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* Director of Economic Research, Economic Analysis Group, Antitrust Division, U.S. Department of Justice, and visiting professor, New Economic School, Moscow. The author benefited from excellent research assistance from Michael Carley. The Antitrust Division encourages independent research by its economists; the views expressed herein are entirely those of the author and are not purported to reflect those of the U.S. Department of Justice.
The stand-alone-cost test has become an expensive, extensive, and time-consuming part of the regulatory practice of the U.S. Surface Transportation Board in the performance of its statutory duty to protect "captive shippers" from monopoly rail rates. Worse, a close examination of the history of its adoption and application suggests only a very tenuous connection with its claimed intellectual foundations, the classic works of Faulhaber (1975) and Baumol, Panzar, and Willig (1982). It is time to retire this tool and replace it with something simpler and more effective and transparent.
Against the Stand-Alone-Cost Test in U.S. Freight Rail Regulation
Rate regulation for the majority of freight movements on U.S. railroads was eliminated by the Staggers Act (49 U.S.C., Public Law 94-473) in 1980. However, one category of traffic remains subject to potential regulation: that carried by so-called "captive shippers," those shippers with no economic alternative to the use of a single railroad. (1) A recent decision by the rail regulator, the Surface Transportation Board (STB), interprets the statutory principle as follows:
In 1985 the predecessor agency to the STB, the Interstate Commerce Commission, issued its Coal Rate Guidelines, Nationwide, which set out the standards by which the Commission (and later the STB) would evaluate the "reasonableness" of rates charged to captive shippers. (3) These standards went under the label "constrained market pricing" (CMP) - a label that could alternatively be phrased "constrained differential pricing".
In formulating CMP, the ICC acknowledged the welfare advantages of differential or Ramsey pricing - prices set inversely to the demand elasticities of customers - in the presence of economies of scale sufficient to render marginal cost pricing impractical. However, the freedom of the railroads to set differential prices would not be unlimited. In particular:
Unfortunately, in the decades following the ICC's issuance of the Guidelines, the stand-alone-cost (SAC) test has become what a reviewing court feared it would be: "a full employment bill for economists". (7) The STB has estimated that "shippers' litigation costs in recent Full-SAC cases have approached $5 million" and cited with approval an estimate that "even a Simplified-SAC presentation would likely cost up to $1 million to litigate." (8) These estimates do not include the corresponding costs incurred by the defendant railroads and the STB. The reason for this is straightforward: given the huge amounts of money at issue, both sides in a rate case have the incentive to add increasing layers of complexity to the inherently uncertain exercise of simulating the costs of a SARR - so long, of course, as each layer added either adds to or subtracts from the costs, as desired - and thus to dissipate rents.
It is worth quoting at length from an STB decision that describes the degree of detail involved in this exercise (and note that the STB is simply stating the facts here, not arguing that the degree of detail is excessive).
At this point,
In the case whose STB decision was just quoted, the shipper posited a SARR of 1400 route miles, traversing five states, connecting coal mines in the Powder River Basin of Wyoming with eleven coal-fired power plants in four states. The SARR was even given a name: the West Texas Railroad. Not to be outdone, another shipper created a 3000-mile SARR, dubbed the Overland Railroad, extending "from Portland, OR to Chicago, IL and Kansas City, MO, with a 375-mile extension into the Powder River Basin (PRB) coal fields." (11) In that case the STB decision Appendix describing the SARR configuration, operating plan, and revenue analysis runs to almost 100 pages.
