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Standard Oil: A Centennial Evaluation (Part II: ‘Unfair’ practices and rebates reconsidered)

[Ed. note: This post, taken from Robert Bradley's Oil, Gas and Government: The U.S. Experience, rebutes the textbook criticisms of the business practices and economic consequences of the Standard Oil Trust. Part I yesterday summarized the manifold contributions of John D. Rockefeller to a fledgling, powerhouse industry. (Documentation for this post can be found on pp. 1094–1099.)]

Critics of Standard Oil, while conceding many of the aforementioned points about how Standard Oil advanced consumer service and resource efficiencies, might accuse the author of painting the picture with only bright colors. What about the other side of Standard’s drive to power? Did the ends justify the means – preferential treatment from third parties over competitors, monopsony power to purchase crude at prices detrimental to producers, predatory pricing to eliminate rivals and raise prices, and excess profits gained at the expense of consumers?

And what about land right-of-way obstructionism, buying into rivals to tame competition, establishing bogus companies, and spying on competitors? If these practices were legal, were they ethical? These points are considered below except for the monopsony argument, which was rebutted in chapter 14 of Oil, Gas, and Government.

It is worth noting at the outset that the complaints did not originate from consumers but from special interests within the industry. The critics were independent (non-Standard) producers, refiners, and marketers and sympathetic academicians and journalists who often had ulterior motives for their views.

Rebates

Price differentiation and individualized bargaining are essential aspects of competition. This is particularly true with railroads and other industries with relatively high fixed costs and low variable costs. Prices vary widely in such instances because incremental business covers at least variable costs. The railway industry in Standard’s day was very rivalrous, and railroads attempted to maximize revenue in each unique situation.

Before railroad interests passed protective legislation to discourage rebates (see chapter 11), the industry custom was to set book rates that were discounted for special customers who provided steady, high-volume business, Standard was the prototype special customer. Rebates off the book rate were, in Rockefeller’s words, “the railroads’ method of business.”

As part of the competitive process, discounts were often kept secret and paid after the fact as rebates. Railroads did not desire to trigger open price wars, and customers preferred to keep their rivals guessing. Whether the rebate was money returned from a book price (rebates) or money received from competitors’ shipments (drawbacks) was academic; preferred customers received lower rates than less preferred customers. Shippers with such scale economies were thus able to cheapen goods for consumers. If discounts could be prohibited by law, railroad interests would gain instead.

Critics of rebates have swallowed the railroad-industry line that rebates were “cutthroat” and bad, and therefore Standard was wrong for asking and receiving them. But rebates are price discounts that qualifying shippers and their consumers are entitled to negotiate in a free market. Moreover, as Standard stressed, rebating did not originate with them; was widely used by other shippers, competitors included; and was stopped once it became illegal in 1887. Before rebates were replaced by regulatory-induced price cartelization, Standard’s ability to negotiate them must be favorably viewed if consumer welfare and the interest of the recipient company are placed above the special interest of less able competitors and the railroad industry.

The last word on rebates was stated by Rockefeller in his memoirs when he called an oft-quoted statement: “ ‘I am opposed on principal to the whole system of rebates and drawbacks – unless I am in it.’ “

Predatory Pricing

The most infamous practice associated with the Standard Trust, predatory pricing, was popularized by Henry DemarestLloyd, Ida Tarbell, and other critics. The charge was that in marketing and particularly in refining, Standard initiated price wars by selling at below cost to weaken competitors and buy them out at depressed prices. Then, with control of the market, prices could be raised to enjoy monopoly profits. This alleged practice attracted so much popular support and political attention that the Clayton Act extended anti-trust law to ban “predatory” price discrimination in 1914.

Economists have shown predatory pricing to be a highly risky and unprofitable strategy in theory, and evidence in the paradigmatic Standard case suggests it is historical myth as well. Predatory intent–a conscious strategy to drive out competitors to restrict supply and raise price–was assumed but never tightly documented. The hard facts of increasing supply and falling prices in the period under review suggest that predation was not operative, whether intended or not.

Indeed, many competitors that testified against the trust were profitable and expanding output in the heyday of Standard’s expansion. More than seventy refineries were purchased and shut down by Standard to reduce overcapacity, but this signified obsolescence and asset replacement more than a strategy of permanently removing competition. The industry by all accounts was overbuilt and inefficient, and  Standard did the dirty work. Standard actively consummated mergers during distress periods, particularly from 1872 to 1874, but not by predatory pricing.

“Standard Oil was not born with monopoly power,” reminds John McGee. Standard was able to weather the competitive storm because of lower costs. Natural incentives dictated that Standard buy and competitors sell. To competing firms, mergers often were a profitable way out of financial problems; for retained managements, they were a new lease on life with a promising company. Certain examples of low purchase prices cited by critics were explainable by excess industry capacity and monetary deflation, which reduced market value below cost. At least one plant was purchased substantially above book value to buy goodwill and management along with the tangible assets. Rockefeller, the evidence suggests, purchased quite fairly; one publicized charge that Rockefeller vastly underpaid the widow and children for a deceased competitor’s refinery has been exposed as fabrication.

