpinnings. For instance, according to a 2013 report of the Department for Transport of UK, such price hikes are monitored regularly and indexed to inflation plus 1% of the base price, limiting the price rise to a maximum of 5% contingent upon price rise by competition. However, the price rise in this case is up to 150%, rationale for which remains opaque.
Railways has been relying on traditional measures to generate extra revenue. The government has recently proposed 8-14% increase in freight rates for coal moved between 100km and 700km. It has also doubled the fares of platform tickets and done away with the concession available for child travellers. While all these measures are means to appropriate extra revenue from the common people, the approach lacks dynamism, innovation and foresight. For example, no concrete plans are laid to effectively utilize the vast land resources at its disposal, a potential source of a sustainable revenue stream.
A public private partnership model to build up commercial infrastructure for better customer services like luxury waiting rooms, better toilets and food courts with appropriate user fees will help increase revenue while enhancing customer satisfaction. Effective bundling strategies could be implemented, mixing different combinations of products and services.
The above is not to suggest that Railways should not increase revenues through fare hikes, but rather to suggest that it should not rely only on taxing the customer to meet its revenue targets. Research by behavioural economists like Daniel Kahneman and others indicate that consumers are generally antagonized by unexpected price hikes, as may happen in this case.
A value-based pricing scheme or price partitioning can be a better approach. Customer annoyance can be addressed by value-added services. When extra premium is charged for better and differentiated services, customer dissatisfaction can be reduced to a large extent. Marco Bertini and Luc Wathieu in a paper published in the Journal of Marketing Science in 2008 have established from different experiments carried out in different settings that customers presented with an all-inclusive price are likely to concentrate their evaluation on the focal attribute of the transaction. On the contrary, a partitioned price increases the amount of attention paid to secondary attributes (value-added services for the extra premium) which in turn affects preference and choice. Presence of multiple price tags can sensitize customers to features they might otherwise overlook.
An influential paper by Morwitz et al, published in Journal of Marketing Research in 1998, has showed that price portioning can indeed increase demand because buyers pay less attention to total cost when associated with multiple charges. Further, this will also help in raising the reference price of the customers. These measures will not only accrue higher revenues, but also help in addressing the emerging threat from other functional substitutes to lure away customers, thereby increasing customer retention and customer loyalty.
Given the constraints of being a public monopoly, surge pricing schemes may usher in negative sentiments. A better strategy would be to graduate to value-based pricing, not only in passenger segment but also across other segments and services, incorporating insights from behavioural economics.
Amarendu Nandy and Abhisek Sur are, respectively, assistant professor and doctoral student at Indian Institute of Management, Ranchi.