Restructuring Regulation of the Rail Industry for the Public Interest

September 1995
To a greater extent than in the past, market forces should shape the prices and logistics of railroad services. Noncommercial services, where needed, should be based on an explicit agreement between the railway and the government, one that views public service obligations as a business relationship between a customer (government) and the supplier (railway).
Throughout the world, the rail industry historically has been one of the most extensively regulated of all sectors. Price, entry, exit, financial structure, accounting methods, vertical relations, and operating rules have all been subject to some form of government control. The public utility paradigm of government regulation has been applied on the assumption that the economic characteristics of the rail industry preclude competitive organization or the need for market responsiveness.
In the past three decades, however, policymakers and economists have become increasingly critical of traditional regulation of the rail industry. It is generally accepted that in markets where rail carriers seek to meet demand, there is often effective competition, and that government restrictions on the structure and conduct of firms in this industry impose considerable costs on society.
Misguided regulatory policies have been blamed for the misallocation of freight traffic among competing modes of transport, excess capacity, excessive operating costs, and poor investment decisions. Regulatory controls have also shouldered much of the blame for the poor financial condition of railroads, the deterioration of rail plant, the suppression and delay of cost-reducing innovations, and the mediocre quality of rail service.
Kessides and Willig suggest principles for restructuring railroad regulation --- indeed, for restructuring the orientation of railroad entities --- for the sake of the public interest.
Much can be learned, they contend, from applying the principles of industrial organization to analysis of the rail industry. To assess the implications of policies aimed at rate regulation or infrastructure investment, it is essential to understand the nature of technology, costs, and demand in the rail industry. Government's role in relation to market behavior should be based explicitly on the economic and technological realities of the railroad marketplace.
Kessides and Willig say that restructuring along the lines they suggest --- putting more emphasis on marketing effectiveness --- will result in a more profitable railway with a better chance of covering its costs for commercial services. Changing the basis for noncommercial services as they suggest will make those services more effective at fulfilling public policy objectives, will eliminate an insuperable drain on revenues that condemns rails to inadequate investment, and will eliminate cross-subsidies that make it difficult for rails to compete against other modes of transport.
This paper --- a product of the Private Sector Development Department --- is part of a larger effort in the department to analyze the regulatory issues in network utilities.