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Agricultural 

Marketing 

Service

October 2015

What is the Issue?

On April 1, 2014, the U.S. Surface Transportation Board (STB or Board) announced an ex parte proceeding 

(EP 722) to evaluate the relationship between revenue adequacy and the procedures it uses to judge the 

reasonableness of railroad freight rates. The announcement raised the possibility that the Board would revise 

or supplement the Constrained Market Pricing (CMP) approach to rate regulation adopted following the 

Staggers Rail Act of 1980. In response to the announcement, USDA’s Agricultural Marketing Service (AMS) 

funded research by McCullough at the University of Minnesota to explore and explain the regulatory concepts 

that the STB would potentially change through the proceeding. 

In terms of background, the Interstate Commerce Commission (ICC)—STB’s predecessor agency-- chose CMP 

as a “practical solution” to the problem of identifying Ramsey prices for the railroad industry. Ramsey pricing 

(sometimes called differential pricing) is a theoretical ideal that economists have proposed for regulating a 

monopoly with high fixed costs when government subsidies are not available. 

Under CMP, a rail shipper cannot be required to pay more than the estimated stand-alone cost (SAC) of the 

service it receives. The SAC procedure is the process ICC and STB have used to identify the approximate 

Ramsey price. However, ICC warned at the time of adoption that this CMP approach is based on “sophisticated 

economic theories which require careful interpretation and application.” Since adoption, shippers have been 

critical of this approach, saying the SAC process is not fair because it is too expensive and time-consuming to 

be of practical use in rate disputes. 

This is a summary of Staff Paper P15-5, “Constrained Market Pricing and Revenue Adequacy: Regulatory 

Implications for Shippers and Class I U.S. Freight Railroads” by Gerard J. McCullough, Department of Applied 

Economics, College of Food, Agricultural, and Natural Resource Sciences, University of Minnesota. This paper 

was developed with funding from the Agricultural Marketing Service (AMS) through cooperative agreement 

number 14-TMXXX-MN-0030. The full paper is available at http://ageconsearch.umn.edu/handle/207766. 

Constrained Market Pricing and Revenue Adequacy: 

Regulatory Implications for Shippers and Class I 

U.S. Freight Railroads (Summary)

Bruce Blanton
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McCullough’s paper reviews the history of freight railroad regulation in the United States since 1980 and 

analyzes the development of CMP and revenue adequacy as regulatory mechanisms. The paper identifies 

several questions the STB—along with affected policymakers and rail market participants–should consider in 

evaluating the relationship between CMP and revenue adequacy. The study also provides two appendixes. 

Appendix A provides empirical estimates of the direct economic effects of a hypothetical revenue-adequacybased rate regulatory regime. Appendix B summarizes arguments made by carriers’ and shippers’ experts and 

others in filings in EP 722. 

What did the study find?

The critical economic doctrine articulated in the Staggers Rail Act and operationalized by current railroad 

regulatory mechanisms is that market-based prices (demand-side signals) are at least as important as costs 

(supply-side characteristics) in enabling the complex railroad industry network to evolve and to adapt to the 

needs of a modern economy. In applying this doctrine over the past 30 years, the ICC and its successor agency, 

the STB, have relied on CMP, which is a novel and sophisticated regulatory approach. Railroads support the 

approach, while shippers do not support it. 

McCullough’s paper analyzes the history of rail regulation and suggests several questions that STB-affected 

stakeholders should consider about the relationship between rail revenue adequacy and SAC. We discuss the 

four questions below. 

1. Does the STB’s revenue adequacy measure define a floor or ceiling for the revenues of Class I freight 

railroads?

The revenue adequacy measure developed by the U.S. Department of Transportation in the late 1970s and 

legislated by Congress in 1980 was a lower bound aimed at protecting railroads by constraining the behavior 

of regulators. The legislative history describes it as the revenue level that enables railroads to continue to 

operate as private enterprises. Revenue levels below that bound over an extended period, presumably, would 

force railroads into bankruptcy and shutdown unless the Federal Government provided support. An alternate 

description of revenue adequacy, articulated in regulations (the so-called Coal Rate Guidelines) by the ICC 5 

years later, is of an upper bound, aimed at protecting shippers by constraining the behavior of railroads. The 

ICC describes it as the highest level of revenue to which regulated railroads are entitled. Above that 

bound, the Guidelines state, “captive shippers should not be required to pay differentially higher rates than 

other shippers.”

