COSTING AND RATE-SETTING IN THE NETHER-LANDS' RAILWAY SYSTEM

By C. J. OORT

There seems to be a growing tendency, among transportation expertsas well as politicians, to regard the co-ordination of transport almost entirelyas a matter of costing. It is argued time and again, in national committeesand in international councils, that we could approach the correct, i.e. themost efficient, division of traffic between competing means of transportationonly, if all rates are based 'squarely and unambiguously' on the totaleconomic cost of providing the service. No more than some very basiceconomics seems to be needed to show that only rates based on cost will leadto a rational allocation of the national resources. A modest dose of rhetoric,using the time-honoured bogy of discrimination and the more moderneconomic taboo of ' distortion' to prove the wickedness of any other pricingrule, completes the case. Of course, most people realize that the breakdownof total cost into components which are meaningful for the purpose of rate-setting meets with certain difficulties. It is, in fact, quite fashionable todiscuss at length such profound (and in most cases insoluble) problems as theallocation of fixed costs, joint costs, and other indivisible items.1 But thesequestions are almost invariably regarded as essentially of a technical nature, tobe solved by further research into technical cost-relationships and by evermore complicated costing conventions.

Economic theory shows that this approach contains at best only a half-truth, but its basic philosophy nonetheless pervades almost every discussionof transport policy. How much sense does it make and where does it gowrong from the economist's point of view? At the outset, the theoreticalwelfare economist will be inclined to argue that the popular view makes verylittle sense indeed. The only cost that can be meaningfully attributed to anyparticular transport operation is the social cost that would be avoided if theservice were not performed. This is by definition equal to the marginal(social) cost of providing the service, a concept which has no place in conven-tional costing procedures. Generally, marginal cost will coincide neither withfully distributed cost, nor with any of the costing experts' measures of directlyallocable costs, since the latter are all calculated not as differentials but asaverages at some standard level of output.2 Marginal cost pricing is mostemphatically not what the experts mean when they argue that the co-ordin-

'Cf., for example, the lengthy study of the E.C.E. Inland Transport Committee, 'TheProblem of Cost in the Inland Transport Industry'.

'In all fairness it should be noted, however, that the 'direct-costing' method, partic-ularly in some of its recently developed versions, appears to go a long way towards recon-ciling accounting practice and economic theory. Cf., for example. J. S. Early, 'RecentDevelopments in Cost Accounting and the "Marginal Analysis", Journal of PolithalRconorny, 1955, pp. 227-242.

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ation of transport should be achieved by means of rates based on the cost ofservice. Since the rather devastating critique of welfare economics by Littleand others, even the theoretical economist will not feel very confident aboutrecommending marginal cost pricing without at least qualifying his statementwith a long list of assumptions concerning the distribution of income, externaleffects, second-best problems, etc. These qualifications, however, wouldseem to carry less weight in cases when marginal cost pricing is employedmainly to regulate the relative position of close substitutes, as in thç area oftransport co-ordination.' Economic theory, therefore, would seem to supportmarginal cost pricing as the best policy with respect to the co-ordination oftransport.

This leaves us, however, with the difficult and controversial 'total-costissue'. If marginal cost pricing does not cover total costas it often will not,for example in the case of the railwaysshould prices be raised above mar-ginal cost in order to cover total cost and, if so, how should this be done? Itis sometimes argued that the problem is not a real one because, according tothis argument, increasing returns necessarily involve the existence of excess-capacity. If the excess-capacity is deliberately maintained as a public service,its cost should be covered out of general revenue. Unintentional over-capacity is by definition a temporary matter which involves a once-for-allcapital loss, but does not give rise to a deficit in terms of true economic(opportunity-) costs. This position, which denies the existence of long-rundecreasing costs, would seem to be untenable. True long-run increasingreturns may occur whenever there are important indivisibilities among thefactors of production. In such cases productive capacity comes only in largeblocks (e.g. a branch line) which can generate large quantities of output.It is quite conceivable that an indivisible asset will pay, when the services itrenders are priced at average cost (indicating that the asset is certainly worthits social cost), but that it will operate at a deficit under marginal cost pricing.Since the asset involved cannot be considered excess-capacity (the consumersbeing willing to pay for its full economic cost), we have here a clear case of themarginal cost dilemma. The problem cannot simply be dismissed as a conse-quence of over-investment. The same applies to the closely related proposi-tion, that no deficit will occur when prices are based on long-run marginalcost. In the long run, it is said, 'all fixed as well as all variable outlays enterinto marginal cost'. Of course, this argument is based on a confusionbetween variable Cost and marginal cost. There is no reason at all, except inthose cases where the increasing returns are due to temporary excess-capacity,why long-run marginal cost should be higher than short-run cost or why theformer should be just equal to average total cost.2

Granted that the marginal cost dilemma is a true long-run problem and

1 For a recent statement to the same effect, see E. J Mishan, Welfare Criteria forExternal Effects', Americai Economic Review, Sept. 1961, pp. 595-96 (note 3).

