Rationalizing the Apparently Irrational:
Shipper Investment in Rail-dependent Facilities
By
Kenneth D. Boyer
Professor of Economics
Michigan State University
(517)-353-9088 voice
(517)-432-1068 fax
[email protected]
June, 2016
Preliminary version. Comments welcome.
1
1) Introduction:
All American railroads have divisions devoted to industrial development and these offices annually
report success in attracting new business to their lines. An example of such success is shown in Table 1,
which reports data from the industrial development department of Norfolk Southern Railway. For
example, in 2014, the Norfolk Southern reports successfully facilitating 94 new or expanded industry
investments on its own lines, with an investment cost of $5.7 Billion, generating 4,422 jobs and 205,731
carloads of freight. Other US railroads report similar success in attracting firms to build facilities on their
lines.
This apparently robust willingness to commit funds to construct facilities that requires partnering with
railroads is paradoxical, however. Most shippers do not have a choice of railroad to serve a plant. A
shipper who wishes to use rail transportation for supply or distribution of output, must deal with the
railroad that owns the track on which the facility is located. Under the current system of American
railroad regulation, this inability to deal with other carriers gives the railroad the ability to dictate the
terms of carriage to the target plant. Assuming, as is standard in economic theory, that firms are
motivated by profit maximization, there seems to be nothing that would prevent the railroad from
insisting on capturing the full benefit of the relationship, leaving the shipper with nothing. Under these
circumstances, a profit maximizing firm will refuse to invest and will instead look for other shipping
options—water or road transportation for example--that do not call for using rail transportation.
The fact that there is continuing investment by shippers in facilities that generate carloads of freight,
as shown in Table 1, argues that there must be some protections possessed by shippers that give the
investors an expectation of a rate of return on the project that makes the investment worthwhile. This
paper investigates what those protections are and what the relative frequency is of the different types of
protections used by shippers against expropriation of value.
1
Section 2 below makes a formal statement of the paradox of investment in rail-using facilities, tying
the problem to the familiar economics of contracting. Section 3 then develops the different types of
protections that are available to protect the shipper’s investment. An overlooked protection, developed in
this section, is that a shipper may have multiple plants with overlapping geographic supply and
distribution areas, thus allowing a shipper to credibly threaten to move production to a plant on a different
railroad line not controlled by the incumbent carrier and serve final customers from the other plant.
Section 4 then presents the results of a comprehensive search of recent rail investments that have been
reported in a leading trade journal. The survey shows that, with the exception of grain transportation,
there is no paradox in shipper investment on railroad lines since virtually all shippers have some
protection against appropriation of value; by far the most common protection is holding investments in
multiple locations. Section 5 summarizes the findings of the paper and notes that while large shippers
may have protection against appropriation, the same cannot be said for small shippers.
Rail shipping is a
game that large shippers may feel comfortable playing, but it is not one that can be advised for a company
owning a single facility on a single railroad line.
2) The Irrationality of Investing in Facilities that Require Rail-Based
Logistics
The focus on investment by railroad customers taken in this paper is a considerably longer-run
perspective than is traditionally used in transportation analysis. As will be shown, this longer-run
perspective can reverse some of the basic policy advice on the railroad industry. In the long run,
investments by railroad customers shape the elasticities of demand for individual corridors or railroad
service, thus calling into question using demand elasticities as a primitive concept for evaluating rate
reasonableness.
2
The desirability of basing rail pricing on demand elasticities, when in the presence of economies of
density, is perhaps the most fundamental idea in modern railroad economics.1 A series of papers in the
1980’s argued that in the presence of scale economies and free entry, a profit maximizing firm would
naturally choose to set prices inversely with the elasticity of demand for services, using the so called
Ramsey Pricing formula. According to this theory, the prices of all outputs sold by a multiproduct firm
with scale economies and that is vulnerable to entry would move a distance from the competitive price
towards the monopoly price based on the elasticity of demand until the fixed costs of operation were
covered.2 This demand-based Ramsey price is then taken as a benchmark to be strived for even in the
case of the railroad industry, where entry could not be expected to discipline pricing.3 While demand
elasticities were unobservable, the doctrine of Ramsey pricing gave a justification for granting railroads
the freedom to price as they wished up to the point where the rate of return on investment exceeded that
available in other industries. The idea that the railroad industry might have returns above normal seemed
so unlikely when the current regulatory statutes were drawn up, that neither the Staggers Act nor the ICC
Termination Act had provisions for how railroad regulation was supposed to be practiced once the
industry achieved normal profitability.4
The Staggers Act and ICC Termination Acts, the current ruling documents on railroad regulation, are
themselves derived from regulatory traditions that go back to the Interstate Commerce Act and even to the
common law on public services in the 19th century.5 In this tradition, the fundamental question is the
reasonableness of a rate. A rate is the amount charged for the service of carrying one unit of a cargo from
one location to another. Thus the Surface Transportation Board adjudicates rate disputes by attempting to
calculate if a rate charged is greater than 180% of the variable cost of making a specific movement,
1
A good description of this economics is found in Committee for a Study of Freight Rail Transportation and
Regulation, 2015.
