What Is Congestion Pricing?

Based on the economic theory of pricing, congestion pricing is a dynamic pricing strategy designed to regulate demand by increasing prices without increasing supply. The word "congestion" comes from using this strategy as a way to regulate roadway traffic.

Congestion pricing is a common ploy in the transportation industry where it aims to decrease both congestion and air pollution by charging more for entering especially congested areas of a city.

This strategy also is used in hospitality (hotels) and utility sectors (electricity), in which demand varies depending on the time of day, or season of the year. Electricity rates may be greater in the summer, for example, because of increased air-conditioner usage; hotel rooms may be more expensive during major holidays.

Nobel-laureate economist William Vickrey first proposed adding a distance- or time-based fare system to manage congestion on the New York City subway in 1952. As a result, Vickrey is considered by some to be the father of congestion pricing. Maurice Allais, also a Nobel Prize-winning economist, elaborated on congestion pricing theory to manage traffic congestion and was central in designing the first road pricing system, the Singapore Area Licensing Scheme, implemented in 1975.

Understanding Congestion Pricing

Congestion pricing is a way of adding a surcharge for services that are subject to temporary or cyclic increases in demand. Companies that engage in excess pricing are trying to regulate excess demand by applying higher prices during peak demand cycles. On New Year’s Eve, for example, taxi and car services increase their rates significantly because of the great demand for driving services. Hotels raise their room rates on days when conventions come to town, and during major holidays, or for special events—when a city is hosting the Olympics, for example—during which they expect tourism to increase.

Congestion pricing is supposed to encourage users who can be flexible with their usage to shift away from peak periods to times when the service or resource is less expensive.

With congestion-pricing, companies hold power because the demand for a service will not be affected by price hikes.

Types of Congestion Pricing

Economists and transportation planners break down types of congestion pricing even further based on a particular functionality.

Dynamic, Peak, or Surge Pricing

Dynamic pricing is a congestion-pricing strategy where the price is not firmly set; instead, it fluctuates based on changing circumstances—such as increases in demand at certain times, the type of customers being targeted, or evolving market conditions.

Dynamic pricing strategies are especially common in businesses that provide a service, such as the hospitality, transportation, and travel industries.

Segmented Pricing

In segmented pricing, some customers are charged more based on their willingness to pay more for a given service. Some may be willing to pay a premium for faster service, greater quality, or extra features, such as amenities. For example, a vendor may offer a product without a warranty at a low price, but if you want the same product to come with a warranty, then you would pay a higher price. Or business travelers may be willing to pay a higher price for an airline ticket that allows them to fly mid-week.

Peak-User Pricing

Peak-user pricing is based on peak travel times and is common in transportation. For example, airline and train companies often charge a higher price to travel during rush hour on Monday through Friday than at other times.

They may also have different prices for weekends, or for a trip that includes a weekday plus weekend. Utility companies also set prices based on peak times. They may charge higher fees for phone calls made between 9 a.m. and 6 p.m., for example.

Key Takeaways

  • Congestion pricing generally imposes price increases for services that are subject to temporary or cyclic increases in demand.
  • It is a common strategy in industries like transportation, tourism, hospitality, and utilities.

Congestion Pricing: Theoretical Background

Congestion pricing is considered a demand-side solution to regulating traffic whose rationale comes from market economics. The idea behind charging a higher price is to make users aware of the consequences, such as increased congestion, that they impose on all concerned when they use a resource during peak demand. The theory posits that consumers will use, and waste, more of a resource that is free or negligible in price than an expensive one. By increasing the price of a resource, users’ willingness to pay for that resource fuels a scarcity of that resource.

Most economists agree about the economic viability of some form of road pricing to reduce traffic congestion, and congestion pricing has been effective in urban areas where it's been tried. However, not all see it as an equitable strategy because of the economic burdens faced by the communities that abut areas of congested traffic. Another criticism of congestion pricing is that, similar to a regressive tax, it could harm low-income users more than other demographic groups.

Examples of Congestion Pricing

Recently, rideshare companies like Uber (NYSE: UBER) and Lyft (NASDAQ: LYFT) have begun to apply surge pricing aggressively during peak hours.

New York City (NYC) is the first major U.S. city to approve a congestion-pricing plan (though many have tried to launch one there, including Mayor Michael Bloomberg in 2008). The plan—to be rolled out in 2021—is based on "cordon pricing," in which motorists pay to enter a zone, in this case, everything south of 60th Street at the end of Central Park.

New York is still drafting details of the plan, including the fee structure. The new program, which has both advocates and adversaries, likely will come with complications for all—the city, commuters, and the Metropolitan Transportation Authority (MTA).

The city of London, England, introduced a congestion-pricing plan in 2003 that initially was successful in reducing congestion and air pollution, and on most counts is still successful today. Currently, London is working out its "lessons learned," and NYC, too, is trying to learn from them.