Railroads and the Market Economy: Economy of Scale and Regulation

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Businesses having a large number of customers can dramatically increase profits with small changes to the price. This simple economic fact led to railroad regulation.

Everybody knows that in the early days of railroading in America a few tycoons who came to be popularly known as the “Robber Barons” made untold (some would say obscene) profits transporting passengers and cargo. This was a natural result of providing a needed and valuable service to millions of customers in an unregulated market economy. It is what is sometimes referred to by economists as “economy of scale”. In short, if you have 100 million customers, and you make an extra penny of profit off of each of them, you make a million dollars, small pricing differences which the market can easily bear can mean huge profit margins.

In 19th Century America, a million dollars was a lot more than it is today. Some thought these profits were unearned and/or undeserved. Ideas about the free market were changing. 1848 was the year of socialist revolutions and the peak of socialist propagandists in Europe. This was generally settled by a compromise between “capital” and “labor” resulting in a variety of similar European governments which came to be known as “Social Democracies”. The social democratization of Western Civilization gave critics of “laissex-faire” market economies added voice. It took longer for these voices to be heard in America, but when they were the clamor was to regulate the railroads and stop the “Robber Barons.”

This eventually led to the formation of the Interstate Commerce Commission, or ICC in 1887. It’s mission was to regulate railroads, fix price ceilings, and generally prevent them from making a profit that would be considered excessive. Even under regulation railroads continued to expand in America until 1916 when they reached a peak of about 254,000 miles of track. They were then nationalized during WWI, during what many would consider the height of the Progressive Era. After the war when control of the railways was returned to their owners they found themselves with poorly maintained tracks needing millions of dollars worth of repairs, and ICC price controls preventing them from raising their rates to pay for them.

Thus, American railroads entered the Great Depression in poor financial condition, and continued to fare poorly until WWII. The war gave them a brief respite. The fever for nationalization had passed, and some railroads showed profits in the war years, but the worst was yet to come. Throughout the 1950’s and 1960’s the ICC maintained regulation that was often irrational when related to the market conditions. Competition from improved roads and waterways was taking market share from railways already in trouble from fixed rates that were too low to maintain long term operations. By 1970 large portions of the American rail system were operating as debtors in possession under bankruptcy protection. Their complaint was that under the regulations on passenger rates they suffered continuous losses that were no longer offset by freight traffic. Amtrak was supposed to be the solution but freight only railroads remained regulated and in trouble. The 1970’s were dark days for railroads in America.

In 1980 the story came almost full circle when the Stagger Rail Act was passed. It basically cancelled the ICC’s 93 year mission of preventing the railroads from making large profits under monopolistic conditions since those conditions no longer existed, and returned almost full management decision making powers for railways to their owners. Not surprisingly, competition in the market place soon found the right price and railroads began to recover. By 1998 they were carrying all time record loads. The moral of this story is that regulation only works sometimes, and that lassaiz-faire always works, but large scale businesses make large scale profits, and that still seems to offend people who believe that large profits are unjust.