2
Baumol and Bradford, 1970. A generalization of the concept of scale economies in a multiproduct firm and
extensions of Ramsey Pricing in this situation is found in Baumol et. al, 1977.
3
The current standards for rate reasonableness are based on the Interstate Commerce Commission’s 1985 Coal
Rate Guidelines. A good description of these guidelines is found in Committee for a Study of Freight Rail
Transportation and Regulation, 2015.
4
This point is elaborated in Macher et. al, 2014.
5
A description of the roots of mid-20th century ICC railroad regulation is found in Boyer, 2013.
3
whether the party making the movement appears to be captive in the sense that it has no other economic
alternatives, and whether the rate is above the so-called “standalone cost” of making the movement.6
Following the practice of more than 100 years, the unit of observation is the carriage of a specific
commodity from a specific location to another well-defined location and the reasonableness of the rate is
determined by comparing the rate with the cost associated with making that movement—inferred before
Staggers by rates charged on similar movements, but under current regulation inferred by computations of
financial figures in a railroad company’s accounts.7
But quoting a rate for moving one unit of a commodity from one location to another is no longer how
the great majority of rail freight is priced. In order to increase the profitability of railroads, the longstanding skepticism about haulage contracts was replaced in the Staggers Act with an explicit
encouragement of the practice. Today three quarters of railroad traffic is carried under contract.8 Not
much is known about the nature of the contracts since the terms of the contracts are secret, with only the
railroad and shippers signing them having full knowledge of contract terms. It seems likely that the
standard contract includes service guarantees and penalties for poor performance—provisions that were
generally forbidden under the doctrine of common carriage. There is, in addition, every reason to believe
that the standard contract involves non-linear pricing in which the amount paid depends on the total
amount of traffic offered by the shipper to the carrier over the course of a year or the proportion of total
traffic tendered to the railroad. While not all traffic is carried under contract, even movements priced
under tariff (and thus potentially eligible for review by the Surface Transportation Board) must be
assumed to have prices influenced by the ability to charge a non-linear rate. In particular, a railroad will
6
The best description of current railroad regulation is found in Committee for a Study of Freight Rail
Transportation and Regulation, 2015.
7
As noted in Committee for a Study of Freight Rail Transportation and Regulation, 2015, this regulation of
railroad rates by reference to URCS variable cost calculations is written into the regulatory statutes. Thus the
Surface Transportation Board seems compelled to use either this method despite the fact that it is widely
condemned as inaccurate and logically flawed.
8
Committee for a Study of Freight Rail Transportation and Regulation, 2015, p. 67.
4
have an incentive to offer a relatively high tariff rate in order to encourage a shipper to sign a contract that
includes discounts on levels of shipment that are beyond what would otherwise be expected.
The changed pricing incentives that come into play when it is possible to sign a contract rather than
use the pre-Staggers method of simply quoting a price are illustrated in Figure 1 which shows the familiar
determinants of pricing using the transportation economist’s favored construction of a full price on the
vertical axis. A full price includes not merely the price per unit paid to the carrier, but also the user-cost
of the service. User costs in turn depend on the quality of service offered by the carriers. Following the
regulatory tradition, railroads are still required to quote a tariff rate for a movement if requested, but the
quality of service for which that rate is quoted is not specified. In order to get a service quality that is
necessary for railroad service to be a profitable part of the supply chain for a firm, it may be necessary to
negotiate a contract specifying the speed, reliability, and other elements of the service. A railroad that
wishes to bargain hard with a shipper may either raise the quoted tariff rate or may decrease the quality of
service, which has the same effect on the full price of the haul; -increasing the tariff rate and decreasing
the quality of the service both enhance the attractiveness to the shipper of signing a contract rather than
shipping under tariff.
The familiar downward sloping demand for rail service for an individual shipper of a commodity
between two end points is shown in Figure 1 as a straight line. Track costs, administrative costs, and
similar fixed costs not directly related to the movement are irrelevant for pricing and so are not shown in
the diagram. Only the marginal cost of the movement is relevant for determining what the traffic will
bear. If there is no congestion on the lines traversed by the movement, the MC will be a horizontal line
like that shown in Figure 1. If congestion is increasing with the level of shipments, the MC will have the
upward-sloping form commonly shown in economics textbooks. If pricing is done by tariff, the profit
maximizing quantity is found at Q*/2, and the corresponding full price is (P’+P*)/2. The money price
5
charged for this haul will be that amount minus the user costs (inventory carrying costs, provision for
buffer stocks etc.) that correspond to the service quality of the movement.9
Figure 1 can also be used to analyze contract terms. Since railroads are profit maximizing firms, the
goal of the railroad in tariff negotiation is to gain for itself the full benefit of using rail transportation,
shown in Figure 1 as the area of the triangle between the demand curve and the marginal cost curve.
