The Social Cost of Railroad Regulation

Mr. Semmens is an economist for the Arizona De­partment of Transportation and is studying for an advanced degree in business administration at Arizona State University.

Despite the fact that the economic regulation of transportation has been an unmitigated disaster from the very beginning, substantive re­form has been negated at every juncture. Worse still, each succeed­ing crisis has instead served as an excuse to aggravate the ills of exist­ing government interventions by enacting even more regulations. These further interventions have been "justified" on the grounds that the consequences of deregulation would be too gruesome to con­template. Removal of government controls would place the transporta­tion industry and its customers at the mercy of the market. And we all "know" how horrible that would be.

Well, perhaps we don’t know how horrible it would be. After all, we cavalierly entrust our survival to essentially unregulated markets for food, clothing, and shelter. Trans­portation, though, we are assured, is different. One could hardly argue with that, if for no other reason than that it has been treated as different through government policy for nearly 100 years. It is a sobering thought to consider that a mere mountain of bizarre and absurd gov­ernment rules and regulations is all that stands between the consumer of America and the menace of competi­tion in transportation.

Given the professed importance of rail transportation to the "public interest" one might have antici­pated that public policy would have paid greater heed to the financial health of the industry. Strangely, though, the importance of rail ser­vice has spawned curious theories of one-sided obligations.

The theory of the railroads’ obli­gation to serve begins innocently enough with the rather bland asser­tion that railroads are different from other businesses. While this is true, it hardly follows that railroads can exist outside the constraints of eco­nomics that face every human en­terprise in a world of scarcity. Rail service is not guaranteed merely be­cause it is necessary or useful. Rail service, like any other economic good, requires resources. Yet, what are we to make of government de­crees that railroads may be required to operate at a loss?’ Or that such mandated losses do not constitute a form of confiscation?2

Ostensibly, the losses incurred in performing the vital public service of expending scarce resources on unused or underused rail service are to be made up by cross subsidy. The idea is that some other part of the rail system will bear an inordinate portion of the costs by excessive charges levied against its custom­ers. However, both economic theory and experience indicate that cross subsidization doesn’t work. Jacking up rates in excess of full cost invites competition to take away the disfa­vored customers. This is precisely what has happened in the transpor­tation industry.

The government can force the railroads to suffer losses on little-used routes, but cannot deliver on the promise of higher profits elsewhere. The result is that despite the legislated "fair" rate of return of 5 1/2% promised by the Transporta­tion Act of 1920, the railroad indus­try has enjoyed a return of less than 5% since 1929, and less than 4% since 1955.³ Even these anemic earnings overstate the return on in­vestment because no adjustment is made for the effects of inflation. The impact of inflation is revealed in the insufficient reserves set aside for capital consumption. Since depre­ciation is based on historical cost rather than replacement cost, the yearly amount allowed for deprecia­tion reserves will, when the time for replacement arrives, amount to too little to replenish the worn out track and equipment. Meanwhile, money which should have been accumu­lated to serve this purpose has been reported, and taxed, as income.

Railroad Earnings

The magnitude of the impact of inflation is indicated by the esti­mated differences in return for the fifteen largest railroads (based on 1977 revenues) for selected years since 1960. As can be seen from the table, after adjustment for inflation, the return on investment never ex­ceeded 3%. Worse yet, by 1977 the return was a pathetic .2% (two tenths of one percent).

IMPACT OF INFLATION ON INVESTMENT RETURNS FOR
FIFTEEN RAILROADS, 1960-1977

Based on                       After

Reported                     Inflation

Year       Earnings   Adjustment

Sources: Moody’s Transportation Manual and Survey of Current Business (Bureau of the Census).

The reported financial results were adjusted using the implicit price deflators for rail structures and equipment and the esti­mated proportion of asset life remaining.

The 15 railroads used in the sample were: Burlington Northern; Southern Pacific; Santa Fe; Union Pacific; Norfolk & Western; Missouri Pacific; Seaboard Coast Line; Louisville & Nashville; Baltimore & Ohio; Southern Rail­way; Illinois Central & Gulf; Chesapeake & Ohio; Chicago & Northwestern; Chicago, Rock Island & Pacific; St. Louis-San Francisco.

