The Surface Transportation Board (STB) applies the theory of contestable markets to regulate dominant railroad freight movements. The STB bases its determination whether railroad avenues are excessive if they would be more than sufficient to support the investment in a hypothetical stand-alone railroad designed to handle the at-issue traffic efficiently. The STB regulatory approach does not take correct account of the importance of sunk costs and irreversible investments in the railroad industry. We estimate how large the mistakes can be by applying a real options approach that takes into account the effect of sunk costs, irreversible investment, and asymmetric returns.

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