This is done by offering a quantity discount for expanded use of the rail service beyond what a shipper
would choose under the tariff rate.
In order to achieve this goal, the tariff rate will need to be adjusted,
raising it in Figure 1 to P’, the full price at which tariff haulage is uneconomic for the shipper. A contract
might then be offered under which a price of P’ is charged for the first Q*/2 amount of shipping during a
year, with a discount to MC for any shipments above Q*/2.10 In Figure 1, the revenue generated by this
pricing scheme will exactly capture the consumers’ surplus of the shipper, leaving the buyer indifferent
between using rail service under the contract offered to it, and abandoning the use of rail service and
shipping by another means of transportation or from other sources or to other destinations, or shuttering
the plant. While the fixed costs of tack and infrastructure are not relevant for determining the structure of
prices, a profit maximizing railroad will need to compare the sum of the revenues above marginal cost for
all the traffic on a line with the costs of operating the line. If revenues do not justify maintaining the line,
it is both efficient and profit maximizing to abandon it.
It should be recognized that once the possibility of contracts and the charging of tariff rates to
encourage contracts is introduced, much of the standard received wisdom on railroad pricing falls by the
wayside. In particular, there is no need to raise prices above marginal cost for the marginal movement,
there is no inefficiency associated with the monopoly contract, and no justification for using the elasticity
9
The identification in Figure 1 of the monopoly output as half of the competitive output and the monopoly price
as the average between marginal cost and the vertical intercept is dependent on a linear demand curve and a
horizontal marginal cost curve. More generally, the proportion of the profit maximizing price that represents the
profit margin is equal to the inverse of the demand elasticity.
10
Note that neither the before-discount price nor the quantity beyond which a discount is given is uniquely
determined; it must be the case, however, that the excess revenue from above marginal cost pricing must equal
consumers’ surplus and it must not be the case that a shipper can get positive surplus by choosing the nondiscounted price.
6
of demand to set prices in a way that minimizes the dead weight loss associated with the monopoly
pricing of rail services. A successful contract will have no dead weight loss at all, with shipments
expanding to the point where the benefit to the shipper of one more carload is matched by the cost to the
railroad of carrying that additional carload. In the case of contract pricing, the efficient marginal price is
based purely on the costs of carriage, not on the elasticity of demand.11
The analysis above follows the classic separation of firm behavior into short run decisions of pricing
and output determination and the long run decision of investment in capacity. This follows from the
development of microeconomics as a generalization of agricultural markets in which large numbers of
buyers and large numbers of sellers of a homogeneous good do not develop business relationships across
markets. In the classic model of pricing, there is no reason for forbearance in pricing since there are no
long-term relationships bridging the buyer and seller sides of spot markets. This is clearly not the case
for railroads and their shippers. With railroads and their customers keenly aware of each other’s identity,
history, and behavior, there is every reason to think that the short run separation of pricing as affecting
only short run decisions only with no effect on investment will not be followed in the market place.
Once a longer run perspective is employed, the lessons of Figure 1 begin to change. In particular, it is
clear that shippers cannot be expected to make any investment in logistics systems that require rail
transportation since all profits from making such investments can be appropriated by the railroad through
appropriate manipulation of tariffs, service quality, and contract terms. Thus the full freedom that
railroads have to contract for service, while guaranteeing efficiency in the short run, will likely have
perverse effects on the decision to use rail shipping in the long run.12 The Staggers Act allowed railroads
to extract what the traffic will bear from captive shippers through the use of contracts. What is unclear is
11
It should be noted that in the case of contract pricing, while the marginal price is unrelated to the elasticity of
demand for the service, the average price paid for all movements over the course of the year will vary inversely with
the elasticity of demand, at least in the case of linear demand curves. The justification for this, however, is not the
result of weighing of output responses at the margin to changes in prices, as it is in simple monopoly pricing but
rather that with lower demand elasticities, there is more surplus to be captured.
12
See Boyer, 2014. The very permissive approach to railroad pricing may have been necessary to prevent a
nationalization of the freight rail industry in 1980, but is unlikely to be necessary in the 21st century.
7
why any shipper would put themselves in a position to allow their profits to be appropriated by their
logistics provider. Table 1 above shows that shippers are apparently continuing to make rail-based
investments. There must, therefore, be complications to the simple model in Figure 1 that allow for
protections to shippers that not accounted for in the previous analysis. The next section explores several
possible protections against captivity that are not allowed for in Figure 1.
3) Factors Providing Protection for Shippers Investing in Rail Logistics.
It should be noted that other modes of transportation do not have the same concern about the ability
of the logistics provider serving a plant to extract from the owner of the plant all of the advantages
associated with using a particular type of logistics. The reason is that the roads and waterways are
publicly owned and access to the infrastructure is available to many potential carriers, including the
shipper itself. Were tracks similarly publicly owned, a shipper who felt that it was being taken advantage
of could contract with a different carrier who offered it a better deal or could carry freight itself, thus
protecting itself from rent appropriation. In the United States, railroad transportation is the only general
mode for which this escape possibility does not exist.
