Growth of Industry After the Civil War

Growth of Industry after the Civil War Changing Industry Structure Capital/labor ratio 1840 1.0 1850 1.24 1860 1.82 1870 2.25 1880 2.51 1890 3.78 1900 4.56 Increased importance of capital in manufacturing, leads to bigger firms • Technological Change – # of steam engines doubled from 1860 to 1880 and then doubled again from 1880-1900 – Electric power began to replace steam power in late 1880 – By 1890 could power machines with electric motors Changing Industry Structure 4 Largest Industries in Value Added (1914 $) 1860 1920 Cotton Goods 58.8 Machinery 575.6 Lumber 54 Iron and Steel 492.8 Boots Shoes 52.9 Lumber 393.4 Flour and Meal 43.1 Cotton Goods 363.7 Increase in importance of industries outside agriculture and increase in size. Changing Industry structure • Some of this change is predictable – Income elasticity of food is low – Income elasticity of manufactured goods is higher Changes in Firm Structure • Increase in Plant size – Increase in K/L ratio • Increase in Firm size – Multi-plant firms – Vertical integration – Merger Movement starts in late 1890s-1904 • New forms of Ownership – Modern corporation • All of these trends are related Increase in firm size • Due to technological change • Two examples, Steel and Oil Steel Industry • Innovations – Bessemer Process and open hearth process kept iron in liquid form though out process of making steel • Result was increase in size of Blast Furnaces and increase in steel production – 1860 Blast furnaces produced 6-10 tons of pig iron per day. By 1910 average production was 500 tons per day Steel Industry • Large increase in steel production and big decrease in price of steel rails 1873 $120/ton 1898 17/ton 1902 28/ton • Decrease in price of machinery made of steel – Price of farm machinery falls over 50% from 1870 to 1910 Two types of Vertical Integration • Blast furnaces and steel plants integrate – Producers of pig iron integrate forward into steel production – Allowed pig iron to be transferred to steel plant in molten form – Big Firms • Even as early as 1870 only 10 firms producing steel in US • In 1901 US Steel has 65% of market • Backward integration into iron mining and processing Oil Industry • Before Civil War, most oil is used for lighting – 20% from coal – 80% whale oil • Civil War disrupts whaling, increase in oil prices (First US energy crisis) • Increases incentives to drill for oil – Oil is discovered in PA, big decrease in price • 1880, 66% of families use oil for heating Oil Industry • Crude oil is refined into kerosene • 1860 1 million barrels, cost $12-16/barrel • 1900 63 million barrels , cost < $1/ barrel Vertical Integration • Refiners first use railroads to distribute oil • By 1880 refiners integrate forward into pipelines and backwards into oil production • By 1890, fully integrated Other industries • Tobacco industry – Bonsack cigarette machines 60,000 a day, much more than could have been rolled by hand. • Grain processing machines lead to modern cereal industry • Leads to new functional areas in the firms, especially in marketing and distribution networks – Chandler Firm Growth • Growth can happen as a result of increase in plant size – Economies of Scale – New technologies change shape of average cost curve Average costs $ Av Cost 1 Av Cost 2 q1 q2 Q Technological change causes average cost curve to shift from 1 to 2. Firm size should shift from q1 to q2. We would expect a decrease in price of product. Firm growth • Firms could also grow large to increase monopoly power. (Ability to set price above marginal cost) • Firms could also achieve power to set price above marginal cost through price fixing agreements. – If there are no economies of scale this would be cheaper than increasing firm size either through growth or merger. – Such agreements were not initially illegal. (Trusts become common) Vertical Integration • Why determines the functions included in a firm? • What is the nature of the firm? – Coase says the firm is a non-market organization where decisions are made by management – What determines which functions will be done inside the firm and which will be contracted out? – Assumption is firm will choose the least cost way • Technological change alters the costs – Steel plant • See increases in vertical integration during this period • Will this increase market power? – Firm is larger, but market share will not increase, unless vertically integrated firm is more efficient Legal ChangesRise of the corportation • Prior to 1880, most firms in the US were owner managed firms which were not incorporated. • Increase in the number of incorporated firms begins after the Civil War • Change in the types of firms that are incorporated, large industrial firm – First jt. stock companies are trading companies or banks or railroads What does it mean to be incorporated? • Corporation – Ownership in the firm can be sold to many investors – Firm is a legal person. – Limited Liability, Firm’s liability is not the owners’ liability • Early Jt stock companies do not have limited liability Benefits of incorporation • Spread risk over many owners • Diversification • Shares can be traded – Incorporation and stock market growth go together – Before 1890, there were few industrial stocks