Evidence with this degree of complexity inevitably invites further regulatory dispute and litigation over a seemingly endless list of details regarding the configuration, costs, and revenues of the hypothetical SARR. Among the issues litigated have been the following:
It goes without saying that a process such as this one is plagued with both problems of asymmetric information and the resulting incentives and ability to pick and choose among such information in order to further one's own agenda. As Heald (1996) points out:
In 1996, Congress directed the STB to "establish a simplified and expedited method for determining the reasonableness of challenged rail rates in those cases in which a full stand-alone cost presentation is too costly, given the value of the case." (18) When no cases were brought under the "simplified guidelines" issued by the STB in response, the STB in 2006 created "a simplified stand-alone cost (Simplified-SAC) procedure to use in medium-size rate disputes for which a full stand-alone cost (Full-SAC) presentation is too costly, given the value of the case" and refined "the 'Three-Benchmark' method of [the] Simplified Guidelines … for small rate disputes for which even a Simplified-SAC presentation would be too costly, given the value of the case." (19)
Such refinements, however, seem only to highlight the importance of a set of more fundamental questions. When does a stand-alone cost presentation become "too costly" - not "given the value of the case" but given its contribution to an efficient and/or equitable outcome to a rate dispute? Where did the stand-alone-cost test come from, and to what degree do its analytical origins and foundations justify the importance granted it by the STB - not to mention the resulting expenditures of real resources on its use by shippers, carriers, and the STB - in large rate disputes? How much justification is there for the STB's stated view that "the SAC test, which judges the reasonableness of a challenged rate by comparison to the rate that would prevail in a competitive market, rests on a sound economic foundation…."? (20) As we will see, the answers to these questions are not reassuring.
Where did the stand-alone-cost test come from? The ICC decision that introduced CMP, Coal Rate Guidelines, Nationwide, places its origins squarely within the concept of contestable markets:
Similarly, an appeals court decision notes that "the SAC test … [is] rooted in the concept of contestable markets…." (22)
In turn, the locus classicus for market contestability, Baumol, Panzar, and Willig (1982, hereinafter BPW), credits the concepts of stand-alone cost and the stand-alone-cost test to the classic paper by Faulhaber (1975). (23) So it is to that paper that we turn first.
Faulhaber addresses "the problem of pricing commodities produced in the presence of common costs by a publicly owned or regulated enterprise." He notes that
Faulhaber proceeds to argue that
This "intuitively appealing notion" might seem to suggest a "fairness" argument, but Faulhaber quickly backs away from this line of thinking. First he notes that "we [are not] entitled to assume that such [subsidy-free] price structures are morally superior to their subsidy-prone fellows on grounds of social justice" (p. 967); then in a footnote he explicitly and forcefully contrasts his own analysis reported in this paper with that of other papers that recommend a certain method of setting prices in public enterprises "on the basis of its purported 'fairness' and 'equity'." (24)
In fact Faulhaber's reasoning is based unambiguously on what BPW will term "sustainability". His game-theoretic analysis asks the question: what is the highest price that a profit-constrained, multiproduct monopolist may charge a particular group of customers without giving that group the incentive to break away and engage in self-supply? This priceis the stand-alone cost, the cost that such a group would have to pay to supply itself only:
If any prices are set above this level - above stand-alone cost - some group of customers will have the incentive to "go it alone," even though "the single supplier is the uniquely most efficient production arrangement" (p. 968). Indeed, if the regulator insists upon setting prices above the stand-alone cost level,
Again, Faulhaber emphasizes that "prices which are subsidy-free do not necessarily promote the common weal or bring about social justice." Furthermore,
Thus Faulhaber. When BPW take up Faulhaber's concept of stand-alone cost, it is once again with an emphasis on the prevention of inefficient entry:
A near-simultaneous verified statement by Baumol and Willig also cites the classic treatise by Kahn in support of this test, and Kahn is specifically discussing "cream skimming" - the question of whether prices higher than stand-alone costs (he does not use this term yet) might attract inefficient entry and so threaten sustainability. (25)
Besides emphasizing sustainability, however, BPW are arguably a bit more willing than Faulhaber to venture into normative grounds:
Thus BPW. According to Faulhaber and BPW, the stand-alone-cost test is motivated and justified mostly by concerns for the sustainability of the natural monopoly in the face of potential inefficient entry. In addition, it may suggest that certain Ramsey prices are cross-subsidizing other prices and are thus in some sense unfair. Not surprisingly, there is not much foundation laid for the fairness argument, and Heald's (1996) evaluation seems on the mark in this respect:
Let us review the bidding up to this point. According to the scholarly works upon which the STB has based its rulings, the application of a stand-alone-cost test to rates charged to customers of a monopolist constrained to earn zero economic profits insures that, in a contestable market, costly and inefficient entry does not take place. In addition, at least one of these works seems to entertain the idea that the stand-alone-cost test guards against such a monopolist unfairly forcing one group of customers to cross-subsidize another group of customers.
