We recently started a Lunch & Learn program at TAS. I did the first one on electronic road pricing and followed-up with the blog post below. Let me know what you think. It’s also cross-posted here on TAS’s website.

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Last week at TAS I kicked started our new Lunch & Learn program with a talk on electronic road pricing. It was based on an HBS case that I had prepared for a pricing class I took at the Rotman School.

The case is essentially about traffic congestion in Hong Kong and a decision to either build more road (a bypass road running adjacent to the harbour: The Central-Wan Chai Bypass) or implement an Electronic Road Pricing (ERP) system, similar to what was implemented in Singapore in the 70s and in London in 2003.

My own view is that road pricing makes a lot of sense. And I’ve written extensively about it on my own personal blog. But to quickly summarize the economics behind it all, take a look at this graph:

What this graph plots is the marginal cost of products and services with a fixed capacity.  An example of a product or service with a fixed capacity would be a road. Roads can only handle a certain amount of drivers before it becomes unusable (gridlock). What this graph tells us is that once you reach that capacity—variable k in the graph—the marginal cost goes from zero to basically infinity.

In laymen terms, it’s telling us that at 4am when nobody is on the road, the cost—to society, to productivity levels, and so on—of adding each one additional driver is basically zero. But, as soon as you hit capacity, at say 830am, and traffic is at a standstill, the cost shoots way, way up!

So how do you solve this problem? Well, you price congestion. This invariably removes or forces drivers to other times of day and makes it so that demand for the road drops below the available supply. Then the road is able to function as it’s intended to. I don’t know about you, but this makes a ton of sense to me. What good are roads if they’re clogged with traffic?

What I’d like to do now is bring the discussion back to Toronto. For those of you with an interest in transit, you’re probably aware that Metrolinx has a “Big Move” transit and infrastructure plan that’s going to cost the region $2 billion a year to implement. I view this as investment in our region and so I think it’s absolutely the right move.

However, the billion dollar question is, where is the money going to come from? Earlier this year Metrolinx proposed 4 main revenue tools. They are:

- A 1% sales tax (estimated to raise $1.3 billion annually)
- A business parking levy (estimated to raise $350 million annually)
- A $0.05 fuel and gasoline tax (estimated to raise $330 million annually)
- And a 15% increase in development charges (estimated to raise $100 million annually)

What I would suggest is that there should be a road pricing plan in this list in addition to—or instead of—some of the items listed above. Taxes are just taxes. And they discourage consumption depending on the elasticity of the demand for those items.

However, I would argue that a well executed road pricing model should be considered not as a tax, but instead as an incredibly accurate way to price roads according to actual usage patterns and costs incurred. Think of it like time-of-use utility billing. Do you think of high-peak utility billing as a tax or as simply the price to use the service when demand is the highest?

The benefits of a road pricing system would be numerous:

- We’d get a consistent revenue stream for transit investment in the region (instead of having to rely on government hand outs)
- We’d be helping to decouple transit building from the political process (because Metrolinx would now make its own money)
- We’d eliminate traffic congestion (yes, it can be done)
- We’d increase productivity levels across the region (people will actually be able to get around)
And we’d be reducing our impact on the environment by encouraging alternate forms of transportation

This is an incredible list of benefits. However, I think one of the challenges with implementing electronic road pricing is that it’s often misunderstood. People just view it as a tax. Hopefully by looking at the economics behind it all, it has become clearer that it’s actually a bit more nuanced than that.