Essentials of Economic Theory / As Applied to Modern Problems of Industry and Public Policy

by John Bates Clark

A Simple Case of Special Costing Applied to Certain Traffic.—We will suppose A and B are connected by a railroad, while C and B are connected by a highway over which transportation proceeds by the primitive means of horses and wagons. It is like one of the cases we have already stated, with the exception of the fact that the carrier over the longer route is a railroad. The limit of what the railroad can get is the natural difference between the cost of making the goods at A and the combined costs of making them at C and carrying them to B. This definitely limits the railroad charges. Whatever difference of cost there is the railroad can get if it chooses, and barring any deduction it may make in order to induce production at A and make traffic for itself, it will get it. The rate which is fixed for the railroad may be sufficient to cover the total costs chargeable to this portion of its traffic on the simple and pro rata plan of costing, or on the other hand, it may cover only a portion of the fixed costs or no portion at all. This means that the standard which is set by the differing values of the goods at A and at B may or may not yield a profit to the railroad. If it is so slight as not to cover even the variable costs of carrying the goods, the railroad will not carry them, and the supply will be allowed to come from C rather than from A. If it covers more than these variable costs, the road will accept and carry the goods. If the traffic affords any appreciable margin above the variable costs, it will be the policy of the railroad to make its charges low enough to attract the traffic, and this will slightly reduce the place value of the goods at B and bring it below the cost of procuring them from C. The railroad will thus secure the whole traffic to the exclusion of that which came from C. If the costs of making the goods at A and C are alike, then the charge for carrying from A to B will be just enough below the total costs of carrying in wagons from C to B to stop the carrying over this shorter route and appropriate the whole business; but this charge may not cover total costs of carrying from A. It may yield only a slight margin above the variable costs attaching to this part of the railroad's business. It thus appears that this carrier can with advantage accept the freight at a rate that by a perfectly normal bookkeeping is below cost, while the teamsters on the road from C cannot do this.

A Second Case in which Carrying is done for Any Amount above Variable Cost.—Let us now suppose there is a railroad from C to B as well as one from A to B. There is now competition between makers at A and carriers from A to B, on the one hand, and makers at C and carriers from C to B, on the other hand; and whichever of these quasi-partnerships delivers the goods at B at the cheaper rate gets the whole traffic. By the terms of our supposition the makers in both places are offering goods at cost, and any cutting of rates that is to be done must be done by the carriers. To reduce the prices of the goods at the mills in either locality would put some of them out of business. We will assume that there is no consolidation and no other means of concurrent action between the railroads, and that the whole traffic will thus go to the route over which the lower rates are made. For simplicity we will still adhere to the supposition of equal costs for manufacturing and of unequal costs for carrying. As the charge for carrying goes down, one or the other of the railroads will reach the point where the variable costs of this traffic are barely covered, while on the other line they are more than covered. Where rivalry is not tempered in any way whatever, the charge made by competing roads falls to a level at which returns only cover the variable costs incurred by one of the competitors, though it may return somewhat more in the case of the other.

How Fixed Costs are Met.—This implies, indeed, that the fixed charges of both roads must somehow be met by the returns from other traffic; and this supposition is in accordance with the facts. A freight war may temporarily carry rates to a level where some traffic does not cover variable costs and where total traffic falls short of covering total costs. Such a situation cannot long continue, and the natural adjustment, under active competition, is one at which rates on the traffic for which the two lines are contending are just below the variable costs incurred by one line but above those incurred by the other. There is nothing to prevent the stronger railroad from thus reducing its rates, attracting to itself the whole of the traffic, and putting an end to the rivalry of the other line. This would mean bankruptcy for that line unless it had other sources of income.

The Effects of Bankruptcy on Costs.—Bankruptcy means a scaling down of the fixed charges of the railroad to such a point that the total traffic can meet them; but it does not enable the company to reacquire business that will not yield enough to cover variable costs. Adhering to the supposition that there is no mutual understanding, no pool, and no other approach to consolidation between the rival lines, we may safely say that the general rule which elsewhere governs rates holds true here. Two roads actively competing for identically the same traffic tend to bring charges to a level at which the variable charges entailed by this traffic on the one route are not quite met and the traffic passes to the other line.[1]

A Principle governing Competition between Railroads and Carriers by Sea.—In a third case there may be between A and B a railroad and a water route also, while between C and B there is a railroad only. On the supposition we have made,—that competition between carriers by water has done its full work,—the charge for carrying anything by water from A to B must be sufficient to cover a pro rata part of the total costs. That may be sufficient to cover the merely variable costs entailed on the railroad, or it may not. If it does not, the railroad will not take any portion of the business except what it may take by reason of the greater speed with which it can transport the goods. If, however, the total costs of carrying by water exceed by a tolerable margin the merely variable costs of carrying by land, the railroad will be able to take the traffic. If this traffic goes to the water route, the charge made by the railroad from C to B is adjusted by a simple rule. This railroad can get the natural difference between the cost of the goods at C and the cost of similar ones made at A and carried by water to B. If the railroad gets the traffic between A and B, and the water route is abandoned, the case becomes the same as that which we have already considered,—the transporting is done at a rate which prevents one of the lines from covering its merely variable costs and secures all the traffic for the other line. The carrying from A to B goes by land or by water according as the variable costs, in the one case, or the pro rata share of total costs, in the other, are the less; and nothing can be carried from C to B unless it can be delivered at B at a price as low as that of goods made at A and transported at the rate just described. If the costs of making at A and C are equal and there are the three carriers seeking traffic, as assumed, the result naturally is to give all the business to the one who will bid the lowest for it. Either railroad will bid as low as the variable costs which the traffic occasions; while the owners of ships will bid no lower than the rate which covers costs of both kinds.[2]

The Case of Railroads having Common Terminal Points.—In the fourth case there are, besides the other carriers, two railroads between A and B which compete for the traffic at these terminal points, but not at intermediate ones. Their facilities for through traffic are alike. The local traffic on the different lines is unlike, since it is affected by the character of the regions through which the railroads pass; but the charges made for local traffic are governed by the comparatively simple principles which we first stated. In contending for freight to way stations we may say that the railroad has to compete with wagons upon the highway, but with nothing more efficient. The charges for local freight may therefore be extremely high, while, if the railroads are really competing as vigorously as pure theory requires, and if the normal results of competition are completely realized, the rate which can be maintained between A and B for any articles carried will be no higher than those which cover the variable costs entailed on the route which is the less economical of the two. The line to which this test assigns the traffic between A and B must then stand the further tests we have described—those involved in contending for business with carriers using respectively the water route and the railroad from C to B.

A Condition leading to a Reduction of Fixed Costs.—It is safe to assume that one of the two railroads from A to B has more local traffic than the other. It may be that even with this advantage its total returns of all kinds may fall short of covering its total outlays. In that case the total returns of any less favorable route must fall still further short of the amount necessary for covering all outlays; and if we adhere to the assumption that neither consolidation nor anything resembling it takes place, we have a case in which both railroads must undergo reorganization. The fixed charges of the better route must be scaled down and the creditors of this railroad must accept the loss, while on the other route the fixed charges must be reduced still more and the creditors must suffer a larger loss. It goes without saying that the prospect of such a calamity means consolidation. It is evident what alternative competitors face in cases in which heroic competition goes on to the bitter end. As a rule this is an unrealized alternative. The mere prospect of the calamity connected with it is bad enough to put an end to the independent action of the different railroads. With the facilities for combination which now exist a far smaller inducement suffices to bring this about.