These and related problems I have treated in more (jetait itt my paper ThéorieMarginaliste et les Prix de Transport Rotterdam, 1960,

COSTING AND RATE-SETFING IN NETHERLANDS' RAILWAY SYSTEM 107

granted that the railways operate under conditions of increasing returns,should they be required to cover total cost out of revenue? Basically, thisinvolves the intriguing problem of investment criteria which has been dis.cussed in a previous issue of this journal.' For the present I shall regretfullyleave this question out of account and simply assume that for whateverreasonsinvestment criteria, efficient management, requirements of thegovernment budgetit is considered desirable that the railways shouldcover their total cost out of revenue. The only question remaining on thepresent level of abstraction is: should the railways maximize their profits orshould they simply cover total cost? In practice, this does not seem to be avery pressing problem, since most railways are run at a substantial loss; theywould be quite fortunate if they were able to eliminate their losses.

The Netherlands' railways provide one of the rare exceptions to this rule.This appears to be due in part to a relatively favourable situation on thedemand side; although competition from road haulage is certainly as stiff, andfrom water transport even more intense than in many other countries, thedemand for passenger transport provides a more important source of revenuethan it does elsewhere: in fact, more than half of total revenue is derived frompassenger services. In part, too, the sound financial position of the Nether-lands' railways would seem to be attributable to the relatively large degree ofcommercial freedom which they enjoy both with respect to pricing (i.e. inthe area of freight charges and in the area of investment.2) However, even inthe case of the Netherlands' railways, the profit position is not such as toworry politicians or economists with its welfare implications.

It seems reasonable, therefore, to consider total-cost pricing in the caseof the railways as equivalent, for all practical purposes, to a policy of profitmaximization. This implies in the first place that every output should beproduced at the lowest possible cost. Obviously, costing studies and researchinto alternative techniques play an exceedingly important role in any attemptto raise the efficiency of railway operations. In the field of pricing, however,cost analysis has to yield first place to the analysis of demand conditions. Ishall attempt to prove this contention in the following paragraphs, where Ishall refer in particular to the actual charging policies practised by the Nether-lands' railways.

In any analysis of railway pricing it is useful to consider separately thepricing of passenger services and of freight, since the economic characteristicsof these two groups of transport operations differ quite markedly. Passengerrates on most railways are government controlled; they are usually setaccording to fairly rigid traditional pattern, consisting of a uniform priceper kilometre with reductions on return fares and season tickets. Freight

'BULLETIN, November 1960. vol. 22.Z It is not due, as is sometimes thought, to government protection of the railways.

Road haulage is subjected to restrictive licensing, but its sole purpose, in theory as well asin actual fact, is the prevention of over-investment. Investment in inland shipping is notrestricted, but all business is conducted through a shipping exchange, which regulates pricesin accordance with supply and demand conditions.

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rates, on the other hand, are potentially more flexible, since most countriesallow at least a certain measure of differentiation according to the serviceperformed and the type of good carried.

Dividing our problem in this manner to most railwaymen appears toimply the need for a criterion which would enable them to distribute totalrailway costs among passenger services and freight. The 'fully distributedcost' figures which are often employed in this context would, however, seemto have only a limited economic relevance (as contrasted to their politicalsignificance!), since they are based on essentially arbitrary conventionsconcerning the division of joint costs. For example, signalling costs might bedivided in proportion to trainkilometres, track costs in proportion to tonkilo-metres (weighted by the average speed of passenger trains and freighttrains), engine costs in proportion to unweighted tonkilometres, etc., etc. Thetheory behind these conventions is often not unreasonable. Although veryrarely sufficient data are available to prove the case, it is assumed that theassets involved deteriorate with use in the proportions indicated. This mayor may not be technically correct, but economically it is largely irrelevant if,as one would suspect, the accumulated value of the actual wear and tear fallsshort of the total economic cost of the assets. In fact, it is the essence ofincreasing returns that this should indeed be so, i.e., that there should be aresidue of costs (interest charges, deterioration due to the mere lapse of time,etc.) which would remain uncovered if true wear and tear, i.e. marginal cost,were charged. In addition, there are other indivisible joint costs which cannotmeaningfully be imputed to the two separate operations at all. There is noreal economic reason why these residual costs should be divided among thetwo categories of railway services in proportion to marginal cost.

