The Role of Economic Theory in the “Deregulated” Rail Industry

Bobby Willig

(with coauthor Will Baumol via telepathy)

Railroad Economics Symposium McDonough School of Business

Georgetown University June 5, 2015

The Basic Problem Posed to Economic Theory By Railroads

• Many services are offered with distinct significant demands from heterogeneous customers.

• The services are inextricably linked by substantial common costs (of both the infrastructure and some train services)

• The services are subject to significant economies of scale and scope.

• Many of the services are subject to effective competition from customers’ logistical and transportation alternatives

• There may be many customers who are “captive shippers” in that their serving railroad has substantial monopoly power in selling to them.

• This monopoly power is robust and structural due to high economic entry barriers, high demand for the service and natural monopoly in the relevant market.

The Basic Problem for Economic Theory

How to regulate the railroad to protect the “captive shippers” from the exercise of its

substantial structural monopoly power over the services they need?

• Without creating excessive social losses from

• Misincentives in the amounts and placements of investments

• Repression and distortions of the extant competition over the services provided to the shippers who are not captive

• Disincentives to entrepreneurship and productivity advances

• Pricing that creates unnecessary suppression of the outputs of the carriers and their customers.

Fundamental Lesson: Do Not Apply the Wrong

Economic Theory Econ 1 teaches “perfect competition” where optimal prices are easy to characterize: prices should equal marginal costs and average costs.

<<two weeks after the final exam, my students just remember it’s good if prices = costs>>

This is the wrong economic theory to guide railroad regulation due to the endemic economies of scale.

Do Not Set Rail Prices = Costs

Prices set at marginal costs cannot recover total costs due to economies of scale

Regulating prices with “average costs” that “fully allocate” fixed and common costs leads to disaster, like before “deregulation.”

coal

wheat

Cost=4

Cost=3

Common Cost=10 D

Total cost=17

coal service wheat service stand-alone cost 14 13 incremental cost 4 3 Fully allocated cost 9 (5+4) 8 (5+3) Willingness to pay 12 6

Price at fully allocated cost? NO! Ramsey pricing: maximize consumer benefit, subject to covering total cost [11.5, 5.5] Unfair?, No cross subsidy: Incremental cost ≤ revenue ≤ Stand-alone cost so the Ramsey prices lead to No Inefficient bypass No foreclosure of efficient alternatives

Dangers of Pricing With Fully-Allocated Costs

No Price Regulation with Fully Allocated Costs

• And of course if prices are constrained by FAC, then decreases in costs force those prices down.

• So the regulated firm has little incentive to decrease its costs with productivity gains.

• And the regulated railroad will not be motivated to offer shippers attractive deals to gain their volume at prices below FAC, due to the lowering of their FAC price ceiling.

Ramsey pricing maximizes consumer welfare subject to revenues covering total costs

Inverse elasticity rule Pi - MCi k Pi ei = > 0

quantity

price

Contribution to fixed + common costs = [p - mc]*q

To maximize consumer welfare: Allow pricing to the market!

Prices higher where service value is greater. Prices different by shipper, commodity, route. Carriers, and not regulators, must price their

own services to the market.

______ __

Individualized Non-linear pricing: Is Even Better – Needs Contracts

Tons.

Total money spent 300 per ton.

10,000

1.5 million + 150 per ton

Two-part tariff

Volume discount Non-uniform price Incentive deal

Tons

MC 100

300 150

Win-win Pareto superior

Does Economic Theory Suggest Any Caps to Pricing?

YES, prices above Stand-Alone Costs: can yield cross-subsidies;

invite inefficient bypass of the service; and

would not be sustainable in a contestable market where firms are subject to competition from potential entrants without entry barriers

Likewise, prices below incremental costs: can be the recipients of cross-subsidies;

can deter use of more efficient substitutes; and would not be sustainable in a contestable

market.

Regulation that constrains the revenues from prices to lie between SAC and IC provides

shippers the same protection from monopoly power they would have in a contestable market.

