(Reprinted from HKCER Letters, Vol.44, May 1997)


Why Regulate Bus Services?

Louis M. Chan


Hong Kong has a much deserved reputation as a laissez-faire open economy. But since few if any governments, and certainly no politician, can resist the temptation to use power for political ends, the amount of government intervention in Hong Kong's economy is probably more than what can be justified by economic reasons alone. This is certainly the case in the bus services industry.

Hong Kong has a long history of government regulation by price and rent controls, subsidies, duties, and monopoly franchises. In particular, virtually all aspects of transportation in Hong Kong are regulated by the Hong Kong government; and bus services in Hong Kong are especially extensively regulated. The Public Bus Services Ordinance gives the government the power to restrict entry by making it illegal, with few exceptions, for anyone to operate a public bus service except under franchise. The Ordinance also gives the government the power to impose various other regulations on bus franchise operators. For example, the government regulates the scale of fares which may be charged and the rate of increase in fares. The government may impose a rate of return regulation by using the profit control scheme. The government may also regulate the frequency, the period of service, the carrying capacity, and the types of buses on any specified routes.

Recently, the government seems to be changing its regulatory policy. For example, the current franchises granted to the CMB and Citybus are on a non-exclusive basis. In addition, the profit control scheme does not apply to the current franchises granted to the CMB and Citybus; and most likely it will also not apply to future franchises granted to the KMB. Since it is known that a firm which is subject to the rate of return regulation will have a tendency to overcapitalize--to use an excessively capital-intensive technology and to take on additional business which may be unprofitable without the rate of return regulation--society probably will find it beneficial overall to scrap the rate of return regulation. However, many regulations are still enforced.

Economic Arguments Frequently Cited for Government Regulation of Industry

Why does the government regulate bus services in Hong Kong? Many economic arguments have been invoked historically and theoretically to suggest that unregulated competition produces "unsatisfactory" results--poor service, high prices, and industry instability. The most frequently used rationalizations of this kind are the unstable natural monopoly argument, the appropriable innovation argument, and the quality of service argument. But only the unstable natural monopoly argument gives good enough economic reasons, and only when cream-skimming competition--entry into only the "lucrative" markets--is a problem for the industry, for government regulation of industry.

When a government is using the appropriable innovation argument, it is saying that the investments of a firm may be appropriated if they are not protected, presumably by government regulation. The quality of service argument says that quality of service in an industry may suffer if firms compete in prices instead of in services. But these arguments do not imply that government franchise and regulation are the only ways (or the best ways) to solve the problems. Market solutions such as brand names, copyrights, and patents may be more efficient tools to protect the rights and ownership of the firm making the investment or offering the service. Of course, government may have a role in helping to enforce the ownership of brand names, copyrights, and patents. But government's role should be minimal. Indeed, if government regulation decreases competition in an industry, then the incentives for firms in the industry to make investments in order to lower cost or to offer better service may also be decreased.

The Unstable Natural Monopoly Argument

The unstable natural monopoly argument says that it is economically efficient for one firm to produce for the entire market; but when a natural monopoly is structurally unstable, cream-skimming competition will make it impossible for one firm to produce for the entire market. Since government regulation is the most powerful entry barrier available to prevent cream-skimming competition, it may be reasonable to argue that government regulation is a solution for the unstable natural monopoly problem. But we should also be aware that government regulation may not be the only solution. Industry self-regulation, by a cartel for example, and anti-competitive measures such as exclusive dealing may also prevent cream-skimming and bring some sort of order to an unstable natural monopoly industry. The advantages of industry self-regulation over government regulation are: (1) entry barriers may not be as effective as when there is government regulation, so that competition may not be completely snubbed out; and (2) government regulation is likely to spread to even perfectly competitive markets.

The problem with applying the unstable natural monopoly arguments to the bus services industry is that the bus services industry is not likely to be a natural monopoly industry. In order for an industry to be a natural monopoly, there must be the presence of large fixed costs, or of economies of scale, or of economies of joint production. But fixed costs are relatively small in the bus services industry--buses pay for the roads they travel only as they use them; each bus is a relatively small investment; and buses can be easily moved from one area to another. Moreover, there is no evidence of significant economies of scale nor of economies of joint production in the industry.