This would suggest the relevance of a few questions regarding the choice by the STB to use stand-alone-cost tests to evaluate rates charged to "captive" freight rail shippers.
First, are freight railroad companies in the U.S. constrained to earn zero economic profits? (26) No, they are not: the "revenue adequacy constraint" referred to above means that once firm-wide economic profits exceed the estimated cost of capital, the STB may regulate the rates charged to captive shippers, but that fact is (obviously) not the same as a regulatory constraint on company profits. In fact, a large-scale study recently commissioned by the STB concludes that the U.S. Class I railroads are now near or at the point of earning economic profits (Christensen Associates, 2008). And yet, in a recent paper that evaluates the experience of regulatory application of the concepts in Faulhaber (1975), Faulhaber (2005) notes that
Second, is the railroad industry contestable? Of course not: a necessary (but not sufficient) requirement for contestability of an industry is that "entry is absolutely free and exit absolutely costless," (27) and the Coal Rate Guidelines, Nationwide, freely concede that "the railroad industry is recognized to have barriers to entry and exit and thus is not considered contestable for captive traffic." (28) (The last three words seem unnecessary.) The STB statement that its "use of SAC introduces the competitive standard of contestability into a non-competitive market" (29) has a reasonable sound but does not really explain why such an exercise is in any sense welfare- or efficiency-enhancing.
One possible path out of this particular conundrum might be the insight of Tirole (1988) that "the theory of contestable markets can … be seen as a generalization of Bertrand competition to markets with increasing returns to scale." There is some limited support in the empirical literature for Bertrand competition as the duopoly outcome of railroads shipping coal from the Powder River Basin (Winston, et al., 2007). As Grimm (2008) points out, language in the most recent STB merger decisions suggests a possible adoption of this view: "We now believe that rail carriers can and do compete effectively with each other in two-carrier markets." (30) However, this is certainly not the standard finding or assumption, and the STB has not relied on this interpretation of contestability in its SAC discussions.
A second possible path is proposed by Fanara and Grimm (1985), who acknowledge the potentially large gap between rates that might attract actual stand-alone entry and the lower rates that are implied by the hypothetical SARR constructed under a CMP analysis. The former rates, they suggest, would correspond to concerns regarding actual sustainability but would be extremely high, while the latter would thus correspond more closely to concerns regarding fairness.
But this suggests a third question: in the freight railroad sector, is stand-alone-cost analysis an important tool for regulators actually seeking to prevent inefficient entry? This seems quite unlikely: new entry into the freight railroad business in the U.S. has been extremely rare; until fairly recently, the industry has been in a long period of shedding excess capacity. Furthermore, it is entirely in the interest of the incumbent railroad to price in such a way that entry into its territory does not appear attractive. In addition, the STB has the authority to deny applications for new line construction if the presence of the new capacity would "unduly harm existing services." (31)
The single major project for new railroad construction advanced in recent years has been for the construction by the Dakota, Minnesota & Eastern Railroad (DM&E) of a new line into the Powder River Basin, the coal producing area served by the carriers in some of the rate cases cited here. In the lengthy STB proceedings that authorized construction (which has not yet taken place, and may not), (32)the principal participating shippers' group, the Western Coal Traffic League, argued that "access to the PRB by an additional … rail carrier would assist in mitigating UP's and BNSF's [the current serving carriers] capacity shortcomings, and thereby improve rail service reliability." (33)
The STB decision alludes briefly to the possibility (and relevance) of harm to existing carriers as an instance or cause of harm to existing services, but the decision does not so much as mention any evidence that the UP and/or BNSF would be significantly harmed by DM&E entry into the PRB - evidence that would seem to be at least related to the sustainability question - rather focusing entirely on the seemingly odd issue of whether the magnitude of the proposed investment project and the possibility of its failure might constitute threats to existing service by the DM&E to its existing, non-PRB customers. (34) Remarkably, then, in the single major SAC case in which the sustainability issue is at least in principle relevant, the STB decision avoids the issue almost entirely.