In perfect theory, there is no direct contradiction between the 1980 congressional view of revenue adequacy 

and the 1985 ICC view. One could imagine a perfect theoretical level of revenue adequacy, a razor’s edge, 

which could serve as both lower bound and upper bound for revenue. It is difficult to imagine, though, how 

the STB could accurately determine or prudentially apply this revenue level. The Guidelines recognize this 

difficulty. They stress that revenue adequacy is a long-term concept, that railroads are subject to the business 

cycle like other firms, and that the constraint should not be used to “freeze” a carrier’s revenue at the breakeven point. On the other hand, most reasonable people would say that railroads should not be entitled to 

ever-increasing revenues with no constraint ever. Nevertheless, as the STB notes in announcing EP 722, the 

details of how they would apply constraint in rate cases have not been worked out. 
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2. Are the revenue adequacy and the stand-alone cost constraints mutually exclusive procedural 

alternatives or can they be applied jointly in STB rate reasonableness proceedings?

Derivation of Ramsey prices requires the use of a mathematical technique, which guarantees that markups 

over marginal cost cover the total economic cost of a firm’s operations. The question, though, is whether an 

accounting-based revenue adequacy constraint is consistent with Ramsey pricing—or with the CMP process, 

whether rates and subsequent revenue levels are constrained by real competition in some markets and by 

simulated competition using the SAC test in others. 

In practice, the revenue adequacy constraint and the stand-alone cost constraint have been used as procedural 

alternatives. The SAC test has been used to identify “approximate” Ramsey prices for particular sets of 

shipments. The Guidelines do not provide clear guidance on how the two constraints could be integrated into 

a single CMP procedure. Proponents of SAC might argue that a full set of existing railroad rates, arrived at 

through a combination of actual competition and SAC-simulated competition, generate revenue levels 

that are competitively determined and are therefore de facto revenue adequate. From a procedural 

perspective, however, it seems clear that one must view the two key constraints in CMP as alternative 

regulatory procedures.

3. Do the simplified procedures that the STB has adopted since the Guidelines provide reasonable 

alternatives to full SAC proceedings in cases where a defendant railroad is not revenue adequate? 

In 1996, when it first adopted simplified procedures for determining rate reasonableness, the STB warned that 

these procedures, based primarily on estimates from the Uniform Rail Costing System (URCS), were “much 

cruder” than CMP. In its 2010 Report to Congress on the Uniform Rail Costing System, however, the STB noted 

that cost-based regulatory methods would play “a more prominent role in determining whether a rate is 

reasonable and what relief a rail shipper should receive.”

Opponents of SAC have argued that the SAC test has become too expensive and too time-consuming and 

that it is time to retire the notion and replace it with a simpler mechanism, possibly a price-to-variable-cost 

ceiling. They acknowledge the difficulty of measuring variable costs but argue that URCS “is already a standard 

methodology for this.” Other economists, including the Transportation Research Board’s (TRB) Committee on 

Modernizing Freight Railroad Regulation, have been more skeptical of URCS’s ability to accurately estimate 

movement-specific variable costs. 

There is no reason why the STB could not initiate other procedural changes (e.g. not based on URCS) to 

make the SAC procedure more accessible and more efficient. However, a simplified SAC would likely still face 

methodological challenges. To approximate ideal Ramsey prices, the SAC procedure must be able to identify 

prices that lie somewhere between incremental costs and stand-alone costs. The Guidelines address this 

procedurally by giving complaining shippers the right to add non-complaining shippers to the SAC traffic group 

to share costs. They recommend that the rates paid by non-complaining shippers be allocated “on the basis of 

Ramsey principles,” but implementation of this suggestion has been contentious.
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4. Should SAC-based rate regulation be abandoned in cases where a defendant railroad is revenue 

adequate and replaced by a revenue adequacy-based procedure? 

The goal of STB intervention in captive rail markets is to duplicate the outcomes that would occur in 

competitive markets. How can the STB achieve this goal using the administrative tools at its disposal? 

