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Railway monopoly and rate regulation,

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RAILWAY MONOPOLY AND RATE REGULATION
STUDIES IN HISTORY, ECONOMICS AND PUBLIC LAW

EDITED BY THE FACULTY OF POLITICAL SCIENCE
OF COLUMBIA UNIVERSITY

Volume LXIX] [Number 1
Whole Number 164

RAILWAY MONOPOLY AND
RATE REGULATION

BY

ROBERT JAMES McFALL, Ph.D.

Sometime Fellow in Economics in Columbia University
Instructor in Economics in the
University of Minnesota

 

New Dork

COLUMBIA UNIVERSITY

LONGMANS, GREEN & CO., AGENTS,
Lonpon: P.S. Kinc & Son, Ltn.

1916

ae
CopyRIGHT, 1916,
BY
ROBERT JAMES McFALL
PREFACE

THE purpose of the following study is to present the
general theory involved in what is understood by railway
commissioners as the cost-of-service principle in rate
regulation. This principle is quite different from that
which has been advanced frequently under that name.
The earlier cost theories were that the rates should
closely follow the cost of each particular service; a prac-
tice which has resulted in unfortunate rigidity of rates
wherever tried. The theory of the present-day commis-
sioners avoids this rigidity by paying considerable atten-
tion to the complementary principle of value in the
adjustment of particular rates, while basing the system
of rates as a whole, in so far as possible, on the total
cost to the railways. The object is to reduce the rates
as a system to the level of cost by means of governmental
regulation, just as it is asserted is done in other fields of
enterprise by the forces of competition, the particular
rates within the system, meanwhile, being allowed a flex-
ibility that would be impossible if cost alone controlled
the situation. The scope of the present study has not
allowed a discussion of particular problems of rate
regulation; the general theory alone has been presented,
and with it a discussion of the more obvious reasons for
its adoption and the difficulties which it encounters.

The writer wishes to take this opportunity of express-
ing his appreciation of the direction of his major professor,
Dr. E. R. A. Seligman, particularly of the stimulation
given for the pursuit of the work and of the liberality

5] 5
6 PREFACE [6

manifested in encouraging the development of an inde-
pendent point of view. To this gentleman as well as to
several of the writer’s fellow students is due great
gratitude for criticism of the manuscript and helpful
discussion of the theory.

R. J. McF.

MINNEAPOLIS, NOVEMBER, IQI5.
CONTENTS

INTRODUCTION. ...... 2 We orev Gace eee ks

CHAPTER I
REGULATION OF WHOLE-RATE SYSTEMS

Reasons for regulation... ... 000 eee ee ee ees
Regulation to care for the social interest. ih feeatin ity aa arse tet
Regulation to the point of restriction ..... 2... 2.52.00.
Protection of railway interests .. ©... 4 wees
Other business still more important. ........
Railway enterprise is properly a monopoly . ....... So
Principle of monopoly price. . . . 2. - e ee e e  ee e
Correlation between price and volume of business as in British
postal reform of 1840 and the introduction of parcel post in the
U.S. Be a a eR a ae as nek
Difference of effect ander din nistiing cost and increasing cost .
Law of diminishing cost losing strength in the railway field .. .
Railways may raise rates at the expense of legitimate traffic .. .
Railway managers are attempting this . = . .....
American railways have been earning sufficient in me past. ...
Question of the principle of regulation to offset railway monopoly
Principle of cost vs. principle of value. ..... Set Bendy aaa a
Defects of value principle ne
Cost principle better for solution of the Groplecn a
‘Content of cost principle A Gi A ee ek

CHAPTER II
VALUATION AS A CRITERION OF RaiLway ABILITY

Railway ability to supply service considered as cost Be eo des

Valuation the best criterion of this for rate-making ......

Magnitude of the task of valuation

Importance % 4

Problem has been brought up by commissioners in execution of
their duties . .... - id, ade ae setter 2 de

7] 7

PAGE
II

19
21
24
24
25
26
30

33
39
40
53
54
60
63
63
64
70
75

76
77

79

81
8 CONTENTS [8

PAGE
Legal basis ...- . soins: Wh eae ae ten Pareto SE He 32 81
Valuation as a minimum Aavdand i) & Aah As: wR See Bo we. OZ)
Application to all rate-making OK gee a OE se 83
State valuation’ 06. a2 cdice an oe gh Wee A He eae eee aarti 84
Federal valuation .. . Bs ale ape eae ee > - OO
Various suggested bases for alison a Pe: Ok We ee - + 94
Original investment vs. cost-of-reproduction- jess-depreciutions. 3 99
Definitions jos oe Sp a es STOO
Items which would erika into et S wnleksland Seh% +. + IO
Theories compared . 2 we (Bae desig teh 8, Se 122
Ethico-legal arguments. . . #5 GR wh OS aw ee ee ee ee 16
Necessities under economic expansion. . . . 131

Need of cost-of-reproduction-less-depreciation ip eantc expansion . 133
Future valuation may follow investment principle if combination is
allowed: 2-6, seb. So eee Ue a eee Re es 141

CHAPTER III

Tur Farr RETURN

Legal basis. . . of GE ee eR eS Soe ee ew : 150
Matters to be ganidered Beas Ue SE RS Gate ALG 150
An attempt to limit monopoly price... .....- nay a 6 ESE
Early returns . as a Spatea td A? ON, <2 3 7 2 ie a STD:
History of regulation a retanis Oia: oh Gola a he sae 54
No definite rate fixable eo Mk 4 Hb be oe TESS
Return on investment not amnecessity..... Pig’) (Sot oe ne 155
Returns must be sufficient to be attractive to new fitaetlate:. - +s 156
Different rates of return on rival roads... . : i 3 158
Rates must be made with a view to the whole sitaation 2 - . 162
Differential return on better roads. ..-..... eu weal 163
Differential return less under combination. . . som % 6g
Question of rate-determining line... . $36 Re a RD 166
Rate necessary onthisline .. . ...... daira nares Bi Belg
Interest changes .. . ane : : bah s 17I
Risks .. . ‘ : soe gel woe a 17
Efficiency . BaP Ste, alae Tad
Question of <alei return to induce favestinent RCE GO: ee. oe SET G
Fair return found from securities market. . . . is Shes le ig ae
Necessity of valuation eS ee 180
Influence of increment of values 181
No necessity for principle of higher valuation flan: investment top
future ..... ieee ecg ae aor £72) Bw Gk ete . 183

Conclisioiis .- 6 8 6 bk me ee ek ee oe a as 183
9] CONTENTS 9

PAGE
CHAPTER IV
REGULATION OF PARTICULAR RATES

Necessity for adjustment of particular rates ... . » . 185
Claims that costs of particular traffic cannot be saeartduedl, -  . 186
Extent of costregulation desired ...-.-.... nee a a 288
Jointcosts ee - 189
Commissioners claim that Sida av of costs can be silonated : 193
Freight vs. passenger - ei gece aap apg Ss 193
State vs. interstate .. ARR ee . oo. 197
Local vs. through traffic mB 0OC”C~C RS - 199
Cost of classes by comparison 3! % ne 201
Cost principle feasible for expenses ....-.-+.+.-+.. 204
Partially feasible for capital charges .-. +... 2... ee, 204
All traffic should bear particular cost ..-.... : 206

Joint cost provided for on principle of differential demand that all
elements of traffic may expand equally freely ......... 210

CoNCLUSION ‘ : e 4.4093 so. « 219-223.
INTRODUCTION

THE hope was formerly entertained that competition
would regulate the railroad industry. In the early days
when railroading was establishing itself in our economic
life, competition was looked upon as the good genius
which would secure justice and fair treatment to all, and
no exception was anticipated in the case of the rapidly
developing systems of steam transportation.

Experience has proved that such was not to be the
outcome. Competition in railroading has shown itself
to be not beneficial but disastrous. The history of our
rate wars has demonstrated this to the satisfaction of all.
It might be more accurate to say to the dissatisfaction
of all, for all suffered by it, the shipper as well as the
investor. Competition in this field is not limited by
bankruptcy, as is the case in the ordinary affairs of busi-
ness. Bankruptcy but makes the struggle more bitter,
for the bankrupt competitor has nothing to lose and uses
any means he may to win a small return. Even if this were
not the case, the introduction of competitors into a field
which can be cared for by the existing lines has proved
itself to be a useless waste. Experience in transportation
the world over is against the paralleling of existing lines
by competitors. The judgment of students of the ques-
tion in all countries is that the railway business is in its
nature a monopoly and should be conducted as such.

Every attempt possible has been made to escape this
conclusion. England attempted to make the railroad a
public highway like a street or a canal on which anyone
might run a conveyance. Needless to say this idea

disappeared very quickly. More hopeful was the attempt
11] II
12 RAILWAY MONOPOLY—RATE REGULATION [12

of Belgium to expose the private companies to the com-
petition of government lines, but this experiment also
proved a failure and has been abandcned. In the United
States many measures have been tried to preserve the
beneficial features of competition, but the features have
proved to be far from beneficial. Pooling has been
prohibited, but the man who pushed the prohibition
through Congress later acknowledged his mistake. Rate
agreements and combinations have been made unlawiul,
but the laws have proved ineffective to prevent the
movement towards monopoly. Canute, in his day, had
about the same success in stopping the advance of the
incoming waves of the sea.

Monopoly being a fact, the question before us now is
the regulation of this monopoly. There are many prob-
lems which arise in this connection, but the one that
will be considered in this discussion is the problem of
price. We are perfectly willing to accept the economies
and conveniences of monopoly, but do we have to sub-
mit to monopoly price? Must our railway rates and
fares be based on the principle of monopoly profits—the
ability of the company to collect the maximum—or may
we hope through regulation to be able to base the
charges on the ability of the railways to supply the
service? Can we retain the privilege of securing our
transportation at or near what it costs to give it, or
must we, when allowing monopoly, allow the companies
to collect as much as they can in the absence of competi-
tors?

