45-855 Railroads, The First Big Business: Topic 6

6. The Nature of Railroad Competition
   
   
1. Railroad competition in the 19^th Century was structured by three basic facts:
   
   
   1. Railroads owned the highway and all the vehicles on the higway.
      
      
   2. Railroads had High Fixed Costs
      
      
   3. Railroads, for political and economic reasons, were not allowed to be Liquidated
      
      
2. The Railroad's Pricing Problem – The decisions of railroad managers in setting or administering their prices reflected two basic conditions:
   
   
1. The pressure of high fixed costs. Costs that did not vary with traffic volume were about two-thirds of the cost of running the railroad!
   
   
1. Interest on invested capital, salaries, insurance, and taxes were all pure fixed costs.
   
   
2. Movement expenses were pure variable costs.
   
   
3. Repair and maintenance of roadbed, buildings, bridges, etc., and station expenses were partly fixed and partly variable.
   
   
2. The existence of unused capacity.
   
   
3. These high fixed costs created an inexorable pressure to attract traffic.
   
   
4. The typical railroad often had no competition for local, short-haul freight. However, almost all large cities were served by several railroads.
   
   
5. The consequence of points B) and C) was that railroads had considerable flexibility in setting their rates. Unlike most other economic actors, the railroads tended to set prices in relation to cost rather than demand.
   
   
6. This inexorably led the railroads into setting rates that discriminated against persons, places, and types of traffic.
   
   
7. Discrimination against types of traffic: Examples


1. Value Based Pricing – One of the earliest realizations of railroad managers was that they could not charge a flat ton-mile freight rate. If they did so, the cost of shipping high value added finished goods would be too cheap and the cost of shipping bulk freight would be too expensive. If the rates were too high then lumber, coal, and minerals would not be produced since it would too expensive to ship them. If the rates were too low, then manufacturers of finished goods would be getting a "free" ride. Consequently, detailed categories of freight quickly evolved and value based pricing became the standard.
   
   
2. Asymmetric Traffic – Traffic on many railroads was asymmetric, more freight was shipped in one direction than the other. Consequently, since some empty cars had to be pulled in one direction, then almost anything at any price to fill those empty cars was profitable. So it could cost less to ship an identical item from city A to city B than from city B to city A.
   
   
3. Volume – Because moving a full as opposed to a partially full car was approximately the same cost, lower rates were charged on carload lots.
   
   
8. Discrimination against places: It was very common for freight rates to be higher between towns along a railroad’s main line – especially if it was a monopoly provider – than the rates between major cities at the ends of railroad’s main line. For example, freight rates between, say, Greensburg, PA, and Altoona, PA, on the Pennsylvania RR could be higher than rates from Pittsburgh to Philadelphia. It was cheaper to ship oil from Cleveland, OH to New York City than it was to ship oil from Pittsburgh, PA to New York City. Cleveland had multiple rail lines and Pittsburgh only had the PARR (the B&O’s line into Pittsburgh could not handle enough traffic to bother the PARR).
   
   

1. Oyster Example – Not every case of discrimination against places stemmed from monopoly conditions. A group of oystermen from a town on the Delaware coast went to the railroad (I believe it was the PARR) that had a branch line from Philadelphia to the coastal town and offered the railroad a deal. If the railroad would add an extra freight car to its regularly scheduled train to the coast and back the oystermen would supply enough oysters to fill the car. This would allow the oystermen to get their product to the Philadelphia fish market. The railroad looked at the costs and decided that at $1 per 100 pounds and a full car it would make money so they agreed to provide the car.
   
   
2. However, the railroad then discovered that the oystermen could only provide a half carload and the railroad was losing money. Rather than end the service, the railroad went to the oystermen in a second Delaware town down the coast from the first town and offered to ship their oysters at $.75 per 100 pounds. It cost about $.25 per 100 pounds to get the oysters from the second town to the first town. The result was that the railroad filled its freight car ½ at $1.00 and ½ at $.75 which allowed it to break even.
   
   
3. Is this fair? The oystermen who live further away are getting a cheaper freight rate! But any other arrangement would result in the railroad losing money and no oysters being shipped!
   
   
4. The moral of the story is that the railroads were not necessarily evil, money grubbing, exploiters of local business!
   
   
9. Discrimination against persons – Rebates and Drawbacks
   
   
1. Because of the competitive nature of the railroad business, large shippers early on insisted upon, and got, price breaks – rebates – from the railroads. These rebates varied with the number of railroads available to the shipper and the market power of the shipper.
   
