; Regulation of Railroads
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Regulation of Railroads


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									Regulation of Railroads
Complaints of Farmers
Many U.S. farmers in the West hated the railroads. Since the railroads were built in part to help farmers
ship their products, why would farmers hate them? Farmers were angered by what they called price
discrimination, practiced by many railroads. Price discrimination occurs when a seller sells the same
product, with the same cost of production, at different prices. Farmers accused railroads of charging low
rates in long hauls where there was great competition and charging high prices on short hauls where
there was no competition. Farmers also complained that railroads were able to get away with these
unfair practices because public officials were corrupt.

Were The Complaints Valid?
There are examples in U.S. history of railroads engaging in price fixing pools, price discrimination,
kickbacks, rebates, and outright bribery. The question of interest is whether the higher prices typically
charged to farmers resulted from price discrimination made possible by monopoly power. Another
possibility is that the prices were a reflection of the railroads’ actual cost of production. Railroad
officials argued that it cost more to serve farmers in the South and West. Unlike eastern manufacturing,
farming was seasonal. Crops required peak loading at harvest time. Many train cars were required. Also,
farm shipping usually involved one–way movement of crops to the East. The cars made the return trip
empty, increasing the cost of providing the service. Also, shipping in the East usually required fewer
cars in an area of the country where the number of cars available was greater. The number of railroad
cars serving the manufacturers in the East tended to be greater than the number of railroad cars serving
the West and South. Thus, the railroads were able to charge manufacturers lower prices.

Were Trunk Lines Natural Monopolies?
When railroads worked together to fix prices, the result was formation of a monopoly or a cartel. A
monopoly or cartel has the power to limit production and set prices above competitive levels, increasing
its profits. Railroad cartels were sometimes successful in the short run when the number of companies
was small. But, as soon as competitors laid track and entered the market, cartels failed. Why were
railroads interested in forming cartels or monopolies? The incentive for railroads to form monopolies
has something to do with railroad trunk lines. In the days before interstate highways and air travel,
railroad trunk lines were examples of natural monopolies. Trunk lines are tracks running between distant
points. For example, a railroad track from Chicago to New York would be a trunk line. A natural
monopoly occurs when production of the product or service requires extremely large capital investments
and when one firm can produce at a lower cost than can be achieved by several firms. This seems to
have been the case with regard to the railroad trunk lines. It didn’t make sense to run two sets of tracks
between distant cities when one would do. Similarly, today it seems to make little sense for each oil or
gas company to build its own pipelines when one would do.

A Role for Government
In the case of a natural monopoly, government regulation is used to try to ensure a fair price to the
consumer and a fair rate of return (profit) to the producer. However, the precise form of government
regulation may vary.

Destroying Natural Monopolies
Natural monopolies are often defeated by new technology. For example, new developments in trucking,
interstate highways, and air travel all fostered competition with railroad trunk lines. More recently,
satellite communications, microwave relays, and optical fiber systems have broken down the natural
monopoly once found in long distance telephone services.
The Economics of Government Regulation
Response to Complaints
Many U.S. farmers were convinced that railroads had become their enemy. What could farmers do to change the
practices of the railroads? They began to push for political action. Government responded to the complaints of
farmers by passing several new laws.
1. Granger Laws set maximum rates for railroads and grain elevators in the 1870s.
2. In 1877, the U.S. Supreme Court affirmed states’ rights to set rates charged by railroads in Munn v. Illinois.
3. In 1886, the U.S. Supreme Court, in Wabash, St. Louis, and Pacific Railroad v. Illinois eliminated state
   regulation and focused attention on Congress for regulation.
4. The Interstate Commerce Act of 1887 was passed by Congress. It was the first large–scale effort of the federal
   government to regulate transportation including the efforts of railroads to reduce competition and charge
   differential rates.
The Act created the Interstate Commerce Commission (ICC), made up of five members appointed by the
President and the confirmed by Senate.

Regulation Offers New Incentives
In a market economy, businesses expect to increase their profits by improving efficiency or expanding production.
Government rules can introduce new opportunities for increasing profits. How? Producers and employee groups
in a regulated industry can try to increase profits by seeking favorable rules from regulatory agencies—rules
restricting competition in their market. Once legislation is passed and regulatory agencies are established, the
public has little incentive to be greatly concerned with regulatory actions. The public tends to believe that the
problems in a particular industry are being adequately addressed. And the effects of particular regulatory
decisions, spread out over the public at large, may appear to have little impact. Unlike the public, producers in
regulated industries have vital interests at stake. Consequently, they pay very close attention to the actions of
regulatory agencies. After all, favorable actions can mean increased profits or losses, more or fewer jobs, and
protection from competitors. It is not a surprise that special interest groups, business leaders, and employee
groups in a regulated industry exert a disproportionately large influence on the political process. Over time, by
supporting political campaigns and speaking about their problems to members of Congress and the President, they
can succeed in ―capturing‖ a regulatory agency. This happens when regulators, those appointed to be ―watch
dogs‖ in an industry, have incentives to establish rules that favor the interests of business leaders and employee
groups over the interests of consumers at large. Higher prices are a common result.

Was the ICC “Captured”?
The Interstate Commerce Commission (ICC) was established in 1887 to regulate the railroad industry.
Representatives of the railroads engaged in intense efforts to influence appointments to the ICC. Did the ICC
become a ―captured‖ agency? You decide, based on the following steps taken by the ICC:
1. Entry of new railroad companies into the market was limited (which limited competition).
2. Regulation was extended from trunk lines (natural monopolies) to shorter, or branch, lines where there was a
   greater potential for competition. This extension of regulation limited price competition through price fixing
   and pooling.
3. The ICC used the stated objective of equalizing rates over different routes to set uniform rates that were above
   what competitive levels would have been. Higher prices resulted in decreased production and excess capacity.

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