Regulation in a `Deregulated' Industry: Railroads in the ... in a ‘Deregulated’ Industry:...

Regulation in a ‘Deregulated’ Industry:Railroads in the Post-Staggers Era

John W. Mayo and David E.M. SappingtonGeorgetown Railroad Colloquium

June 5, 2015

Mayo and Sappington Georgetown Railroad Colloquium June 5, 2015 1 / 23

What we know a lot about: Deregulation

“The Railroad Deregulation Act”

• “Railroad Deregulation, Innovation, and Competition: Effects of the

Staggers Act on Grain Transportation”

• “Mergers, Deregulation and Cost Savings in the U.S. Rail Industry”

• “Railroad Deregulation and Consumer Welfare”

• Hearing to Focus on Deregulation of the U.S. Rail Industry

What we know less about: Regulation in the Post-Staggers Era

• What regulations were retained in the wake of Staggers?

• How have these regulations evolved over time?

• Are there lessons from economic theory about how these regulations mayaffect economic outcomes?

• Incentives for cost reductions

• Incentives for innovations

• Incentives for efficient investment

Outline

• Evolution of post-Staggers pricing regulation

• Review of relevant economic literature

• Stylized framework of rail regulation

• Reflections and Implications

The Evolution of Post-Staggers Regulation

• 1887 – 1980 – Comprehensive regulation

• Staggers Act – moved industry governance from highly granular regulatoryapproach to market governance (supply and demand)

• Successes have been well documented

• “The Staggers Act is considered the most successful railtransportation legislation ever produced ...” Senate Commerce Committee

• Economic evidence

• Cost, pricing, innovation, output, safety, quality

U.S. Freight Rate Regulation in the Post-Staggers Era

a All U.S. freight rail traffic

Non-exempt, non-contract traffic with revenue/variable cost (R/VC) >180%

Potentially captive

“Dominant”

Potentially Captive

Authority to

price regulate

Reasonable Unreasonable

Rate regulation Market rate

But how to determine “reasonableness”?

• Complicated by substantial joint and common costs (nearly 40 percent oftotal)

• Fully allocated (distributed) costs (FDC)• A reasonable price should not exceed the attributable (variable) costs

associated with a shipment plus the allocation of fixed costs assigned tothat shipment

• Dismissed (1981) – “A meaningful maximum rate policy could not befounded on a strictly cost-based approach.” Coal Rate Guidelines

But how to determine “reasonableness”? (cont.)

• Constrained Market Pricing (1985)

• Differential Pricing (Ramsey Pricing)

• Contestable Markets - Stand-Alone Cost

• The Revenue Adequacy “Constraint”

• Staggers calls for regulators to “assist rail carriers in attaining revenuesthat are ‘adequate ... to cover total operating expenses ... plus areasonable and economic profit or return (or both) on capital employedin the business.” ’

• Adequate Revenues = Cost of capital

• Adequate Revenues ... an informational benchmark

• “[o]ur revenue adequacy standard represents a reasonable level ofprofitability for a healthy carrier ...Carriers do not need any greaterrevenues than this standard permits, and we believe that, in a regulatedsetting, they are not entitled to any higher revenues.”(Coal Rate Guidelines, p.12)

ASSOCIATION OF AMERICAN RAILROADS

RR Cost of Capital

RR Return on Investment

Class I Railroads’ Cost of Capital vs. Return on Investment

Source: Surface Transportation Board. Note: blue = industry cost of capital; yellow = return on investment. In 2006, the Surface Transportation Board changed the method by which it calculates the rail industry cost of capital.

Rate reasonableness (cont.)

• Three Benchmark Method (1996)

• Revenue Shortfall Allocation Method (RSAM)

• “The uniform markup above variable cost that would be neededfrom every shipper of potentially captive traffic (the >180 trafficgroup) in order for the carrier to recover all its ... fixed costs”

• “appropriate ... for assessing ... a carrier’s revenue needs”

• Allocates fixed costs that are unrecovered in the deregulated sectorto the regulated sector

• Effectively re-introduces FDC

• R/VCCOMP

• Markup over variable cost that railroad secures on “traffic that involvessimilar commodities moving under similar transportation conditions.”

• A point of comparison between the traffic at issue and “similar” traffic• If issue traffic is greater than other comparable >180 traffic, then

presumed not to be justified by elasticity considerations

• R/VC>180

• A measure of the extent to which a carrier is marking up its >180 trafficon average.

• Compare traffic at issue with R/VC>180• Purpose – to ensure that the traffic “is not bearing a disproportionate

share of the carriers’ revenue requirements.”

