Disambiguating Impacts of U.S. Railroad Deregulation / by Robert Gallamore

I. Positive Effects and Benefits of Deregulation

1. By moving most railroad operating decisions (pricing, financing, services) out from under from the purview of Federal regulatory agencies and, instead, allowing them to be governed by the private marketplace, partial economic deregulation of railroads rewarded consumers and the U.S. economy with historic levels of improved railroad economic performance. Partial rail deregulation returned everyday business decisions on pricing, investments, and service offerings to the owners and operators of railroad companies, enabling railroads to speed adjustments to new opportunities in the marketplace. Deregulation permitted lower costs for railroads and lower rates for shippers.

2. American railroads had been in deep decline throughout the Twentieth Century, as measured by losses of freight and passenger market share, employees, track mileage, and stock market value – until passage of the Staggers Rail Act of 1980 triggered a Renaissance for the industry. The Staggers Act was the core piece of legislation reversing traditional Interstate Commerce Commission (ICC) regulation of railroads, and at the heart of deregulation was the new freedom for carriers and customers to enter into rate and service contracts. These had been considered a form of discrimination, and hence illegal, under ICC regulation. Contracts were the means by which carriers and shippers could agree on ways to match supply and demand, saving costs and
providing greater value.

3. Federal regulation of railroads began in the Act to Regulate Commerce (1887), although many states had set up Railroad Commissions to issue railroad charters and oversee operations within their borders earlier. Interstate Commerce Commission (ICC) regulation was conducted under a long series of statutory rules and precedents designed for an earlier era with vastly different transportation challenges. Regulatory decisions were made in court-like adversary settings by political appointees who often came under the influence of special interests.

4. Partial economic deregulation under the Staggers Act made it clear that railroads could act like other businesses in choosing their markets, pricing their products, and contracting with customers for terms of service. Railroads were encouraged to find new sources of traffic, innovative ways of operating, and to improve profitability of underperforming traffic segments. The result was a better and quicker match of railroad supply capabilities to market demands and opportunities. Although politicians generally feared that deregulation would allow railroads to charge much higher rates, the actuality was quite different. Average rates unambiguously fell by about fifty percent in the deregulatory period. (See chart below).

5. Lower rates and the freedom to enter into long-term rate and service contracts (previously illegal under ICC regulation) induced new traffic. Also in the Post-Staggers period, railroads benefitted from a boom in western low-sulphur, long-distance unit-train movements of coal. The strong dollar and new international trade agreements stimulated development of international containerized intermodal traffic to ports and domestic distribution centers. New tax rules for handling accelerated depreciation of old frozen railroad assets infused cash into the industry. A Presidential Emergency Board ruling (PEB-219) in 1989 allowed railroads to operate trains with smaller crews.

6. Improved cash flows from deregulated operations enabled railroads to spend more earnings on, or reinvest more capital in, better track, facilities, locomotives, and equipment. These physical improvements in turn incorporated new technologies and better designs that contributed to safety, fuel economy, less pollution – and further improved cash flows: a virtuous circle. Importantly, the infrastructure improvements after deregulation were achieved largely without direct federal financial assistance – and in contrast to transport operations over federally-aided highways and waterways by modes with which railroads compete.

7. The Staggers Rail Act also allowed railroads to spin-off segments of their networks to “new railroads” formed without carrying-over traditional labor contracts (which might have had “full crew” requirements or other restrictive work rules). These new “shortlines” (there were hundreds of them formed in the post-Staggers period) or “Regional Railroads” (branded collections of small carriers assembled from old or new shortlines) filled niche markets with aggressive marketing, innovative management, and new capital.

8. Deregulation also had a positive effect on railroad mergers, because it improved the prospects for the industry generally, and (in combination with enlightened oversight by the Surface Transportation Board) changed the trend of rail mergers from parallel line combinations (that reduced rail-to-rail competition) to, instead, end-to-end mergers that extended the reach of railroads into new market territories. While the impact of the new merger trends after deregulation was to continue to reduce the number of railroads and to make them larger, they also became more competitive – both with each other and vis-à-vis other modes of transport.

9. Post-Staggers mergers may have enabled railroads to achieve some economies of network efficiency through economies of size or density. An MIT team of economists led by Nan Friedlaender wrote that post-Staggers competitive economics is “nine parts deregulation and one part merger consequences.” (Cited in Gallamore and Meyer, American Railroads, p. 305.) It would be difficult to establish econometrically the shares of public benefits attributable to deregulation, mergers, or other causes, but they were a substantial feature of recent railroad economic history.

10. A particularly important development in railroad merger history was to reverse the negative impact on railroad industry structure of the Penn Central Merger (1968), which had been a key factor in the bankruptcy and collapse of Northeast Railroads. Under the “Three R” Act of 1973, these in turn led to government’s take-over of Penn Central and other Northeast railroads in reorganization, and the formation of Conrail through the U.S. Railway Association (1974-1976).