The influence of cost as an element in determining
price is generally recognized in those fields of produc-
tion not controlled by monopoly. It is a limit below
which price cannot remain without destroying the busi-
ness in question. It is, on the other hand, the level
13] INTRODUCTION T2

toward which price tends to be reduced by reason of
competitors entering the field. In a sense, also, cost
determines the value to the consumer, in that his esti-
mation of an article frequently is based upon what it
would cost him to make a similar article or to purchase
a substitute. Cost is an ever-present element in price
determination until we enter the field of monopoly, and
the price in turn is one of those factors which determine
the number of customers who will be able to avail
themselves of the goods or services in question.

When monopoly is the controlling factor, cost is the
margin below which price cannot remain; but if the
monopoly be unregulated it is very generally admitted
that the price may be fixed at a considerably higher
point than the cost. The ability of the producer to
continue producing the services ceases to be the deter-
mining factor and the charges are fixed at the price which
the producer thinks will yield him the maximum net
profits.

The mere fact of higher price may not in itself be an
evil. The trouble with monopoly price is that, being
high, it limits the number of consumers who are able to
avail themselves of the service. So, for that matter,
does the competitive price fixed by cost. But the com-
petitive limitation is a necessary one. Neither competi-
tion nor monopoly can continue to supply at less than
cost. The monopoly limitation to the consumption of
goods or use of service is almost always greater than the
limit of cost, and this added limitation is what is felt to
be an unnecessary burden.

Confining ourselves to the railway question, it is evi-
dent that if the monopoly be unrestricted, rates and fares
may be fixed at a higher figure than is necessitated by
the cost of the service. This practice, of course, will
14 RAILWAY MONOPOLY—RATE REGULATION [14

lessen the amount of the railway’s business, but a some-
what lesser traffic at higher rates is almost always more
profitable than the greatest possible traffic at cost, cost
always being assumed to include all expenses and the
ordinary remuneration of enterprise. The result of this
practice then would be that those who are able to avail
themselves of the service of the railway would do so at
less profit than if the rates were fixed at cost, or ability
of the railway to serve; and, in addition, many who might
be patrons of the road are unable to use it because the
price is beyond their ability to pay. Hence, unrestricted
monopoly means less profit to the actual users, and fewer
actual users; in other words, the business of the country
is restricted.

The purpose of this present inquiry is to see to what
extent this restriction of business has been and can be
prevented by government regulation. We want to know
how far the ability of the railways to provide the service,
rather than their ability to charge for it, can be made
the basis for rates. It is this question which the com-
missioners are attempting to solve in their efforts to
apply what they call the cost-of-service principle in reg-
ulation.” The movement towards the use of this principle
is an attempt to refer rates to the ability of the companies
’ to supply the service, as shown in their fair or necessary
income. By this effort the hope is entertained of allow-
ing the public all the advantages which could be hoped
for from an ideal state of competition without at the
same time bringing in the evil effects which competi-
tion is always found to involve in railway enterprise.

There are two general phases of the cost principle as
developed by the commissions. One phase is the rela-
tion of the cost of the total service rendered by the
railway to the income derived from the whole traffic,
15] INTRODUCTION 15

that is, basing the system of rates as a whole on the
total costs, the costs always allowing reasonable returns
on the enterprise. The other aspect of the question
considers the relation of particular rates within the total
system to each other and to cost; should the particular
costs of each branch of the traffic be worked out and
made the basis for the rate on the traffic in question?

There is an unfortunate ambiguity in the use of the
phrase “‘ cost-of-service principle”. When railway men
and economic writers in general use the phrase, the
emphasis is laid on the latter aspect of the question as
just outlined. Mr. Peabody, the statistician of the
Santa Fe, says, ‘“‘The cost theory of rate-making would
put a flat mileage rate on all articles and utterly upset
the commerce of the country’’.* It is very evident which
phase of the principle Mr. Peabody is considering. Pro-
fessor Ripley, in speaking of the cost principle, says,
“The freight service of a railway comprises the carriage
of all kinds of goods simultaneously, from the most valu-
able high-priced commodities such as silks and satins,
down to lumber, coal, cement, and even sand. To com-
pel each of these classes of goods to bear its proportion-
ate share of the cost of carriage would at once preclude
the possibility of transporting low-priced goods at all’’.
Professor Ripley also very clearly has in mind the latter
phase of the question, that is, basing the rates of par-
ticular traffic on its own peculiar costs.

The emphasis of the commissioners who are working
on the problem is on the former phase of the question.
Their contention is that rates as a system should be
based on the cost of service as a system, and that the

1 Letter of Nov. 25, 1911. (Private correspondence.)
2 Ripley, Railroads: Rates and Regulation, p. 169.
16 RAILWAY MONOPOLY—RATE REGULATION [16

division into particular rates should be based, not wholly,
but only partially on the comparative costs of the par-
ticular branches of the traffic. As Mr. Staples, Commis-
sioner of Minnesota, and President for 1912 of the
National Association of Railway Commissioners, in a
committee report presented at the convention of that
body in 1911, said, ‘Common carriers are entitled to
rates for their services that cover reasonable amounts
for operating expenses, including returns upon a fair
cost—that is, the value of the property necessarily em-
ployed...... In connection with the freight trans-
portation service, it has been further ruled that the cost
of transportation thus established should be borne by
the various articles and commodities transported some-
what in proportion to their value, the cost of handling
them, the risks involved therein, etc. The law, and the
rulings under it, has established a so-called ‘cost of
service theory’ of rate-making, under which articles of
higher value are made to contribute more to the income
of the carriers for interest and profits than articles of
lower value. Under this theory the higher profits con-
tributed by the former or high-priced articles are as
much a part of their cost of transportation as is the case
for the relatively lower profits that are borne by the

lower-priced ones. ... The basis for rates or for
charging that has thus been briefly outlined is in fact
the so-called ‘cost of service’ basis for rates”. And

again: “In order to fix rates upon the cost basis, it is
necessary to determine the approximate cost per unit of
traffic as well as to weigh these costs for each class of
the traffic in proportion to the value of the articles con-

yy

tained in each of these classes’... And Commissioner

1 Proceedings of the Twenty-third Annual Convention of the Na-
tional Association of Railway Commissioners, 1911, pp. 32-33.
17] INTRODUCTION 17

Erickson, in speaking of the view of the Wisconsin Com-
mission on the subject, says, ““The total cost is first
determined. This cost is then distributed between the
various branches of the traffic. That part of the cost in
turn which should be borne by the freight traffic is then
distributed between the various classes and commodities
on the basis of cost, and this cost per unit of transporta-
tion is then weighted, so to say, on the basis of the value
of the articles transported.” *

The object of the following study will be, primarily,
an investigation of what is involved in the attempt so to
base rates on the ability of the railways to provide for
the transportation of the traffic; for that is what the cost-
of-service principle, as understood by the commissioners,
really amounts to. The movement has risen very largely
out of consideration of what justice to all parties calls
for. It is held that the railways, being public servants,
should give their services on the most advantageous
terms possible to the public. On the other hand it is
intended that no injustice be done to the vested interests
of the railways. But beyond this consideration for
vested interests on each side, the study of the question
reveals that there are more vital considerations. It is
not in the long run so much a matter of a just return
being allowed to the railways as it is a matter of giving
them sufficient income to provide accommodations for
the commerce of the country, particularly when the
business is constantly increasing. The emphasis in the
past has been on the ethical aspect; it grows out of
statical conceptions and looks principally to past and
present conditions. It is being seen more clearly now
that we must look ahead. We have a dynamic problem.
The ethical considerations are not set aside—they are

1 Letter of Dec. 15, 1911. (Private correspondence.)
18 RAILWAY MONOPOLY—RATE REGULATION [18

included in the larger considerations of the ability of the
railways to provide the facilities for an expanding traffic.
The railways must be allowed an income sufficient to
provide these facilities; any more income than this is a
restriction of the other business of the country that is
not justifiable on the grounds of social welfare.

An investigation into the possibility of relating rate
regulation to the ability of the carriers to provide
transportation involves primarily a study of what is the
measure of such ability. The ability to serve will be
found to lie in the income derived from the traffic at the
prescribed rates, for it is income which warrants capital
and provides for running expenses. In inquiring what
the income must be, it is a matter of first importance to
consider upon what capital basis the income is computed.
Hence we must make a study of the question of the
valuation of the property, the principles involved therein,
and the connection between valuation and rate-making.
We must know in what way capital value is a criterion
of railway ability; we must look into the principles of
valuation for such a purpose, and then we can consider
what income is necessary on such a valuation.

Manifestly, this only provides for the regulation of
systems of rates as a whole in relation to the cost of
service as a whole. A practical system of rate regulation
must go farther than this; it must consider the regula-
tion of the rates on the particular branches of the traffic.
To this end a study will be made of the method which
the commissioners are advocating for the purpose under
the so-called cost-of-service principle. The first task at
hand, however, is a more careful consideration of the
principles involved in the relation between government
regulation of rates and the ability of the roads to supply
the service.
CHAPTER I

REGULATION AFFECTING WHOLE-RATE SYSTEMS

THE regulation of railway rates by governmental
authority has been justified in various ways. It may be
defended on the grounds of the extensive public aid
which has been given to the railways; it may be taken
from their quasi-public character as performing a dele-
gated function of Government by permission of the state ;
or it may be demanded on the grounds of social welfare
or benefit to the public. All these reasons and many
related ones may be advanced, but, whatever justification
be expressed, all parties are agreed that government
regulation is a necessity and is here to stay as long as.
we retain private railway ownership.