Seen from this perspective, the STB statements justifying the use of the SAC test seem more to avoid than to address the questions of economic efficiency and total welfare:
We would seem to be left only with arguments for the stand-alone-cost test related to fairness. As I discuss in the companion paper to this one (Pittman, forthcoming), fairness is a perfectly relevant topic for discussion regarding rates charged to captive shippers; in a sector with a high level of fixed and sunk costs, there is no single, optimal way to set rates for full cost recovery. (37) Particularly once the railways are earning their cost of capital - as they are now, arguably - any increase in rates to the railroads (part of which goes to stockholders, but part of which goes to labor, and part to maintaining and improving capacity, including new and expensive statutory requirements for the installation of Positive Train Control equipment) comes at the expense of coal mine owners and labor and investment, electric utilities, and electricity rate payers (and customers of commercial rate payers).
What is the right mix of charges to those diverse groups? Rates set at "what the market will bear" economize on judicial and regulatory costs and fund railroad investment. Rates constrained to be below that level leave more resources in the hands of the coal and electricity industries and electricity customers. Ramsey prices achieve revenue adequacy at a minimum cost to total welfare, but customers with the fewest economic alternatives may pay very high - even "unfair", even "cross subsidizing" - rates. Even Ramsey prices constrained by SAC analysis leave shippers - by definition - with zero share of the economies of scope of the overall railway enterprise. We have not even touched on the question of environmental externalities: whether, as complainants argued in the DM&E matter before the STB, lower rates for shipping coal may be a bad thing if they encourage the construction of more coal-fired power plants and the consumption of more electricity. (38) Large sums of money are at stake here, and political resolutions may be inevitable.
What seems clear, however, is that a focus on the best level of the rates themselves is much to be preferred to a lengthy and expensive examination of various cost issues that - as I have argued in this paper - are not obviously relevant to the desirability of the rates themselves. Whatever is the fairest or best or most equitable way to divide the available quasi-rents among various claimants, it would seem to have extremely little to do with the choices of rules for introducing expected productivity improvements or for cost sharing on two sections of track on a hypothetical railroad over a twenty year period in the future - or with any of the other myriad of complex and expensive details that constitute the stand-alone-cost test as it is implemented in the context of U.S. freight rail regulation. Meitzen and Larson (1992) generalize this point:
Surely a simpler, more straightforward, and above all cheaper way could be chosen to protect "captive" shippers. As I suggest in the companion paper to this one (Pittman, forthcoming), one possibility would be a ceiling on the price-to-variable-cost ratio - corresponding to the floor on this ratio below which the STB lacks jurisdiction to challenge rates - that would, like the stand-alone-cost test, act as a constraint on the degree to which Ramsey pricing is permitted. In fact the STB imposed exactly such a rate ceiling as a remedy in a recent matter where the shipper was able to demonstrate that the rates it had been paying had been greater than SAC. (39) Alternatively, the literature on incentive regulation (Laffont and Tirole, 2000; Joskow, 2005) might be a fruitful source of ideas.
Baumol, William J., and Robert D. Willig, "Verified Statement," III Ex Parte No. 347 (Sub-No. 1), Coal Rate Guidelines - Nationwide, May 11, 1981.
_____, John C. Panzar, and Robert D. Willig, Contestable Markets and The Theory of Industry Structure, New York: Harcourt Brace Jovanovich, 1982.
Borrmann, Jörg, and Klaus G. Zauner, "Cross-subsidization when Firms Are Allowed to Make Non-zero Profits," International Journal of the Economics of Business 11 (2004), 241-247.
Christensen Associates, A Study of Competition in the U.S. Freight Railroad Industry and Analysis of Proposals that Might Enhance Competition, prepared for the Surface Transportation Board, November 2008.
Fanara, Philip, Jr., and Curtis M. Grimm, "Stand-Alone Cost: Use and Abuse in Determining Maximum U.S. Railroad Rates," Transportation Research-A 19A (1985), 297-303.
Faulhaber, Gerald R., "Cross-Subsidization: Pricing in Public Enterprises," American Economic Review 65 (1975), 966-77.