While direct means for preventing location rents from individual investments from being appropriated
by railroads do not exit, a series of less direct methods is available. This section describes four possible
indirect protections.
3a) Contracts Covering the Economic Life of the Plant
In the theory of the firm, providers of transportation services and shippers have a vertical relationship
to one another. For most sectors outside of transportation, if one party had the ability to hold up the other
in the way described in the previous section, this function would be brought in-house and the firm would
vertically integrate. 13 In other words, the railroad would engage in its own production or the
13
For a discussion of the determinants on the boundaries of a firm, see Williamson, 1975.
8
manufacturer or mine owner would own its own railroad. While examples of railroads owning facilities
that generate freight for them do exist, they have long been discouraged by law.14 The regulation of
railroad charges by means of rate-to-rate comparisons for similar hauls and the encouragement of intramodal competition that existed prior to 1970 were assumed to be an alternative way for protecting
potential shippers from market power of the railway to which it was connected.
The literature on the theory of the firm argues that vertical integration may under some circumstances
not be necessary to protect parties against hold-up and thus encourage efficient investment by both
parties.15 The key determinant is whether it is possible to enumerate all possible states of the world that
might exist over the life of the plant and then to agree in advance how each party will act under all
possible contingencies. If these are possible, vertical integration is unnecessary since each party is
adequately protected by a long term contract and thus decision to go forward can be made.
Unfortunately, it is most cases it is not possible to anticipate what might happen years in the future and to
write into a contract the response that each party will take if the event occurs. Contracts are generally
thought to be a less powerful mechanism than vertical integration for protecting parties against hold-up
when the future is uncertain. Much depends on the length of the expected economic lifetime of the
investment. If a facility that a shipper might use has a very short economic life, a long term contract
covering the life of the plant seems to be a reasonable response to the problem of opportunistic behavior:
before building a plant, the shipper would sign a long term contract with the railroad, thus protecting itself
from the pricing described in the previous section.
The contracts described in the previous section and that are used today are much shorter than those
anticipated by the literature on the theory of the firm. While rail contracts have terms that are invariably
secret, it appears that most cover service for a year or perhaps two years. Since investment in rail-based
logistics involve investments that are in general much longer than a year or two, it seems reasonable to
14
Under the Commodities Clause of the Hepburn Act, railroads were generally forbidden from carrying
commodities that they had produced themselves.
15
This analysis is best described in Klein et al., 1978
9
assume that the purpose of rail contracts as currently written are to specify service quality commitments
and to facilitate the capture of consumers’ surplus; contracts that are much shorter than the economic life
of the facilities are unsuited as a protection against opportunism. Although there may be shipper
investments that have very short economic lives and can thus be covered by standard rail contracts, this
seems to not to be a commonly used protection.16
3b) Concerns for Reputation
The analysis presented in Figure 1 assumes that railroads are profit maximizers and will not leave
money on the table in negotiations with their customers. Profit maximization is synonymous with the
maximization of shareholder value which is generally assumed to be equal to the present discounted value
of expected future earnings of the firm. To the extent that a practice of pricing high today restricts
demand in the future, depending on the discount rate applied to expected future earnings, it may be profit
maximizing to forgo some profit this year in order to protect future earnings.
Pittman, in his study of sidetrack agreements prior to the Staggers Act, finds evidence of what
appears to be this type of forbearance. His analysis shows that prior to the Staggers Act, there was a
uniformity in contract terms that would not be expected if railroads were sizing up each shipper’s
vulnerability and pricing to extract consumers’ surplus from each. His explanation for this apparent
forbearance was that railroads were investing in a reputation for honest dealing. It should be noted,
however, that this analysis was for contracts negotiated during the era of regulated pricing during which
differential pricing among shippers based on the ability to pay was explicitly discouraged. Under the
Staggers Act, this is no longer the case.
To the extent that railroads forbear extracting the maximum consumer surplus that is generated in
each year, such actions may represent investment in reputation—that a railroad prices lower than it could
16
It is interesting to speculate that during the height of the investment in loading facilities for crude oil from
shale formations, the payback period for such a facility could well have been within the one to two year period that
is generally assumed to be the length of time covered by railroad/shipper contracts under the Staggers Act. This is,
however, an unusual case.
10
during any particular year, hoping that a customer will thereby make decisions on an expectation of
similarly low prices in the future. This seems to mirror the common perception that if one wishes to
develop a good business relationship with a customer or supplier, it is wise to cultivate a perception that
one is not solely self-interested in the hope that an economic actor will choose to do business with you
rather than with a competitor. It has turned out to be extraordinarily difficult to model this logic in a
formal manner, however, and particularly in the case where your customer or supplier does not have the
ability to defect to a competitor if they are dissatisfied with your price or service. A railroad does not
have a mechanism to credibly commit to forgo capturing surplus in future years. A logistics manager for
a shipper must be concerned that, even if this year’s railroad negotiator appears reasonable, a future
negotiator may not be and will attempt to improve the railroad shareholder’s value at their expense.