Whatever the real reason for government regulation
may be, it should not be lost sight of, when we consider
restrictive regulation at the present time, that during an
earlier period the public contributed a vast amount to
the building of these railways and assumed a very con-
siderable amount of the risk of their success. Authorities
state that land was actually given to the promoters to
the extent of 155,000,000 acres, or 242,000 square miles,
which is equal to one-fifth more than the total area of
either France or Germany.* Vast sums backed by the
public purse were given into the hands of the companies
with no other security than the success of the enterprise.
And when we see how little of the stock issue was actu-

1 Ripley, Railroads: Rates and Regulation, p. 36.
19] 19
20 RAILWAY MONOPOLY—RATE REGULATION [20

ally paid up in some instances, we conclude that at the
time when the railways really were a speculative venture,
the proportion of risk by private capital was not so large
that the public is guilty of confiscation when it fails to
allow the companies to charge as much as they please.
The public has been an investor looking for returns, not
in dividends, but in the best possible service at reason-
able rates.

Perhaps the most common justification of regulation
is the so-called quasi-public character of these common
carriers. As the Interstate Commerce Commission has
said: ‘The providing of the highways of a nation is an
act of sovereignty essential to the existence of the
nation. These highways may be provided directly by
the Government itself or by private individuals under
sanction of the Government. If the duty is delegated
to a private individual, that individual, whether person
or corporation, is the agent of the Government and acts
subject to the well known laws of agency. If being au-
thorized to impose for its services a reasonable charge,
it in fact imposes one that is excessive, it is answerable
to the Government.’”’* Or again, the Railroad Commis-
sion of Wisconsin draws attention to the fact that the
companies hold the place of agents of the State by virtue
of the powers of eminent domain which have been con-
ferred upon them. ?

Not only are these companies agents of the State, but
by reason of the privileges granted to them by the State,
they have been placed beyond the range of regulation
by natural forces. By reason of the franchises, the right
of way, the financial aid given in the period of specula-

"15 1. C. C. Rep., 414.
7W.R.C., A. E. Buell v. Chicago, Milwaukee & St. Paul Ry.
Co., page 12.
21] WHOLE-RATE SYSTEMS at

tion, in short by reason of government act creating them
legal corporations to do business which must become a
monopoly, and by assistance towards success in that field,
the Government has placed these companies in a position
where nothing but regulation by the creative power can
operate. That it is justified in undertaking this regula-
tion when necessary is now generally admitted by all and
even acquiesced in by the companies themselves. That
regulation is necessary is also a very generally admitted
fact and forms the real reason for its application by the
only power competent to apply it.

The necessity for regulation is found in the common
good, the general welfare. As Professor Seligman
pointed out at the time when the Interstate Commerce
Act was first placed on the statute books: “ Railway
tariffs may be regarded from two essentially different
standpoints—the private and the public. In so far asa
railway is a business corporation it is a private matter.
It may fix its prices in accordance with general business
principles. It will endeavor to subserve primarily the
interests of its owners. It will strive for the greatest
possible profits. Its course is legimate and praiseworthy.
But in so far as the railway forms our public highway,
it is a public matter. The objective point is now the
general welfare, the interest of the community. It aims
not at the greatest possible profits, but at the greatest
possible benefits. It looks not at the interest of its
owners, but at the interests of the public. The one point
of view is individual, the other social’’.?

Now, it is precisely because of the fact that the railways
left to themselves act so frequently solely from the stand-
point of their own private interest that regulation has

1 Political Science Quarterly, vol. ii, p. 223.
22 RAILWAY MONOPOLY—RATE REGULATION [22

become necessary. The real reason for railway regula-
tian is to supply the factors neglected by the railway
managers, that is, to secure the ends of social justice, and
to promote the interests of the community. Itis not for
us scornfully to censure the companies because they have
attended to their own interests rather than those of the
public which they serve. The object of railway enterprise
isnot philanthropy. Its object is the same as that of
any other business, namely, tomake money. And so long
as it does this lawfully the railways should not be made
the target of our accusations. It is the duty of the
public, since it is an interested party in the compromise,
to see to it that the social interests are maintained. Just
as surely as the shareholder should have his voice in the
matter of the making and distributing of dividends, so
surely the public should have a voice in determining the
relation between the amount of the dividends and the
scope and efficiency of the service.

It is not to be claimed that the railways have totally
neglected this social element: they have not gone to this
length. It has not been to the business interests of the com-
panies to act in this manner. The success of all agencies
of transportation is very closely connected with the business
and industrial development of the communities which they
serve. It is to the advantage of the railways that their
patrons should be prosperous. But this prosperity has been
fostered in such a manner as to work mainly to the interest
of the railways and their promoters; the general business
and industry of the country have been made subsidiary to
railway success rather than the chief ends in view as it is
right they should be. As we should expect, the history of
railroading in the United States shows that the corpora-
tions, both as competing systems and as monopolies, have
neglected the interests of society as a whole. It is prob-
23] WHOLE-RATE SYSTEMS 23

ably true that in the past the public has suffered more from
the evil effects of competition than from monopoly, but this
is no guarantee that conditions might not be yet worse under
undisturbed monopoly. In years past, government regula-
tion, both by legislation and by commission, has done much
to mitigate the effects of unrestrained competition. We
may reasonably hope that it will solve the problems involved
in the increased effectiveness of monopoly.

In the earlier days while new and independent lines were
continually coming into the field, regulation was needed to
check the railroads in their relations with each other. We
are accustomed to think of regulation solely as a protection
to the shipping public. Aside from protecting the railways
from the attacks of over-zealous public enthusiasts, regula-
tion has been a boon to the railways in their dealings with
each other; it has materially aided them in doing away
with the weapons of cut-throat competition. Probably
neither regulation alone nor yet the power of the railways
unaided could have done away with those policies of re-
bating and rate-cutting which have been suicidal alike to
railway and to public interests. Certain it is that the rail-
ways, hampered as they were in their combination by our
anti-trust restrictions, could hardly have achieved the steadi-
ness and certainty of rates necessary alike for railway and
private interests. It may not be so readily admitted that
public regulation alone would have been unable to arrive
at this goal, but a careful study of the history of American
railroading will show that such has been the case. So long
as the railways were actively competing with each other,
secret rebating and rate-cutting persisted; the power of the
law was unable to do away with the practice. Thus we
may say that government regulation in conjunction with
railway combination has done away with pernicious cut-
throat competition.
24 RAILWAY MONOPOLY—RATE REGULATION [24

Regulation may thus serve railway ends. It may be of
such a character as to be readily approved by the railway
managers themselves. But this is not the only regulation
possible, nor is it the only kind with which we are familiar.

Since the railways have become monopolistic, the cry of
extortionate rates has been raised and has been followed
by restrictive regulation. And so long as our transporta-
tion systems are in the hands of private monopoly with its
ability to raise rates and restrict the service beyond the
natural limits of competition, we may look for restrictive
regulation. This is simply supplying the social factor in
our rate-making system for which we cannot expect the
private companies adequately to provide.

When we begin to talk of restriction, we must bear in
mind that justice demands that when the state under-
takes to restrict the railway policy of private interests, it
should not at once plunge to the opposite extreme. When
the government deals with a powerful corporation it is not
on a footing on which equal meets equal. When we stop
to think that there is no limit to what the state can do if it
wishes, and when we hear men all about us talking of con-
fiscation in general and of confiscation of the value of rail-
way property in particular, we see that we have another
basic principle to be considered. Justice to the vested in-
terests of the railways is a vital part of any sound theory of
rate regulation. The railways have been public bene-
ficiaries, but they have been none the less truly public bene-
factors. They have been given great areas of land, but
they have increased the value of the land through which
they run by an amount vastly in excess of the value of the
original land grants. This nation owes too much of its
prosperity to its excellent railway system, despite its short-
comings, to begin any general system of confiscation by
denying the railways a fair return upon what they have
25] WHOLE-RATE SYSTEMS 25,

been freely allowed to build up and legally acquire. In
our list of industries which it is the duty of the state to
protect, we cannot justly class the railways as outsiders
from whom the state must protect its protegees in the
other fields of production. Though perhaps the most
powerful of all, nevertheless provision must be made for
their lawful interests.

The part the government must play to be consistent with
our modern ideas of social justice is that of an equalizer be-
tween these powerful monopolistic organizations and the
less powerful and frequently unorganized shippers. Our
general feeling is that justice is most likely to be done when
the parties meet each other fairly as equals. It is very
similar to the principle of collective bargaining which is.
being developed by the labor unions. Our justification of
just regulation is that the shipping public may through
their representatives, the regulative commissioners, meet
the common carriers in positions of equal bargaining
strength. And our ideas of what principles should thus be
artificially enforced are that they should be the same prin-
ciples, as far as possible, which operate in the relations
between equals in free competition. That is, such prin-
ciples and methods must be applied in this artificial regula-
tion as will prove fair to the railroads, and at the same time
allow for all the expansion of other business consistent
with this fairness.

The railway interest, while important, is not that for
which the rest of the business of the country exists. It
would be much truer to say that the railways exist for the
sake of our other industries. If this be so the railways
cannot be allowed to bargain for their services on mono-
polistic principles. They cannot be allowed to fix their prices
simply with the view to getting the greatest profits. Their
returns are made from the product of rates and volume
26 RAILWAY MONOPOLY—RATE REGULATION [26

of business. If, then, they increase their profits by raising
their rates to the limit where any further increase would
so lessen the volume of traffic that the product would be
diminished, the presumption is strong that the public inter-
est is being neglected. The social good demands that the
traffic, the amount of business done, shall be the greatest
possible consistent with a reasonable return to the railways.
It is the quantity of business that must be increased at the
expense of rates, rather than the rates at expense of the
volume of traffic; due regard always being paid to an ample
return to the railways.

The assumption has been made so far that the railway
business is a monopoly. This view will to a certain extent
be challenged. In view of the fact that ever since the
enactment in 1887 of the Act to Regulate Commerce there
has been a prohibition to prevent pooling, and in view of
the recent legislation to retain competition as far as pos-
sible, it will be well to look into this matter a little more
closely. The problem is how far the railway industry is
subject to monopoly law, and what the effect of this would
be on the nation’s business if unrestrained by government
regulation.