In this, as in many other cases, much of cost allocation would seem to belargely a matter of self-deception. It is relatively harmless, as long as itconsists simply in juggling with indivisible costs such as to allocate them tothose categories of output where the optimum price exceeds direct costanywayalthough what the point of this exercise is, other than for ex-postaccounting purposes, has always eluded me. It becomes dangerous, however,when management attempts to use fully distributed cost figures for thepurpose of rate-setting. It is all too easy to forget that the whole procedurerests on essentially arbitrary accounting conventions, that the allocation ofindivisible costs is a veil behind which rates are (or should be) set on the basisof marginal cost and the elasticity of demand.

The previous discussion is not intended as an argument in favour ofcharging whatever the traffic will bear in excess of marginal cost. The scopeof profitable discrimination in the area of passenger rates is severely limitedon account of practical as well as economic and political factors. But therewould seem to be a good case for diverting the efforts now spent on allocatingindivisible costs to research into marginal cost on different routes and atdifferent times of day, week and year, so as to determine whether somepassenger rates are not systematically below marginal cost (e.g. low-priced

COSTING AND RATE-SETFING IN NETHERLANDS' RAILWAY SYSTEM 109

season tickets for travel at peak hours) and others unprofitably far above it.Some differentiation of rates along these lines could well be applied in prac-tice, while it might lead to a social gain (diverting peak demand to times ofsurplus capacity) and to an improved financial position of the railways.

The Netherlands' railways do not apply such differentiation, but neitherdo they attempt to divide the indivisible. Passenger services and freight areeach charged with their respective direct costs, the remainder being treatedas a residual to be recovered out of passenger and freight revenue according tothe conditions of demand. If the general level of passenger fares is no longerconsidered optimal, an adjustment will be proposed on the basis of theover-all financial position of the railways, without any appeal to fully distri-buted cost figures. The internal structure of passenger rates has occasionallybeen adjusted (e.g. the reductions on return fares have recently been lowered),but the traditional pattern of uniform charges per kilometre has so far beenmaintained.

There is obviously far more scope for differentiation of charges in thefield of freight services. Granted that the railways are obliged to cover theirtotal costs and that they can only hope to do so by a policy of profit maximiz-ation, they should ideally apply discrimination of the first degree in thePigovian sense, that is, attempt to appropriate all rent incomes which derivefrom their services.1 In general, perfect discrimination can be applied orapproached only by way of a two-part pricing scheme, charging a price perunit equal to marginal cost and a (discriminating) fixed charge which extractsthe full amount of each consumer's surplus. In the case of the railways, thisprocedure is facilitated by the fact that the curve of an individual firm'sdemand for railway freight services is strongly kinked. Up to a point the firmconcerned prefers shipping by railway to all alternative possibilities open to it(such as shifting to a competing carrier, moving to a different location,abandoning operations altogether). I shall refer to this price as the finn's'shift price'. Assuming that the demand for the firm's product is not veryelastic with respect to freight charges (these generally being only a fractionof the total cost of the product), the rate charged will hardly affect the firm'stotal demand for freight services. Since at any price below the shift price alltraffic will move by rail, the firm's demand for railway freight services will behighly inelastic up to that point. At the shift price, however, one of thealternatives becomes operative and the firm's entire demand for freightservices is shifted away from the railways. Under these conditions a priceper unit of service, consisting of marginal cost plus a (discriminating) péageequal to the consumer's surplus expressed per unit of service, will do just aswell as a two-part pricing scheme.

It is tempting to look upon this as a two-step method of cost allocation.Marginal cost serves as a basic charge, differentiated according to the cost

1 An excellent discussion of discriminatory pricing by the railways is contained in aiaper presented by D. L. Munby at a railway conference at Nice (October 1961). RailwayCharges and the Co-ordination of Transport.'

Cs

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characteristics of the particular type of service involved (load factors, timing,routing, special handling, etc.). The surcharge is then determined by aprocess of allocating the 'non-marginal 'residue of total cost.1 This approach,however, would seem to be rather misleading in that it gives undue weightto the element of costing; it is apt to cause the illusion that rates are set on the'objective basis of cost'. In fact, the allocation of non-marginal costs is aresult of pricing; it can never be a means towards arriving at a correct policy-decision. Charging-policy sht.uld be aimed at contracting with each customerat a price equal to, or just below his shift-price. This involves primarilyresearch into demand conditions, particularly concerning the price and therelative efficiency of alternative means of transportation. It is not a matter ofcosting at all, except to the extent that marginal cost determines the floorbelow which a contract should not be accepted. Everything else should bea matter of evaluating the individual shift prices.

