The Economic Effects of the 19 th Century Monopoly AN ECONOMIC MYSTERY

Mystery The late nineteenth century was a time when business leaders used a variety of tactics in their efforts to establish monopolies in many key industries. The railroads were prominent among these concentrated industries. Fear of business collusion caused the federal government to enact laws and develop regulations to stop businesses from colluding. Yet, relatively few businesses were ever broken up by the actions of the government. What happened to all the others? Where did all the monopolies go?

Is bigger better for firms / consumers? Benefits Increasing returns to scale (economies of scale) Standard / reliable products Costs Market power by large firms Narrowing of consumer choice

Some Nineteen Century Trusts Trust: two or more firms in the same industry that work together to reduce competition American Sugar Refining Trust American Tobacco Trust Copper Trust Standard Oil Trust Steel Beam Trust United States Steel Corporation

Railroads in 1860

Railroads: Good or Bad? Good: Allow transportation of people and goods Contributed to expanded output Bad: Farmers complain they are charged more by railroads Railroads benefit from land grants and low- interest loans from U.S. government

Business Entities Type of Business Firm Is goal to max profits? Price Determination Profit Levels Pure Competitor YesBuyers and Sellers in Market Zero economic profits MonopolistYesDetermined by Monopolist Positive economic profits Cartel (Trust)YesDetermined by Cartel Positive, if collusion

Economic Concept Economic profit – includes all costs including the opportunity cost of capital, the competitive return on capital (interest) Opportunity cost – the value of the next best alternative Zero economic profit – means all costs plus a competitive rate of return on capital are covered. No profit above the competitive rate is earned – you are doing as well as everyone else. Positive economic profit – will attract competitors since you are making more than a competitive rate of return.

Discuss: A monopoly can charge whatever it wants and get away with it. Law of demand Monopoly chooses price to maximize its profits If you increase price: Earn more per unit (price effect) Sell fewer units (quantity effect) Example: Graph of demand and per unit cost

How monopoly / cartel sets price

How Monopolies Raise Price Must be willing to restrict output At higher price, sell less, but make more profit How can a cartel or trust do this?

How Can Cartels or Trusts Collude and Raise Prices Simulation: Get into groups of threes Distribute index cards; name your railroad cartel of three people Write first name and cartel name on your card

Rules Members of the Railroad Cartel can assume: Members provide identical services No costs of production (simplified) Customer must ship 10 items (simplified) Cartel agreement: The Cartel can agree to choose a pricing scheme given below Each member is to write the cartel price on the paper provided. The number written can be changed at any point prior to the time the transaction between the customer and railroad begins.

Rewards Actual Prices QuotedTotal Revenues (PxQ) $4 - $4 - $4Each firm makes $13 $4 x 3.33 = $13 $3 - $3 - $3Each firm makes $10 $3 x 3.33 = $10 $3 - $3 - $4Two firms charging $3 make $15, other makes $0 $3 x 5 = $15 and $4 x 0 = 0 $3 - $4 - $4One firm charging $3 makes $30, other two make $0. $3 x 10 = $30, $4 x 0 = 0

Decide! In your cartel: Discuss prices each person will charge How you will enforce that price I will come back to “buy” from each group.

Debriefing the Game What is incentive to collude? What is the incentive to cheat? Why do we see competition when we might suspect collusion?

Were Railroads Competitive in the 1870s? Some railroad engaged in anti-competitive practices such as price fixing. However, it remained difficult to suppress competition even in the railroad industry. Railroads added tens of thousands of miles of track in the 1870s and 1880s. Additional track provided opportunities for increased competition. Short hauls in rural areas faced little direct competition. However, long hauls between cities usually had two or more railroads in competition. Efforts by railroads to form agreements to fix their rates and find other means to reduce competition almost always failed. Aggressive managers or owners (such as Jay Gould) would break the agreements and begin price cutting. Price cutting took a variety of forms such as price discrimination and rebates. The effect to drive down rates, however, was the same.

Laws Enacted to Control Monopolies Sherman Anti-Trust Act of 1890 Clayton Act of 1914 Activity 25.1: Were Robber Barons Really Robbers? Jay Gould, James J. Hill, John D. Rockefeller, J.P. Morgan, Andrew Carnegie Price of oil fell / wages increased

Conclusions Competition makes collusion difficult to uphold. While some trusts last for a while, many others fail. What ALTERNATIVES are there for consumer => competition