When the Act to Regulate Commerce was first passed the
idea was certainly prevalent that the principles of competi-
tion were the necessary rules in the railway field in order
to secure fairness. Not only was it held that the results
of normal competition were the desired end, but it was
thought that by means of supervision by the Interstate
Commerce Commission the forces of competition could be
preserved and made to act normally and regularly in the
transportation business. As Professor Hammond says,
“The act to regulate commerce was passed by a Congress
which was strongly of the belief that competition between
railroads was salutary in its workings and to be fostered.
27] WHOLE-RATE SYSTEMS 27

The purpose of regulation was not to thwart competition
but to check monopoly.” And again, ‘The members of
the Interstate Commerce Commission appointed to carry
out the provisions of the act were fully aware of the in-
tention of Congress in this matter, and in good faith under-
took to apply the competitive principle to railway rates.” *

Recently, however, the Interstate Commerce Commission
has expressed quite a different opinion. In fact the com-
mission has seen for some time the necessity for combina-
tion. In 1901, after the attempt to break up the traffic
associations by law, the commission said that not only were
conditions practically the same as before the court decisions,
but that it was necessary for associations to exist. Since
then they have stated the matter more strongly. In their
opinion given by Commissioner Prouty in “ Re Advances
in Rates by Carriers in Official Classification Territory ” the
statement is found:

There is but little competition in the price at which the com-
modity produced by these railroads, viz, transportation, is sold;
that is, in the rate. This was not always so. In the past the
most violent competition in railway rates has prevailed, and
this competition has often gone to the point of imperilling the
financial integrity of great railroad systems; but all that is a
thing of the past. The law itself practically forbids it, and if
it were permitted by law it is inconceivable that the practices
of former years would recur.”

This expression not only shows the present non-existence
of competition but also its undesirability. In the same
opinion a still stronger statement is made on the subject:

1M. B. Hammond, Railway Rate Theories of the Interstate Com-
merce Commission, pp. 108-9.

220 I. C. C. Rep., p. 264.
28 RAILWAY MONOPOLY—RATE REGULATION [28

“The railroad is a monopoly. Its rates are not made
under the influence of competition.” *

The Interstate Commerce Commission considers the rail-
roads to be monopolies; Congress maintains the struggle to
preserve competition between them. What then is the true
status of the business? ‘The fact that Congress has at-
tempted to preserve competition, and that meanwhile the
commission has become more firmly convinced of the fact
of monopoly, is perhaps the most striking indication of the
true state of affairs.

As the commission says, railway rates are not made under
the influence of competition. That is, rates are not made
under the influence of competition of the so-called compet-
ing railway lines. The most striking apparent contradic-
tion to this statement exists in the Southern Basing Point
System. But even in that field the railways now acknowl-
edge that competition does not determine the lower rates
to the basing points. The system was built up under the
influence of competition among the railways and with the
water carriers, but now the competition has disappeared.
The lower rates to the basing points exist on account of the
jobbing business in the towns and the competition between
the markets, but not on account of the competition between
rival carriers. Likewise the rates to the Atlantic seaports
are determined by port differentials arising from the com-
petition between these ports as markets for the trade, but
the railways supply the same service to the same place on
the same terms and do not compete at all in their fixing
of rates. The competition that exists in such cases as
these, where no other system of transportation enters the
field, is not now competition between the carriers in the
matter of rate quotation. It is a competition between the

+20 1. C. C. Rep., p. 780.
29] WHOLE-RATE SYSTEMS 29

patrons of the railways. This competition in no way affects
the fact of the monopoly of the railway service.

A certain amount of competition does exist between the
railway and the water carriers, and probably this will in-
crease with the growth of business through the Panama
Canal. But looking at the railway field as a whole, this is
rather a disturbing element in what is otherwise a situation
ruled by monopoly. It may be objected that the advertising
campaigns carried out by some lines are a form of com-
petition. They are, but not a form of competition that has
a regulatory effect on rates. They are a form of competi-
tion for traffic at an established rate. But even this form
of competition has its decided limitations under the present
system,—although it may be, as some railway men assert,
too much practiced even yet. There still exists more or
less bidding for traffic at established rates. Every line in
a definite passenger field must maintain a service similar
to that of its rivals. The main lines west from Chicago
must maintain similar fast trains on each line, whereas if
all the lines were consolidated under one management the
traffic might be divided and the total number of trains might
be cut down, thus allowing a considerable saving of expense.
But when the management is separate, each company must
bid through its service for the traffic. The Pennsylvania
and the New York Central both maintain their twenty-
hour and other fast trains between Chicago and New York.
What service one line gives, the other must supply also.
But is this competition? Is it not rather agreement?
While each maintains its twenty-hour train the other is not
trying to outdo it in the matter of speed. In fact they
maintain similar service by agreement, just as they do
similar rates.

A survey of the field in the United States shows that the
same rule holds here as in other countries. The railway in-
30 RAILWAY MONOPOLY—RATE REGULATION [30

dustry, whether in the hands of a single management, as
under government operation, or in the hands of numerous
private companies, as we have it, tends in its rate fixation
as well as largely in its service to follow the rule of mono-
poly. To prevent this tendency resort must be taken to
rate-cutting. Rate-cutting tends inevitably to unfair re-
bating, which is more injurious to the shipping public than
are uniformly high rates, and also it tends to the bank-
ruptcy of the roads and the impoverishment of the shipping
facilities. This policy is now strictly prohibited by law.
Of the policy of the interholding of stock and interlocking
directorates which may lead to manipulation of the financial
market and of contracts between the railroads and its cus-
tomers we have nothing to say here. But as for rate-
making, as the commission says, we have to do with a
monopoly whose rates are not subject on the whole to the
influence of competition:

What then are the rules which govern rate fixation?
And what are the principles that must be considered in the
regulation of railroad rates?

Stated briefly, the principle of monopoly price is that the
price is raised at the expense of the amount of business done
until the point is reached where the gain netted from the
rise in price is offset by the restriction of the business done.

The gross returns in any business are the amount of the
business transacted multiplied by the price at which the
business is carried on. There may be lines of business in
which, within reasonable limits, an increase in price will not
decrease the amount of business done. An example of this
would be an article which is used in conjunction with
other things and, while being a small part of the complete
product, is nevertheless essential to the product. The
platinum wire is a necessity for an electric lamp bulb, and
yet an increase in the price of platinum wire will not
31] WHOLE-RATE SYSTEMS 31

materially limit its use in that field. But this is an excep-
tion to the general rule which is that the higher the price
be pushed the less will be the demand for the article in
question, and even here if the price of platinum be pushed
high enough its use will be restricted or perhaps a sub-
stitute discovered. It can be stated as a general rule that
every commodity has a more or less elastic demand schedule;
that is, the demand for it falls off with an increase in its
price. That different articles have different demand
schedules is obvious, and that aspect of the matter will be
considered later; the point to be emphasized here is that for
commodities and services in general the demand is elastic,
the amount of business transacted falling off as the price
increases. Exceptions to this rule may be found in the
field of particular railway services, but it is certain that
while the demand schedules for railway services remain
substantially the same, the higher the rates as a system be
placed the less will be the amount of business transacted.
Neither is it necessary that the demand schedules remain the
same in order that a rise in price exert a downward pull
in the amount of business done. The apparent exception
to this “downward ” effect of a rise in rates would be seen in
a period of rising prosperity, when the amount of business
in all spheres is increasing. In this case a rise in rates
might not stop the increase in the amount of business trans-
acted, the business might increase in spite of the higher rate,
but the business would not increase as much if the rate were
raised as it would if the rate were not raised. In dealing
with such a complicated matter as a system of railroad rates
and the business depending upon them, it can be asserted
safely that an increase in rates will tend to decrease the
amount of business transacted.

It would not be easy, nor is it necessary to cite an ex-
ample where, in the field of transportation, the price has:
32 RAILWAY MONOPOLY—RATE REGULATION [32

been raised so that the traffic has actually fallen off on
account of the greater charge. It must be remembered
that the normal state of affairs in the transportation world
at present is expansion, an expansion due to entirely dif-
ferent causes from the influence of the rates. This expan-
sion had been going on with minor set-backs ever since, if
not before, the discovery of America, and has received great
impetus from the industrial revolution in England over a
century ago and later from the opening-up of the American
West. True, we have periodical set-backs, as in the year
after the crisis of 1907, but the ruling state of business,
and with it transportation, is a steady expansion. The
effect then of an increase of rates, if the increase were only
moderate, would be merely to reduce the rate of expan-
sion; expansion would perhaps still continue, but at a slower
rate. In fact it would require a considerable advance in
the charge absolutely to check the expansion, and a still
greater advance to change the expansion into actual contrac-
tion. So when we speak of the influence of an increase in
rates being a decrease in the amount of business transacted,
we mean that the amount of business is less than what
it otherwise would have been.

The field of transportation does not even abound in ex-
amples where the rates have been raised for the field as a
whole. The rule has been that rates have actually declined
with the expansion of business. Until within the last few
years the expanding business has brought with it such great
economies in the cost of conducting the business that the
normal charge per unit has declined. The business expan-
sion and the normal charge, which has declined during the
same period, might both be likened to streams, where even
to be anchored and to remain at the same place in either
would be retrogression as far as the normal current of af-
fairs was concerned. For business to cease its expansion
33] WHOLE-RATE SYSTEMS 33

and to stand still is a limitation of the normal current of
affairs. For price to maintain even a steady level, if ex-
pansion of traffice means economies of operation, is to limit
the normal expansion of the traffic.

