What Is Congestion Pricing?

The term congestion pricing refers to a dynamic pricing strategy designed to regulate demand by increasing prices without increasing supply. The strategy, which is based on the economic theory of pricing, is a common ploy in the transportation industry where it aims to decrease congestion and air pollution by charging more for entering especially congested areas of a (major metropolitan) city.

Congestion pricing is also used in hospitality (hotels) and by utilities (electricity), in which demand varies depending on the time of day, or season of the year. Electricity rates may be greater in warmer months while hotel rooms may be more expensive during major holidays.

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 the transportation, tourism, hospitality, and utility industries.
  • Congestion pricing comes in demand or surge pricing, segmented pricing, or peak-user pricing.
  • The idea behind congestion pricing is that consumers will use and waste more of a free or negligibly priced resource than an expensive one.
  • Congestion pricing may increase revenues, but the costs associated with plans may be high.

Understanding Congestion Pricing

Congestion pricing, which is also called "surge" or "value" pricing, adds a surcharge for services that are subject to temporary or cyclic increases in demand. It's meant 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.

As mentioned above, it is commonly used as a way to curb traffic on the road to reduce congestion on the road and improve air quality. The travel and tourism industry also uses this form of pricing, often called surge pricing, during times of peak travel. Utility companies charge a higher rate for usage at peak times as well.

The goal is to regulate excess demand by applying higher prices during peak demand cycles. For example, car services increase their rates on New Year's Eve because of the high demand for rides. Hotels raise room rates during conventions, major holidays, or special events. Electricity rates may be greater in the summer because of increased air-conditioner usage.

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. This is why Vickrey is considered to be the father of congestion pricing. Maurice Allais, another Nobel Prize-winning economist, elaborated on congestion pricing theory to manage traffic congestion. He was instrumental in designing the first road pricing system, the Singapore Area Licensing Scheme, implemented in 1975.

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

This structure charges customers 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 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, which is also called peak-load or time-of-use 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 9:00 a.m. and 6:00 p.m.

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

Congestion Pricing: Theoretical Background

Congestion pricing is considered a demand-side solution to regulate traffic driven by market economics. Charging a higher price is meant to make users aware of the consequences (increased congestion) that they impose on everyone else 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 that have adopted the plan. However, not everyone considers it an equitable strategy.

Critics say it leads to economic burdens faced by the communities that abut areas of congested traffic. Another criticism of congestion pricing is that it may harm low-income users more than other demographic groups, just like regressive tax systems.

Advantages and Disadvantages of Congestion Pricing

Advantages

The most obvious benefit of implementing congestion pricing is that it controls congestion on the roads, thereby reducing stress and delays on the road. If drivers are charged (additional) tolls to enter certain parts of a city, they'll be less likely to use their own cars on the road and may, instead, turn to public transport. Similarly, utility companies can curb usage during peak times for services like water and electricity.

Higher prices lead to an increase in revenue. Money collected from tolls can be used for road improvement and to improve public transport, which gives commuters other options for transit to and from the city. Companies like those involved in ridesharing and travel can see a boost in their bottom line.

Congestion pricing helps reduce pollution and the consumption of energy. Pulling cars off the road means fewer exhaust fumes. And charging more for electricity when resources are already strained during peak times can influence consumers to spread out their usage to other times.

Disadvantages

Critics of congestion pricing argue that it puts a heavy burden on people who drive and may financially impact those who fall into lower-income ranges more than others. Just like regressive taxes, congestion pricing ends up taking more of their income compared to those with higher incomes.

Because congestion pricing discourages people from activities like driving, it could hurt businesses in certain parts of the city. That's because public transit may not be an option for certain people who can only rely on their own vehicles. If they are forced to pay, they may choose not to go into those areas at all.

Although it may increase revenue, the cost to oversee and administer congestion pricing plans can be hefty. Authorities may need to pay for new technology, salaries for new workers, not to mention billing and other ways to account for those who evade payment.

Pros
  • Controls congestion and usage

  • Increases revenue

  • Reduces pollution and energy consumption

Cons
  • Burdens drivers and those with lower incomes

  • Businesses may see a drop in revenue from a loss of traffic

  • Associated costs may be high

Real-World Examples

You don't need to look beyond your own roads to find examples of congestion pricing. Rideshare companies like Uber (UBER) and Lyft (LYFT) aggressively apply surge pricing during peak hours. The companies say this pricing structure is in response to the high demand during rush hour, periods of bad weather, and when there are special events.

New York became the first state to approve a congestion-pricing plan. The plan would implement mandatory tolls or cordon pricing based on zones in Manhattan for drivers going anywhere south of 61st Street at the end of Central Park in New York City. It aims to reduce traffic congestion and improve air quality while helping boost the city's public transit system. Details of the plan are still under review as of May 2021, including the fee structure.

The plan is meant to mirror those already in place in other major international cities. London introduced ints congestion-pricing plan in 2003. Drivers are charged £15 per day between 7:00 a.m. and 10:00 p.m. every day when they travel to certain zones in the city. The plan successfully reduced congestion and air pollution.