In very broad lines this is the theory behind the system applied by theNetherlands' railways with respect to freight charges. Of course, perfectdiscrimination is unattainable and impracticable. A small part of freighttrafficmainly small irregular consignments, for which special bargainingwould not paymoves at fixed published rates. These rates are historicallydetermined; on the whole, they bear little relevance to the modern conditionsof competition on the transportation market. They are, however, of littlepractical relevance, since by far the greater proportion of freight is carried atprices set by individual contract. A study of freight charges on the Nether-lands' railways is therefore primarily a study of the manner in which theterms of the individual contract are arrived at.

A contract will usually be concluded in three stages. At the first stage, therailways executive in charge will meet with the potential customer in orderto determine the latter's shipping requirements in complete detail. He willalso attempt to get some idea concerning the customer's shift price. Hisprovisional evaluation of the shift price will later be corrected or confirmedon the basis of the data, available to the railways, concerning the prices andthe relative efficiency of alternative means of transportation.

The second act is played entirely behind the scenes. After the mostefficient method of routing the traffic involved has been established, thecosting department determines the minimum price below which the contractshould not be offered. This minimum price is closely related to the econom-ist's concept of marginal cost, since in principle only those costs directlycaused by the traffic concerned are taken into account. There are some differ-ences, however, which can be explained by the requirements of a simple andrelatively quick costing procedure. Out of all the separate operations whichare needed to produce the total stream of transport services required by thecustomer concerned, many are evaluated not at their true marginal cost butat a standard rate, derived as an average cost at normal capacity. In the

'Cf., for example, J. C. Bonbright, Fully distributed Costs in Utility Rate Making,'American Economic Review, May 1961, pp. 305-312.

COSTING AND RATE-SETTING IN NETHERLANDS RAILWAY SYSTEM I I I

case of wagons, for example, it simply wouid not pay to differentiate betweentrue marginal cost and average cost per transport-operation. The differencebetween the two will in general be small, and the information required forprecise marginal cost pricing is usually not available. For example, in mostcases, it can hardly be foreseen whether wagons will have to be expresslyprovided for the transport in question or whether they will be on an emptybackhaul anyway. The same applies to a number of other operations. Onlythe contributions of the larger indivisible unitstrack, signalling, adminis-tration, etc.are evaluated at the estimated marginal cost of their use (includ-ing the cost of congestion, such as extra shuntings, etc.) at the time andbetween the points specified by the potential customer's transport require-ments. The minimum price thus arrived at is therefore a hybrid, consistingof true marginal cost as regards the larger indivisible assets and of averagedirect cost with respect to the contributions of the remaining factors.

In a few exceptional cases, however, when there are sound a priori reasonsfor supposing that a more refined method of costing may lead to a substantiallylower minimum price, a different procedure may be followed. If, for example,it is known that the proposed traffic runs in the opposite direction of an exist-ing preponderantly one-way traffic stream, or if it is known to be concentratedin seasons of low demand, a good case can be made for costing the use ofwagons and engines at no more than the additional cost of traction. It has beenfound, however, that very often later developments change the underlyingsituation (traffic streams, seasonal patterns, etc.) to such an extent, that thesespecial prices become sub-marginal and the traffic is carried at a loss. Therailways are, therefore, justifiably reluctant to apply the more refined method ofcosting except in very especially convincing cases.

At the final stage of the contracting process, the commercial departmentwill quote a price to the potential customer which will be just below what therailways estimate to be his shift price, unless the minimum price exceeds thislevel. In the latter case, the contract will be offered at the minimum price; ifthe railways' evaluation of the shift price was correct, the contract will thenpresumably fail to be accepted. It should be noted, however, that very oftenin this system cost analysis will turn out to have little operational significancewith respect to pricing. The minimum price as established by the costingdepartment only provides the floor below which a freight contract shouldnot be offered. The actual prices charged are in the great majority of casesdetermined not by the floor of cost, but by the estimated shift prices of thecustomers.

The experience of the Netherlands' railways seems to show that underconditions of increasing returns a rational charging system, which aims atcovering total cost out of revenue, cannot be based on considerations of costalone. Non-marginal cost cannot be meaningfully allocated to the separateoperations of the railway system. Under these conditions the commercialinterests of the railways and the precepts of welfare economicsgranted thatwe want the railways to reach independent budgetary equilibrium without

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restraint of competitionboth point towards a differentiation of freightcharges according to the elasticity of demand. Inevitably, therefore, theemphasis in railway charging should be placed on the analysis of demandrather than on costing. At the same time, this implies that railway freightcharges should be determined by individual contract. Published rates couldin theory produce the same pattern of differentiation as results from thesystem of individual contracts, but in practice published rates are less flexibleand they inevitably create pressures towards more uniform charges. Thisendangers the budgetary equilibrium of the railways, while it denies both to therailways and to its customers all traffic which does not move at the publishedrate but which at a lower price would be profitable to both parties.

University of Utrecht