That there is this correlation between price and the
amount of business transacted is admitted by economists.
But so little emphasis has been laid upon the fact that, in
the railway field, even in the absence of actual falling-off
of business, too high rates may mean limitation of traffic,
that we cannot forbear citing two very striking examples of
a tremendous increase of the traffic effected by a sudden
reduction of rates. In each case the reduction of rates
was so sudden as to preclude the possibility of the expansion
being due to other causes, and in the latter case the ex-
pansion has gone forward even in the face of depression
in other fields of business. Reference is made to the classic
story of the expansion of the post-office business in Great
Britain resultant upon Hill’s reform in rates; and to the
recent case in the United States of a tremendous expansion
of the carriage of parcels which took place with the re-
duction of rates at the time of the introduction of the
parcel post.

Hill’s reform has now so far passed into history that we
dare make only brief reference to it. Suffice it to say that
Hill, a postal clerk, conceived the idea that if the price of
postage were reduced to one penny from what averaged at
least a shilling, the amount of mail matter offered at this
lower rate would be so increased that the postal receipts
would be fully as large as before the reduction in price.
Hill’s expectations were not immediately fulfilled, but after
a few years the postal business did sufficiently increase as
the result of this reform fully to justify even such a drastic
reduction in rates.

The correlation between the reduction of rates and the
34 RAILWAY MONOPOLY—RATE REGULATION [34

consequent expansion of business is illustrated in a still
more spectacular fashion by recent events in the carriage of
parcels in the United States. Up to January 1, 1913, this
carriage of parcels was altogether in the hands of the express
companies, but on that date the government instituted a
parcel-post system which since then has been a most im-
portant factor in this business. The government went into
competition with the private companies and cut rates in a
rather drastic fashion. Since then the express rates have
also been reduced quite materially. We have in this a
very striking example of the growth of the business form-
erly handled exclusively by the companies and now carried
jointly by the companies and the parcel post.

It was expected that the reduction in price would bring
about an increase in the business as a whole; the business
handled by the companies might be reduced, but this re-
duction would be more than compensated for by the in-
crease in the business carried by the parcel post. It is im-
possible to secure data that will show the exact effect of the
change of rates, owing to disturbing influences and to the
fact that the data kept by the express companies and those
kept by the parcel post are not comparable in all particulars,
but facts enough are available to prove that the expectation
of expansion of business was more than justified.

The express companies have suffered. It is not a matter
for surprise that such should be the case. How much their
present difficulties are due to the advent of the parcel post
and how much to the general financial depression is a matter
that cannot be decided accurately. The New York World
is responsible for this statement regarding the situation of
the companies: *

During 10 months of the fiscal year ending last April (1914).
1N. VY. Werld, Aug. 18, 1914.
35] WHOLE-RATE SYSTEMS 35

the eleven largest American companies, two of which operate
in Canada as well as the United States, had an aggregate net
income from operation amounting to only $628,437, whereas
during the 10 months of the preceding fiscal year their net
income aggregated $4,231,465.

How much of this loss is due to slackness of business not
connected with parcel-post rates or order of the Interstate
Commerce Commission it has been impossible to estimate ac-
curately, but it is assumed that at least $2,000,000 of the loss
is due to parcel-post competition.

At this same time the gross earnings of the same com-
panies for the fiscal year of 1914 showed a falling off in
comparison with 1913 of $10,000,000.' Just as in the case
of the net earnings, this cannot by any means all be credited
to the influence of the parcel post. A general decrease in
express rates ordered by the commission went into effect
during this period, namely on February 1, 1914. And the
World assumes that a great deal of the falling off in the
net earnings was due to slackness of business in general.
We know from the evidence presented in the Five Per Cent
Case revision that the general transportation business was
very slack at this time. If we assume that the estimate of
the World as to the proportion of the decrease of net earn-
ings due to the parcel post would apply as well to the de-
crease of gross earnings, the amount of such loss to the
express business during the fiscal year of 1914 would be
some $5,500,000.

If the accounts showed that the business of the parcel post
had amounted to a sum equivalent to this loss to the ex-
press companies, then, in view of the fact that the business
was being handled at much lower rates and that we are now
measuring the business in terms of the money received for

1N. Y. Times, Nov. 18, 1914.
36 RAILWAY MONOPOLY—RATE REGULATION [36

its carriage, the only conclusion possible would be that the
amount of the traffic had increased sufficiently to make up
for the decrease in charge. But what do the figures show us?

It is impossible to determine exactly what traffic was
handled by the parcel post during this period. The post-
office does not enumerate all its handlings. It samples them
twice during the year. But a comparison with one of these
samples will suffice for an approximate conclusion. The off-
cial count for the first two weeks of the month of April,
1914, is very significant. The receipts from the postage on the
parcels carried by the parcel post during these two weeks
of enumeration amounted to $2,119,410... Just $119,410
worth more business in two weeks than what it is alleged the
express companies lost in net earnings during the whole
ten months. If these two weeks can be taken as a sample
for the year we can say that the parcel post business for the
full 52 weeks was approximately $55,000,000. During this
time the express companies lost $5,500,000. For every
dollar’s worth of business that the express companies lost
the parcel post secured ten dollars’ worth of traffic. And
it must be remembered that this is expressing the traffic
in terms of receipts, and to show increase of traffic due to
decreased charges in terms of the receipts from these low-
ered charges is in effect discounting the actual increase by
the percentage of the decrease of the charge. The only
possible conclusion is that the decrease of rates co-incident
with the inauguration of the parcel post has tremendously
increased the traffic in parcels handled jointly by the two
rival systems. Moreover it should be emphasized that this
increase occurred not during a time of business expansion
but in a time of quite decided depression. The increase
came in spite of business depression and hence can safely be

1 Annual Report of the Postmaster General for 1914, Appendix B.
37] WHOLE-RATE SYSTEMS a7

said to be due to the decrease in rates. This increase was
held in check by the high rates formerly imposed by the ex-
press companies. Could any proof be more striking that
even the maintenance of an old rate may be a serious cause
of limitation upon the expansion of traffic?

And yet “the traffic all moved out’ before—all that
existed at that rate of charge. The former rates met the
railway managers’ standard of fairness: “Any rate is rea-
sonable under which traffic will move absolutely. It all
moves out, it must be a reasonable rate.’ The new rates
built up new business, business that never existed before.
That is, within certain limits, the lower the rate the
more the business. Because, besides those producers.
who are in the field at any ordinary rate, there are
others who could and would be in business at a lower
rate. They cannot afford to pay the rate as estab-
lished, and so they are not in the field. Their traffic is not
there to move out. But if the rates were lowered they could
produce, and the business of the country would be increased.
Of course, this could not go on indefinitely, even though
the railways might be subject to the law of diminishing
costs. Toa certain extent the increase of the traffic would
make up for the lower rate; but there would be a decided:
limit here, beyond which the very continuance of the busi--
ness of the company would not allow a decrease in rates;
a limit where the increase in traffic fails to make up for
the decrease in rates. Needless to say, this limit is care-
fully avoided by monopolists. The price rule in monopoly
at least is to maintain price levels at the expense of possible
expansion, as shown in the case of the express companies,
if not actually to raise the rates beyond their former level,
as the railways are attempting to do at present.

In the ordinary fields of business subject to competitive
influences, the rule is that the price is raised as far or kept
38 RAILWAY MONOPOLY—RATE REGULATION [38

as high as the entrance, or the fear of entrance, of com-
petitors into the field will permit. When the price is raised
and the profits rise with it, competitors will tend to enter
the field so long as their ability to produce the goods or ser-
vices in question will permit; that is, the price limit is found
at the cost of production for the least capable of the com-
peting producers. But in the railway field we do not have
competitors entering the field, and consequently we lack this
limit, at least when we do not have outside regulation. The
point of similarity between competitive price and monopoly
railway rates is that each one tends to be as high as it can
be maintained. In competition the limit is in the ability of
competitors to enter the field, or, as the language of eco-
nomics would have it, the cost to the marginal producer.
In the case of monopoly there are no actual or possible com-
petitors to enter the field, and consequently, if there be no
outside regulation, this limit or norm for price does not
exist. But there is another limit. This limit grows out of
the state of affairs described in the preceding paragraph.
As the price is raised the amount of business falls off. After
a certain point the business becomes so much less that the
actual ‘income, in spite of the increase of price, is less than
it would be if the price had not been raised. Naturally this
is where a sensible monopolist becomes public-spirited and
restricts his rates. Sometimes, strange to say, this limit
is lower than the former. There are ill-favored and badly-
situated businesses which, even though they charge so much
that any increase would not result in more but even less
actual profits, yet are not making as much as the ordinary
competitive return on investments. Naturally such enter-
prises could not be expected to survive; capital would not
be likely to remain in them. However, such enterprises
do exist and that in the railway business; the reason being
that it is impossible for capital to get out once it is sunk in
39] WHOLE-RATE SYSTEMS 39

them. It might be said to be wedded to the enterprise with
no hope of divorce. Money laid out in railway track can-
not, if the enterprise prove unsuccessful, be taken up and
applied to another business. It is there to stay and must be
thankful to win any returns that fortune and good man-
agement may swing its way. Of course, it is true that as
the plant wears out and new capital is needed to keep the
business going, such enterprises will be hampered most ser-
iously unless their capitalization be reorganized.

Although there are railways which get all possible re-
turn out of the traffic and yet no reasonable income, still
in any well-situated and carefully-managed business such
is not the case. In any well-ordered railway the rule is that
the business should yield a return greater than that which
could be obtained from a competitive enterprise. Such rail-
ways, unless subject to rate regulation, may raise their rates
above the point where they will secure a return greater than
that enjoyed by competitive industries before they come to
the monopoly limit where any further increase would dimin-
ish their gross returns.

