When Discrimination Is Good: A Comment on Ukrzaliznytsia’s New Tariff Policy

Currently the debate in Ukraine concerns legislation in parliament that would reorganize Ukrzaliznytsia along European lines: the opening up of the infrastructure to multiple train operating companies, competing with each other for the business of freight shippers, a model of railways organization sometimes called “vertical separation.” Under these circumstances, the tariffs charged for rail service by the train operating companies would likely be set freely, but the tariffs for use of the infrastructure – the “access price” – would likely be regulated.

The recent article in VoxUkraine by Andreii Shkliar on the future freight tariff policies of Ukrzaliznytsia (“Ukrzaliznytsia’s New Tariff Policy: How to Find a Balance with the National Economy,” October 19, 2015) raised some very important issues – none, I think, more important than the potentially beneficial role of price discrimination in the railways sector.

In many aspects of our lives, we consider “discrimination” to be wrong. It is generally wrong, most of us believe, to “discriminate” against a person of a different race, nation, religion, gender, or sexual orientation, for example by denying them service in a restaurant or refusing to rent them a flat. And it seems, if not wrong, then at least a little unfair, for a business to charge me 1000 hryvnias for a product or service when it charges you 500 hryvnias for the same product or service.

And yet economic discrimination of this sort takes place all the time. Restaurants may offer “senior citizen discounts”; bars may offer “happy hour specials”; and I will likely pay less for my airline ticket if my dates of travel are flexible or far in the future than you will if you are buying your ticket for travel today. While some of these differences may reflect differences in cost, they also likely reflect the ability of businesses to increase their revenues and profits by charging higher prices to those whose demands are more intense or less flexible.

In the case of an enterprise with high fixed costs, like railways, price discrimination may even be a necessary tactic for economic survival, and especially for the earning of sufficient surpluses to cover both maintaining the infrastructure and expanding the system – two extremely high priorities for Ukrzaliznytsia going forward. As Mr. Shkliar explains, discrimination in this situation has been well analyzed by economists, and often takes the form of something called “Ramsey pricing”, after the great British economist Frank Ramsey.

Ramsey pricing in the railways sector looks like this:

1. Shippers of bulk commodities like iron ore and coal typically are dependent on the railway to both bring in their inputs and send out their outputs; motor carriers cannot economically handle their business, even in countries with much better highway systems than that of Ukraine. Thus most railways around the world “mark up” the tariffs of trains carrying these products a great deal over their variable cost; the shippers have no good options – their demand is “inelastic” – and will pay the marked up tariffs.
2. On the other hand, shippers of containers or boxcars full of high-price manufactured goods may easily switch from railways to motor carriers if they face high rail tariffs – their demand is “elastic.” Thus most railways around the world set tariffs for such shippers at only a small mark-up above variable cost.

Is a pricing system like this “fair”? Certainly many shippers of bulk commodities do not think so. And yet note the advantages of the system:

1. Because railways have high fixed costs, they must mark up their tariffs a good deal over their variable costs to some customers; otherwise they will not be able to maintain and expand their systems. (Governments sometimes make up the difference, but these days there are very many demands on government budgets, in Ukraine as much as anywhere, so that governments have not turned out to be a reliable source of railway capital spending.)
2. If the railways try to mark up the tariffs of shippers of containers or manufactured goods much more above their variable costs, these shippers will abandon the railway and ship by motor carrier –remember, their demand is “elastic”. And in this case both the railway and the shippers of bulk commodities are worse off – railways have more difficulty meeting their revenue requirements, and shippers of bulk commodities are threatened with deteriorating service or even losing their sole means of economic transport entirely.
3. So long as all iron ore shippers pay similar mark-ups, this discrimination does not harm competition in iron ore markets. The same is true for other commodities so long as discrimination is across rather than within particular commodity groups.
4. There are certainly limits to how much the shippers iron ore (and coal, and steel) can pay for rail transportation and still remain competitive in their domestic or export markets – but it is very much in the interest of the railway to understand this, so as not to lose this very valuable business.

For all these reasons, it is actually the policy of the US freight rail regulator, the Surface Transportation Board, to encourage Ramsey pricing by freight rail shippers, as the most efficient (or, equivalently, the least costly) way for the private railroads that carry freight in the US to pay their bills, including those on their very heavy capital requirements.

As readers of previous articles in VoxUkraine by Svitlana Zabolotska, Jefferson Sinclair, and myself are aware, the US freight railways, like those of Canada, Mexico, and Brazil, are vertically integrated enterprises – they run their own trains over their own infrastructure. I have argued for the consideration of such a system of organization of the railways for Ukraine, but that is not the point under discussion here.

Currently the debate in Ukraine concerns legislation in parliament that would reorganize Ukrzaliznytsia along European lines: the opening up of the infrastructure to multiple train operating companies, competing with each other for the business of freight shippers, a model of railways organization sometimes called “vertical separation.” Under these circumstances, the tariffs charged for rail service by the train operating companies would likely be set freely, but the tariffs for use of the infrastructure – the “access price” – would likely be regulated. This does not change the principles discussed above – it just moves them to a different step in the vertical chain. Under a system of vertical separation between train and infrastructure operations, it is perfectly sensible – even desirable, for the reasons just presented – to allow at least some discrimination in the access prices charged to different train operating companies.

Now, it is important to be very clear what this does not mean. It does not mean that the new Ukrainian infrastructure company should be able to charge higher access prices to private train operating companies than to its old friends at the restructured Ukrzaliznytsia train operating company. It does not mean that the new Ukrainian infrastructure company should be able to charge higher access prices to private train operating companies owned by people belonging to one political party, or loyal to one region of the country, than those of another. It does not mean that the Ukrainian infrastructure company should be able to charge higher access prices to trains owned by foreign firms – by the Policy railway PKP or the German railway DB, for example – than it charges to Ukrainian trains. Such differential charges would be “discriminatory” in the bad sense, potentially creating significant distortions to competition, and should be protected against by the National Commission for Transport Regulation or the Antimonopoly Committee of Ukraine. As Mr. Shkliar argues eloquently, a strong regulatory policy insisting on transparency will play an important role here.

On the other hand, as I and others have argued, a very high priority for the Ukrainian railways going forward will be to generate the revenues and profits – the margins over variable costs – necessary to fund a great deal of maintenance and expansion work on the track network. As in other countries, the government budget of Ukraine has not been a reliable source of such funds in the past – this is one reason for the poor state of the infrastructure, with bottlenecks in crucial locations – and it is not more likely to be a reliable source in the future. It seems almost inevitable that if future Ukrainian economic growth is to be supported by a vibrant, efficient rail system, the moneys to restore and maintain that system will come from the private sector. And it seems to me that that likely will mean some form of discrimination in the good sense – Ramsey pricing, or something like it, in the setting of infrastructure access charges.

One final word. If discrimination in access charges take the form of “good” discrimination – of something like Ramsey prices, so that all iron ore shippers pay equally higher tariffs, and competition within the iron ore sector is not harmed – does this mean that the Ukrainian rail infrastructure operator should face no limits in how high it may set such charges? In the US and Canada, at least, the answer would be “no”. It is a perfectly consistent policy to allow discriminatory pricing but to set limits on the degree to which the most inelastic demanders may be discriminated against. Such limits are set generally by what is called the “stand-alone-cost test” in limited circumstances in the US and by price ceilings and mandatory binding arbitration in limited circumstances in Canada. Under the railways restructuring policy currently under debate by the parliament, the railways infrastructure company seems likely to enjoy market power or even monopoly power over bulk shippers and the train operating companies that carry their products, and the prevention of monopolistic exploitation will be another important task for the regulator.