Russell Pittman[1]
Director of Economic Research & Director of International Technical Assistance
Economic Analysis Group, Antitrust Division, U.S. Department of Justice
The railway system in the United States – the largest railway system in the world, carrying predominantly freight, made up of vertically integrated firms that run their own trains over their own infrastructure – was significantly deregulated by several pieces of legislation that culminated in the Staggers Act of 1980. Under this law, most freight shipments carried by rail were to travel at rates set by the railroad or in negotiations between the railroad and the shipper, without the involvement of regulators.
There were two main rationales for this policy change:
- First, the close regulation of the railroads by the Interstate Commerce Commission(ICC) – enacted under very different conditions in 1887 – was hampering the ability of the railroads to compete for business against the fast-moving trucking industry. In fact several railroad companies, restricted in freight rates, prohibited from abandoning unprofitable lines, and forced to provide passenger service that had become increasingly unprofitable, were at or near bankruptcy.
- Second, competition from trucking, as well as from other railroads and sometimes from other modes, was to be counted on to protect shippers from monopoly rates.
However, the legislation recognized that even in a very changed world, there were some shippers who could not economically use other transport modes AND were served only by a single railroad company: they were “captive” both to the rail mode and to a particular railroad. The Staggers Act called for the ICC to implement regulations to protect those shippers.
The ICC crafted a detailed set of regulations that in practice boiled down to a fairly simple concept. For shippers who were served by a single railroad who could not economically ship by other modes, the rates charged had to be “reasonable”. But what did that mean?
“Reasonable” prices (and mark-ups) were permitted to vary a great deal by shipper and by commodity; in fact, the ICC accepted the advice of economists that “differential pricing” – also known, more pejoratively, as “price discrimination” – is the most efficient way for an enterprise like a railroad with high fixed and common costs to recover those costs. (In technical economics, this concept is called “Ramsey pricing”, after the British economist Frank Ramsey.)
However, the regulations set a limit on the degree to which railroads could discriminate in price – in particular, a limit on how much they could charge their shippers who had the fewest options. Under a concept termed “constrained market pricing”, the railroad company was prohibited from charging a rate greater than the “stand-alone cost” (SAC) of serving that customer: how much, in other words, a newly built railway would have to charge to carry the freight for the origin-destination move under investigation. Using theories also developed by economists – especially an idea called “contestability” – the ICC reasoned that if some shippers were paying a price greater than SAC, then other, more favored, shippers, must be paying a rate below the incremental cost (IC) of serving them. Such “cross-subsidization” was considered undesirable.
Over the years, the SAC test was used often enough that it became progressively more detailed and complex. Complaining shippers and their opponents the railroads hired lawyers, economists, and consultants who build complex models of hypothetical “stand-alone railroads” (SARRs) that sometimes covered hundreds or even thousands of miles. The lawyers, economists, and consultants argued details as minute as how much traffic from other railroads an SARR would attract to help cover its costs, how much agricultural land near the SARR would be planted to yield how much grain for shipment, how many bridges and culverts would need to be build, and how wide they would be, and so on. Many millions of dollars were spent in each exercise of this dispute. Some observers came to be convinced that the whole exercise was mistaken in concept – that a policy to limit the ability of a railroad to set high prices to a captive shipper should properly be focused directly on how much of the fixed costs of the railway should be borne by the multiple groups of shareholders, workers, communities, and customers involved, but that the details of the cost of building a hypothetical substitute railroad were not obviously relevant.
My own article in the Journal of Regulatory Economics in 2010 made this point. It was followed by two regulatory filings in 2014 by Gerald Faulhaber, the father of the SAC test in an article in an academic journal in 1975, and then by a report of an expert panel organized by the National Academy of Sciences and the Transportation Research Board, Modernizing Freight Rail Regulation, in 2015. Alternative, commodity-specific rate ceilings to protect captive shippers were proposed, including a ceiling on the mark-up of the rate over variable cost and a rate based on charges to shippers of the same commodities who were not captive. (Note that almost all captive shippers ship one of a very small set of commodities, including coal, bulk chemicals, and grains.)
The Surface Transportation Board (STB), the successor agency to the ICC, recently commissioned a consultants’ study of the issue, with the instruction to examine both a) modes of rail regulation in other countries, and b) modes of regulation of other industries in the United States, to see if other methodologies seemed likely to be superior to the SAC test in protecting captive shippers.
The consultants’ report, issued in September, found that none of these alternatives seemed superior, though it had a few good things to say about the Canadian provisions for “interswitching” and mandatory arbitration. In the end, the report argued for maintaining the SAC test but applying it in simplified form. In a roundtable convened by the STB in October, the critics expressed their dissatisfaction.
Meanwhile, the STB continued its separate regulatory proceeding examining a proposal by shippers for mandatory reciprocal switching orders.
by Russell Pittman
Director of Economic Research and Director of International Technical Assistance in the Economic Analysis Group, Antitrust Division, U.S. Department of Justice
[1] Antitrust Division, U.S. Department of Justice, and Kyiv School of Economics. The views expressed are those of the author and are not purported to reflect the views of either institution.
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