One approach would require that the rate charged by a regulated railroad for an individual freight movement 

not exceed the average variable cost of that movement by an unreasonable amount. This is the revenue-tovariable cost test. It makes sense because large revenue-to-variable cost margins do not exist in competitive 

markets where they attract entry by competing firms. 

A second approach would require that the revenue a regulated railroad receives for serving a particular 

customer or set of customers not exceed the total cost of providing that service. This is the stand-alone cost 

test. It makes sense because revenues that exceed stand-alone cost in competitive markets would also attract 

entry by competing firms. 

A third approach would require that the total revenue the regulated railroad receives not exceed the overall 

total costs—capital costs included—of viable multi-year operations. This is the revenue adequacy test. It 

makes sense because firms operating successfully in competitive markets are expected to make what the STB’s 

governing statute terms “a reasonable and economic profit or return (or both) on capital employed in 

the business.”

In each of the three approaches, the STB observes the rates that a railroad charges (or proposes to charge) 

and the revenue it actually receives (or would receive under a set of proposed rates). In each of these 

approaches, though, the STB must depend on estimates of the costs involved, and this is where the difficulties 

begin. At one end of the spectrum is the difficulty of estimating the variable costs of specific point-to-point 

rail movements. At the other end is the difficulty of estimating the multi-period cost structure of a “revenue 

adequate” Class I railroad that must respond to changing operating requirements and changing investment 

horizons. Between the two is the difficulty of measuring the stand-alone costs of providing service on a 

hypothetical rail system to a particular shipper or set of shippers. 

STB faces significant potential challenges here. One is to identify which, if any, of the three regulatory 

processes allows for the accurate measurement of rail costs. The other is to identify which of the procedures

best approximates competitive market outcomes. Underlining the importance of these challenges is the TRB 

Committee on Modernizing Freight Regulation’s conclusion that none of the three potential STB approaches 

mentioned above works very well. 

The TRB Committee recommended that Congress simply eliminate the STB’s direct role in maximum rate 

determinations. It suggested that rate disputes be handled, as they are in Canada, by independent arbitrators 

and that competitive rate benchmarking replace URCS in screening rates for eligibility to be challenged.

The TRB Committee characterized the SAC process as “slow, costly, and inappropriate to many shippers.” It 

cited, as an example, the problems that grain shippers would face in using SAC.

Grain shippers in particular have argued that the design of a standalone railroad entails large 

litigation expenses that cannot be justified when a grievance involves a relatively small claim. 

In addition, these shippers, whose traffic may not be the dominant flow (or remotely close 

to it) in a corridor or set of corridors, must depend heavily on the profits generated by any 
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crossover traffic to cover common costs and lower the revenue-adequate rate as determined 

by SAC. These profit contributions, in turn, are computed from R/VC markups derived from 

the unreliable URCS. Complainant shippers can therefore face substantial uncertainty about a 

fundamental aspect of their SAC case. 

The report was even more critical of the STB’s use of the revenue-to-variable cost criteria in its Three 

Benchmark Approach and Simplified-SAC procedures, which are dependent on the “unreliable and arbitrary 

cost allocations of URCS” and offer in the words of TRB, “even less predictable decision criteria and lack even 

[SAC’s] weak conceptual basis.” The report also recommended elimination of the STB’s annual revenue 

adequacy determination, which it characterized as “ritualistic, while offering little substantive information for 

regulators or policymakers.”

When the STB announced its decision to receive comments in EP 722, it said that it would focus on two 

issues—its methodology for “determining” revenue adequacy and its “use” of revenue adequacy in rate 

proceedings. The focus of McCullough’s research was on the latter task, the potential regulatory application 

of revenue adequacy, as opposed to the regulatory measurement of revenue adequacy. Both issues are 

important, of course, and it may be that the STB will focus its decision on the measurement of revenue 

adequacy. However, as discussed in the paper, EP 722 also presents a timely opportunity for the Board to 

address fundamental questions about regulatory procedure that are of importance to shippers, carriers, the 

public, and to the STB itself.

Preferred citation:

Blanton, Bruce, Constrained Market Pricing and Revenue Adequacy: Regulatory Implications for Shippers 

and Class I U.S. Freight Railroads (Summary), U.S. Department of Agriculture, Agricultural Marketing Service, 

October 2015. Web <http://dx.doi.org/10.9752/TS215.10-2015>

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