A Look at Railroad Costs, Scale Economies, and Differential Pricing (Summary)

Excerpts: Setting and regulating prices in the rail industry is challenging. Economists typically refer to “marginal cost pricing” (i.e., setting price equal to marginal cost) as a kind of benchmark for functioning markets. However, in the case of railroads, marginal cost pricing would cause railroads to go out of business. Railroads have exceptionally high fixed costs and common costs that make marginal cost pricing unprofitable. High fixed costs and common costs also mean railroads experience economies of scale—as they increase their output, their per-unit costs fall, at least up to a point. Thus, at high levels of output (and low per-unit costs), railroads can lower their average per-unit prices while remaining profitable. However, at low levels of output (and high per-unit costs), railroads must maintain higher per-unit prices overall. As both rail rates and railroads’ revenue adequacy have increased in recent years, so, too, have calls for reforming various elements of rail regulation. This study of the rail industry’s cost structure is an attempt to help rail analysts and regulators accurately assess the extent of economies of scale in the industry and their implications for prices charged to shippers. The report is also a potential resource to inform current policy debates. The study presents a nontechnical explanation of cost concepts, discusses the role of cost in rail pricing, and empirically examines costs in the rail industry.