Investment in reputation is especially problematic in the post-Staggers environment in which contracts
between railroads and shippers are secret—if a low price cannot be shown to other parties to demonstrate
the good will of the railroad, the reputation value of each contract must be low. While an individual
shipper may have their expectation of future behavior affected by forbearance in any contract year, there
seems no mechanism whereby this investment can be extended to affect expectations of future customers.
3c) Location Where Railroads Cross
A more logical source of protection from opportunistic behavior would be to build the plant requiring
rail transportation at a location where it has access to more than one railroad. In this case, unless the
railroads tacitly or overtly collude with one another, opportunism is limited by the credible threat to
defect to another railroad if the full price of service contained in the contract offered by one railroad is too
high. In the case of such structural competition, the incentive to forbear from extracting the full annual
social surplus of any shipper seems to be based on more tangible grounds than the assumption that your
counterpart on the railroad side is making a long-run investment in reputation.
11
Of course railroads do not offer perfectly substitutable offerings since they do not serve the same
cluster of destinations or have the same routes between two locations. Some surplus capture will be
expected as the more advantaged railroad bids for traffic knowing that the limited ability of the shipper to
divert traffic to the other carrier if the full price gets above the level where it is economic for the less
advantaged carrier to handle. The same logic also governs the location of a plant on a waterway or a
plant located to take advantage of highway distribution rather than rail-based logistics. These locations
that are characterized by inter-modal and intra-modal competition may not be the lowest cost locations in
terms of production, but a shipper will be willing to sacrifice some productive efficiency in order to
protect itself from the capture of consumers’ surplus from a its logistics provider if it locates at the most
efficient point on a single railroad line.17
3d) Developing a Logistics System to Reduce Capturable Surplus.
The analysis earlier in this paper in which a shipper’s consumers’ surplus is calculated and captured
by the railroad on which a plant is located, follows the tradition of transportation analysis in which rate
reasonableness is determined by reference only to the cost and demand conditions on a single origindestination-commodity triad. The amount of consumers’ surplus is determined by the marginal
profitability of production curve (that is, the demand for transportation) and the marginal cost of
providing the transportation, as shown in Figure 1. While the demand for an input to production—like
the demand for transportation—is often seen as technologically determined, in fact a multi-plant firm can
organize logistics to affect the elasticity of demand for transportation (and thus the capturable surplus) on
a single corridor. A final protection against rent expropriation is to organize your logistics in a manner to
reduce the capturable surplus on individual corridors by organizing the firm’s logistics to decrease the
slope of the demand curve on any corridor.
Figure 2 is used to illustrate how a multi-plant firm can reduce its vulnerability to hard-bargaining on
the part of the single railroad that serves its plants. Figure 2 shows two railroad lines, one connecting a
17
This argument is developed in Boyer, 2016.
12
collection point A with a plant at X from which the area surrounding the plant is served. The second rail
line connects point B with a plant at Y. For mathematical simplicity, assume that the only cost of
producing at either plant X or plant Y is a fixed cost of F per year. Again, for the sake of simplicity
assume that collection at A and B is done by truck with costs that vary as a linear function of distance and
that distribution from X and Y is similarly done by trucks with costs that are a linear function of distance.
Finally, assume a featureless plane with a uniformly distributed population of demanders around X and Y
and of suppliers around A and B. For a given rail rate on the northern route, there is a locus of origins
that are on the margin of economic viability shown by the circle surrounding location A. There is a
similar locus of destinations that are economically marginal shown by the circle surrounding destination
X. Assuming equal rail rates between B and Y as between A and X, and assuming equal costs of
trucking to B and from X as on the northern line, the locus of marginal locations around B and X look
identical to those around A and Y.
The slope of the demand curve for transportation from A to X will depend on how rapidly the size of
the hinterlands surrounding A and X shrink as the cost of transportation rises. As the rate from A to X
rises, the locus of marginal locations shrinks towards the loading and unloading points. Assuming a
featureless plane that is uniformly populated, the demand for transportation decreases quadratically as the
rate rises. In this model, product prices are determined by the cost of shipping to the economically
marginal origin or destination. Profit, and thus captureable surplus, is determined by the difference
between trucking costs to infra-marginal and marginal locations.
A shipper from A to X is vulnerable to having the entire profit of the plant at X captured by the
railroad between the two locations in the form of a contract like that described in the discussion of Figure
1; the marginal movement is priced at the marginal cost of the railroad while inframarginal units are
priced at a level such that that the combination of the fixed cost of operating the plant and the extra rate
charged on inframarginal units equals the total revenue of the firm. The shipper from A to X can improve
its bargaining position, however, by investing in a new plant at Y, served from B, assuming that a
13
different railroad connects the collection area and the plant. As shown in Figure 2, the hinterlands of the
collection points and the hinterlands of the distribution points overlap. This means that each plant is
capable of economically serving some of the customers of the other plant and some suppliers can
economically move their goods to either loading point. As a result, if the railroad connecting location A
and X fully extracts all consumers’ surplus from that haul, the shipper can credibly threaten to shut down
the plant at X with the result that the profit will rise at plant Y. With this ability to profitably move
production away from the A-X corridor to the B-Y corridor, the railroad connecting A and X can no
longer demand the full consumers’ surplus on that corridor.
