Growth of Industry after the Civil War

Changing Industry Structure Capital/labor ratio 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 – Electric power began to replace steam power in late 1880 – By 1890 could power machines with electric motors

Changing Industry Structure Cotton Goods58.8Machinery575.6 Lumber54Iron and Steel492.8 Boots Shoes52.9Lumber393.4 Flour and Meal 43.1Cotton Goods Largest Industries in Value Added (1914 $) 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 Decrease in price of machinery made of steel – Price of farm machinery falls over 50% from 1870 to $120/ton /ton /ton

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 million barrels, cost $12-16/barrel 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 $ Qq1q2 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 Changes- Rise 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 NE 1860MW 1860 S Machinery Iron Bars Lumber Cotton Goods

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 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 Not clear there was any effect

US Steel Andrew Carnegie pioneered new techniques in steel production – Carnegie Steel had % of market in 1898 JP Morgan created Federal Steel by merging several companies in About same size as Carnegie Steel US Steel result of merger of these two companies in 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 /ton

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