How Do Passengers Respond to Fare Changes? Does Inflation Matter?
Matthew Shepherd, Oxera Consulting LLP, Pantelis Solomon, Oxera Consulting LLP
How passengers respond to changes in fares is important in any transport appraisal. Conventional economics says that passengers respond to real fares (i.e. net of inflation). We present an investigation into whether this is actually the case.
One of the foundations of the appraisal of any transport scheme (whether it be a bus or tram operator changing fares for the following year, or the appraisal of a multi-billion-euro high-speed line or toll road) is the level of demand from passengers. Part of predicting the level of demand is assessing how passengers will respond to different fare levels—in conventional economics and appraisal, passengers are thought to respond only to changes in real prices (that is, changes relative to inflation). However, the relatively new field of behavioural economics suggests that this is not entirely accurate and that consumers experience a phenomenon known as money illusion, where they respond to changes in nominal prices instead of real prices. Whether passengers respond to changes in real or nominal prices is an important issue for the transport industry. This paper will contain a summary of the behavioural economics literature to outline where money illusion may hold, and the results of an empirical investigation into this issue using GB rail data.
As outlined above, money illusion is the tendency of consumers to think in terms of nominal rather than real monetary values. In other words, if the price of a good (or service) increases, the consumer will not take into account the rate of inflation when deciding how much to consume of that good.
While money illusion has significant implications for economic behaviour, it cannot be explained by rational economic models. By incorporating insights from cognitive psychology, behavioural economics sheds light on both the causes and consequences of money illusion. An important insight of behavioural economics is that people tend to process only the most salient information. The nominal representation of prices is simpler and more salient—consumers are aware of the existence of inflation and the difference between nominal and real values, but because the cash value of a product is clearer than the inflation-adjusted price, people often think of price changes in nominal terms.
Furthermore, people’s decisions depend on their reference point. For example, this could be the price at which the consumer last bought a certain good. For example, consider two passengers who are considering purchasing train tickets. The tickets now cost €30. The last time the first passenger bought a ticket, the cost was €25, while the second passenger previously bought the ticket for €35. The decision to buy the ticket for the two passengers will tend be different because they will anchor their decision on the point at which they last bought the ticket. So the first passenger might be more willing to buy than the second. Again, in this case the reference point will tend to be nominal rather than real.
The empirical investigation into whether passengers suffer from money illusion will use a time-series dataset of GB rail data, drawn from publicly available sources. We will use a variety of econometric approaches to assess whether models specified in nominal terms perform better or worse in forecasting than those specified in real terms. As with all investigations of this type, it will be necessary to control for other factors affecting the demand for rail travel (to the extent that this is possible with the available data). This will include factors such as income, car ownership, etc.
The paper will draw conclusions on the circumstances under which money illusion may hold and the difference in implied responsiveness to changes in fares. We believe that this paper will provide an important first step in integrating the insights from behavioural economics into transport planning and appraisal, and will be of interest to all those involved in pricing transport services or appraising transport schemes.
Association for European Transport