Saturday, December 09, 2006

My Industrial Organization Term Paper, read it if you dare

Northern Securities Company vs. United States

In 1903 the Supreme Court ruled in a 4 to 5 decision that the Northern Securities Company (NSC) had violated the Sherman Act of 1890. This came as something of a surprise to the key personalities of the NSC because it violated good law, good economic theory, good trade, and good common sense. But perhaps they should have known better. Railroads in America had always been highly politicized, with one exception. The Great Northern Railroad (GN) of James J. Hill, the only transcontinental railroad to be built without federal subsidies, without wooing hordes of bureaucrats, was also the only transcontinental railroad never to declare bankruptcy. And it was this railroad that President Theodore Roosevelt pressured the U.S. Department of Justice to prosecute for antitrust violation.

Railroad History
Building a railroad in the second half of the 19th century was a highly profitable venture. The government loaned railroads the money to build, and gave them the land to build on, plus the surrounding territory, for free. Builders were also free to contract out supply functions to other firms which they also owned and to overcharge the railroad, thereby insulating personal profits from the required repayment of the loans. They could build anywhere they wanted, and thanks to an artificial incentive structure, building in the mountains was more profitable than on flat land. Since railroads were paid for the number of miles laid, there were incentives to build winding, indirect roads.
Winding, indirect, mountainous routes define the romantic relationship many Americans have with railroads. History frequently romanticizes those aspects of our past which were mistakes. The wasteful behavior of those who were building the railroads for immediate gain resulted in grossly inefficient lines defined by high fixed costs. One such railroad was the Northern Pacific (NP) which, though running closely parallel to GN, and serving many of the same locations, was 115 miles longer from St. Paul to Seattle.
Hill’s GN was built in a completely different manner than these others. Hill bought the bankrupt St. Paul and Pacific Railroad with the long term goal of opening trade to the Orient. He did not seek out government favors, but looked to satisfy the needs of his customers. He built slowly, deliberately, exploring various possibilities “to get the shortest route on the best grade with the least curvature .” He developed a region, helping settlers get started, before moving on. He built many spurs on to his railroads, serving otherwise out of reach locations, and encouraged the use of new agricultural methods in these areas to make them more productive. Other lines were prohibited from building spurs by their charters until later. Hill’s success earned him the title of “Empire Builder” and the respect of those who dealt with him. He discovered the key to free entrepreneurship: you only get ahead by helping someone else to get ahead, too.
Hill’s closest competitor, NP went bankrupt, like all the other railroads. Not only were federal subsidies used to build these railroads, but the public was forced to bail them out, too. Collusion among railroads was not illegal before the Sherman Act. Multiple lines serving the same market frequently established agreements regarding prices. Pooling encouraged efficiency improvements such as development of spurs and standardization of gauges and other equipment. However, collusive high rates often attracted new firms into the market, as we would expect. Many of these firms built new lines anticipating a buyout by the incumbents.
The balance between collusion and competition was volatile to say the least. Rates were unpredictable and often more expensive between locations that were closer together, but not served by competing lines. The literature suggests that “what the majority of the electorate wanted in 1887 was simply stability of the railroad collusions.” Railroad customers became frustrated with the volatility in rates and pushed congress for regulation of the industry including fixed, although higher, rates. This seems unlikely. I’m more inclined to believe that the industry incumbents pushed for regulation to help protect their investments. It also seems that railroads continued to court lawmakers who helped protect their interests at the expense of paying customers. At any rate, in 1887 the Interstate Commerce Commission (ICC) was formed, making collusion the law, adding policing costs to the public subsidization of the industry, and establishing the first of many independent federal agencies.

The Sherman Act
The Sherman Act was passed in 1890. It made illegal, “every contract in the form of trust of otherwise, or conspiracy, in restraint of trade or commerce,” and monopolization, “or attempt to monopolize.” The Sherman Act has been found to lack a common law foundation. Robert Bork states that,
Congress intended the courts to implement… only that value we would today call consumer welfare… The policy the courts were intended to apply is the maximization of wealth or consumer want satisfaction. This requires the courts to distinguish between agreements or activities that increase wealth through efficiency and those that decrease it through restriction of output.