_____, "Cross-Subsidy Analysis with More than Two Services," Journal of Competition Law and Economics 1 (2005), 441-448.
Freeman, James W., "The Ties That Bind: Railroads, Coal, Utilities, the ICC, and the Public Interest," Transportation Law Journal 14 (1984), 1-38.
Gaskins, Darius W., Jr., "Regulation of Freight Railroads in the Modern Era: 1970-2010," Review of Network Economics 7 (2008), 561-572.
Grimm, Curtis M., "Merger Analysis in the Post-Staggers Railroad Industry," in P. Carstensen and B. Farmer, eds., Competition Policy and Merger Analysis in Deregulated and Newly Competitive Industries, Cheltenham, UK: Edward Elgar, 2008.
Heald, David, "Contrasting approaches to the 'problem' of cross subsidy," Management Accounting Research 7 (1996), 53-72.
Joskow, Paul L., "Incentive Regulation in Theory and Practice: Electricity Distribution and Transmission Networks," working paper 05-18, AEI-Brookings Joint Center for Regulatory Studies, September 2005.
Kahn, Alfred E., The Economics of Regulation: Principles and Institutions, New York: Wiley, 1971.
Laffont, Jean-Jacques, and Jean Tirole, Competition in Telecommunications, Cambridge, MA: MIT Press, 2000.
Lenard, Thomas M., Monica M. Bettendorf, and Stephen McGonegal, "Stand-Alone Costs, Ramsey Prices, and Postal Rates," Journal of Regulatory Economics 4 (1992), 243-262.
Meitzen, Mark E., and Alexander C. Larson, "The uses and abuses of stand-alone costs," Utilities Policy 2 (1992), 135-148.
Pittman, Russell, "Russian Railways Reform and the Problem of Non-Discriminatory Access to Infrastructure," Annals of Public and Cooperative Economics 75 (2004), 167-192.
_____, "The Economics of Railroad 'Captive Shipper' Legislation," Administrative Law Review 62 (forthcoming).
Sidak, J. Gregory, "Declaration" before the U.S. Federal Trade Commission, Postal Service Study, Project No. P071200 (n.d.; 2007?), at 35.
Tirole, Jean, The Theory of Industrial Organization, Cambridge, MA: MIT Press, 1988.
Winston, Clifford, Scott M. Dennis, and Vikram Maheshri, "Duopoly Equilibrium Over Time in the Railroad Industry," unpublished paper, September 2007.
1. In a companion paper (Pittman, forthcoming), I discuss legislative proposals to increase the protections offered to captive shippers by removing the partial antitrust exemption currently enjoyed by U.S. freight railways.
2. Major Issues in Rail Rate Cases, STB Ex Parte No. 657 (Sub-No. 1), October 30, 2006, at 5-6, emphasis added, citations omitted.
3. 1 I.C.C. 2d 520 (1985).
4. Major Issues in Rail Cases, at 6-7.
5. Ibid. at 7, emphasis added.
6. BNSF Railway v. STB, U.S.C.A. (D.C. Circuit) No. 06-1372, May 20, 2008.
7. Consolidated Rail Corp. v. U.S., 812 F.2d 1444 (3d Cir. 1987), at 1463 (Becker, J., concurring in part).
8. Simplified Standards for Rail Rate Cases, STB Ex Parte No. 646 (Sub-No. 1), September 4, 2007, at 5. See also Gaskins (2008).
9. West Texas Utilities Company v. BN Railroad, 1 S.T.B. 638 (1996), at 13-14 (parentheses in original).
10. Ibid. at 14 (footnotes omitted).
11. FMC Wyoming Corporation and FMC Corporation v. Union Pacific Railroad, STB Ex Parte No. 346 (Sub-No. 29A), May 10, 2000.
12. Major Issues in Rail Cases, at 61-66.
13. BNSF Railway v. STB (2008).
14. Arizona Electric Power Cooperative v. STB, U.S.C.A. (D.C. Circuit), No. 05-1136, July 18, 2006, at 2; see also Pennsylvania Power & Light Co. vs. Consolidated Rail Corp, Decision, ICC Docket No. 38186S, July 24, 1984.
