American manufacturing firms became large, multiunit enterprises in two ways, by adding marketing and purchasing offices or by merger. The first embodied the strategy of vertical integration. The second was almost always an expression of the strategy of horizontal combination. The first aimed at increasing profits by decreasing costs and expanding productivity through administrative coordination of the several operating units. The second aimed at maintaining the profits by controlling the price and output of each of the operating units.
In the United States horizontal combination rarely proved to be a viable long- term business strategy. The firms that first grew large by taking the merger route remained profitable only if after consolidating, they then adopted a strategy of vertical integration.
Nearly all enterprises that grew by merger followed the same path. They had their beginnings as trade associations that managed cartels formed by many small manufacturing enterprises. These federations then consolidated legally into a single enterprise, taking the form of a trust or a holding company. Administrative centralization followed legal consolidation. The governing board of the merger rationalized the manufacturing facilities of the constituent companies and administered the enlarged plants from a single central office. The final step was to integrate forward into marketing and backward into purchasing and the control of raw or semifinished materials. By the time it completed the last move, the consolidated enterprise was employing a set of lower, middle, and top managers to administer, monitor, coordinate, and plan for the activities of its many operating units and for the enterprise as a whole. By then the visible hand of management replaced the invisible hand of market forces in coordinating the flow from the suppliers of raw materials to the ultimate consumer.
American manufacturers took this road at different speeds and in different ways. A few charted their courses with deliberation. A greater number moved from one step to the next in response to specific and immediate business problems. Some completed the course within a relatively short time. Others dawdled along the way for two or three decades. Nevertheless, very few American mergers remained large or profitable unless they followed this road to its logical end—that is, unless they moved beyond a strategy of horizontal combination to one of vertical integration. Even then they rarely became and remained powerful business enterprises unless they were in industries employing mass production technologies for mass national and global markets. Only in such industries did the advantages of administratively coordinating high-volume flows provide continuing market power.
In reviewing the history of the enterprises that followed the merger route, two points need to be kept in mind. First, mergers on a national scale appeared only as the railroad and telegraphic network went into full operation in the 1870s and 1880s. By lowering transportation barriers, the railroads permitted many small enterprises to compete in the national market for the first time. At the same time the telegraph and then the tele- phone helped to make possible centralized supervision of a number of geographically scattered operating units.
Second, until the passage of the Sherman Antitrust Act in 1890 and, indeed, until the act’s interpretation by the Supreme Court, horizontal combination did not violate federal law. Until the 1880s only ill-defined and difficult to enforce concepts of common law provided any legal restraint to the formation of such cartels. In the 1880s a few states passed antimonopoly laws. It was, however, not until the Supreme Court handed down its decisions on the Sherman Act that effective legal action could be taken against nationwide combinations in restraint of trade.1
American manufacturers began in the 1870s to take the initial step to growth by way of merger—that is, to set up nationwide associations to control price and production. They did so primarily as a response to the continuing price decline, which became increasingly oppressive after the panic of 1873 ushered in a prolonged economic depression. That longterm price decline reflected the complex interaction between the supply of money (including the velocity with which it was used in making trans- actions) and the rapid expansion of output.2 Industrial output soared as manufacturers widely adopted the new factory form of production. The wholesale price index on all commodities fell from 151 in 1869 to 82 in 1886, on farm products from 128 to 68 in the same span of years, and on metals and metal products from 227 to 110. To most manufacturers the only practical response to rising output and falling prices was to form national associations to maintain prices by curtailing production.
By the 1880s these federations had become part of the normal way of doing business in most American industries. Trade associations for the purpose of controlling price and production had appeared in the mechani- cal industries, including those making lumber, woodware, flooring, furni- ture, even caskets, and those producing shoes, saddlery, and other leather products. They came, too, in the refining and other chemically oriented industries—those producing petroleum, rubber footwear, explosives, glass, paper, and leather; and in the foundry and furnace industries—those making iron, steel, copper, brass, lead, and other metals. In addition, they occurred in industries fabricating metals into bars, wire, rails, nails, sheets, and all types of metal implements and machines. In the hardware indus- tries alone, over fifty different trade associations managed cartels for as many specialized products (see table 5).3 No industry appears to have been immune. Only in textiles, apparel, publishing, and printing were the number of trade associations small.