So far we have only considered the effect upon gross re-
turns. This, of course, is not the ultimate goal of business.
The question 1s as to what the net return may be. And this
adds to the problem the question as to whether or not the
business is subject to the law of diminishing cost, whether
or not the cost per unit of business decreases as more busi-
ness is transacted. It has been maintained, and is a fact,
that in the past the railway business has been so sub-
ject to the law of diminishing cost that as its traffic in-
creased it was cheaper per unit to maintain the traffic. If
this be so, it means much in the question of where the
monopoly price will be fixed. The aim of the enterprise
is to gain the greatest possible net return on all the business
transacted. The gross return increases for a time as the
40 RAILWAY MONOPOLY—RATE REGULATION [40

price advances and then after more or less gradually ceas-
ing to increase, on account of restriction of traffic, it begins
more and more rapidly to decrease. Since the net return is
the difference between this gross return and the cost, it
makes considerable difference whether the cost is decreasing
or not during the fluctuation of the gross return. Obviously
the point of greatest difference between this gross return
and the cost will be at a different place if the cost be dimin-
ishing as the business increases than if the cost remain con-
stant. Under the law of diminishing costs the point of
maximum net returns will be reached at a lower price and
greater amount of business than if the law of constant cost
obtains, and it will be at a still lower price comparatively
than it would be were the costs increasing all this time. If
the railway situation is, as has been maintained in the past,
that increased business is handled at less cost per unit of
traffic, then it is not to the advantage of the companies to
raise the rates and consequently decrease the traffic. But
if there be a limit to the operation of the law of diminish-
ing costs in the railway business, and if we have now
reached this limit, as there is much cause to fear, then the
companies are free from the above restrictions and may, as
monopolies, raise their rates higher than would be to their
advantage in the former situation.

As intimated above, the railroad business has been in
the past subject to the law of diminishing cost. To the
extent that property and equipment are only partially util-
ized, the business can be increased without a correspond-
ing increase in cost per unit. But a railway track reaches
its limit of efficient carrying capacity and then a new track
must be laid down, and terminal facilities must be enlarged
at high cost, while all the time the increase of equipment
must keep pace quite closely with the increase of business.
For many years, as the railway traffic increased, the rail-
41] WHOLE-RATE SYSTEMS 4l

ways were able to, and did, decrease their rates, but the
figures for the last fourteen years indicate that this is a
thing of the past. As the Interstate Commerce Commis-
sion pointed out in the first five-percent case,’ the transpor-
tation and traffic expenses have very substantially advanced
in ratio to revenue during the last fourteen years on lines
then under consideration. That this is due to a breakdown
of the law of diminishing returns as applied to railways may
be questioned, as the years 1906 and 1910, which had the
greatest relative density of traffic, show the least relative
ratio of cost to revenue. A more careful consideration of the
matter will show that declining costs cannot be so readily as-
sumed. A great density of traffic will for the time cause the
operating ratio of cost to amount of business to decline, but
that does not prove diminishing costs in reality. The cost
incurred by the traffic is not all laid out at the time, but is
spread out over a period of years. The actual operating
expenses must necessarily follow the density of traffic
pretty closely, but the replacement of worn out and obsolete
equipment is spread out in the expenditures of several years
after a rush of traffic. During a boom year the need of
many new tracks and much new equipment may be seen,
and the orders for these may be largely placed, but the
completion of all this new work and the payment for it will
not all be shown on the accounts of the companies for some
years. Consequently, to determine the question of the in-
fluence of the law of diminishing costs we must rely on the
statistics covering a period of years. The figures show that,
while the railroad business has increased a great deal, since
the opening of the century, the operating ratio, or ratio of
the costs to the returns, has also risen. During these last
fifteen years the traffic, both passenger and freight, has very

131 I. C. C. Rep., 376.
42 RAILWAY MONOPOLY—RATE REGULATION [42

nearly doubled, while the operating ratio instead of declin-
ing, as would be expected under circumstances of diminish-
ing costs, has actually risen more than ten percent. This
would look on the face of it as though the days of dimin-
ishing cost were a thing of the past. Certainly during the
last fifteen years, while the traffic has increased, the cost
per unit has not diminished but actually risen. But this
does not prove the actual breakdown of the formerly ac-
cepted principle. Too many disturbing factors enter the
field. It does, however, give strong reasons to fear that
though a sudden increase of traffic may cause a diminution
of cost per unit at that immediate time, yet, if the traffic be
already dense, this is only a temporary situation which will
pass away as soon as the requisite items of cost are added
to the balance sheet. It certainly appears that there has
been a weakening of the tendency toward diminishing costs
on the lines of denser traffic.

The increase of cost per unit is by no means altogether
due to the increase of traffic. It is a patent fact that the
price of labor has also risen rapidly during this period, and
this rise in the rate of wages has no direct connection with
the increase of business, and it may have no necessary cor-
relation with it. Neither has the increased tax bill arisen
from the increase of traffic and it is certain that this has
played a large part in the change of the operating ratio.
When we add to these disturbing factors the fact that the
rates have not been retained at the same point per ton-mile
and per passenger mile, we must conclude that the operating
ratio does not answer the question under discussion with
any clearness. Costs, to be sure, have advanced with an
increase of traffic, but there have been other causes that
have had a large influence in the change. The question is:
have these other factors produced all the change?

’ From 64.62 per cent to 75.96 per cent. 321. C. C. Rep., 350.
43] WHOLE-RATE SYSTEMS 43

The ratio of the revenue to the operating expenses is
not the only thing to be investigated. The increased traffic
and the accommodations which it has demanded have neces-
sitated an increase in property investment. Has the oper-
ating revenue during this period been increasingly profitable
or not, when viewed as a percentage on the property invest-
ment?

During the first five years of this period the revenue did
rise as a percentage on the investment. It continued rising
till the crisis of 1907. From then on it has fluctuated
widely, the total operating revenue averaging for the last
ten years about the same percentage to investment that it
assumed a year before the high mark of 1907. A straight
line fitted to the very irregular curve of the last ten years
would show a very slight rise in this percentage.’

CuHart I—fatio of total operating revenue to property investment for
all 35 systems

4900 1901 1902 1903 1904 1905 1906 1907 1908 1909 {910 191! 1912 1913 1914

 

Within this ten-year period during which the percentage
of revenue to investment has remained at about the same
general level, the rates, both passenger and freight, have
fallen to a certain extent. The average rate per ton-mile
in mills for freight fell from 6.94 in 1904 to 6.37 in 1913.

132 I. C. C. Rep., 349, Chart I.
44 RAILWAY MONOPOLY—RATE REGULATION [44

The passenger fares per mile have in this same time de-
clined, on the average, four-tenths of a mill, from 1.89c to
1.85c per mile. This decrease is due in part to reductions
forced on the railways by state legislation, and in part to
the fact that the cheaper freight traffic has increased more
rapidly than the higher classes. The effect of this latter
fact should not be to overturn the expected increasing re-
turns. Neither is the former fact of a decrease of rates for
the same kind of traffic by any means wholly responsible
for the failure of the percentage of revenue to investment
to rise. The increase of traffic has caused an increase in
investment, and in many cases investment at much higher
prices than previous investments. Certainly in so far as
railway expansion requires investment in new land, its busi-
ness departs from this rule of increasing returns as much
as does farming; perhaps more so, for its expansion is in
large measure at the cost of purchasing the very highest-
priced lands for terminals. And again as the Interstate
Commerce Commission shows,’ the increased traffic is de-
manding expenses that were never met at all in the past:

Another cause which has depressed the ratio of revenue to
investment in recent years, is the increasing proportion of in-
vestment in property, which, although used in transportation
and acquired in response to a public demand for better service,
is relatively unproductive under present practices. Among
other things, investments in equipment of improved type, dis-
placing other equipment of equal capacity, the elevation of
tracks, and the construction of expensive terminal facilities
in the large cities, while adding to the value of the service
rendered, have not yielded proportionate returns in revenue.
The greater part of these expenditures has been for the
immediate benefit of the passenger service. For instance, the

131 1. C. C. Rep., 375.
45] WHOLE-RATE SYSTEMS 45

Pennsylvania station in New York City has involved the ex-
penditure to date of about $114,000,000; and with respect
to the new passenger terminal of the New York Central in
that city it was said in 1910 in Advances in Rates—Eastern
Case, 20 I. C. C. 243,283, that:

“When its passenger improvements are completed in the
city of New York the New York Central will have expended
in that betterment $82,000,000, nearly one-half the capitaliza-
tion of that magnificent property, the Lake Shore & Michigan
Southern Railway.”

The Interstate Commerce Commission said in its first de-
cision on the Five Per Cent Case, ‘‘ The decrease in the capi-
tal cost per unit of production was so great that the ratio
of net operating income to property investment was larger
in 1913 than it was in 1900.” *

We have already pointed out that during the first part of
this period the ratio of revenue to investment did rise, but
that the average trend from about 1906 has indicated but a
very slight rise. The table which the Interstate Commerce
Commission publishes in support of the statement imme-
diately above * shows a very similar relation between the in-
crease in property investment and the increase in ton-miles
and passenger-miles. There was sufficient rise in the ratio
in the years up to 1906 to make a rise in the ratio for the
period as a whole. But if the figures from 1906 on be
treated separately a different aspect of the matter is shown.
It will be remembered that the significance of the ratio of
the revenue to the investment was complicated by the fact
that the rates for both passenger and freight traffic had
slightly fallen during this time. But the figures given in
this table by the Commission separate this element. We

131 1. C. C. Rep., 368.
2 Ibid., 360.
46 RAILWAY MONOPOLY—RATE REGULATION [46

have an opportunity to compare the increase of investment
directly with that of the freight and passenger traffic. Un-
fortunately the latter are separate and cannot be added nor
reduced to a common denominator readily except through
the medium of price. However, the figures are very sig-
nificant. The percentage of increase of both ton-miles and
passenger-miles up to 1906 over 1900 was double that of
the percentage of increase of the investment during the
same period. The increase of freight was 42.27 per cent
and of passenger-miles 42.26 per cent, while the increase
of investment in property was only 21.91 per cent. But
from 1906 till 1913 it has been quite a different story; the
passenger-miles have actually not increased as much as the
investment, while the freight has not by any means pre-
served the former tendency to increase twice as fast as the
property investment. The figures are, comparing those of
the year 1913 with those of 1906, an increase of thirty per
cent for investment, thirty-eight per cent for ton-miles, and
twenty-nine per cent for passenger-miles." We see that
even when the decrease of rates is eliminated, the invest-
ment has at present a very much greater tendency closely
to follow the increase in traffic.