The discussion above shows that treating each corridor separately and evaluating the incentives to
price on an origin-destination-commodity triad ignores some important incentives in the case of firms
with multiple plants and the flexibility to reorganize logistics in response to rate changes. While firms
with single plants are vulnerable, those with multiple plants served by multiple carriers have greater
protections despite the fact that they may be served by single railroads at each of their locations. It should
also be recognized that this protection comes at a cost. A firm with facilities collecting at A and
distributing at X would not have as its first choice the creation of a logistics system with redundancies in
it. It would be more profitable in Figure 2 to open a new supply area farther from A and a new
production/distribution plant at a greater distance from X rather than to situate the new facilities so close
to each other that their supply and distribution territories intersect. But in doing so, it makes itself
vulnerable to opportunistic behavior from the owner of the track between A and X. By investing in an
uneconomic location, it can get some protection against rent extraction and open the possibility that both
the old plant as well as the new plant can be operated profitably.18
18
A familiar measure of a railroad merger’s effects is the number of shippers who drop from two possible
carriers to one or from three to two. See, for example, Kwoka and White, 2004. But in fact there may be issues even
where a plant does not change the number of carriers with which it can negotatiate. For example, in the previous
diagram, if the line connecting A to X merges with that connecting B to Y, it will affect bargaining despite the fact
that no shipper has lost a shipping option.
14
4) An Empirical Investigation of Investment in New Rail-Using Facilities.
The previous section of this paper has identified some possible ways in which an investor in a facility
that will require rail transportation for either supply or distribution can protect the profitability of the plant
from opportunistic behavior by its rail partner. Without such protection, the management of the shipping
firm cannot be expected to place at risk the private funds necessary to build and operate the new facility.
Since there seems to be ongoing investment in new facilities that use rail transportation, as recorded by
the industrial development departments of US railroads, the research question is which of these
protections is used and the frequency with which different types of protection are employed.
To answer this question, a survey was undertaken of all new rail-based investments in the United
States that have been announced in the rail news section of the website, Progressive Railroading, the
most comprehensive trade publication for the railroad industry. The goal of the research is to understand
the conditions under which new investments were made in which private funds of a rail customer were
put at risk through the investment. This research did not consider investments made by railroads or by
public agencies since there is no paradox about why they would be willing to risk their own funds.19 The
focus was limited to new investments in plant or capacity made by profit-seeking customers of the
railroad industry. Thus, for example, investments made at ports by port authorities were not considered.
Investments made by railroads to develop intermodal facilities were similarly excluded from the research.
Since it is difficult to separate the replacement of track required by normal depreciation from truly new
investment, the research described here insisted on finding examples of laying new track to serve the new
facility in the form of a loop or spur or siding. While investments that were solely funded by government
agencies were excluded from the analysis on the grounds that they did not constitute the type of
investment whose logic seemed to require some explanation, the research did consider investments in
19
It is true that if a railroad lays track to serve a single customer, it can lose its investment if the customer
chooses not to use the spur. However, the railroad does not put up more funds than is required for providing the rail
service. This is in contrast to a customer whose entire investment in the facility is put at risk if the facility requires
rail distribution.
15
which there was some sharing of the cost of attaching the new plant to a rail siding so long as it appeared
that there were also private funds that were put at risk. Shipper investments that include cost sharing with
public agencies are considered to have some protection through the fact that not all investment funds are
private.
The research proceeded by making an exhaustive search all rail news bulletins published in
Progressive Railroading during 2015, identifying instances in which a private firm made a new
investment in plant or capacity that would use either rail for supplying the plant or for distribution from
the plant. The news items that seemed to cover private investment by a shipper being put at risk by the
decision to build a new facility that would use either inbound or outbound rail transportation were
identified and these stories were then used to identify key words that would identify such projects in a
Google search of the entire universe of Progressive Railroading rail news in the Rail Insider section
throughout the years from 2000 when the database starts through the Spring of 2016.20 These news
articles that were identified by Google using the search terms that seemed to find 2015 investments were
then read to determine whether or not what was described in the article did in fact represent private nonrailroad investment dollars put at risk by the decision to invest in a facility. Each instance of an such an
investment was then coded with industry of the investor, the number of railroads that the news release
said that the investment had access to, whether any public funds were also put in place when the decision
to invest in the rail-served facility was made, and whether this was the only plant of the potential shipper
or whether the new plant was an additional facility among several held by the shipper. While in a few
instances there was a description of whether the other facilities were on the same line as the new facility,
in most cases this could not be determined, and thus the coding was simply a binary variable of whether
the new facility was one of several operated by the investor or was unique to that shipper.