Richard Posner agrees,
The framers of the Sherman Act appear to have been concerned mainly with the price and output consequences of monopolies and cartels, whereas the common law… had a miscellany of objectives mostly unrelated and sometimes antipathetic.

This foundation becomes relevant when we examine Justice Holmes’ dissent later.
Hilton contends that the, “writers (of the Sherman Act) were uniformly hostile to the idea of generating competition among the railroads.” So when NP went bankrupt and Hill moved to consolidate it with the GN, and to complete the route by also buying the Chicago, Burlington, and Quincy (CBQ) line in 1901, he and his partners, J. P. Morgan and Edward H. Harriman, believed they were acting within the confines of the law. Harriman had attempted to keep the CBQ from Hill, and already owned the Union Pacific (UP), but was convinced by Morgan to work together by forming NSC. Harriman shared Hill’s vision for efficient railroads, making improvements to the UP line, and increased efficiencies helped both the UP and GN to cut rates.
Hill’s vision was farther reaching than most could understand. He saw himself as competing not against other railroads between Superior and Seattle, but against water shipping enterprises running from Chicago through the Suez Canal to the Orient, where he wanted to introduce American grain and other products. Thus the acquisition of the CBQ was essential to completing the route and establishing efficient carriage overland from Chicago to Seattle, and then by his own steamboat line to Japan and Hong Kong, which once completed opened up broad new markets to a wide variety of American produced goods.

Northern Securities vs. U.S.
Teddy Roosevelt may be another example of a romanticized mistake. As a charismatic leader he strengthened central control of government and encouraged imperial expansion of U.S. power. He also surprised American industry by taking on the role of “Trust Buster” to gain public approval. Thus NSC found itself under prosecution by the U.S. Department of Justice for violation of the Sherman Act. Roosevelt so desired a defeat of Morgan and Hill that he chose Oliver Wendell Holmes Jr. as his nomination to the Supreme Court just before the proceedings. Holmes’ later defection was a disappointment to the President.

The Defense:
NSC argued that their behavior did not fit the description of cartelization or monopolization as described by the Sherman Act. They believed that the Sherman Act was meant to be a codification of earlier common law. It defined monopoly according to the common law tradition, meaning a government franchise with barriers to entry. Attempts to monopolize were applications to the government for enfranchisement. Ironically, this is what Hill had been fighting against in the other railroads. The common law never found mergers to be in restraint of trade because they were not contracts, but transfers of ownership. The intention of the law-makers was relevant to the application of that law. If the law were to find NCS guilty it would declare itself too vague and without clarification, no mergers could ever happen again.
Railroads enjoyed a special protection under the law, and thus were exempt from prosecution under the Sherman Act. Since none of the other railroad combinations have been prosecuted, this combination would also be legal. If the NSC combination was illegal then so were all the combinations under jurisdiction of the ICC, retroactively. (When this failed, it nearly had the effect of destroying the ICC, would that it had!)
Economically speaking, intentions and market power of firms were irrelevant. A combination might destroy competitions without restraining trade. NCS argued that the combination was an aid to commerce and not a restraint. Granting the federal government power to regulate interstate commerce in all situations where commerce might occur would return the economy to a mercantilist state, and rob States of the sovereignty. That contracts were implicitly restraints on trade does not necessitate that they were injurious to public welfare.
NCS also questioned the procedure of the prosecution, saying the Sherman Act did not apply to transportation, only to transported goods. If the parties involved were both already involved in an industry, the Sherman Act would not apply to them. (This seems to mean that the Sherman Act was designed to prevent vertical integration rather than horizontal.) Congress did not have the power to grant monopoly privileges, though it did have the power to regulate commerce. Commerce meant intercourse, which Congress might only regulate, and only on commerce directly, not incidentally. State law did not apply to interstate commerce, though it did apply to intrastate commerce. Supreme Court precedent only judged on acts which restrained commerce directly, not indirectly.

