On the problems of applying Ramsey Pricing to the railroad industry with uncertain demand elasticities

Abstract

Ramsey Pricing, or the Inverse Elasticity Rule (IER), has recently been proposed as a pricing strategy to improve the fortunes of the railroad industry under Interstate Commerce Commission regulation. According to the theory of Ramsey Pricing as articulated by Baumol and Bradford, rail rates would be set so that the deviation of price from marginal costs for each product or service is inversely proportional to the elasticity of demand. This paper first demonstrates that "Baumol and Bradford Ramsey Pricing" is not a practical approach to railroad ratenaking chiefly because the resulting rate structure is unduly sensitive to small changes in highly uncertain demand elasticities. Under such cirucmstances, the purported consumers' surplus benefits of Ramsey Pricing are likely to be modest and highly uncertain as well. The rail industry's proposed cure for the defects of Baumol and Bradford Ramsey Pricing, "Bayesian Ramsey Pricing", does not provide an attractive alternative. © 1983.