During the 1870s and 1880s, manufacturers working through their trade associations devised increasingly complex techniques to maintain industry- wide price schedules and production quotas.4 The associations allocated specific markets to different firms. They followed the example of the railroads by forming money pools in which each was allocated a specific amount of income. Those that sold less than their quotas were paid the difference out of profits contributed to the pool by those that sold more than they had been allocated. They set heavy fines for making false reports or not providing complete records of sales and profits. In addition, the manufacturers’ associations worked closely with individual wholesalers and selling agents and with the trade associations of wholesalers also being formed in these years.
But, as in the case of the railroads, the manufacturers and their marketing allies found these horizontal combinations difficult to maintain. The temptation always existed to increase returns by cutting prices through secret rebates, by falsifying reports, or by failing to record sales. Often after the association appeared to have successfully stabilized prices, manufacturers would leave the cartel, openly cutting prices to obtain more trade. Basically, the industrial cartels failed for the same reason as did those in railroads. The agreements did not have the binding effect of a legal contract. They could not be enforced in courts of law.
Whereas the railroads had responded to this problem by urging state and federal legislation to legalize pools or cartels, the manufacturers turned to developing tighter legal controls over the members of cartels. Owners of the leading firms in an industry purchased stock in each others’ enterprises and in the smaller companies in their trade association. Stock ownership permitted them to look at the books of their associates and thus better enforce their cartel agreement.
Yet this strategy had its weaknesses. Buying into other companies was expensive. Often, too, the new stockholders were still uncertain whether the company accounts they had access to were accurate. Moreover, firms were often still partnerships, whose control could not be obtained through the buying of shares. Nor did stock purchasing rectify the greatest weak- ness of the cartel. None of these trade associations could make decisions concerning the internal management of the individual firms. Nor could they decide where to build new plants or to shut down or modernize old ones. In other words, the associations managing cartels could not make either day-to-day operating or investment decisions for their members. They were merely federations of legally independent enterprises whose representatives met weekly and monthly to set price and production schedules.
Source: William H. Becker, “American Wholesale Hardware Trade Association, 1870- 1900,” Business History Review, 45:183 (Summer 1971). This list makes no pretense at completeness. Associations came and went too quickly and the trade press was too limited to record them all. The major sources are Iron Age, 18731880, and the Hardware Reporter, 1879-1880. For the 1880s sources are rather limited, but what data there are indicate that there were a large number of associations. American Artisan, Hardware, and Hardware Dealer are the major sources.
More effective control over the companies in the combination required the merger of the constituent firms into a single legally defined entity. If this entity owned the majority of the stock of constituent companies, the board of the new overall enterprise could then institute and maintain more rigorous control over their operations. It could also consolidate and rationalize manufacturing facilities of the several subsidiaries.
The obvious legal form to meet these needs was the holding company— the device first used by railroads to merge hitherto independent corpora- tions. The difficulty was that the formation of a company to hold stock in other companies required a special act of a state legislature. As many manufacturers were planning to use the device to strengthen existing cartels, they did not want to risk the publicity required in order to get a special act through a legislature. Nor could they expect legislators to endorse their plans with any enthusiasm.
So the trust was born. By this device a number of companies turned their stock over to a board of trustees, receiving in return trust certificates of equivalent value.5 (Constituent companies that were still partnerships had to incorporate in order to have the stock necessary to make the exchange.) The board of trustees was then specifically authorized to act as a board of managers with the power to make operating and investment decisions for the constituent companies that had entered the consolidation.
The trust was, however, only a temporary expedient. It quickly came under attack in state and federal courts and in state legislatures.6 What was needed was a general incorporation law that permitted the formation of holding companies simply by filing a few outline forms and paying a standard fee. The New Jersey legislature quickly obliged. In its session of 1888-1889, that body modified the state’s general incorporation law to permit manufacturing companies to purchase and to hold stock in other enterprises within and without the state, and to pay for property owned outside the state with stock issued for that purpose. A year later the United States Congress, responding to the increasing protests against the cartelization of so many American industries, passed the Sherman Antitrust Act, declaring illegal “combinations in the form of a trust or otherwise in restraint of trade.” Immediately the “New Jersey holding company” took the place of the trust as the legal form used to merge a number of single-unit enterprises operating facilities in several states into a single, large consolidated enterprise. The holding company, like the earlier trust, provided the legal form to maintain tighter control over a federation of small, single-unit, single-function manufacturing firms. Such legal consolidations also provided the first essential step in the transformation of such federations into modern industrial enterprises by means of administrative consolidation and centralization.
Source: Chandler Alfred D. Jr. (1977), The Visible Hand: The Managerial Revolution in American Business, Harvard University Press.