The Railroads in 1870s-1880s: Cooperation to Control Competition

Before considering the central role that the new transportation system played in revolutionizing the processes of production and distribution, the story of the growth of the first modern business enterprises needs to be carried to its logical conclusion. Although the railroads had by 1880 been integrated into a single national network, the individual enterprises had not yet taken on their permanent form. The network was operated by a sizable number of lines of a few hundred miles in length. Then in the last two decades of the nineteenth century, the earliest and longest established roads created giant systems operating from 5,000 to 10,000 miles of track.

By 1900 these systems had reached the geographical boundaries they would retain into the second half of the twentieth century. The rapid growth of the nation’s first modern business enterprises was almost wholly a response to competition and the failure of interroad cooperation to control competition.

Competition between railroads bore little resemblance to competition between traditional small, single-unit commercial or industrial enterprises. Railroad competition presented an entirely new business phenomenon. Never before had a very small number of very large enterprises competed for the same business. And never before had competitors been saddled with such high fixed costs. In the 1880s fixed costs, those costs that did not vary with the amount of traffic carried, averaged two-thirds of total cost.25 The relentless pressure of such costs quickly convinced railroad managers that uncontrolled competition for through traffic would be “ruinous.” As long as a road had cars available to carry freight, the temptation to attract traffic by reducing rates was always there. Any rate that covered more than the variable costs of transporting a shipment brought the road extra income. Normally the only way a competing road could retain such traffic was to make comparable cuts. The weak roads whose lines were longer and less advantageously located and less efficiently managed tended to succumb first. They needed the traffic to remain financially solvent. If such tactics resulted in bankruptcy, a road actually had a competitive advantage. It no longer had to pay the fixed charges on its debt. Since American railroads were financed largely through bonds, these charges were high. To both the railroad managers and investors, the logic of such competition appeared to be bankruptcy for all.

From the start, railroad men had looked on interfirm cooperation as the way to control interfirm competition. As soon as they went into operation, the roads followed what has been aptly termed a “territorial strategy.”20 By making informal alliances with connecting and competing roads, railroad managers expected to maintain the flow of traffic necessary to assure a profitable return on the investment made in their facilities. Such alliances would permit the roads to provide the transportation services in the “nat- ural territory” they had been built to serve. Feeder lines were constructed or bought only when such alliances failed to maintain a continuing flow of traffic across their lines.

As long as through traffic expanded, a territorial strategy carried out by informal alliances worked well. But once the volume of through traffic began to fall off and competitive pressures increased, railroad managers and owners found the informal alliances inadequate. They turned increas- ingly to employing closer and more formal methods of cooperation to control competition. Only after the most concerted and most sophisticated attempts at cooperation had failed did railroaders turn in large numbers to system building as a means of eliminating the threat of ruinous com- petition.

An understanding of the later efforts of formal cooperation to control competition requires a review of the earlier policy of alliances. In the 1850s many, though not all, major roads embarked on such a policy as soon as they had, and sometimes even before they had, completed construction. Alliances with connecting roads were usually cemented by purchasing securities in the feeder lines. The Pennsylvania, for example, began in 1852 to invest in roads then under construction westward from Pittsburgh. In 1858 it already had invested $1.6 million in the Pittsburgh, Ft. Wayne & Chicago, the Steubenville & Indiana, and the Marietta & Cincinnati.27 The Baltimore & Ohio followed a similar strategy in the 1850s. So too did the first of the largest midwestern roads—the Michigan Central and the Michigan Southern. The investors in the first helped to organize and finance the Chicago, Burlington & Quincy and the New Albany & Salem; those in the second the Rock Island. Both groups next financed connecting lines across Iowa. Other lines out of Chicago, including the Chicago & Northwestern, the Milwaukee & St. Paul, and the Illinois Central, followed the same plan. In the south the Georgia and the Georgia Southern both placed funds in their westward connections.

