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This study analyzed economies of scale and density as a rationale for subsidizing transit agencies in small urban areas. A long-run cost model was estimated that included the addition of external costs, such as environmental effects, and benefits. Results show that small urban transit agencies experience economies of scale and density. The study estimated the marginal social cost of providing service and the level of subsidies required to maximize social welfare. The results provide a justification for subsidizing transit. Included in the study is a survey of transit agencies in small urban areas regarding recent changes in fares, service levels, and funding.