Price Discrimination on Virgin Trains

No, nothing to do with Peter Andre, but a thought provoking economics article about the concept of Price Discrimination on Virgin Trains by Business Studies teacher Mark Brassington.  For more about Mark and the private tuition he can offer for A level Business Studies and Economics student please scroll to the end of the article.

Whilst planning to attend an AS Revision course at Easter 2007 I was horrified at the full £46.10 cost of a standard return to Manchester. But using the much cheaper £28.00 off-peak saver ticket would have meant leaving Birmingham too late to arrive there by 11.00 am.Whilst planning to attend an AS Revision course at Easter 2007 I was horrified at the full £46.10 cost of a standard return to Manchester. But using the much cheaper £28.00 off-peak saver ticket would have meant leaving Birmingham too late to arrive there by 11.00 am.

There was however a third option. Buying the much cheaper Virgin Value tickets. These must be bought in advance, are subject to availability and are usually only sold for trains that are expected to be quiet. Virgin Value ticket holders must also travel on the booked train.

How is it that Virgin Trains are able to offer such diverse fares for the same journey? The concept is known as price discrimination.

Price discrimination is used by organisations as different as Wetherspoons (which regularly discounts drinks between Sunday and Thursday when it is usually quietest) BT (with cheaper week-end and evening charges) and electricity distribution companies with their much cheaper night-time economy 7 tariff. Nightclubs usually charge high entrance fees at weekends, but are often free during the week.

At the heart of the policy is the realisation that different user groups demonstrate varying levels of willingness to pay for a particular product or service. One of the most notable examples is the early morning London commuter trains.

The table below summarises the principal fares to and from London Euston

There are four different first class fares and five standard fares, some omitted for clarity. However, travelling from Birmingham still costs £208 first class and £120 standard if travelling before 9.30 am during the week. Travelling later in the day with advanced tickets the same journeys can cost as little as £59 and £20 respectively. What Virgin Trains are doing is maximising their fares in the peak time when the trains are mainly used by business people. And many of those travelling on business will have their fares paid by their employers.There are four different first class fares and five standard fares, some omitted for clarity. However, travelling from Birmingham still costs £208 first class and £120 standard if travelling before 9.30 am during the week.  Travelling later in the day with advanced tickets the same journeys can cost as little as £59 and £20 respectively. What Virgin Trains are doing is maximising their fares in the peak time when the trains are mainly used by business people. And many of those travelling on business will have their fares paid by their employers.

Most other users are aware of the fact that the trains will be both quieter and cheaper if they travel later. Such people are likely to be going shopping or visiting friends and relatives. Such users are much more price-sensitive and would probably elect not to travel if peak fares were charged all day.

The train companies have invested billions of pounds in equipment that could only be used for a few hours a day if cheaper off-peak fares were not charged. Provided that the company can cover its marginal costs such as the fuel and the staff on that train, it will make a contribution to its huge fixed costs even if much lower fares are charged.

Peak hour commuters will usually have to reach work by 9am. In the case of those working in London, they are effectively captive as there are few viable options. Heavy traffic and congestion charging discourages driving or using a coach or bus.

Of paramount importance is the concept of elasticity. In economic terms the responsiveness of demand to change in price is known as price elasticity of demand, or P.E.D.

The commuters are heavily price inelastic probably with a P.E.D. of about –0.2. This means that with a ten percent increase in the price there will be only a two percent fall in demand. This will mean that there will be an overall increase in revenue for the company as shown in the diagram below. Here demand has fallen from Q1 to Q2 as a result of the increase in price from P1 to P2. The increase in revenue is shown by the area A and the loss by B. The former clearly exceeds the latter and vindicates the decision to increase faresThe commuters are heavily price inelastic probably with a P.E.D. of about –0.2. This means that with a ten percent increase in the price there will be only a two percent fall in demand. This will mean that there will be an overall increase in revenue for the company as shown in the diagram, left. Here demand has fallen from Q1 to Q2 as a result of the increase in price from P1 to P2. The increase in revenue is shown by the area A and the loss by B. The former clearly exceeds the latter and vindicates the decision to increase fares

Conversely off peak users are often making discretionary journeys and tend to have high P.E.D. values, maybe of the order of 3 or 4. With a value of 4, it would mean that a 10% fall in price would lead to a 40% increase in demand. By reducing fares the total revenue gained from lowering the fares clearly exceeds that lost through charging existing customers less as shown by the diagram below.Conversely off peak users are often making discretionary journeys and tend to have high P.E.D. values, maybe of the order of 3 or 4. With a value of 4, it would mean that a 10% fall in price would lead to a 40% increase in demand. By reducing fares the total revenue gained from lowering the fares clearly exceeds that lost through charging existing customers less as shown by the diagram, left.

Virgin Trains are therefore able to fill trains at all times of the day and offer very low fares to people who can demonstrate flexibility when they travel. For the system to work they must ensure that travellers with heavily discounted fares do not use the peak hour trains.

Wetherspoons use price discrimination between branches and at the time of the week. Where there is limited competition higher prices are charged for both meals and drinks. The lower prices charged Sunday to Thursday are discontinued during the Christmas and New Year period and bank holidays, when they know in advance that they will be busy.

BT operate a lower pricing strategy at weekends and evenings as most calls made then are for social reasons. This helps ensure that their extensive infrastructure, designed essentially for business usage, is well used outside of the working week.

