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Unchecked Economic Freedom and The Real History of the Standard Oil Company - Part 1

By MasterResource | Tue, 30 August 2011 13:17 | 0

[Author’s Note: This year marks the 100th anniversary of the Supreme Court ruling that found Standard Oil guilty of violating the Sherman Antitrust Act. As punishment, the world’s largest and most successful oil company was broken into 34 pieces.

Ever since, Standard Oil has served as the textbook example of why we need antitrust law--in the business world in general and in the energy business in particular. The Court’s decision affirmed a popular account of Standard Oil’s success, first made famous by journalists Henry Demarest Lloyd and Ida Tarbell. In the absence of antitrust laws, the story goes, Standard attained a 90% share of the oil-refining market through unfair and destructive practices such as preferential railroad rebates and “predatory pricing”; Standard then leveraged its unfair advantages to eliminate competition, control the market, and dictate prices.

Within the oil and electricity industries in particular, the spectre of a coercive monopoly developing in the absence of government intervention was used to justify coercive, monopolistic behavior by the government in the “common good,” be it by the Texas Railroad Commission or by government electrical utilities. This article challenges the mythology of the Standard Oil case and, more broadly, the notion that a coercive monopoly can arise in the absence of government intervention. By implication, it illustrates that there is nothing standing in the way of a truly free, competitive energy market--an energy market free of antitrust law.]

em>Who were we that we should succeed where so many others failed? Of course, there was something wrong, some dark, evil mystery, or we never should have succeeded!
—John D. Rockefeller

In 1881, The Atlantic magazine published Henry Demarest Lloyd’s essay “The Story of a Great Monopoly”—the first in-depth account of one of the most infamous stories in the history of capitalism: the “monopolization” of the oil refining market by the Standard Oil Company and its leader, John D. Rockefeller. “Very few of the forty millions of people in the United States who burn kerosene,” Lloyd wrote,

know that its production, manufacture, and export, its price at home and abroad, have been controlled for years by a single corporation—the Standard Oil Company. . . .

The Standard produces only one fiftieth or sixtieth of our petroleum, but dictates the price of all, and refines nine tenths. This corporation has driven into bankruptcy, or out of business, or into union with itself, all the petroleum refineries of the country except five in New York, and a few of little consequence in Western Pennsylvania. . . . the means by which they achieved monopoly was by conspiracy with the railroads. . . .

[Rockefeller] effected secret arrangements with the Pennsylvania, the New York Central, the Erie, and the Atlantic and Great Western. . . . After the Standard had used the rebate to crush out the other refiners, who were its competitors in the purchase of petroleum at the wells, it became the only buyer, and dictated the price. It began by paying more than cost for crude oil, and selling refined oil for less than cost. It has ended by making us pay what it pleases for kerosene. . . .

Many similar accounts followed Lloyd’s—the most definitive being Ida Tarbell’s 1904 History of the Standard Oil Company, ranked by a survey of leading journalists as one of the five greatest works of journalism in the 20th century. Lloyd’s, Tarbell’s, and other works differ widely in their depth and details, but all tell the same essential story—one that remains with us to this day.

Prior to Rockefeller’s rise to dominance in the early 1870s, the story goes, the oil refining market was highly competitive, with numerous small, enterprising “independent refiners” competing harmoniously with each other so that their customers got kerosene at reasonable prices while they made a nice living. Ida Tarbell presents an inspiring depiction of the early refiners.

Life ran swift and ruddy and joyous in these men. They were still young, most of them under forty, and they looked forward with all the eagerness of the young who have just learned their powers, to years of struggle and development. . . . They would meet their own needs. They would bring the oil refining to the region where it belonged. They would make their towns the most beautiful in the world. There was nothing too good for them, nothing they did not hope and dare.

“But suddenly,” Tarbell laments, “at the very heyday of this confidence, a big hand [Rockefeller’s] reached out from nobody knew where, to steal their conquest and throttle their future. The suddenness and the blackness of the assault on their business stirred to the bottom their manhood and their sense of fair play. . . .”