Such low rates of return are clearly inadequate to sustain any­thing close to existing levels of rail service regardless of the legislated "obligations to serve." Under such conditions, the shift of capital out of the railroad business becomes inevi­table. Since capital is a limited re­source, those opportunities which offer better rates of return go to the head of the line. Almost anything beats the return yielded by rail in­vestments. It should come as no sur­prise, then, that the management of railroad firms would seek to diver­sify out of the rail business.

Some degree of concern has been voiced that the diversion of rail re­tained earnings to non-rail invest­ments will weaken the capacity to provide rail services. There can be little doubt that the trend is away from rail investment and that this must inevitably reduce the capacity of the rail system. Far from being a sinister threat to the public welfare, however, this shift of resources from potential rail investment to other lines of business is a pragmatic re­sponse to a more urgent order of consumer needs. Channeling re­sources to these more urgent needs is a prime example of the exercise of socially responsible corporate man­agement. Since resources are lim­ited, it is desirable that they be put to their best use. The venture into non-rail lines of business by railroad firms is a reaction to, not a cause of, low returns in the rail industry.

Signals for Change

Low return on investment is a social signal indicating that con­sumers want less of the particular product or service offered and more of some other product or service. Railroad management would be misusing the resources under their control if they were to ignore this signal. Perhaps the signal is less than completely valid given the fact of heavy governmental interven­tion in the business. It is quite pos­sible, even likely, that this interven­tion, itself, has played a key part in reducing returns and diverting re­sources out of railroading. If legiti­mate high order of urgency needs for rail service are not being met, we must look to the constraints imposed by public policy for an explanation, not fault railroad management for pursuing sound investment oppor­tunities through diversification.

It may be that the low return in regulated industries results from the old theory that such industries, having an "assured" level of profit written into law, were less risky, and therefore, would normally be expected to experience low rates of return. In recent years, though, it has become painfully obvious that the "assured" level of profit all too often has proven a ceiling rather than a floor. Consequently, at the same time that the internal rate of return on rail investment has been declining, the return on investment demanded by securities holders has been increasing.4

Capital Requirements

Investors looking to the future are unimpressed by the regulatory au­thorities’ concern with insuring that firms recover historical costs. Stock prices have been bid down below tangible book value, effectively cut­ting the regulated firm off from new equity capital. Access to external sources of capital may be critical to the railroad industry in the years immediately ahead. The U.S. De­partment of Transportation has es­timated the railroad industry will re­quire $16 billion in outside capital between 1980-1985 in order to maintain the existing level of ser­vice. Unless the rate of return on rail investment improves markedly in this period, the public interest can be best served by reduction of service and disinvestment in low-yielding rail facilities. In this way, resources that would be underuti­lized on lightly traveled rail lines could be redirected to society’s more urgent needs.

It is unreasonable to expect rail­roads to continue to invest money at such low rates of return. This reali­zation has spawned a number of subsidy proposals. In 1970 the Rail Passenger Service Act established Amtrak—a government-owned and operated passenger service. In 1976 the Railroad Revitalization and Regulatory Reform Act led to the formation of Conrail—a gov­ernment-owned and operated freight service. The 1976 Act also set up procedures whereby unprofit­able branch lines could receive sub­sidies to retain rail service. While it is true that government subsidies could improve the return on invest­ment from the perspective of the railroad firm, the subsidy, since it is a transfer payment, does nothing to improve the total return on society’s limited resources. In fact, since the funds for subsidy must be drawn from investments with higher rates of return, the net social benefit of the transfer is negative. That is, fewer goods and services in total will be available than if the transfer were not made.