Alliances with competing roads came as quickly as those with connect- ing ones. At the regional meetings in the mid-i850s where railroad ex- ecutives grappled with the principles of ratemaking and first determined official rates for their territories, they also agreed not to cut rates or to make excessive use of agents or “runners” to drum up business.28 However, they did little to provide means of enforcing these decisions. Only the east- west trunk lines set up an enforcing organization which was formed in 1858 after the panic of 1857 had reduced traffic and increased competition. However, it accomplished little before it was abandoned during the Civil War.29

After the war these informal alliances began to be strained. Not only did through traffic become increasingly critical for a road’s profit, as has been indicated, but also there were often several alternate routes where before 1861 there had been one. Feeder lines felt less reliance on or allegiance to their sponsors. A desire for independence and financial needs led them to look to other sources for carrying their goods. At the same time, other major roads began to ally themselves to or even take over the feeder lines of competitors. In fact, the attempt of Jay Gould in 1869 to take control of the Pennsylvania’s connections west of Pittsburgh caused the Pennsylvania’s president to create the first great self-sustaining system in the United States. However, except for the Baltimore & Ohio, no other American road followed the Pennsylvania’s example until the 1880s.

For more than a decade American managers continued to hope to con- trol competition through cooperation. They preferred to stick with a strategy of alliances rather than turn, as had the Pennsylvania, to the building of a giant system. The managers opposed expansion because they considered any road much over five hundred miles in length to be too large and complex to manage. The investors were even more adamant. The cost of such expansion could only result in reducing the funds available for dividends. In addition, investors and managers agreed that there was another reason for not building giant railroad enterprises. They concurred with J. Edgar Thomson’s arguments for maintaining the Pennsylvania system of alliances before 1869:

Sensible of the prejudice against large corporations since the failure of the United States Bank, the policy of this Company was first directed to the procuring of these connections by securing the organization of independent railway companies, and their construction by such pecuniary assistance as was required to effect this business. This course, it was confidently expected, would meet the objects desired without involving this company in the direct management of distant enterprises.30

Nevertheless, in the early 1870s many roads were having increasing difficulty in maintaining their strategy of alliances. In the trunk line terri- tory competition was not yet a critical problem. Paul MacAvoy, the most careful student of trunk line competition, has noted that until 1874 there was “a general adherence to official rates in large volume shipments.”31 But in the south, roads found themselves buying or building more track than they wanted to in order to maintain their territorial position.32 And in the west, where so much of the through freight consisted of the grain trade, some companies were devising new techniques to maintain rates. They had set up informal pools for allocating traffic and profits. Such allocations, they reasoned, removed the incentive for rate-cutting, since lower rates could not bring either increased traffic or more revenue. In 1870 the Burlington, the Rock Island, and the Chicago & Northwestern set up an informal unsigned money pool—the Iowa Pool—that divided equally between the three roads 50 percent of the income from freight, and 55 percent from passenger traffic.33 In September 1874 the three roads connecting Chicago and St. Paul adopted similar pooling procedures. As business fell off, other roads in the country began organizing informal traffic and money pools.

With the onslaught of the depression after 1873 nearly all managers and investors agreed that informal cooperation was no longer adequate.

With the increasingly desperate search for traffic, rate agreement collapsed. Secret rebating intensified. Soon roads were openly reducing rates. Nor were the informal pools able to maintain rates. Their members took traffic that was not allocated to them and often failed to return income to be redistributed by the pool. Some railroad managers argued that the Pennsylvania had the right answer. They urged their boards of directors to build comparable large, self-contained interregional systems. To most managers, however, the problems of administering such a giant enterprise still appeared formidable. For nearly all investors, the costs of such system-building in the depressed years when dividends were already low seemed prohibitive. In the mid-1870s American railroaders grasped at another solution to meet the threat of ruinous competition. They decided to transform weak, tenuous alliances into strong, carefully organized, well- managed federations.

Source: Chandler Alfred D. Jr. (1977), The Visible Hand: The Managerial Revolution in American Business, Harvard University Press.

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