Recovering capital expenditures: The railroad industry paradox

Following deregulation in 1980, the U.S. freight railroad industry invested large amounts of capital, expanded output and increased earnings, but—paradoxically—it did not earn a competitive return on investment. As a result, investors became increasingly wary of expanding investment in this industry, even as demand for rail transportation services continued to grow. In recent years, investment has been constrained, capacity has become more restricted, prices have risen, and returns to investment have improved but continue to fall below the industry's cost of capital. This research examines the possibility that railroad capital expenditures represent an incremental cost of traffic that was, and may continue to be, substantially underestimated in industry calculations of marginal cost. As a result, railroad pricing strategies may rely on overstated contribution ratios that do not consider the full incremental capital cost associated with each shipment. Because railroads invest more capital, as a percentage of revenue, than any other major industry sector, they are particularly vulnerable to such miscalculations. All variable costs (expenses and investments) must be included in marginal cost calculations if the economic value of the firm is to be maximized in the way it prices its goods and services. This research combines engineering, economic, and financial methods and makes contributions in each area. Railroad maintenance strategies that rely more heavily on capital investment are more cost effective. Infrastructure capital spending is caused by current and future output, and is therefore a short run marginal cost. Railroad marginal cost formulae appear to substantially underestimate the true incremental nature of ongoing capital expenditures. Regulatory average variable cost formulae do not incorporate variable capital expenditures suggesting that Surface Transportation Board estimates of revenue to variable cost are overstated, subjecting a larger share of rail traffic to potential economic regulation than would otherwise occur.