20
The keywords that seemed to be most effective at finding news in Progressive Railroading of new investment
by potential railroad shippers were variants on Investment or expansion or capacity and plant or facility along with
the words loop or spur or siding or served by. No time limit was placed on the Google search but most articles
returned by the search terms were between 2007 and 2015.
16
The results of the survey are shown in Table 2. The most striking number in the table is that for the
number of investments described in the pages of Progressive Railroading. While the data from the
Norfolk Southern Industrial Development Department reported in Table 1 showed roughly 100 projects
per year, the survey found only 85 projects in total for all years and for all railroads. It is possible that not
all shipper investments were reported through the press releases shown in Progressive Railroading. A
more likely explanation is that Table 1 reports investments using a much looser criterion than that used in
Table 2—which counts only new facilities in which new track was laid, not expansions, and requires that
the shipper put up funds for the facilities, excluding railroad investment and that solely financed by the
public. For example, intermodal facilities and port investments were excluded in Table 2, but are counted
in Table 1.
While there is a large discrepancy between the number of projects reported in this research than the
number reported by US Railroad Industrial Development departments, there is no reason to think that
there is a bias in the characteristics of the projects. Table 2 shows that of the 85 projects, 24 projects
(28%) were placed in a location where there were multiple railroads that could be accessed. A further 14
projects (16%) had some help from the public sector to make the investment profitable. Finally, 76
projects (89%) represented second, third, or higher multiple plants for the shipper. When a count is made
of projects described in the trade journal that did not refer to any of the protections described in the
previous section of this paper, only 5 projects—one ethanol plant and four grain loading facilities—had
no description in Progressive Railroading of any of the three protections considered here.21
The conclusion of the survey is that in fact there probably is no paradox of why investors will put at
risk funds for new facilities that use rail logistics. If shippers are willing to make an investment, they
seem in almost all cases to have some protection from expropriation of rents by a railroad that might try
to maximize value for its own shareholders at the expense of the shipper. By far the most common form
21
It should be noted that ethanol can be profitably distributed by truck if the density of ethanol customers is
high enough. Grain investment is typically by cooperatives who are geographically bound to particular locations
and grain is the one major commodity that is typically still shipped by tariff rather than under contract.
17
of protection is that new investors have other facilities and thus can credibly threaten to alter its own
logistics pattern as a bargaining tool at the annual contract negotiation with the railroad that owns the
tracks on which the facility is located.
5) Summary and Extensions
The traditional economic model of rail transportation starts with a single shipper and a single railroad
line and assesses the reasonableness of an individual rate by comparing a price with the expected cost for
hauling a unit of commodity between two points on the line. This removal of market power
considerations from the more complex geography within which it is situated is the tradition of railroad
economics extending at least as far back as the middle of the 1800’s. It is still used today in the rate
reasonableness criteria used by the Surface Transportation Board as it evaluates rate reasonableness by
demand and cost on a single line.22
The findings of this paper suggest that this focus on looking for rate reasonableness within a model of
individual customers on individual lines is likely to be misplaced. For the great majority of rail shippers,
a new facility—even if placed in a position where there is only one railroad serving it—is simply one part
of a much larger logistics puzzle. While one plant may be captive to the railroad, its profitability may be
in part due to the increased bargaining power that it gives the parent firm for negotiating rates for other
plants on different railroad lines. To assume that each plant operates separately from others is to miss the
logic of the investment. In short, to evaluate the reasonableness of a rate, it is important not only to
understand the elasticities of demand for individual shippers in discrete locations, but also to understand
the cross elasticities of demand among different plants on different railroad lines. It appears that this is
the main source of the willingness to invest in rail-based logistics for a new plant despite the fact that the
decision locks you into a single railroad to provide distribution or supply of commodities. This paper did
22
The calculation of standalone costs of a commodity-origin-destination rate does allow the inclusion of other
traffic also carried on the line, using the widely discredited calculations of the Uniform Rail Costing System. See
Committee for a Study of Freight Rail Transportation and Regulation, 2015.
18
also note a significant frequency of choosing locations for investments that allowed access to multiple
railroads
While the results of this paper suggest that railroad customers are not as captive as it appears from
traditional models of railroad economics, this protection comes from the fact that railroad shippers are
large firms with diverse interests in different locatations. The rates charged for rail shipments in the
United States are, for the most part, the result of bargaining between large railroads and large shippers.
There is nothing in this paper to suggest that small shippers have the ability to negotiate rates that are not
confiscatory, short of locating at a position where it can bargain with multiple carriers or access water
transportation as an alternative. With the exception of grain shippers, the results of this paper suggest
that there is essentially no investment by smaller firms in plants that lock them into using a single rail
carrier. Until a regulatory regime can be established that provides some protection to small shippers, we
should expect to see them staying away from rail based logistics and using water and highway instead or
carefully choosing to locate where they are not locked into using a single carrier.
