Magazine article Regulation

When Law and Economics Was a Dangerous Subject: How the Early 20th Century Controversy over Railroad Regulation Embarrassed the University of Chicago and Ruined an Economist's Career

Magazine article Regulation

When Law and Economics Was a Dangerous Subject: How the Early 20th Century Controversy over Railroad Regulation Embarrassed the University of Chicago and Ruined an Economist's Career

Article excerpt

At the turn of the 20th century, railroad regulation was hotly debated in the United States. Railways were accused of abusing their monopolistic positions, particularly because of their use of rate discrimination--the charging of different rates for seemingly similar services. Public pressure for tighter regulation led to the 1906 Hepburn Act, which strengthened the regulatory powers of the Interstate Commerce Commission (ICC).

American economists were actively involved in this debate. While most of them belonged to the pro-regulation camp, the best economic analysis came from those who used the logic of modern law and economics to argue that most railroads' practices, including rate discrimination, were rational, pro-efficiency behavior. However, as one of those economists, the University of Chicago's Hugo Richard Meyer, would discover, arguing those ideas before they had gained broad scholarly acceptance could prove professionally costly.

This article uses Meyer's sad tale to review the pre-1906 American debate on railroad rate regulation. My goal is to show how a few economists had already embraced the gist of what would become law and economics, but also how the majority of the discipline, as well as legislators and public opinion, rejected this approach and, with it, what today's observers would consider sound economic analysis.

The incident illustrates two broad points: First, new industries always challenge economists and public authorities in their attempt to determine whether market forces are working satisfactorily and what the effects of government intervention would be. Late 19th-century railroads raised puzzles for scholars and regulators. That those who in hindsight got the puzzles right had little effect on their profession and policy at the time should somehow reassure those who despair today about the ill-devised regulation of, say, Internet industries. In matters of regulation, it can take a long time for public policy to get things right. Second, my story shows that economic ideas never fail or succeed in a vacuum. Regardless of their intrinsic validity, they are only accepted when their end-users--be they economists or policymakers and lawmakers--find them persuasive in terms of a broader socio-political framework. The economists' power to persuade is, in short, always contextual.

THE (ALLEGED) INEVITABILITY OF RATE REGULATION

The free play of market forces would benefit society as a whole: that was the main message--and promise--of classical economics. The message was supported by a theoretical apparatus in which full capital mobility and the profit equalization theorem (that is, the tendency of risk-adjusted rates of return to equalize across industries) occupied center stage.

Railways presented post-Civil War America with a wholly different scenario, one where, because of the enormous amount of fixed capital required, a business could not easily enter and exit the market, while competition led active firms toward either financial ruin or absolute monopoly. The underlying assumptions and fundamental theorems of classical economics simply made no sense in the industry, or so it seemed. "The railway system is not one which is amenable to the laws of supply and demand," observed Charles Francis Adams, a pioneer of modern regulation. The reason was scale economies: "It is an undisputed law of railway economics that the cost of movement is in direct inverse ratio to the amount moved" (emphasis in original). Competition simply did not apply in this case. The inverse relation between cost and traffic pointed to "a conclusion which is at the basis of the whole transportation problem: competition and the cheapest possible transportation are wholly incompatible."

A decade later, every American economist had become aware of the peculiarities of the railway industry. Another Adams, University of Michigan economist and ICC statistician Henry Carter Adams, was archetypal of the almost universal recognition that "where the law of increasing returns works with any degree of intensity, the principle of free competition is powerless to exercise a healthy regulating influence. …

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