   
2. A good example of this was the Standard Oil. Cleveland, Ohio was served by three railroads – the New York Central, the Erie, and the Pennsylvania. The prevailing rate in 1867 was $.42 a barrel to ship from the Oil Regions in PA to Cleveland where it was refined by the Standard. Henry Flagler, Rockefeller’s capable partner, negotiated a secret rebate of at least $.15 per barrel from the railroads (needless to say, no records survive of these transactions!). Given its volume, this gave the Standard a big competitive advantage.
   
   

3. Drawbacks – In some situations shippers were powerful enough to force the railroads to given them drawbacks on competitors. For example, in one instance the Standard Oil got a rebate of $.25 per barrel on the published rate of $.40 so its true cost was $.15 a barrel. It then forced the railroads to charge its competitors the published rate of $.40 and refund $.25 of the $.40 directly to Standard Oil. This was known as a drawback and note that it is a capital transfer from the competitors!
   
   
4. William H. Vanderbilt admitted to the Hepburn Committee (an investigation by the New York State Senate) in 1879 that all large shippers who applied for special rates normally received them. In the first six months of 1880 the New York Central system granted 6,000 special rates.
   
   

10. The Perversity of Rate Competition
    
    
1. By 1873 nearly all the railroads had excess capacity. Consequently, prices on competitive through traffic quickly dropped below rates on local non-competitive business. Because of the over capacity, one railroad’s gain was another’s loss so rate wars were severe.
   
   
2. Railroads with high bonded debt would cut rates to generate cash to pay the interest on their debt thereby forcing the stronger, better capitalized, roads to match freight rates. The weaker road would then go into bankruptcy and, with protection from its creditors, would cut rates further. The problem was that federal judges (bankruptcy, unless the Congress permits the States some flexibility, is a U.S. government concern) were very reluctant to allow the physical liquidation of a railroad’s assets because of the political implications! Once towns had service, they did not want the railroad to disappear! As a practical matter most Railroads were more valuable if they were left intact and running than they were if they were liquidated! In addition, during the 19^th Century there was no federal bankruptcy law that covered corporate enterprises! From 1867-78 there was a law that covered bankruptcy by individuals and merchants, but not corporations! Consequently, the federal courts were forced to innovate!
   
   
1. Beginning in the early 1870s the federal courts developed a set of rules known as Equity Receivership so that major corporate enterprises could be reorganized. This process has been outlined in detail by Peter Tufano ("Business Failure, Judicial Intervention, and Financial Innovation: Restructuring U. S. Railroads in the Nineteenth Century," Business History Review, 71:1-40.)
   
   
2. Before the 1850s Railroads were financed mostly with sales of Stock. By the Civil War most Railroads were using bonds and stock. The problem with bonds was that they carried a strict lien on the real property of the railroad in the form of a mortgage. Consequently, the bond holders were almost always senior claimants when the railroad went into bankruptcy because they held a mortgage.
   
   
3. Equity Receivership proceded as follows: the Court appointed Receivers - usually the exiting management of the bankrupt railroad. The Receivers were allowed to:
   
   
1. Break leases and contracts
   
   
2. Withhold interest payments due existing creditors
   
   
3. Obtain interim financing to keep the Railroad running
   
   
4. The Court allowed Receivers to issue Receivers' Certificates to raise cash. These allowed the receivers to borrow against the "whole estate" of the railroad and were super-senior borrowings.
   
   
5. The basic goal of the reorganization was to reduce fixed charges. This was achieved by:
   
   
1. Exchanging old securities for new securities.
   
   
2. Assessment - current holders of securities had to invest more capital.
   
   
6. A key innovation was the setting of Upset Prices by the Court. If an investor decided not to participate in the reorganization then he received a cash payment for his existing securities. The Court set the Upset Values for all the various claims on the defaulted railroad. These prices were usually set LOW in order to "encourage" broad participation in the reorganization and to increase the likelihood of success of the reorganization.
   
   

11. Because of this perverse logic of competition the railroads put together various mechanisms to fix rates to prevent the ruinous competition. They tried a number of schemes the most popular of which was freight pooling. Traffic was divided between the competing roads based upon an agreed upon formula and all roads maintained the prevailing freight rate. These arrangements more often than not broke down for obvious reasons.
    
    
12. Another solution was consolidation. This was effectively achieved in the mid to late 1890s by J.P. Morgan and other investment bankers after a devastating wave of railroad bankruptcies in the early 1890s.
    
    

11. Economic Effects of Rebates and Drawbacks
    
    
1. Promoted industrial consolidation.
   
   
2. Favored big cities with multiple railroad lines.
   
   
3. 1) and 2) led to the development of factory cities in the U.S.