The Prosecution:
The government’s argument stated that the Sherman Act was not a codification of the common law, but a new measure of monopoly defined as suppression of competition. Actual possession of monopoly power and method of combination don’t matter, if the combination would tend to bring about such power, and the very existence of the power to restrain trade constitutes a restraint. Monopoly could mean ownership of a controlling portion of stock.
The words “in restraint of trade or commerce”, were not confined to unreasonable acts, but extended to any and all direct restraints of trade or commerce, even if reasonable or only partial. Any combination that avoided the effects of competition might be prohibited. Railroads were not exempt from the Sherman Act.
The Sherman Act was not primarily a criminal statute, so both restitution and punishment might be sought. Congress might limit contracts in order to protect competition. An agreement or contract in the technical sense was not at all essential. Commerce also included transportation, or the means to commerce. The goal was to keep the channels of commerce open and free from restraint. The federal government could and should police industry for antitrust behavior. Government acquiescence of previous combinations did not justify this one.

The Court:
Justice Harlan delivered the majority opinion. They decided that if NSC were allowed to proceed all railroads might eventually be consolidated and the public be placed at the mercy of the holding corporation. The evidence showed a violation of the act of Congress, in so far as it declared illegal every combination or conspiracy in restraint of commerce among the several states and with foreign nations, and forbade attempts to monopolize such commerce or any part of it. This combination was, within the meaning of the act, a 'trust;' but if not, it was a combination in restraint of interstate and international commerce; and that was enough to bring it under the condemnation of the act. The mere existence of such a combination, and the power acquired by the holding company as its trustee, constituted a menace to, and a restraint upon, that freedom of commerce which Congress intended to recognize and protect, and which the public was entitled to have protected. If such combination be not destroyed, all the advantages that would naturally come to the public under the operation of the general laws of competition, as between the Great Northern and Northern Pacific Railway Companies, would be lost, and the entire commerce of the immense territory in the northern part of the United States between the Great Lakes and the Pacific at Puget sound will be at the mercy of a single holding corporation. The court was not impressed by the scheming method of a trust. The Sherman Act was not limited by a test of reasonableness.

Justice Holmes wrote a scathing dissenting opinion recognizing the amount of politicking that had led up to this case. He wrote, “Great cases, like hard cases, make bad law… because (public) interest appeals to the feelings and distorts the judgment.” Yet even his opinion may have been bent by a dogmatic dedication to the common law. He looked for precise definitions of words instead of applying economic principles, and he accepted the defense’s definition of monopoly. He concluded that the majority opinion went too far in making any combination liable under the Sherman Act and importantly resisted the atomization which occured under the perfect competition model.

This case preceded an era of centralization of government power and regulation over the lives of its citizens. The court’s decision makes antitrust regulation arbitrary due to its broad reading, and resulted in large firms holding back innovation for fear of prosecution. It also set the precedent for an attack on John D. Rockefeller and Standard Oil just a few years later. When the law is vague and subject to an unpredictable power, entrepreneurs become more risk adverse. The ICC was “left in the unenviable situation of being established to facilitate something which had become unambiguously illegal.”
Application of the perfect competition model to legal measures of competition and monopoly power were in the vanguard. Posner demonstrates that even if the model were accepted it would be difficult to demonstrate whether a merger would create monopoly power unless the various possible average cost factors were known. It is quite possible that a merger could result in expansion of supply and lower prices even if the resultant firm were to act monopolistically. The fallacies of this economic methodology in a dynamic marketplace and in relation to entrepreneurship are scarcely recognized or accepted today. Political power prefers to take a static view of the world, reserving the only opportunity for change to its own fancy.
The subsidization of railroads in America had created a monopolistic situation with limited entry to the market. The result was bankruptcy due to inefficiencies in these railroads. The solution offered was to enforce collusion, making the railroads more monopolistic by virtue of control by a single entity, the ICC. When yet another subsidized railroad failed, the NP, the only free railroad in the country, the GN, stepped in to improve efficiency and lower rates. For this, NSC was accused of breaching antitrust laws. Interestingly, Morgan and Roosevelt were later able to enter into a now-famous “gentleman’s agreement” whereby GN and NP were able to act together. It seems that political control over the factors of production was the goal all along.

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