Driven by insatiable greed and pursuing his firm’s self-interest above all else, the story goes, Rockefeller conspired to obtain an unfair advantage over his competitors through secret, preferential rebate contracts (discounts) with the railroads that shipped oil. By dramatically and unfairly lowering his costs, he slashed prices to the point that he could make a profit while his competitors had to take losses to compete. Sometimes he went even further, engaging in “predatory pricing”: lowering prices so much that Standard took a small, temporary loss (which it could survive given its pile of cash) while his competitors took a bankrupting loss.

These “anticompetitive” practices of rebates and “predatory pricing,” the story continues, forced competitors to sell their operations to Rockefeller—their only alternative to going out of business. It was as if he was holding a gun to their heads—and the “crime” only grew as Rockefeller acquired more and more companies, enabling him, in turn, to extract ever steeper rebates from the railroads, which further enabled him to prey on new competitors with unmatchable prices. This continued until Rockefeller acquired an unchallengeable monopoly in the industry, one with the “power” to banish future competition at will and to dictate prices to suppliers (such as crude oil producers) and consumers, who had no alternative refiner to turn to.

The Shared Narrative

Pick a modern history or economics textbook at random and you are likely to see some variant of the Lloyd/Tarbell narrative being taken for granted.
Howard Zinn provides a particularly succinct illustration in his immensely popular textbook A People’s History of the United States. Here is his summary of Rockefeller’s success in the oil industry: “He bought his first oil refinery in 1862, and by 1870 set up Standard Oil Company of Ohio, made secret agreements with railroads to ship his oil with them if they gave him rebates—discounts—on their prices, and thus drove competitors out of business.”

Exhibiting the same “everyone knows about the evil Standard Oil monopoly” attitude, popular economist Paul Krugman writes of Standard Oil and other large companies of the late 19th century:

The original “trusts”—monopolies created by merger, such as the Standard Oil trust, or its emulators in the sugar, whiskey, lead, and linseed oil industries, to name a few—were frankly designed to eliminate competition, so that prices could be increased to whatever the traffic would bear. It didn’t take a rocket scientist to figure out that this was bad for consumers and the economy as a whole.

The standard story of Standard Oil has a standard lesson drawn from it: Rockefeller should never have been permitted to take the destructive, “anticompetitive” actions (rebates, “predatory pricing,” endless combinations) that made it possible for him to acquire and maintain his stranglehold on the market. The near-laissez-faire system of the 19th century accorded him too much economic freedom—the freedom to contract, to combine with other firms, to price, and to associate as he judged in his interest.

Unchecked, economic freedom led to Standard’s large aggregation of economic power—the power flowing from advantageous contractual arrangements and vast economic resources that enabled it to destroy the economic freedom of its competitors and consumers. This power, we are told, was no different in essence than the political power of government to wield physical force in order to compel individuals against their will.

In the free market, through unrestrained voluntary contracts and combinations, Standard had allegedly become the equivalent of a king or dictator with the unchallenged power to forbid competition and legislate prices at whim. “Standard Oil,” writes Ron Chernow, author of the popular Rockefeller biography Titan, “had taught the American public an important but paradoxical lesson: Free markets, if left completely to their own devices can wind up terribly unfree.”

This lesson was and is the logic behind antitrust law, in which government uses its political power to forcibly stop what it regards as “anticompetitive” uses of economic power. John Sherman, the author of America’s first federal antitrust law, the Sherman Antitrust Act of 1890, likely had Rockefeller in mind when he said:

If we will not endure a king as a political power we should not endure a king over the production, transportation, and sale of any of the necessaries of life. If we would not submit to an emperor, we should not submit to an autocrat of trade, with power to prevent competition, and to fix the price of any commodity.

An Overdue Reconsideration

But Rockefeller was no autocrat. The standard lesson of Rockefeller’s rise is wrong—as is the traditional story of how it happened. Rockefeller did not achieve his success through the destructive, “anticompetitive” tactics attributed to him—nor could he have under economic freedom.

