Market Power, Cost Structure, Externalities and Moral Hazard

Written by Peter H. Swan, Ph.D.
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Union Pacific photo

The railroad industry is in crisis. Many people outside and inside the industry are quick to blame its current state on Precision Scheduled Railroading (PSR) and Wall Street. However, several instances of market failure, from economics, provide useful explanations for current industry behavior. These include:

·      Market power, where a provider can control the price to its advantage.
·      Cost structure, or economies of density where fuller vehicles and longer trains lead to lower costs.
·      Externalities, where railroad service increases cost to customers with no cost to the railroad.
·      Moral hazard, where the risk of unsafe or immoral action is removed.

Examples of all four market failures exist in the railroad industry. These market failures make it possible for railroads to increase rates, while decreasing and sometimes shifting costs to shippers. Railroads continue to increase rates dramatically to both maximize return on investment and de-market traffic that provides insufficient return on investment. The longer, general-purpose trains run under PSR rely on yard operations to absorb the effect of running excessively long trains. Yard operations have become more chaotic under PSR and this chaos often results in missed connections and missed customer switches.

The resulting variance in door-to-door transit time and increased car cycle times increases shipper cost due to lost production and decreases annual turns for private cars. Recent changes to the demurrage rules and assessorial charges shift costs from railroads to shippers. These events cause many to believe that current railroad policies ignore common carrier obligations, greatly damage the economy and unfairly enrich shareholders.

What options are available to remedy the situation? The current policies of the STB appear to be ineffective and limited to wagging a finger and asking for more reports. The STB exists because two previous options have proved unworkable. These are nationalization, where the government runs the railroads, and complete economic regulation where the government specifies both services provided and rates. There is ample evidence that nationalization is a poor choice based on experience here and in other countries. Similarly, government has proven that it should not directly control what each railroad can haul and what it can charge, because the U.S. railroads almost died under Interstate Commerce Commission regulation.

Another solution provided by Neo-Liberal economists is to open railroads up to competition by eliminating vertical integration and permitting any train operating company to operate on any track and carry any freight. Europe has been moving to this competitive structure for several years. It enables competition for all freight and for all rail equipment. Track remains a monopoly, but maintenance of track sections is contracted out to provide competition for maintenance. While eliminating vertical integration does provide competition, it produces several forms of market failure itself.

First, economies of density in linehaul train operation are impossible to achieve for carload freight because each piece of business is contracted separately. Second, equipment providers have no incentive to design equipment to reduce track damage as they only contract with train operators. Similarly, track maintenance companies have little incentive to provide track structure and availability that enhances train operations. Finally contracting of track maintenance produced a “moral hazard” as seen in Great Britain, where several fatal, track-related derailments occurred due to faulty maintenance. Eventually, Great Britain’s track management was re-nationalized both due to crashes and financial difficulties.

So where does this leave us? One example of what could be done to solve some of rail’s problems can be found in the airline industry. Several aspects of airline operations have historically proved problematic for airline passengers. Airlines’ practice of overbooking to maximize revenue for each plane initially created substantial problems for passengers on over-booked flights. Regulations mandating what airlines must do when flights are over-booked appear to provide good resolutions to this problem. Airlines are free to remedy overbooking as they see fit within the guidelines, thus promoting efficient solutions. Likewise, fines exist for keeping passengers sitting on the ground for excessive periods. In both cases, the rules internalized the cost of practices that previously generated costs for passengers (negative externalities).

Some issues with rail service might be dealt with in a similar manner.

Externalities: Railroads could be fined for missing customer switches, forcing them to internalize the cost. Such fines would providing economic relief for shippers and incentive for railroads to meet customer switch requirements. Long transit times similarly generate costs for customers from delayed shipments and longer cycle times for private equipment. Longer cycle times for private equipment increases the number of cars required for a particular movement. Because private railroad cars only generate a mileage charge for railroads, there is no economic incentive for railroads to expedite either their loaded or unloaded movements. A way to change this would be to charge per diem for private cars online while there are under movement orders. It would be easy to include private cars in the per diem system used for railroad owned equipment.

Moral Hazard: Railroad labor relations are at an all-time low. While pay is an issue handled by mediation and/or arbitration, two other aspects of the relationship could be improved by changes to federal regulations. First, hours-of-service rules should change to provide railroad employees with the ability to take more time off, reducing burnout and improving quality of life. Second, the current system for compensating injured employees (Federal Employers Liability Act, FELA), encourages an adversarial relationship between management and employees because finding employees at fault on a regular basis reduces the risk of railroad liability for injuries under FELA. Replacing this system with Workers Compensation would reduce the need for management to determine that employees are always at fault for injuries. Tax breaks could encourage railroads to provide surge capacity in locomotive and/or crews, thus making service meltdowns less frequent.

Cost Structure and Market Power: Railroads often set rates based on the value-of-service (what customers will pay) without considering the railroad cost of service. Railroads often use extreme tariff rates to force shippers to sign contracts and therefore avoid any risk of adverse rate rulings by the STB. These policies result in decreased rail traffic and flout the industry’s common carrier duty. The proposed solution of forcing reciprocal switches under limited circumstances is likely to provide little meaningful relief to shippers and will increase costs for the industry. Alternatively, the STB could require railroads to publish bottleneck rates, which could then have cost-based caps. Because there is no consensus from economists on how to measure railroad costs, and almost complete agreement that the Uniform Rail Costing System (URCS) is flawed, regulating rates is extremely problematic. However, it is unwise to let the search for the perfect answer stand in the way of the possible. My suggestion would be to outlaw rates higher than two times last year’s inflation-adjusted URCS variable costs for any move, except where railroads can prove abnormal costs exist. Some classes of traffic might be exempted to start such as hazmat shipments and intermodal for obvious reasons. However, the onus of proving rates lawful should be placed on the railroads instead of the shippers.

The key to restoring the industry is not to assign blame, but to change the marketplace to incentivize behavior more in line with common carrier responsibility. If we fail to act now, I fear that extensive financial regulation or nationalization of the railroad industry could be in our future.

Dr. Peter F. Swan, Ph.D., is Associate Professor of Logistics and Operations Management at The Pennsylvania State University. For a more detailed explanation of economic concepts in this editorial, CLICK HERE.

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