11. After expenditure of some $8 billion in reorganizing and rehabilitating Conrail, and with the help of Staggers Act reforms skillfully deployed by its new management, downsized Conrail became profitable and was privatized in an Initial Public Offering (1987). Conrail reduced its employee count by some 60 percent (from more than 80,000 in 1977 to about 30,000) by the time of the IPO. Conrail operated successfully on its own until 1999, and was then divided and sold to Norfolk Southern (58%) and CSX (42%).

12. A final positive assessment of the American experience under railroad deregulation, at least in a relative sense, is that U.S. freight railroads are enormously productive by international standards. No other railroads in the world combine the reach and profit performance of deregulated American railroads.

II. Negative Effects and Unresolved Issues

1. The Staggers Rail Act did not settle all questions regarding adequate competition for shippers and
adequate revenues for railroads. Some shippers continued to believe they were “captive” to dominant railroads that could command high rates and fail to provide adequate service; these shippers wished to continue the traditional regulatory “safety net.”

2. Relief for captive shippers might be realized by an alternative regulatory procedure called the “Stand Alone Cost” (SAC) procedure authorized by public law and administered by the transportation regulatory agency. The SAC relied on a complex and logically challenging process to review maximum rates in cases where inadequate competition had been demonstrated. The process allowed complainants to create a “hypothetical railroad,” – one designed to serve the “captive” traffic at issue; this hypothetical efficient railroad’s costs could then be used to establish a ceiling rate for the traffic. The SAC rules were designed by a brilliant group of economists associated with Princeton University (professors Baumol, Panzar and Willig); their purpose was to design a system that would determine the maximum rate any so-called “captive shipper” could be charged in a hypothetical competitive/contestable market – thus providing shippers served by only one railroad some protection from monopoly exploitation.

3. In actual practice, however, the SAC hypothetical railroad might have to rely on so-called “crossover” traffic to reach economic viability and be useable as a test case for rates. (Crossover traffic was remunerative traffic that was supposed to remain with the original carrier, i.e., was not included in the design of a minimal hypothetical railroad to serve captive traffic.) This meant that the stand-alone hypothetical costs were not a fixed and knowable standard model for determination of maximum rates, but a fungible and arbitrary artifice. As Professor Gerard McCullough of the University of Minnesota says, the difficulty always is knowing the virtually unknowable – what are the shapes of cost curves and demand elasticities?

4. A complex SAC case (of which there have been relatively few), might take many months and cost several millions of dollars to litigate. Revision of these rules to make the SAC process (or an alternative) more accessible and less costly to complaining parties is still under active consideration by lawmakers and regulatory officials. The problem is that in realizing the otherwise laudable objective of making preparation of a SAC case less costly, shortcuts might be taken that would undermine credibility of the results. Today’s rules encourage railroads and shippers to negotiate rates rather than ask the Surface Transportation Board to determine what they should be. In effect, a shipper with “captive traffic” decides whether it is better off negotiating or litigating. If the costs of litigating decrease, more cases will wind up back in the regulatory system, and if shortcuts are taken to estimate SAC costs, rates could (likely would?) move away from, rather than toward, optimality.

5. Deregulation under the Staggers Act also did not completely address the problem of sunk costs for long-lived assets that were created in the development of railroad networks, but outlived their economically useful lives. Among the most fundamental observations about railroad costs is that large capital expenditures are required to construct a new railroad and launch operations.
These initial costs are “sunk” into the railroad’s construction, infrastructure, and initial operation,
but how should they be treated in regulatory practice and deregulation theory?

6. Infrastructure sunk costs might in themselves pose a substantial barrier to the entry of a new
competitor desiring to serve the same market as an incumbent, especially if the potential entrant is
not already in a related part of the industry (and thus able to leverage its operational know-how, its
own maintenance shops, and its established access to connecting traffic). Substantial barriers to
entry might also be faced by a potential market entrant proposing to compete against incumbents
with a different technology – the possibility of a coal slurry pipeline competing against railroads
moving unit trains of coal, for example, or a firm operating driverless trucks on separated highway
lanes in competition with intermodal containerized railroad service. Clearly some major portion of
the competitive discipline for U.S. railroads comes from cross-modal rivalries (often subsidized by
the government explicitly to counter railroad pricing power). (See American Railroads, pp. 98-99). If
there are barriers to entry in cross-modal rivalry, inter-modal competition is imperfect.