Rockefeller had no coercive power to banish competition or to dictate consumer prices. His sole power was his earned economicpower—which was no more and no less than his ability to refine crude oil to produce kerosene and other products better, cheaper, and in greater quantity than anyone thought possible.

It has been more than one hundred years since Ida Tarbell published her History of the Standard Oil Company. It is time for Americans to know the real history of that company and to learn its attendant and valuable lessons about capitalism.

Real vs. ‘Pure and Perfect’ Oil Refining Market

Any objective analysis of the nature of Rockefeller’s rise to dominance—Standard Oil had an approximately 90 percent market share in oil refining from 1879 to 1899—must take into account the context in which he rose. This means taking a thorough look at the market he came to dominate, before he entered it.

Traditional accounts of Rockefeller’s ascent, which began in 1863, portray the pre-Rockefeller market as a competitive paradise of myriad “independent refiners”—a paradise that Rockefeller destroyed when he drove his competitors out of business and wrested full “control” of the oil refining business for himself.

This idealized view of the early oil refining market appeals to most readers, who have been taught that a good, “competitive” market is one with as many viable competitors as possible, and that it is “anti-competitive” to have a market with a few dominant participants (“oligopoly”), let alone one dominant participant (“monopoly”). This view of markets was formalized in the 20th century as the doctrine of “pure and perfect” or “perfect” competition, which holds that the ideal market consists of as many distinct producers as possible, each selling equally desirable, interchangeable products.

Under “perfect competition,” no one competitor has any independent influence on price, and the profits of each are minimized as much as possible (on some variants of “perfect competition,” prices equal costs and profits are nonexistent). Although advocates of this view acknowledge (or lament) that it cannot exist in reality, they view it as a model market toward which we should at least strive.

By this standard, the early oil refining market was “perfect” in many ways. Many small, “independent,” practically indistinguishable refiners were in business. No one threatened to drive the others out of business, and the market was extremely easy to enter; those with no experience in refining could buy the necessary equipment for three hundred dollars and start making profits almost immediately. Some refiners recovered their start-up costs after one batch of kerosene.

But the traditional perspective ignores the crucial aspect of markets relevant to their impact on human life: their productivity—how much it produces, the value of that which is produced, and the efficiency with which it is produced. By this standard, the oil refining market was anything but perfect—refiners were at an early, primitive stage of productivity, which happily ended.

This is not a moral criticism of the early oil refining industry. The first five years of that industry, along with the crude production industry, from 1859 to 1864, were full of great achievements. It is almost impossible to overstate the dramatic and near-immediate positive effect of a group of scientists and businessmen discovering that “rock oil,” previously thought to be useless, could be refined to produce kerosene—the greatest, cheapest source of light known to man.

In 1858, a year before the first oil well was drilled, only well-to-do families such as that of 11-year-old Henry Demarest Lloyd could afford sperm whale oil at three dollars per gallon to light their homes at night. For most, the day lasted only as long as did the daylight. But by 1864, just five years into the industry, a New York chemist observed:

Kerosene has, in one sense, increased the length of life among the agricultural population. Those who, on account of the dearness or inefficiency of whale oil, were accustomed to go to bed soon after the sunset and spend almost half their time in sleep, now occupy a portion of the night in reading and other amusements; and this is more particularly true of the winter seasons.

Still, the market’s primitive methods of production and distribution at this early stage made it impossible for it to have anywhere near the worldwide impact it would have by the time Lloyd’s famous essay damning Rockefeller was published.

A particularly problematic area was transportation, which was convoluted and extremely expensive. Oil was transported in 42-gallon wood barrels of spotty quality, costing $2.50 each. Each one had to be filled and sealed separately and piled onto a railroad platform (where barrels were prone to leak or fall off) or occasionally onto a barge (where barrels were prone to fall off and start fires). The myriad small refiners each could ship only a handful of barrels at a time; this required the railroads to make many separate stops at different destinations for different refiners, which resulted in a lengthy and expensive journey for both railroads and refiners.