The Regulatory System “Constrained Market Pricing”

Under the 1980 Staggers Act Saved The US Railroad Industry

• Decentralized pricing and routing by RRs (rather than pricing by regulated rate bureaus) • Differential pricing based on demand welcomed as Ramsey (rather than prohibited) • No regulation where effective competition is available to consumers (rather than the ICC as “giant handicapper”) • “Captive” shippers entitled to regulated simple (uniform) prices • RR and its customers may negotiate individual contractual deals without additional regulation (rather than such being illegal) •Regulated prices must generate revenues that

i. exceed incremental costs ii. lie below stand-alone costs

The ICC Relied on the Theory of Contestable Markets

A rate level calculated by the SAC methodology represents the theoretical maximum rate that a railroad could levy on shippers without substantial diversion of traffic to a hypothetical competing service. It is, in other words, a simulated competitive price. (The competing service could be a shipper providing service for itself or a third party competing with the incumbent railroad for traffic. In either case, the SAC represents the minimum cost of an alternative to the service provided by the incumbent railroad.) The theory behind SAC is best explained by the concept of 'contestable markets.' This recently developed economic theory augments the classical economic model of 'pure competition' with a model which focuses on the entry and exit from an industry as a measure of economic efficiency. The theory of contestable markets is more general than that of 'pure competition' because it does not require a large number of firms. In fact, even a monopoly can be contestable. The underlying premise is that a monopolist or oligopolist will behave efficiently and competitively where there is a threat of losing some or all of its markets to a new entrant. In other words, contestable markets have competitive characteristics which preclude monopoly pricing. Coal Rate Guidelines, Nationwide, 1 I.C.C.2d 520, ___ (1985), aff’d sub nom. Consolidated Rail Corp. v. United States, 812 F.2d 1444 (3d Cir. 1987).

The Elements of CMP Are Consistent With the Theory of

Contestable Markets Of course railroad markets are generally not at all contestable by new railroads due to high economic entry barriers.

But CMP allows competition to work without intervention where it is effective, and regulates to mimic potential competition where actual competition is absent.

As a matter of theory, Ramsey pricing and subsidy-free pricing are consistent with each other under the conditions of the “weak invisible hand theorem” (Baumol, Bailey and Willig).

Firms have incentives to employ Ramsey prices, (but are not compelled by market forces to do so as strongly as pricing at marginal cost in perfectly competitive markets).

Regulatory Price Ceilings • Stand-alone cost for end–to-end service:

complaining shipper chooses group of services plus its own and RR revenue must be less than Forward Looking Economic Cost for the group. No adverse cost incentives from such regulation!

For Access • RR has economic incentive to negotiate

efficient access since can make more $$ that way – like make-or-buy decision

• On complaint: if an access seeker has no competitive alternative, and if it is efficient, then ceiling on access price is prescribed or arbitrated, (for efficiency under the ecpr or “parity pricing” standard).

STB 1998 pricing study

Differential Pricing At Work

Bottleneck Access Prices for Efficient and Fair Competition

• should permit efficient suppliers to prevail in the market while discouraging inefficient supply • ECPR: incumbents and entrants should pay the same price for the same bottleneck service (if costs are unequal then parity of mark-ups)

Two Broad Options for Structure

• Vertically integrated private firms owning infrastructure and cars, running operations, and dealing directly with shippers

• Mandated separation of track infrastructure ownership (by private or public enterprises) from other firms that conduct operations and deal directly with shippers

Goals for the Policy Architecture

• Good investments by RR’s and shippers – incentives, information, appropriate

funding • Efficient pricing to shippers

– adequate funding of supply, guide for shippers’ decisions, incentives for entrepreneurship by RR’s and others

• Low costs and high quality of service – incentives and opportunities for

management and competition (efficient industry configuration)

Separate Operations & Infrastructure:

Beneficial Opportunities

• No initial economic incentives for favoritism

• Best opportunity for competition in operations

• Opportunity to confine domain of regulation to the infrastructure

• Opportunity to confer subsidy on infrastructure, without soft budget constraint on operations

• Entrepreneurial RR operations and services need coordinated investment in infrastructure

– how to harmonize investment incentives and commitments?

– how to motivate without exclusive contracts undermining openness?

Separate Operations & Infrastructure

How to Solve Endemic Problems?

• Efficient, safe and timely RR operations need closely coordinated utilization of scarce facilities – how can trackco change prices for

utilization with sufficient speed and accuracy for shipper priorities to be reflected in allocations of congested track and yard facilities?

