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.