• 2007 Simplified Standards

• Stand-Alone Cost [large disputes (27%)]

• Simplified Stand-Alone Costs [medium disputes (28%)]

• Three Benchmark [small disputes (45%)]

Revised Three Benchmark

• Identify comparison group for R/VCCOMP benchmark

• Rates for this group are scaled up (for revenue inadequate firms) or down (forrevenue adequate firms).Note that this scaling depends on whether RSAM R R/VC>180

• Price for at issue traffic is compared to 90th percentile of the distribution ofadjusted comparison rates

Relevant Economic Literature

• Fully Distributed Costs• “bears no direct relationship to economically efficient pricing ...” [Owens

and Braeutigam (1978)]• “rate ceilings derived from fully distributed costs are inimical to the

public interest.” [Baumol and Willig (1983)]

• Rate-of-Return Regulation• “limited incentives for innovation and cost reduction;• Over-capitalization• High costs of regulation• Excessive risks imposed on customers• Cost shifting inappropriate levels of diversification• Inefficient choice of operating technology• Insufficient pricing flexibility in the presence of competitive pressures.”

[Sappington (2002)]

A Stylized Model of Rail Regulation

• A railroad (R) produces one service in a regulated sector (sector 1) and oneservice in an unregulated sector (sector 2)

• Demand is inelastic for output X1

• ci are the unit costs• F is R’s fixed costs• C (X1,X2) = F + c1 X1 + c2 X2

• Bertrand competition for service 2• R chooses three types of cost-reducing efforts

• e1 ≥ 0• e2 ≥ 0• eF ≥ 0

• Ei (ei ) is the (unmeasured) expense that R incurs in cost-reducing effort

A Stylized Model of Rail Regulation (cont.)

• The total costs for R, including effort costs, are

• F (eF ) + c1(e1)X1 + c2(e2)X2 + EF (eF ) + E1(e1) + E2(e2)

• The levels of effort that minimize total resource costs are

• (e∗1 , e∗2 , e∗F ), which are determined by

• −F ′(e∗F ) = E ′F (e∗F ) and − c ′i (e

∗i )Xi = E ′i (e

∗i ) for i = 1, 2

Comprehensive Earnings Regulation (CER)

• Comprehensive earnings regulation (CER) requires• [ p1 − c1(e1) ]X1 + [ p2 − c2(e2) ]X2 − F = 0

• Conclusion 1. When it operates under CER, R will set e1 = 0,e2 = 0, and eF = 0

• Implications of CER• Rail carriers are precluded from earning more than the industry cost of

capital• Incentives for innovation and cost reduction are eliminated• Incentives for quality-enhancing innovation are eliminated• Profit enhancing demand increases or cost reductions can expand the

scope of regulation• Can encourage revenue or output maximization

Focused Earnings Regulation (FER)

• Focused Earnings regulation (FER) can be represented as:• [ p1 − c1(e1) ]X1 − f1 F = 0

• Conclusion 2. When it operates under FER, R will set e2 = e∗2 ande1 = 0. R will also set eF < e∗F if f1 > 0

• Implications of FER• Efforts to reduce production costs in the deregulated sector are efficient

• Efforts to reduce production costs in the regulated sector are zero

• Efforts to reduce fixed cost will typically be less than efficient

Focused Earnings Regulation (FER) (cont.)

• But higher levels of fixed cost investment might reduce marginal productioncosts.

• Can FER induce R to adopt the cost minimizing mix of fixed and variablecosts?

• Suppose that higher investments in F reduce variable unit production costs inboth 1 and 2

• In this case, the total costs are:• c1(F )X1 + c2(F )X2 + F and F ∗ is given by c ′1(F

∗)X1 + c ′2(F∗)X2 + 1 = 0

• Conclusion 3. Suppose R operates under FER and c ′1(F ) = c ′2(F ) for allF . Then R will set F R F ∗ as f1 R X1

• Conclusion 4. Suppose R operates under FER and f1 = X1X1+X2

. Then R willset F R F ∗ as | c ′2(F ) | R | c ′1(F ) | for all F

∗)X1 + c ′2(F∗)X2 + 1 = 0

Price Cap Regulation (PCR)

• Price cap regulation (PCR) is a type of incentive regulation which has beenextensively studied over the last 20 years

• PCR replaces earnings regulation with a ceiling price p1

• Formally, the firm’s problem becomes:

• Maximizep1 ≤ p1, e1, e2, eF

[ p1 − c1(e1) ]X1 + [ p2 − c2(e2) ]X2 − F (eF )− E1(e1)−

E2(e2)− EF (eF )

• Which, when solved, yields:

• Conclusion 5. When it operates under PCR, R will set p1 = p1,e1 = e∗1 , e2 = e∗2 , and eF = e∗F

Conclusions

• The Staggers Act largely deregulated rail pricing, with great success

• A detailed and growing regulatory framework has emerged Post-Staggers

• The emerging framework has elements of FDC and prospectively threatensearnings regulation

• A stylized model of such regulation reveals that earnings regulation threatensconsiderable distortions that limit economic efficiency

• Price cap regulation in theory resolve these distortions but experience hasshown that price caps are often tied to earnings

• In an environment of successful governance, additional regulatory controlsthat improve economic efficiency may be difficult, if not impossible, toachieve.

Conclusions

Thank you!

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