– how can trackco issue usage directives under open access?

Separate Operations & Infrastructure

How to Solve Endemic Problems?

• RR operations may show economies of scale and scope, and entry barriers, from running long trains; classification yard blocking; and utilization of crew, rolling stock and yard, loading, car maintenance, and spur facilities – How to rely on competition in

operations? – How to regulate pricing of monopoly

RR operations, and harmonize double levels of Ramsey pricing?

Separate Operations & Infrastructure

How to Solve Endemic Problems?

• Efficient Ramsey pricing requires that shipments of different commodities on different origin-destination routes for different shippers with different volumes bear prices with different margins over marginal costs. – How can trackco monitor usage to do

such Ramsey pricing? – How can trackco earn enough without

Ramsey pricing? • Separation architecture will constrict

pricing by trackco to fully allocated costs, due to its lack of information about the end shippers.

Separate Operations & Infrastructure

How to Solve Endemic Problems?

Separate Operations & Infrastructure Some Determinative Questions

• Are these problems significant in the industry in question?

• In other settings, these are the kinds of problems that are solved by vertical integration.

• How are they being solved here? • Do the benefits from separation

outweigh the endemic problems that could be mitigated by permitting private vertically integrated firms?

Australian Experience With Separation The Australian Rail Track Corporation (ARTC) is a federal government-owned agency, created in 1997, which is intended to provide a one-stop shop for rail transport undertakings that wish to access the interstate rail network. It invests federal money and its own. Operators pay a two-part charge for access to these lines, comprising a fixed component based on capacity usage and a variable component based on the tonnage of the train plus distance travelled.

(OECD Report on Experiences with Structural Separation, 2011)

.

OECD Backs Way Off From Recommendation of Separation

“It would be misleading to conclude that every experience with separation has been straightforward and wholly successful. In addition to the costs of separation—both the once-off costs of breaking up the firm, as well as the costs resulting from possible losses of economies of scope and scale -- a frequent fear is the potentially detrimental effect that structural separation has on investment incentives, in particular large-scale investment in network development and upgrading. The impact of separation policies on investment incentives has been an issue throughout the sectors and in many of the Member countries surveyed in this report.” (OECD Report on Experiences with Structural Separation, 2011)

OECD Backs Way Off From Recommendation of Separation

“Furthermore, structural separation has, in a number of instances, resulted in co-ordination problems between network operators and users. A lack of co-ordination can lead to inefficient usage of infrastructure and, as some tragic examples from the rail sector illustrate, can have serious negative consequences in terms of performance and even safety.” “… structural separation is a remedy that is not appropriate for all markets or circumstances. It can involve a trade-off between competition and efficiency that depending on the existing market conditions may or may not, ultimately, bring economic and public benefits that justify its implementation. In particular, the impact of structural separation on corporate incentives to invest is an important issue that warrants its express reference in the Recommendation among the potential costs and benefits of structural separation.”

UK Experience With Separation In the mid-1990s, the old vertically integrated British Railways was entirely broken apart, with the infrastructure privatized into Railtrack, which failed, and was brought back as Network Rail, which is a quasi public sector organisation established as a company limited by guarantee (for profit but not for dividend). The Department of Transportation from then on took a more direct role in overseeing and funding the system, in particular investments in infrastructure. Taxpayer funding rose to £5.2 billion in 2008/9. The McNulty Report published in 2011 generally concluded that while the concept of franchising should be retained, the UK was 20 to 40% more costly than comparable EU systems, and that a reconsideration of the total separation of infrastructure from the operators should be entertained.

The EU Experience With Separation Since 1991, the EU has been promoting an open-access segregated or vertically separated railroad industry model. As of 2012, “modest progress has been made in stabilizing the position of the EU railways in the transport market, but many of the objectives of the rail reform have been frustrated by slow or incomplete implementation… Hence, to date at least, the expected favourable impacts of separation and competition, such as traffic growth, higher market share compared to other transport modes, increase in cross-border traffic or lower end-user charges do not appear to have emerged to any great degree… (OECD 2013, Recent Developments in Rail Transportation Services, Working Party No. 2 on Competition and Regulation, DAFFE, May.)