Toward a positive compensation policy for rail transport via mechanism design: The case of China Railway Express

Abstract

This paper addresses one of the key challenges in the China Railway Express (CR Express) service industry, which is the asymmetry of information between the government and a CR Express operator. We formulate the CR Express service delivery problem with asymmetric information and other unique characteristics as the incentive compensation problem via the principal-agent approach. This is the first paper to develop an incentive-compatible (IC) compensation mechanism to improve CR Express service in the presence of adverse selection and moral hazard. Compared to the generic form of compensation, this paper proves that such an IC scheme with a linear compensation contract is optimal. Our optimal compensation mechanism provides a “positive incentive”, where the monetary compensation is higher for the CR Express operator with lower operating costs, as opposed to the current compensation policy, which can create a “negative incentive”. We find both underestimation and underinvestment problems, which become smaller when the CR Express operator's gross margin is relatively high. When the CR Express service level is discrete-valued, it is optimal to adopt a fixed compensation scheme. Finally, in the scenario with multiple CR Express operators, we propose a generalized Vickrey (GV) auction, which implicitly obtains both true gross margin and service level. The compensation offered by the government is indeed negative in the case of GV auction. Surprisingly, in this scenario, we find problems of both underestimation and overestimation.