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Game theory provides a framework for analyzing problems when there are a small group of participants. This is unlike the economic model of perfect competition, which requires several participants. Game theory began as a way to analyze parlor card games but has developed into a rigorous analytical technique for evaluating strategic interactions. These interactions could be between hostile countries, competing companies or between a shipper and railroad. In fact, game theory provides a useful structure for analyzing the interactions between a shipper and a railroad. To frame a problem in game theory terms, we must consider what strategies each player might employ. We also need to determine the sequence of play: whether the players interact simultaneously or whether one player moves first and the other reacts. Finally, we must calculate payoffs each player gets from the interaction of those strategies to identify the likely outcome. The issue to be analyzed is the strategic interaction between a railroad and a shipper. The railroad provides services that the shipper uses for input to its production. The shipper has alternatives for some of the railroad’s services, which could be other modes or even other railroads. However, there are many instances when there are no alternatives. This creates market power for the railroad and has precipitated the implementation of railroad regulation. 3 We can frame the railroad-shipper interaction as a game with 2 players. The railroad moves first and has two strategies: price to avoid litigation or price to maximize profits. In this paper the railroad’s ability to short run profit maximize is limited by the shipper’s ability to re-source its transportation through a competitive build-out. In response, the shipper has 3 strategies: 1. Accept the railroad’s offered price 2. Invest (build-out) to achieve access to the nearest competing railroad and gain a competitive price 3. Litigate the offered price at the regulatory agency (Surface Transportation Board) As a simplification, we can say that if the shipper accepts the railroad’s rate, the shipper will sign a contract that locks in that price for a fixed term. A build-out requires the shipper to accept the offered rate for the duration of construction. However, once the build-out is complete, competition between the railroads will drive rates down to marginal cost. Litigation requires the agency to determine if the offered rate exceeds a rate reasonableness standard. The paper develops a model of this type of regulatory interaction. The model provides a tool to analyze the decisions of two parties. The railroad aims to maximize its profits. The shipper wants to minimize its costs. The railroad offers a rate and then the shipper chooses to either accept the price, build-out to gain competitive entry or litigate at the regulatory agency. The 4 model is used to analyze a series of different cost assumptions on each strategy.


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