Paying the Price

Two general policy directives pro­vide the guidance for Interstate Commerce Commission regulation of transportation. On the one hand, the Commission is bound to prevent rate discrimination. On the other hand, the inherent advantage of each mode is to be preserved. To begin with, "preventing" and "pre­serving" are innately conservative activities. Even if such activities were appropriate when first insti­tuted, time would inevitably render them less and less satisfactory. As it is, though, the directives are based upon fallacious economic doctrine and are representative more of wish­ful thinking than practical policy.

The social prejudice against rate discrimination springs from the no­tion that it is unfair to charge differ­ent prices to different buyers for the "same" service. The early examples of rate discrimination involved cir­cumstances in which a railroad might charge a lower rate for a long haul than for a short haul. The lower rate is to be distinguished from a mere quantity discount. The long haul total charge would amount to less than a short haul charge, sometimes over the same track. Superficially, using estimates of average costs to provide service, it can appear "unfair" that a short haul which should cost less to sup­ply, has a higher price tag. The problem with this line of reasoning is two-fold. First, no two buyers of rail service are purchasing identical service. Second, the reported "cost" of providing a service, even if it can be accurately determined, may be relatively unimportant in establish­ing the price of any specific transac­tion.

Transportation is purchased in terms of origins, destinations, and time periods. Even goods moving between the same two points may require different handling in terms of quantity, time of year, hour of the day, and the like. The service pro­vided cannot be uniformly divided into equivalent units, such as ton-miles. Yet, this is precisely what regulation has led to. The imposi­tion of this type of price control can have two kinds of results: none and bad. In the instances where the reg­ulated price exactly matches what would have been the free market price, the regulation will have no impact. In the far more frequent instances where the decreed price is either higher or lower than what the market price would have been, un­desirable consequences will result.

Wasteful Controls

In the cases where the controlled rate exceeds what would have been the market rate, traffic will be di­verted to a second best alternative. This leads to inefficient use of re­sources, as the second best alterna­tive will almost certainly be at a higher cost. At the same time, the loss of revenue occasioned by the diversion will reduce the incentive and capacity of the firm to produce and provide the first best alterna­tive. This phenomenon is demon­strated when the regulatory author­ity prohibits rate reduction by in­sisting that a move must cover fully allocated costs. Given the high pro­portion of fixed to variable costs typi­cal in the railroad business, this regulatory approach prevents the realization of certain economies of scale, places the railroad at a com­petitive disadvantage, lowers total economic output, and increases the aggregate expenditure of resources.

In cases where the controlled rate is less than what would have been the market rate, uneconomic de­mand for the service will be stimu­lated. If the rate control were the only intervention, the suppliers of the service would seek to withdraw from the market. Unfortunately, further regulatory impositions usu­ally prevent this from taking place. Railroads are frequently required to retain service which cannot earn enough to pay its own way. The retention of such "vital" services is not without its attendant social cost. The resources expended at a loss are thereby unavailable for more useful employment.

Furthermore, the alternative modes which could have provided economical service are prevented from making a contribution toward a net societal profit. This regulatory approach is especially insidious. The preservation of lightly traveled branch lines is the readily observa­ble effect. What is not seen is the sacrifice of more beneficial alterna­tives. In this case, certain disecono­mies are enforced, leading to a weak­ening of other rail services, lower total economic output, and wasteful consumption of scarce resources.

The 1940 Transportation Act in­structed the Interstate Commerce Commission to preserve the inher­ent advantages of each mode under its jurisdiction. As anyone familiar with economics knows, the market, left to itself, will promote efficiency. As resources seek the highest rates of return, the "inherent advantages" of any operation will most assuredly be employed. Since the economy is dynamic, today’s "inherent advan­tages" may be tomorrow’s outmoded techniques. Instructing the ICC to preserve the inherent advantages of each mode in 1940 has had the un­happy result of retarding progress.

That this preservation policy has stifled innovation is demonstrated by the historical record. The ICC’s persistent adherence to full cost al­location, as exemplified in "Rail Form A" costing rules, has killed off several rail car innovations. The re­quired average cost basis for rate making would not permit rates low enough to generate the volume needed to support the innovations. Interstate Commerce Commission rigidity resulted in some classic in­stances of delay in the introduction of rail inventions, including retard­ing the spread of unit train technol­ogy for over 40 years.5

Who’s to Blame?