15. Ibid. at 24-39.
16. Western Fuels Association and Basin Electric Power Cooperative v. BNSF Railway, Decision, STB Docket No. 42088, February 17, 2009, at 17-18.
17. West Texas Utilities Company v. BNSF Railway Company, STB Decision, Docket No. 41191, September 2007, at 7.
18. 49 U.S.C. 10701(d)(3).
19. Simplified Standards for Rail Rate Cases, STB Ex Parte No. 646 (Sub-No. 1), September 4, 2007, at 4.
20. Ibid. at 13.
21. Coal Rate Guidelines, Nationwide, at 5, 9.
22. PPL Montana v. STB, U.S.C.A. (D.C. Circuit) No. 04-1369, February 17, 2006, at 9.
23. See also Sidak (2007): "The stand-alone cost test and the related incremental cost test are two standard methods in the economics of regulation for detecting the presence of cross-subsidy. Gerald Faulhaber formally proposed both tests as a part of an economic framework developed for cross-subsidization analysis in a classic 1975 article." (p. 35; emphasis and footnotes removed)
24. Thus Borrmann and Zauner (2004) seem to be simply incorrect when they argue that "There is a fundamental ambiguity in Faulhaber's (1975) concept. Is cross-subsidy about fairness or about market entry?" (p. 246, fn. 1)
25. Baumol and Willig (1981), at 74; Kahn (1970), at II:220-224.
26. The principal reason for the importance of this question is the showing by both Faulhaber and BPW that in the presence of a zero profit constraint and under the assumption of efficient operations, if one group of shippers is paying more than SAC, it necessarily follows that some other group is paying less than its incremental cost - i.e., is being subsidized. See, e.g., Faulhaber (1975), BPW, Lenard, et al. (1992), and Meitzen and Larson (1992).
27. Coal Rate Guidelines, Nationwide, at 8, quoting testimony by Baumol.
29. Ibid. at 9.
30. Union Pacific - Control and Merger - Southern Pacific, STB Finance Docket No. 32760, Decision No. 44, August 6, 1996, at 116-17.
31. Dakota, Minnesota & Eastern Railroad Construction into the Powder River Basin, STB Finance Docket No. 33407 (3 S.T.B. 847; 1998 STB LEXIS 968) (December 10, 1998), citing 49 U.S.C. 10901(c) and Tongue River R.R. - Rail Construction & Operation - Ashland to Decker, MT, STB Finance Docket No. 30186 (Sub-No. 2) (Nov. 8, 1996).
32. See U.S. Federal Railroad Administration, "FRA Administrator Denies DM&E Powder River Basin Loan Application Citing Unacceptable Risk to Federal Taxpayers," February 26, 2007.
33. Dakota, Minnesota & Eastern Railroad Corporation Construction into the Powder River Basin, 3 S.T.B. 847 (1998), at 7.
34. Ibid.; see also the subsequent STB decision granting approval for construction following investigation of possibly averse environmental impacts, Dakota, Minnesota & Eastern Railroad Corporation Construction into the Powder River Basin, 2002 STB LEXIS 74, and the decision granting final approval for construction following court appeal and remand, Dakota, Minnesota & Eastern Railroad Corporation Construction into the Powder River Basin, Decision, STB Finance Docket No. 33407, February 15, 2006.
35. Coal Rate Guidelines, Nationwide, at 9.
36. Major Issues in Rail Rate Cases, at 7. See also Freeman (1984), who asks why, "where competition does not exist, it is [reasonable] to define maximum rate levels on the basis that nonexistent competition will keep them reasonable."
37. See also the more basic microeconomic presentation in Pittman (2004).
38. See especially Mid States Coalition for Progress vs. STB, 345 F.3d 520 (8th Cir. 2003) and Dakota, Minnesota & Eastern Railroad Corporation Construction into the Powder River Basin, Decision, STB Finance Docket No. 33407, February 15, 2006.
39. Western Fuels Association and Basin Electric Power Cooperative v. BNSF Railway (2009), supra note 16. See also the similar ceiling imposed in West Texas Utilities Company v. BN Railroad (1996), supra note 9.