But the operating expenses are by no means to be disre-
garded in this question. While in many points the increase
in operating cost is due to factors independent of railway
growth, yet in many ways it is directly brought about by
the increase in the traffic. And to the extent that it is
brought about by the expansion of traffic, its influence must
be added to the above-mentioned tendency of investment to
follow more closely in the wake of traffic. In regard to this
increase of operating expenses due to enlarged traffic the
Commission says :?

*31 1. C. C. Rep., 360.

2 Ibid., 377.
47] WHOLE-RATE SYSTEMS 47

The last ten years has been a period of remarkable develop-
ment among the railroads. During that period heavy loco-
motives have taken the place of the lighter types formerly in
use. The small and relatively light wooden freight and pas-
senger cars have been replaced by larger and heavier equipment,
some of the cars of each class being made entirely of steel;
many of the old cars have also been reconstructed partly with
steel. The more powerful locomotives haul longer and heavier-
trains with larger trainloads, and this has required the re-
tirement from service of many of the lighter cars, although
still in good repair, because they can not safely be operated
in the same train with the heavier cars of the more recent
type. The use of larger and stronger equipment and the
running of heavier and longer trains has necessitated a heavier
rail, stronger bridges, more and better ballast, more cross ties
per mile, larger tunnels, more ample roundhouses, stronger and
larger turntables, machine shops equipped with larger and
stronger tools to handle the equipment, the raising of over-
head bridges, and the enlargement and change in many other
ways of the facilities devoted to the service. In that period
also very large expenses have been incurred in the reduction
of grades, in straightening curves and in relocating bridges..
The volume of traffic also has constantly increased, necessitat-
ing the enlargement of platforms and warehouses, and many.
similar changes and additions to their facilities in order that
the carriers may meet the increased demands made upon them
by the shippers. In reconstructing their tracks and in chang-
ing and adding to their facilities in this manner the carriers,
wisely as we think, have endeavored somewhat to anticipate
the future and have not limited themselves to an effort to meet
only the current demands upon them for transportation. In
some instances changes of the character described have re-
sulted in the practical rebuilding of lines, and there are few
roads in the territory under consideration on which work of
this nature has not been done more or less extensively. To
provide for these changed conditions the carriers have ex-
pended during recent years enormous sums in the aggregate,
48 RAILWAY MONOPOLY—RATE REGULATION [48

much of which has properly been charged to their capital
account; but a very substantial part of these expenditures has
been charged to operating expenses through the maintenance
accounts.

This discussion applies to the railways in the north-east-
ern part of the United States, where the railway traffic is
more dense than in other sections. The facilities for handl-
ing the traffic are more nearly utilized up to the maximum
of efficiency than in the more sparsely settled districts in
other sections of the country. It may be that the time is
still far off when the railways in the South and West will
crowd this efficient utilization of their plant so closely that
the law of diminishing costs will cease to have any control-
ing influence in American railroading. But if this rule once
ceases really to operate in the East, we cannot hope that it
will perpetually continue to dominate conditions in the coun-
try at large.

It is not claimed that this law has wholly ceased to work,
even in the East. There are too many disturbing factors
which tend to becloud the issue. But in the light of the
facts and figures cited above, the conclusion can hardly be
avoided that as a controlling factor it cannot now be de-
pended upon to maintain railway rates at a low level.

If it were only the operating expenses which were forg-
ing ahead with the expansion of business, we might ascribe
the phenomenon to some other cause. Or if it were only
the capital investment which was tending to keep pace with
traffic, we might say that the companies were charging to
capital account what formerly went to running expenses.
But this cannot be true, for the criticism of the railway pol-
icy of the last few years has been rather that they have
sought to make as much as possible appear on their main-
tenance accounts. Neither can it be claimed that in these
last eight years the companies have invested more heavily
49] WHOLE-RATE SYSTEMS 49

than their traffic would warrant. The claim of the railways
has been that their income was too low to warrant even
enough investment for the public interest, and this claim has
been allowed by the Commission in recent years. No, not
only has investment tended to follow the expansion of
traffic since 1906, but when we add to the increase of in-
vestment the greater operating expenses, part of which are
unquestionably due to the expansion of traffic, we find a
marked falling-off in the ratio of operating income to prop-
erty investment; such a falling-off as cannot be ascribed to
the slight decrease in average rates, nor to the increase in
taxes. The ratio rose unsteadily till 1906, and with the ex-
ception of the year 1910, when owing to large increases in
traffic, which could not affect the investment at once, the
ratio rose to the average for the years 1906 and 1907; it
has fallen rapidly ever since. Instead of 6.31 per cent in
1906 it was in 1914 at 3.97 per cent for the thirty-five east-
ern systems, as will be seen from the following chart: *

Cuart IIl—Ratio of net operating income to property investment for
all 35 systems

1900 1901 1902 1903 1904 1905 1906 1907 1908 1909 1910 t91f 1912 1913 1914
| !

A
y1\

 

 

 

6.31
|

 

 

 

 

 

 

 

 

ae ©
° aN
fo) ty w o wi Ne 2
2 a 3 wo °
wo © wo
S a Ahi ey
ao we 0 w x
| IN
| nD
1 3

 

 

 

 

 

 

 

 

 

 

 

 

 

 

1Chart H, 32 I. C. C. Rep., 348.
50 RAILWAY MONOPOLY—RATE REGULATION [50

This, to be sure, is citing extremes of the curve, but if we
fit a straight line to the curve of the ratio from 1906 to
1914 we none the less would find a very rapid and cer-
tain fall in the ratio; such a rapid fall that it would be
very difficult to ascribe all this change from an increasing
ratio (which would be expected to go with the great in-
crease in traffic if this brought with it diminishing costs) to
the increased prices which the companies have to pay for
labor and supplies. It must be remembered that while this
decrease in the ratio dates from about the year 1906 the
general rise of prices began a full decade earlier. Rising
prices which have affected other business since 1896 would
not wait till 1906 to make their presence felt in rail-
roading.

The situation with the north-eastern railways leads to
but one conclusion in so far as it can be taken as an indi-
cation of what does or what will ultimately obtain with
respect to the railways as a whole in the United States.
The law of diminishing costs has lost its potency. We may
not enter at once into a period of increasing costs. Inven-
tion, either mechanical or fiscal, may to a great extent coun-
teract this new tendency. We may be able to maintain con-
ditions at constant costs, or even retain a slight degree of
diminishing costs, but the outlook at present is that, as far
as economic factors are concerned, the power of diminish-
ing costs is a thing that is passing. In our more settled
regions railway facilities are so fully utilized that increased
traffic must bring its share of increased outlay; and this is a
condition which apparently must eventually apply to the
country as a whole.

In earlier days the railway business was subject to both
competition and the law of diminishing costs, and it may
very easily be that there were periods when it would have
been to the public interest that rates should have been higher
51] WHOLE-RATE SYSTEMS 51

than they actually were. Certainly for brief periods rates
were so placed in some localities, and we know that many
railroads, if not most of them, have passed through periods
of severe financial embarrassment. Injudicious investment
and bad management, even with unrestricted monopoly,
may easily fail to secure a living return. This was espec-
ially true when the railroads were in the experimental stage.
But the experimental stage has passed. Unfortunately this
is not the case with bad management. Yet the time of ex-
perimental risks and cut-throat competition has gone, and
with it any likelihood that a well-located and well-managed
railway will not be able quite easily to earn enough on which
to grow and prosper, unless it be the victim of over-regula-
tion.

When we notice the immense fortunes that were built up
in the past and the continued enormous investment in rail-
roads, our suspicions are aroused that, even in the period
of competition, the trouble, taking it all in all, was not in
insufficient earnings, but in misapplication of the earnings
once they were garnered from the public. But this is a thing
of the remote past, and why concern ourselves about it?
Within recent times competition has fled before the laws
of econonomics and of legislators. Then the railroads be-
came monopolistic and their business became subject to the
law of diminishing cost. Also, until quite recently, govern-
ment regulation has been for the most part an adjustment
of the proper relations between the various patrons. Under
such conditions what can we expect?

We can expect that the railroad business would be pros-
perous. And at the same time we can expect that rates
would be retained at such a moderate level that the other
business of the country would be fairly prosperous also,
and this without material restriction of rates by the com-
missions. As we have seen, when a monopoly is subject to
52 RAILWAY MONOPOLY—RATE REGULATION [52

the law of diminishing costs, it is to its advantage to keep
its charges fairly low in order that its business may expand.
Even under such circumstances, however, we cannot expect
this tendency to go as far as it would normally if the busi-
ness were subject to the influence of competition. What the
monopoly naturally seeks is the greatest possible net return
upon its investment. And this rate of return is usually,
even under diminishing costs, greater than the rate of re-
turn enjoyed by business subject to competition. The usual
condition under unrestrained monopoly is that the rates are
higher than they might be, without reducing the net in-
come of the enterprise below the level of returns usual
under competition. This fact requires no discussion; the
railway field is full of examples. That the traffic over the line
would be increased by a reduction of rates can also hardly
be denied. That this state of affairs, when existent on a
particular line or system, is always opposed to the social
interest is not claimed. Neither is it a question just here
whether or not the charges under such a system are higher
than they would be if competition ruled in this particular
field. The contention is that since monopoly rules in the
railway field as a whole, the charges, to meet the private
interests of railways, are higher and consequently the
traffic less, than what would be necessary to give the rail-
ways a rate of return similar to what they or any other
business could reasonably hope to secure under competition.
This may be disputed, for it is a patent fact that some of
the railways are not now earning a living. But it must be
remembered that rates are subject to government regula-
tion now, and again that these railways which are doing
badly under present conditions would be doing far worse
if subject to competition. They would then follow the way
of the insolvent lines in the days of competition and laissez
faire, and of the derelicts in the other spheres of business
which pile up at every period of financial depression.
53] WHOLE-RATE SYSTEMS 53

But we have shown grave reason to fear that the law of
diminishing costs does not operate as strongly now as it
once did; that, as conditions give evidence these last few
years, the power of this economic law to keep rates down
cannot be counted on as in the days when the railway prop-
erty was less fully utilized. It cannot be claimed that the
days of diminishing costs are over for the American rail-
ways. But the facts do point to the conclusion that the costs
do not decrease with expansion of traffic nearly so much as
they did formerly. And to the extent that costs cease to
diminish this economic law ceases to hold down the natural
level of the charges.