19
References
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American Economic Review, Vol. 67, No. 3 (1970) pp. 265-83.
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Sustainability of Multiproduct Natural Monopoly, The American Economic Review, Vol. 67, No. 3 (Jun.,
1977), pp. 350-365
Boyer, Kenneth D., “Understanding ICC Rate Structure Regulation: A Spatial Analysis,” Review of
Industrial Organization: Volume 43, Issue 1 (2013), Page 121-144.
Boyer, Kenneth D., Why is the Rail Share of U.S. Freight Traffic so Low?, Journal of Transportation
Economics and Policy, Vol. 48, Part 2, (May 2014), pp. 333-344.
Committee for a Study of Freight Rail Transportation and Regulation, Modernizing Freight Rail
Regulation, Special Report 318, Washington D.C.: Transportation Research Board, 2015.
Gómez-Ibáñez, José A., “Open Access to Infrastructure Networks: The Experience of Railroads,”
Review of Industrial Organization, forthcoming.
Joskow, Paul L. "Contract Duration and Relationship-specific Investments: Empirical Evidence from
Coal Markets." American Economic Review (1987): 168-185.
Klein, Benjamin, Robert G. Crawford, and Armen A. Alchian, “Vertical Integration, Appropriable
Rents, and the competitive Contracting Process,” Journal of ‘Law and Economics, Vol. 21, No. 2
(October, 1978), pp. 297-326.
Kwoka, John E., Jr., and Lawrence J. White, “Manifest Destiny? The Union Pacific and Southern
Pacific Railroad Merger,” in Kwoka and White, eds., The Antitrust Revolution: Economics, Competition,
and Policy (4th ed), Oxford: Oxford University Press, 2004, pp. 27-51.
20
Macher, Jeffrey T., John W. Mayo and Lee F. Pinkowitz. “Revenue Adequacy: the Good, the Bad and
the Ugly,” Transportation Law Journal, Volume 41, 2014, pp. 85-127.
Mohring, Herbert, “The Peak Load Problem with Increasing Returns and Pricing Constraints,”
American Economic Review, Vol. 60, No. 4 (Sep. 1970) pp. 693-705.
Nash, Christopher, “Transportation Infrastructure Pricing: A European Perspective,” in Verhoef, Erik,
Bleimner, Michiel, Steg, Linda,and van Wee, Bert, Pricing in Road Transport: A Multi-Disciplinary
Perspective, (Northampton: Edward Elagar, 2008.)
Pittman, Russell. "Specific investments, contracts, and opportunism: the evolution of railroad sidetrack
agreements." Journal of Law and Economics (1991): 565-589.
Williamson, Oliver, The Economic Institutions of Capitalism: Firms, Markets, Relational Contracting,
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Williamson, Oliver, Markets and Heirarchies, (New York: The Free Press, 1975.)
21
Table 1
Project Results: New and Expanded Industries Located on the NS
Year
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
Totals
Total
Projects
94
92
94
100
95
93
115
98
115
121
101
89
126
109
Industry
Investment
$5.7 billion
$2.3 billion
$2.1 billion
$9.5 billion
$2.5 billion
$3.1 billion
$2.2 billion
$2.2 billion
$2.0 billion
$2.0 billion
$1.6 billion
$1.5 billion
$4.0 billion
$3.0 billion
Jobs
Created
4,422
3,127
6,167
6,831
2,084
3,003
3,623
3,554
3,578
7,700
4,395
7,212
4,771
5,144
Total
Carloads
205,731
136,035
141,114
152,716
132,060
138,542
136,504
118,924
95,246
88,404
109,333
85,218
91,135
95,051
1,442 $43.7 billion
65,611
1,726,013
Source: Norfolk Southern Railway, Industrial Development Department, 2016.
22
Table 2
New Investments on US Railroads, 2000-2015
Sector
Automobile
CBR/Fracking
Condensate
Cement
Chemicals
Ethanol
Fertilizer
Fracking Sand
Grain
Lumber fabrication
Refrigerated Storage
Steel
Sugar Storage
Tires
Wood pellet
maufacturing
Wood tie recycling
Total
Number
Number
Number
Number of
w/multiple w/public
w/multiple
investments rails
participation facilities
Number
w/some
protection
3
2
1
3
3
29
2
6
9
4
12
10
2
1
3
1
1
11
1
3
2
1
1
1
0
0
2
0
0
1
1
0
1
0
0
4
0
1
2
1
1
29
1
6
7
4
12
5
2
0
3
1
1
29
2
6
8
4
12
6
2
1
3
1
1
1
1
85
0
0
24
1
0
14
1
1
76
1
1
80
Source: Survey using the trade journal, Progressive Railroading. See text for a description of the
search method.
23
Figure 1
Setting the Profit Maximizing Tariff Rate and Contract Terms
P’
(P’+P*)/2
MC
P*
Demand
Q*
Q*/2
24
Figure 2
How Overlapping Hinterlands Protect Shippers from Opportunism
A
X
B
Y
25