traded on New York exchange – By 1914, rare to find a large industrial firm which was not publically held Costs of incorporation • Separation of Ownership and Control • What keeps manager’s acting in the shareholders best interest? How does incorporation take place? • In England, an act of parliament • In US choice between incorporation by legislative charter or general incorporation laws – Early general incorporation were restricted to certain business types or states • Incorporation laws liberalized in first in New Jersey in 1889 Changes in Industry Structure • Increase in size of firms, both vertically and horizontally and change in structure of firms cause concern about monopoly power • Trusts (Organizations of firms to control price and output) and mergers also caused concern • Sherman Antitrust passed in 1890 • Outlawed “every contract, combination in the form of a trust or otherwise or conspiracy in restraint of trade…” illegal. • Also made it illegal to monopolize or attempt to monopolize an industry • Not clear what this meant. Determined by the courts Important Cases • 1899 Addyston Pipe and Steel Company v. United States ruled cast iron pipe pool illegal • Price fixing is illegal per se – only defense is “we did not do it” • Economist agree that cartels create nothing but dead weight loss • What about mergers or large firms? • 1904 Northern Securities ruled mergers for monopoly power were illegal • Court ruled against Standard Oil in 1909 • Court ruled in favor of US Steel in 1920 – “Size alone is no offense’’ • Mergers or large firms are not per se illegal When should mergers be illegal? • Economist’s answer is “it depends” • If merger creates monopoly power and no efficiency or cost savings it should be illegal • If merger creates no monopoly power it should not be illegal – Vertical mergers generally do not create monopoly power • If merger does both, then court should decide which is larger Two Questions • What about mergers during this period were the for monopoly power or cost savings? • How were Antitrust laws enforced? What were the effect on efficiency? Cause of mergers? • If mergers increase monopoly power, prices should increase – If there are no barriers to entry high prices should attract entry and firms would loose monopoly power and prices would go down eventually • If mergers were to lower costs and take advantage of economies of scale prices should decrease Market Share • 4 firm concentration ratio – Share of industry output produced by 4 largest firms • • • • Can be misleading No clear link between structure and performance Concentration does not increase by that much Chandler finds evidence that mergers for market power loose market share over time Industrial Concentration S 1860 1901 1963 Machinery NE 1860 MW 1860 30 15 25 41 93 Iron Bars 29 100 37 46 50 Lumber 10 6 9 .5 11 Cotton Goods 14 99 30 20 30 Prices • Wholesale price index declines during this period • Price of steel rails falls from $120/ton in 1873 to $17/ton in 1898 and then is stable at $28/ton from 1902-1919 • Price of farm machinery falls 55% from 1870 to 1910 • Price of oil falls from $24.67 in 1865 to $3.36 in1884 • Evidence does not suggest monopoly power in spite of mergers, trust and other price fixing agreements • Consistent with what economic theory would predict • Chandler’s work is consistent with this Antitrust • Economic theory suggests practices which do not increase monopoly power should not be prohibited • Assumes consumer welfare is goal • Law may have other goals – Protect competitors • How were cases decided? What was effect on efficiency? Standard Oil • Formed in 1872 by JD Rockefeller – – – – – – Refining Cleveland, favorable for Rail transport 10 % of refining market Market competitive Attempt to form cartel in 1870s failed Increases size of Standard oil through merger to get rebate from RR – Integrates forwards into pipelines in 1880 • Reduced number of firms • Integrates backwards into oil drilling in late 1880s • Fully integrated by 1890s • Market share in 1880 was 95% • Justice dept brought suit in 1911 – Predatory behavior in acquiring rivals, reducing price to reduce value of assets – Not clear this would pay, must be able to increase price latter on and keep entry out – Not clear whether they did this • Court ruled against Standard Oil – Broken up into 33 companies What was effect of decision on efficiency? • Price had fallen from $24.67 in 1873 to $3.36 in 1884 • Market share was falling as well 1880 95 1899 62 1906 70 1911 64 • Not clear there was any effect US Steel • Andrew Carnegie pioneered new techniques in steel production – Carnegie Steel had 15-20 % of market in 1898 • JP Morgan created Federal Steel by merging several companies in 1898. About same size as Carnegie Steel • US Steel result of merger of these two companies in 1901. Had about 65% of market. • Justice dept brought suit in 1911, not decided until 1920 • Court ruled in favor of US Steel in 1920 – “Size alone is no offense’’ • Market share was 40% in 1929 • Prices 1873 120/ton 1898 17 1902-1919 28 • US Steel was not dissolved because it did not lower prices competitively • Good for competitors, not for consumers • Overall, not clear what effect antitrust laws have had on industry structure or efficiency