The Consequences of Pricing Policies on Investment Decisions

Abstract

Pricing and investment decisions are not independent. Pricing affects demand and, hence, social welfare. The social profitability of the project can be quite different depending on the pricing policy. Therefore, before deciding whether it is socially worthy to invest in a transport project, the team responsible for a project evaluation needs to know the charging scheme that will be applied. In this chapter, we show that when comparing different transport alternatives, a particular charging scheme may favour the creation of a particular transport infrastructure network, leading to irreversible long-term equilibria that would not be optimal under other charging schemes.

Appendix

In this chapter, we consider three alternative transport projects: to construct just the air transport infrastructure, to construct just the rail infrastructure, or to construct both the air and rail infrastructure. For the sake of simplicity, we assume infinite-life projects. Thus, the NPV_s of each alternative project can be written as:

$${\text{NPV}}_{s} = - I + \frac{{\overline{B}}}{{r_{S} }},$$

(4.22)

where $I$ is the construction cost, $\overline{B}$ are annual net social benefits which are constant during the whole life of the project, and $r_{S}$ is the social discount rate. In this case, NPV_s > 0 implies that $\overline{B} > r_{S} I.$

The decision about constructing today instead of postponing the investment (optimal timing) is taking considering the following expression:

$$\frac{\overline{B_{1}}}{{1 + r_{S} }} > \frac{{r_{S} I}}{{1 + r_{S} }} ,$$

(4.23)

where $\overline{B_{1}}$ represents net social benefits during the first year. In other words, if net social benefits during the first year are higher than the opportunity cost of the investment, we should construct the infrastructure today. If annual net social benefits are constant, $\overline{B} = \overline{B_{1}}$, and we consider infinite-life projects, optimal timing condition is satisfied if and only if NPV_s > 0.

If annual net social benefits are not constant and the growth rate is $\theta < r_{S}$, NPV_s > 0 does not imply that the optimal timing condition is satisfied, since now the NPV_s is given by:

$${\text{NPV}}_{s} = - I + \frac{{\overline{B_{1}} }}{{r_{S} - \theta }}.$$

(4.24)

In this case, it might be the case that the NPV_s is positive ($\overline{B_{1}} > \left( {r_{S} - \theta } \right)I$) but the optimal timing condition is not satisfied since $\overline{B_{1}} < r_{S} I.$ However, notice that if the optimal timing condition is satisfied $\overline{B_{1}} > r_{S} I,$ then the NPV_s is positive since $\overline{B_{1}} > r_{S} I > \left( {r_{S} - \theta } \right)I$.

In the model used in this chapter, the first year social welfare is defined as first year net social benefits (obtained as the sum of consumers’ surplus, transport operators’ profits and the surplus due to the use of transport infrastructures) minus the investment opportunity cost. With this definition and considering infinite-life infrastructure projects, a positive first year social welfare implies, on the one hand, that it is optimal to construct the transport infrastructure today instead of postponing the investment one period and, on the other hand, that the NPV_s associated with such an infrastructure is positive.