Standard avoided predatory tactics because of the business judgment of Rockefeller. He knew better than to engage in cutthroat pricing to subsidize consumers at the expense of company stockholders. As Leeman and McGee have explained, the decision to initiate a price war in hopes of a distress merger on very favorable terms – as opposed to making an immediate purchase at a price tending toward the firm’s discounted profit stream – requires the dominant firm to forgo full margins for a period that can only be known afterward. The expense of a price war is great for the dominant firm since relatively more units are sold at depressed prices. (In Standard’s case, as much as 90 percent of the market would have to be price discounted.) The beleaguered refinery could hold on longer than expected thanks to investor interest or consumer goodwill or decide to temporarily shut down to reenter with new contracts when “monopoly” prices arose. In such cases, the predatory refinery could find itself mired with low prices. Standard, therefore, did not covet price wars with its high-volume business. Standard considered itself the “brand-name” supplier that received a premium for quality, compared to less established suppliers who discounted to attract consumer interest.

As the dominant firm, Standard priced to discourage new entry. But this was not predatory pricing, and consumers were all the better off for this barrier to entry.

Rockefeller’s merger strategy, based on financial incentives rather than “fights to the finish,” was not problem free. Sometimes Standard would buy a refinery only to have the displaced principals construct a new one. Some rivals refused Standard’s merger offers and enjoyed long-lived profitability. Standard gadfly George Rice would enter a Standard stronghold, cut prices, and “blackmail” Standard by raising his sellout price. While this worked in some cases, Rice tried it once too often when he tried to sell a $20,000 refinery plus subsequent improvements for $500,000. Standard’s Archbold refused to pay. Battered in competition by the trust, Rice spent his last years in court seeking to recover a sizeable refinery investment lost as a result of “unfair” competition by Standard.

The last word on Standard Oil and predatory pricing may be given to John McGee. After exhaustively studying Standard’s pricing strategies, he concluded:

Judging from the record, Standard Oil did not use predatory price discrimination to d rive out competing refiners, nor did its pricing practice have that effect…. Standard Oil did not systematically, if ever, use local price cutting… to reduce competition. To do so would have been foolish; and, whatever else has been said about it, the old Standard organization was seldom criticized for making less money when it could have made more.

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Postscript: Update on the predatory pricing debate taken from “Predatory Pricing: Stractegic Theory and Legal Policy” (1999) by Patrick Bolton (Princeton), Joseph F. Brodley (Boston University),  and Michael H. Riordan (Columbia).

“A powerful tension has arisen between the foundations of current legal policy and modern economic theory. The courts adhere to a static, non-strategic view of predatory pricing, believing it to be an economic consensus. But this is a consensus most economists no longer accept. The tension is reflected, however, not so much in the legal rule, which at least in theory would allow arguments based on modern strategic analysis.

Rather the tension appears in an extreme judicial skepticism against predatory pricing cases that has led to the dismissal of almost all cases since the Brooke decision by summary motion. In order to understand this judicial skepticism and the tension it creates with modern economics, we must examine its source, evaluate its merit and appreciate the challenge posed by modern analysis.*

* One of the first economists to call for judicial evaluation of predatory pricing in light of modern strategic theory was Alvin Klevorick. See Alvin K. Klevorick, The Current State of the Law and Economics of Predatory Pricing, 83 AM ECON. REV. 162 (Papers & Proceedings, 1993).

Also see Predatory Pricing: Response to Critique and Further Elaboration (joint with Joseph F. Brodley, and Michael H. Riordan), The Georgetown Law Journal, Vol. 89, No. 8, pp. 2496-2528, August 2001.

1 comment

1 rbradley { 05.17.11 at 4:45 pm }

After the book came out, an essay was published challenging McGee’s classic article: “Monopolization by ‘Raising Rivals’ Costs’: The Standard Oil Case,” by Elizabeth Granitz and Benjamin KleinSource: Journal of Law and Economics, Vol. 39, No. 1 (Apr., 1996), pp. 1-47.

The abstract read: “Standard monopolized the petroleum industry during the 1870s by cartelizing the stage of production where entry was difficult–petroleum transportation. Standard enforced the transportation cartel by shifting its refinery shipments among railroads to stabilize individual railroad market shares at collusively agreed-on levels. This method of cartel policing was effective because Standard possessed a dominant share of refining, a dominance made possible with the assistance of the railroads. The railroads facilitated Standard’s refinery acquisitions and prevented new refiner entry by charging disadvantageously high rates to non-Standard refiners. While Standard used its dominate position in refining to sell refined products at a monopoly price and to purchase crude oil at a monopsony price, Standard did not possess independent market power in refining. Whenever the transportation cartel broke down, Standard’s pricing power vanished.”

I am looking for a critical evaluation of this article, but I did see this point about ‘raising rivals’ costs’ in general:

“A more serious limitation of the RRC analysis is that it does not provide guidance on how to distinguish cost-raising strategies from “competition on the merits,” or pro-competitive strategies that shift business from rivals. As a matter of simple theoretical modeling, in principle the RRC models could tackle this by having the cost-raising strategy also impact market demand and/or the production costs of the dominant firm (to incorporate the possibility that the strategy that increases rivals’ costs makes the dominant firm more efficient). Needless to say, such changes greatly increase the ambiguity of the competitive effects of cost-raising strategies.”

Twenty Years of Raising Rivals’ Costs: History, Assessment, and Future,” by David T. Scheffman and Richard S. Higgins Winter, 2003. 12 Geo. Mason L. Rev. 371 (2003).

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