7. The circumstances of large threshold costs and presumed barriers to entry had traditionally limited
market and pricing studies of railroad-to-railroad competition to consideration of “who goes
where?” and “how good are its routes?” Even normal antitrust analyses applied in other industries –
(definition of “relevant markets” with cross-elasticities of demand, investigation of product and
geographic competition, and national branding and price-maintenance [Robinson-Patman Act
strategies]) – have had relatively minor importance for railroads. Minor, that is, as compared with
the effects of traditional “ICC-style” regulation of rates and services conducted by the Interstate
Commerce Commission or Surface Transportation Board. (“ICC-style” regulation included
competitive analyses of mergers and trackage rights, and approval or not of line
abandonments and passenger train discontinuances.)

8. Only in the last three to four decades (and as a result of railroad rate deregulation
effectuated by the Staggers Rail Act) have economists broadened their microeconomic and industrial
organization analyses beyond merger studies to consider railroads’ competitive efficiency and its
impact on pricing. The new attention of economic theorists, lumped under the idea of
“contestability theory,” has turned to the question of whether or not, in the absence of ICC
regulation, markets served by railroads would be sufficiently competitive to serve the public’s
important interest in economic efficiency. Today’s railroad industry is clearly more concentrated
than it was prior to mid-century; is it still sufficiently competitive to perform well under

9. A broader and better way to phrase the question is this: In the light of both intra-modal (rail-rail)
competition, and cross-modal competitive rivalry, is the current structure of the U.S. railroad industry
workably competitive? Under what conceivable circumstances (new and larger regional or transcontinental mergers? Other circumstances?) would the industry cease to be workably competitive? Just where would we draw the line between workably competitive and not workably competitive?

10. A final unresolved regulatory issue in this list is the matter of proposals to help so-called captive
shippers by mandating reciprocal switching (or some other variant of compelled competitive
access to facilities owned and operated by a dominant railroad in the market). These proposals
generally would require that a railroad providing the only direct access to a single-served customer,
one able to demonstrate economic harm from inadequate competitive alternatives, would be
required to allow the customer to arrange competitive rail service from an independent operator
over fee-based trackage rights on the incumbent railroad. Thus, the privately-owned railroad would
be forced against its will to facilitate competition against itself. These tenant operations might
interfere with the incumbent railroad’s own service or create a safety issue due to conflicting
operations. American Railroads (p. 248) opposed compelled access as an intrusive regulatory
complexity, and possibly unconstitutional if the “host” railroad were not fully compensated.

11. Again, there is a policy dilemma. Efforts to increase intra-rail horizontal competition by mandating
compelled access could create more issues for regulatory determination. Important among these would be trying to determine what access fees should properly be charged to a new tenant rail operator, and what compensation should be made to the incumbent railroad for access to the property and to avoid an unconstitutional taking of his property.

The Bottom Line: What Staggers Act Deregulation Accomplished *

The Staggers Rail Act quite literally rescued the railroad industry from four-score years of
economic decline and set railroad finances on a path of Renaissance that has lasted for another
three decades. While the Great Recession of 2008-2009 cut deeply into the promise of the Rail
Renaissance, it did not reverse its potential completely. Also, recent experience has exposed the
industry to the fact of substantial and probably irreversible losses of coal traffic long-term, due
to the nation’s remarkable shift in sourcing fuel for generation of electricity from coal to natural
gas obtained from fracking. There remains robust growth in intermodal container traffic,
however, and other sources of rail traffic with a great deal of upside potential that would benefit
from possible improvements in railroad on-time service quality. Chemicals and agricultural
commodity movements are strong, and construction materials are poised to gain from any
increase in the nation’s infrastructure rebuilding initiatives.

The best summary description of the quantitative impact of Staggers Act deregulation of
American railroads is a graph designed by Gallamore and Meyer in the 1990s that has appeared
in many publications and which has been maintained and periodically updated for many years
by the Association of American Railroads. (A version of the graph from a few years ago is
reproduced below as a color chart.) The graph displays and contrasts annual trends in railroad
productivity, volume, revenue, and average rates over two periods – fifteen years before the
Staggers Rail Act and about twenty-five years afterward.

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* Economists are reluctant to ascribe causality to specific circumstances in a time series, and many or most might prefer to say that the productivity, volume, revenue, and rate trends in the post-Staggers period shown here were not exactly accomplishments of deregulation. They were outcomes for the industry, nevertheless, and they certainly help explain the impact of deregulation. (-REG)

In the period after deregulation, railroad firm productivity (measured by revenue ton-
miles of output per constant dollar value of unit input expenses) shot up to a peak of about 175 percent of the 1980 level before settling into a range easily doubling historic levels. This surge in
productivity allowed historic volumes of traffic to be handled efficiently, while average railroad
rates fell by about fifty percent. The lower rates stimulated traffic volume growth, and while
they were a reason industry revenues declined, they were an enormous benefit to shippers and
the general economy. Deregulation was clearly a win-win-win for railroads, shippers, and the GDP.