The railroad industry and its managers have often been chided for lack of imagination. It is sometimes claimed that the poor rates of return enjoyed by the industry are a result of this lackluster management. But which is cause and which effect? The poor returns on investment are di­rectly traceable to regulatory policy. In turn, poor investment return re­duces the resources available for in­novation. Finally, the necessity to have changes in business operations approved by a group of politically appointed Commissioners must frustrate whatever innovative urges may arise. The fact that business is dynamic and forward looking, while the process of regulation is deliber­ative and static, poses a serious threat to the survival of the railroad industry.

The magnitude of the social cost of railroad regulation is enormous. One author called the welfare loss "huge" and "certainly greater than all of the welfare losses from pure enterprise monopoly combined." In 1969 the social cost of railroad regulation was estimated at between $2.7 and $4.1 billion per year.’ Given the rampant inflation of all costs since that time, especially rail inputs which have increased in cost faster than the more general con­sumer price index, a reasonable es­timate of the current social cost of railroad regulation would range from $5.5 to $8.0 billion per year.

Conclusion

There can be no question but that regulation of the railroads has led to higher overall transportation costs, serious resource misallocation, and sacrificed alternatives. Public policy has made the economic pie smaller by its intervention into the trans­portation industry. That this result could be in the "public interest" seems ludicrous. Yet, promoting the "public interest" is the reputed goal of public policy. Two explanations come readily to hand. It may be that various "private interests" may ma­nipulate public policy to their own advantage.⁸ Alternatively, it may be that the makers of regulatory law fail to anticipate the consequences of their actions.9

Wherever the truth may lie, the observable consequences of economic regulation of the railroad industry are demonstration enough that the current system not only imperils the railroads, but has a negative net impact on the general welfare. This in itself should be suf­ficient evidence that deregulation will benefit both the railroads and the U.S. economy.

—FOOTNOTES—

‘Arizona Corporation Commission vs. Southern Pacific, 87 AZ 310.

⁼Northwest Pacific Railroad vs. ICC, 288 F. Supp. 690.

‘Alexander Morton, "Northeast Railroads: Restructured or Nationalized?" American Economic Review (May, 1975), pp. 284-288.

‘Stevan Holmberg, "Investor Risk and Re­quired Rate of Return in Regulated Indus­tries," Nebraska Journal of Economics and Business (Autumn, 1977), pp. 61-74.

⁵Paul MacAvoy and James Sloss, Regulation of Transport Innovation (N.Y.: Random House, 1967).

⁵George Hilton, The Transportation Act of 1958 (Bloomington: Indiana University Press, 1969).

‘Ann Friedlaender, "The Social Costs of Regulating the Railroads," American Economic Review (May, 1971), pp. 226-234.

8George Stigler, "The Theory of Economic Regulation," Bell Journal of Economics (Spring, 1971); Sam Peltzman, "Toward a More General Theory of Regulation," Journal of Law and Economics (August, 1976), pp. 211-240; and John Semmens, "Regulation of the Truckers, By the Truckers, For the Truc­kers," Reason (March, 1979), pp. 26-29.

⁹Robert Harbeson, "Social Welfare and Economic Efficiency in Transport Policy," Land Economics (Feb., 1977), pp. 97-105, and William Capron (ed) Technological Change in Regulated Industries (Washington, D.C.: Brookings Institution; 1971.)

In studying the impact of intervention in a particular industry, Throttling the Railroads, Dr. Clarence Carson came to this con­clusion: "As things stand, the future of the railroads is bleak. So is the future of consumers of their ser­vices. Over a period of about ninety years, virtu­ally every sort of interven­tion has been tried—inter­vention which has brought us to the present pass. It is time for yet another ex­periment—an experiment with freedom .. ."

Throttling the Railroads, 140 pages (1971), is avail­able from The Foundation for Economic Education, Irvington-on-Hudson, N.Y. 10533.       $4.00 cloth

$2.00 paperback