US railroads offer lessons on the perils of regulation as a substitute for 'competition'

US railroads offer lessons on the perils of regulation as a substitute for 'competition'
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An important lesson in economics is to consider the unintended impacts of policy. On Friday, The Biden administration issued an executive order with the stated aim of addressing competition in a variety of industries, including healthcare, transportation, agriculture, the internet, technology, and banks.  

Of course, competition in markets is good, enabling prices to guide efficiency in the types and quantities of goods produced, the mix of resources used to produce them, and the allocation of those goods to consumers. The executive order does include some things that will promote competition; for example, it includes a provision to reduce occupational licensing — a phenomenon that often prevents low income workers from moving up the economic ladder. However, most of what is in the executive order suggests the addition of regulation instead of removing barriers to competition. Although some industries may be characterized by situations where regulation is necessary, past regulatory experience in the U.S. shows the large potential damage that is likely with such broad increases in regulation.

The executive order is filled with statements that “encourage” or “direct” a number of government agencies to implement new rules or to monitor pricing. Examples include: directing Health and Human Services to issue “a comprehensive plan…to combat high prescription drug prices and price gouging,” directing the Department of Agriculture to consider issuing new rules aimed at “stopping chicken processors from exploiting and underpaying chicken farmers,” and to consider new rules on what meat can be labeled as “Product of USA,” encouraging the Federal Communications Commission to “limit excessive early termination fees” on internet service, and encouraging the Federal Maritime Commission to prevent shipping companies from “charging American exporters exorbitant charges” for waiting for freight to be loaded.

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While it may be tempting to think that government agencies can easily fine tune markets with various regulations for the benefit of society, the American experience shows that such attempts often cause much more harm than good. A good example is the U.S. railroad industry, an industry I’ve studied for much of my career as an academic economist. 

Biden’s executive order takes aim at the railroad industry by pointing out that 33 Class I freight railroads existed in 1980, compared to seven today. As a prescription for railroads’ ability to “overcharge other companies’ freight cars,” the order suggests pursuing regulations pertaining to “competitive access.” One version of such regulations, known as reciprocal switching, would allow the regulator (under certain circumstances) to require a railroad to carry the traffic of a customer to a competing railroad for final delivery at the request of a customer. Other, more radical versions, would require railroads to provide physical access to their lines for competing railroads.

In pointing out the decline in the number of railroads since 1980, the executive order neglects to mention several important facts. Faced with heavy regulations on pricing and service, nearly one-third of Class I railroads were earning negative rates of return on investment in 1976 and the average return on investment was 1.2 percent in 1975. This led to deferred maintenance and deteriorating service, with an estimated $4 billion in deferred maintenance in 1976. Since the industry was deregulated in 1976 and 1980, railroads have made investments of $740 billion. Railroads have been able to make these investments and improve safety as a result of increased profitability. In contrast to the poor financial performance of railroads in the 1970s, most railroads are currently earning a rate of return that allows them to continue to attract investment and innovate.

But given concerns in the executive order over railroads “overcharging” and over high industry concentration levels in general, did this lead to increased prices? The answer is a resounding no, with real railroad freight prices dropping by more than 44 percent since railroads were allowed increased pricing and operational freedom in 1980. A large body of research, including my own, shows large productivity gains in the railroad industry since 1980, with cost savings and innovations resulting from less rigid work rules, increased freight traffic densities, and increased merger activity. In fact, my most recent research highlights the importance of the rate flexibility that has enabled such cost savings. Attempts to limit the extent of pricing flexibility in the railroad industry would likely have adverse effects on costs, innovation, and service quality, and the resulting detrimental effects on railroads and their users.

In terms of the executive order’s recommendation that encourages pursuing rulemakings related to “competitive access,” previous research suggests this is a bad idea. These rules would result in large cost increases, harming the viability of railroads and their ability to make the type of cost saving investments that have benefited their users.  

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Although the executive order targets several industries in addition to railroads, the railroad experience is illustrative of the damaging effects that are likely to result in broad attempts to control pricing and services in a variety of industries. For example, a plan to “combat high prescription drug prices” could result in a decline in pharmaceutical breakthroughs that result in life saving drugs.  Rules to “prevent underpaying chicken farmers” or strengthening rules on labeling the origins of farm products are likely to lead to increased food prices.  Limiting “excessive early termination fees” by internet service providers may limit pricing and service innovations, while preventing shipping companies from imposing “exorbitant charges” to customers for the time shipments are waiting to be loaded may lead to slower and less reliable service. 

The examples above are just a few of the provisions included in the executive order.  Nonetheless they provide intuition into the types of problems that may be realized through introducing new economic regulations to a variety of industries.  It would be a huge mistake to go back to policies that aim to give broad power to regulatory agencies to attempt to determine market outcomes.  The railroad experience highlights the beneficial effects that an increased reliance on market forces can have for an industry and consumers themselves. 

John Bitzan is the Menard Family director of the Sheila and Robert Challey Institute for Global Innovation and Growth, at North Dakota State University.