And for some time, this was the best aspect of the process. In the early days, to get barrels of crude oil from assorted oil spots in northwest Pennsylvania onto railways headed for the refineries, oil was transported by horse and wagon by teamsters, often through roadless territory and waist-high mud, with barrels perpetually bouncing and frequently breaking or falling out. (Because of government intervention, the teamsters had a huge influence in politics and for years prevented the construction of local pipelines—an incomparably superior form of oil transportation.)

The refining process, the core of the industry, was also at a primitive stage. To refine crude oil is to extract from it one or more of its valuable “fractions,” such as kerosene for illumination, paraffin wax for candles, or gasoline for fuel. The heart of the refining process uses a “still”—a distillation apparatus—to heat crude oil at multiple, increasing temperatures to boil off and separate the different fractions, each of which has a different boiling point.

Distillation is simple in concept and basic execution, but to produce quality kerosene and other by-products requires precise temperature controls and various additional purification procedures. Impure kerosene could be highly explosive; death by kerosene was a common phenomenon in the 1860s and even the 1870s, claiming thousands of lives annually. In fact, the spotty quality of much American kerosene is what inspired John Rockefeller to call his company Standard Oil.

Some refineries in the early 1860s, such as those of famed refiners Joshua Merrill and Charles Pratt, produced safe, high-quality kerosene, but most did not. Tarbell’s exalted “independent refiners” from the Oil Regions of Pennsylvania, incidentally, produced the worst quality kerosene.

“Deluded by petroleum enthusiasts as to the simplicity of refining,” write Williamson and Daum in their comprehensive history of the early petroleum industry, “individuals inexperienced in any form of distillation flocked into the new business. . . .” But, they note,

successful petroleum refining . . . called for the utmost vigilance. . . . Real separation of the various components of crude oil was no objective at all; their major purpose was simply to distill off the gases, gasoline and naphtha fractions as fast as heat and condensation could permit. All condensed liquid that conceivably could be fobbed off as burning oil . . . was recovered and the tar residue was thrown away. . . . Only in the provincial isolation of the Oil Region and nearby locations did such outfits receive serious designations as petroleum refineries.

In a mature market, such operations, with their inferior, hazardous products, would never succeed. But in the early stages of the market, anyonecould succeed, because the overall refining capacity was insufficient to meet the enormous demand for kerosene.Even lower-quality kerosene was spectacularly valuable compared to any other illuminant Americans could buy.

The supply-and-demand equation of kerosene even made it possible for refiners with low efficiency to profit handsomely. In 1865, kerosene cost fifty-eight cents a gallon; at one-fifth the cost of whale oil this was a great deal for consumers—and it was a price at which anyone with a still could make money. Even if the still was very small, requiring much more manpower and other expenses per gallon of output than a larger still; even if the still refined only kerosene and failed to make use of the other 40 percent of crude; even if the still was low-quality and needed frequent repair or replacement—the owner could turn a healthy profit.

This stage of the industry was necessarily temporary. As more and more people entered the refining industry, attracted by the premium profits, prices inevitably went down—as did profits for those who could not increase their efficiency accordingly.

Such a process, which began in the mid-1860s, was more dramatic than almost anyone expected. Between 1865 and 1870, refining capacity exploded relative to oil production, and prices plummeted correspondingly. In 1865, kerosene cost fifty-eight cents a gallon; by 1870, twenty-six cents. Refining capacity was increasing relative to the supply of oil; by 1871 the ratio of capacity to crude production was 2.5:1. At this point, those who expected to make a livelihood with three-hundred-dollar stills found the market very inhospitable.

A shakeout of the efficient men from the inefficient boys was inevitable. In the mid-1860s, no one imagined that the best of the men, by orders of magnitude, would turn out to be a 24-year-old boy named John Davison Rockefeller.

By. Alex Epstein

This article was provided by MasterResource

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