The Real Reason--Politics

In order to understand why governments regulate bus services, we have to look beyond economic arguments, which justify regulation on efficiency grounds, and look to political reasons, which have nothing whatsoever to do with efficiency. Political goals can be distinguished from economic efficiency goals by one key factor--politics are partisan in nature. In addition to using taxation and government spending, a government may grant exclusive franchises to reward political favorites; sell exclusive franchises to raise money for the government or its officials; and regulate prices to curry favor with certain constituents. If a government does not interfere in the marketplace, then it cannot get hold of resources to further its political goals. Therefore, even when there is no economic reason for regulation, a government may regulate--for political reasons.


A major political reason behind government regulation of the bus services industry is that the government wants to subsidize certain users of bus services. Subsidization can be done through either direct subsidy or cross-subsidization. Compared to cross-subsidization, direct subsidies may be more unattractive politically because they are more obvious and may be just as costly economically because they usually come from taxes, which are generally welfare-decreasing. Cross-subsidization or internal subsidization is the practice of charging a group of customers a price higher than the total cost of serving them alone in order that another group may be charged a price lower than the total cost of serving them alone. For example, in 1921, the Attorney General said in Legco that government regulation of the bus services industry enables the government to subsidize constituents living in "outlying districts". Subsidizing users of bus services in "outlying districts" means that they are charged prices below the cost of serving them and that bus companies lose money on routes where they have to charge prices lower than cost. Bus companies will be willing to operate such routes only if they can charge higher prices than cost in some other market segments--these will be considered "creamy" routes; without these "creamy" routes, bus services operators will make negative profits overall and they will rather go out of business.

When government regulation of the bus services industry is used to cross-subsidize some bus routes, the government has to make sure that no cream-skimming competition occurs. We can easily see that competition for only the "creamy" routes will make cross-subsidization impracticable. Suppose that in a market segment a regulated firm is charging customers a price higher than the total cost of serving them alone in order to make up for losses suffered in other market segments. If other firms are allowed to enter and compete only in this "creamy" part of the market, then the regulated firm will no longer be able to charge higher than competitive prices and enjoy higher than competitive profits in this creamy market segment. As a consequence, the regulated firm will have losses overall and will prefer to cease operating the franchise.

Some Policy Suggestions

In a world in which economic efficiency is the only objective of government policies, complete deregulation of the bus services industries seems to be justified. By complete deregulation of the bus services industry I mean mainly that the government ceases regulation of entry, routes, and fares in the bus services industry. But complete deregulation does not mean that there should be no operational rules and no operational coordination. Indeed, complete deregulation will require changes in some operational aspects as well, and perhaps government involvement in making these changes. With government permission and aid, bus services operators may be able to use common terminals and cooperate in disseminating information on fares and schedules. There may be some initial problems and confusion; for example, bus operators may compete for curb-side stop spaces and there may be confusion about bus fares and schedules. But such problems will go away once coordination is fully developed.

Let Potential Competition Work--Use Competitive Tendering

But for political reasons, the government may want to continue cross-subsidization in the bus services industry. This will especially be the case if the government decides against direct subsidy of certain bus services and bus routes. If the government continues to follow a policy of cross-subsidization in the bus services industry, then the government has to make sure that no cream-skimming competition occurs. Cream-skimming competition in a cross-subsidizing industry is likely to lead to industry instability and poor service. At the same time, the government should let forces of potential competition work by using, for example, a competitive public tendering process in granting franchises. Letting potential competition work is likely to be the only way to better service and lower price.

A comprehensive and carefully considered competitive tendering process has the additional advantage that, when preparing any package for competitive tender, the effect of the package on each bus services operator's network may be assessed and any likely money-losing routes may be balanced by routes that earn above-competitive profits. For operational considerations, the government may need to look ahead in time when preparing a package for competitive tender. This would give the successful tenderer sufficient time to raise capital, commit capital investments, and build up and retain staff; and the incumbent franchise operators enough time to dispose of assets and separate staff. To summarize, if for political reasons the government continues to grant franchises, then it is a good idea to grant franchises using a comprehensive and carefully considered competitive public tendering process.

Louis M. Chan is assistant professor in the School of Economics and Finance, The University of Hong Kong.


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