Electricity companies operate night time economy 7 tariffs at well below half the price of the standard rate. Power stations cannot be turned off over-night and there is a real danger that much of the electricity generated will simply be lost as it cannot be effectively stored. Some industries requiring large amount of electricity can help negate the cost of employing staff during the night through benefiting from such low prices

In summary price discrimination is a highly effective pricing strategy which can help reduce peak hour problems and can give both people and business a very good deal, providing that they can demonstrate sufficient flexibility to use it.

RAILWAY OLIGOPOLIES

This Virgin Pendolino train from London Euston has just arrived at Glasgow Central station, the northern limit of the West Coast Main Line franchise held by Virgin Trains in the summer of 2007. Visible in the background however are some of the red-banded blue carriages of a train operated by the Great North Eastern Railway (GNER ) GNER trains reach Glasgow Central from London Kings Cross via the East Coast Main Line and, like the Virgin Pendolino, are designed to run at high speeds using the same overhead electrification system. Both trains, too, use expensive modern technology to promote passenger comfort and safety on the move.This Virgin Pendolino train from London Euston has just arrived at Glasgow Central station, the northern limit of the West Coast Main Line franchise held by Virgin Trains in the summer of 2007.  Visible in the background however are some of the red-banded blue carriages of a train operated by the Great North Eastern Railway (GNER ) GNER trains reach Glasgow Central from London Kings Cross via the East Coast Main Line and, like the Virgin Pendolino, are designed to run at high speeds using the same overhead electrification system. Both trains, too, use expensive modern technology to promote passenger comfort and safety on the move.

In economic terms, the rival Virgin and GNER train services from London to Glasgow – both established through competitive franchising – could possibly be seen as part of an oligopoly: a market in which there are only a few companies producing similar products and competing with non-price competition.

However a true oligopoly can be recognised by the following characteristics:

  • There are only a few main firms in the market. For example, there are only two major producers of soap powder – Proctor & Gamble and Unilever. Similarly, there are only three main producers of pet food – Spillers, Quaker and Pedigree.
  • The firms are selling, essentially, the same product. Most soap powders are almost identical, as are most brands of petrol, most tins of cat food and most of the standard range of products sold by supermarkets.
  • The businesses have what is called a kinked demand curve (see graphs above) and therefore they usually compete by using non-price competition.
  • They are interdependent and are affected very strongly by what any of their competitors do.
  • There are high entry costs so the number of firms in the industry does not change very much. Most oligopolies such as petrol companies, pet food producers and washing powder manufacturers, have had the same firms competing for decades.

With oligopolies, the demand curve has two different shaped depending on whether the price is being raised (upper graph ) or lowered ( lower graph ).

Using petrol stations to explain the concept of the kinked demand curve, there is very little difference between one brand of petrol and the next – all cars within their respective octane ratings running on the same formula fuel.

If one firm tried to put the price up by itself, from P to P1, it would find that the demand curve between A and B was very elastic. Customers would simply go elsewhere. The company raising its prices might gain some additional revenue ( area J ) from the customers who stayed loyal, but they would lose much more revenue ( area K ) because they are selling Q to Q1 fewer products.

On the other hand, if the firm tried to gain extra customers by lowering the price from P to P2 it would be faced with a very inelastic demand curve between A and C. The other petrol stations know that this firm could capture extra sales by lowering the price so they immediately prevent this by lowering their own prices as well. The firm may gain a few extra sales and revenue ( area L ) but it will have lowered prices for all its customers – old and new – and will have lost a great deal of revenue ( area M ).

Oligopolies cannot easily change their prices because they will lose revenue and hence profits. As a result, they resort to non-price competition.

Virgin Super Voyager "Sir Francis Chichester" en route to Glasgow. Like the Virgin Pendolinos, these trains tilt to improve speed and passenger comfort over the twisting West Coast Main Line but being diesel powered – like their non tilting Voyager brethren – can also operate away from overhead power lines.Virgin Super Voyager 221 115 “Sir Francis Chichester” en route to Glasgow. Like the Virgin Pendolinos, these trains tilt to improve speed and passenger comfort over the twisting West Coast Main Line but being diesel powered – like their non tilting Voyager brethren – can also operate away from overhead power lines. In 2015, 221 115 has been de-named but carries a variation of the Virgin West Coast livery with dark grey Bombardier branding on the driving vehicles.  It is maintained by Bombardier Transportation at its Central Rivers depot near Barton-under-Needwood.

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Mark Brassington (above, left) doesn't just talk the talk - he walks the walk with successful students and giants of modern economic theory - like Tim Harford, the Undercover Economist.Mark Brassington ( left) doesn’t just talk the talk – he walks the walk with successful students and giants of modern economic theory – like Tim Harford, the Undercover Economist.

Tim Harford is a member of the Financial Times editorial board. His column, “The Undercover Economist”, which reveals the economic ideas behind everyday experiences, is published in the Financial Times and syndicated around the world. He is also the only economist in the world to run a problem page, “Dear Economist”, in which FT readers’ personal problems are answered tongue-in-cheek with the latest economic theory.

He presented the BBC television series “Trust Me, I’m an Economist” and now presents the BBC radio series “More or Less”. He is a frequent contributor to other radio and TV programs, including the Colbert Report, Marketplace, Morning Edition, Today, and Newsnight.

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