We may then reasonably conclude that, since the rail-
way rates are not now held in check as formerly by the law
of diminishing costs, the policy of their directors may legiti-
mately be to raise rates at the expense of the expansion of
traffic. No one would expect them so to raise rates that
the traffic in future would be less than it is at present. That
would cause disuse of their property and equipment as at
present organized. Neither is it at all to be expected that
rates, if unrestricted by government regulation or the con-
sciences of traffic managers, would be raised so high as al-
together to stop the expansion of business which, with
occasional set-backs, is continually going on. The ten-
dency would simply be to skim the cream of the business
expansion a little more closely, rather more intensively than
extensively ; to raise the rates so as to retain only the more
lucrative part of the business while at the same time trying
to make it more lucrative. This is only legitimate busi-
ness, especially when the public has able representatives
who can look out for the social interests. It is the same
general principle which operates in all lines of business en-
terprise; only in spheres subject to competition is this ten-
dency held in close check by the underbidding of com-
54 RAILWAY MONOPOLY—RATE REGULATION [54

petitors. As we have seen when the law of diminishing
costs obtains, there is a strong limit to the tendency to raise
prices even in monopoly, but this limit is not likely to be
reached so early as in the former case. To the extent that
competition and diminishing costs are both absent or negli-
gible, the price, while still having its profitable limits, would
naturally be placed higher than in either of the preceding
cases, and this at the expense of the expansion of the busi-
ness. The natural policy of the railway managers would
then be so to raise rates that the amount of traffic actually
handled would be considerably less than it would be if the
rates were maintained at as low a level as they could be
kept and still allow the railways to earn as much as invest-
ments in competitive industries. This tendency exists to a
certain extent as soon as competition ceases to control, but
it becomes seriously operative when the tendency toward
diminishing costs loses its strength; and this certainly ap-
pears to be the situation at present.

So much for what the railway managers would naturally
be expected to do under the circumstances. It is probably
what many of their democratic shareholders would have
them do. In so far as the private interests of the railways
are all that are considered, or in so far as the social interests
are only a matter of subsidiary importance, this struggle
for net profits at the expense of expansion of traffic is legi-
timate business.

The statements of the railway managers as to their
policies does not give any very clear light on the question.
One might almost suppose, from some of their statements
before the Interstate Commerce Commission, that their
main object was philanthropy. But a more searching en-
quiry into their position shows that they are not proving
false to their shareholders’ interests, at least in this par-
ticular manner.
55] WHOLE-RATE SYSTEMS 55

Turning to the Interstate Commerce Commission report
on the Western Advance Rate Case, by Commissioner Lane,
we find an account of the views of President Ripley of the
Santa Fe, as expressed by him in that hearing:

“The maker of the rate,’ he says, “in the first instance
must make the rate such as to permit of the freest intercourse
and the freest interchange of commodities in the country, re-
gardless of capital, regardless of cost—almost regardless of
cost, but entirely regardless of capital.” Discarding the ele-
ments of cost and capitalization, he was asked to define a
reasonable rate, and replied that it was one that the traffic
would bear, “and the amount that the traffic would bear,” he
said, “is that amount of charge at which it will most freely
move over the lines of transportation.” This definition he
again repeated when he was asked if the phrase “ what the
traffic will bear” meant the rate at which the commodities
would “most freely move over the lines of the carrier,” to
which he replied, “I will qualify that by saying, ‘ What the
traffic will bear and still move most freely and enable the
products and the manufactures of one part of the country
to be used to the utmost possible extent in the other ’.” +

As Commissioner Lane says, “‘ This is the latest, the most
modern, and the most liberal definition of this much abused
phrase. Indeed, it is so liberal that it is impracticable un-
less properly qualified. Mr. Ripley would not have us to
understand that a railroad is an eleemosynary institution.”

It is clear that Mr. Ripley could never seriously have
meant what his words would at first glance imply. If the
last sentence quoted from his statement were to be taken
literally we would have to look for the Santa Fe to adver-
tise transportation free or at rates next to nothing. For
it is a patent fact that no matter how low the rates be, if

120 I. C. C. Rep., 349.
56 RAILWAY MONOPOLY—RATE REGULATION [56

they are charges at all, still more traffic might be hauled
if less were charged. To move most freely traffic must be
free of all charge. Mr. Ripley never meant that. He is a
sane man. That he did not mean that the traffic be hauled
as freely as the ability of the railways would allow is also
clear.

Judging by other contentions made by this gentleman in
the same case it would be hard to give the statement under
consideration any more liberal interpretation than that given
by the Commission, which says:

We assume that Mr. Ripley stated his principle of rate-
making, not only with the limitation we have already noted—
that rates were to be made so that, as a whole, they yielded
adequate return to the carrier—but with the further limitation
that they must be subject to the prohibitions of the law. Mani-
festly, under this principle all that stands between the shipper
and extortion is the wisdom and the good sense of the traffic
manager who makes the rates. If, in his judgment, it is ad-
visable to carry a small volume of traffic upon a high rate,
rather than a large volume of traffic upon a low rate, there is
nothing to interfere with this decision, and all the consequences
affecting the country at large, excepting now the right of
appeal to the government as represented in this commission.

Rates being made upon this theory, the function of the
traffic manager is that of a statesman; he determines zones of
production and consumption, the profits of the producer and
the cost to the consumer; he makes the rates, if he so pleases,
to offset and nullify the effect of import duties and determine
the extent and character of our foreign markets.

To make rates for transportation based solely upon the abil-
ity of the shipper to pay those rates is to make the charge for
transportation depend upon the cost of production rather than
upon the cost of carriage—to measure a public service by the
economies practiced by the private shipper. This necessarily
gives to the carrier the right to measure the amount of profit
57] WHOLE-RATE SYSTEMS 57

which the shipper may make and fix its rate upon the traffic
manager’s judgment as to what profit he will be permitted.
This theory entitles the railroad to enter the books of every
enterprise which it serves and raise and lower rates without
respect to its own earnings but solely with respect to the
earnings of those whose traffic it carries. This is not regu-
lation of railroads by the nation, but regulation of the in-
dustries of the country by its railroads.1

Even disregarding the fact that a rate may be so high
as to check the growth of business while still permitting the
movement of all the traffic already built up, yet the charges
may be unreasonably high from the standpoint of the ship-
per. As Commissioner Staples of Minnesota says:

If shippers generally would and could withdraw from the busi-
ness as soon as any rate becomes unreasonably high, it is, of
course, likely that the rates that would move the traffic would
not be lifted above a reasonable point. But there is hardly a
shipper who is in a position to do this, even if fully aware of the
fact that his rates are unreasonable. Few, again, stop their
business or withdraw from it at all. This especially is true in
undertakings requiring large fixed investments in plant and
equipment which can not be used for any other purpose.
They are often better off with one or two per cent profit than
with none at all, and will therefore continue to ship under rates
that would absorb most of the profits, although they may be
high enough to yield to the common carrier many times the
profit to which it is entitled. It is manifest that such rates
are not reasonable rates although the traffic moves out under
them.?

This statement of affairs is an argument against the oppres-
sion of the vested interests of shippers already in the field

120 J. C. C. 'Rep., 349-50.
2 Proceedings of the Twenty-third Annual Convention of the National
Association of Railway Commissioners, p. 35.
58 RAILWAY MONOPOLY—RATE REGULATION [58

and of the business already built up. If, as Mr. Staples’
experience as Commissioner has shown him, the actual prac-
tice of the traffic managers is to raise rates, if possible, so
high as to encroach upon the profitableness of established
business, it must certainly be holding back much more traffic
that might be moved if the rates were lower. Apparently
Mr. Ripley’s description of the principle of rate-making is,
if a literal interpretation be taken, a Utopian dream. Pro-
spective traffic is held up by the scale of charges imposed by
the railways. And if there were no other restriction on
charges than the ability to make net profits, there would be
strong reason to suppose that the public interest was not
being cared for.

It is only reasonable, as already pointed out, that the
railway managers should seek to increase their profits.
Even President Ripley, of the Santa Fe, whose remarks
quoted above bear witness to his care for the social interest,
sought to raise the charges on his system so that the profits
might be raised higher than it had been possible to maintain
them in the period when the Government had imposed no
restriction. As Commissioner Lane says on this subject:

It is apparent that the carriers at present in this and similar
cases are relying upon the restrictive provisions of the law
which declare concessions from the published rate to be crim-
inal and thus give stability to rates—at least as between carriers
—to permit the elevation of rates to a standard which under
the force of competition the carriers were unable to reach
and maintain.

President Ripley, of the Santa Fe, in his testimony, which,
it may be said, was the broadest and most statesmanlike of any
given herein, said that in the past the rates in the territory
through which his road runs had not been sufficiently high, al-
though they had been made without any substantial regula-
tion. Being asked if in his opinion the result of operating
39] WHOLE-RATE SYSTEMS 59

railroads without regulation had resulted in not making a
proper return to the carriers, he answered emphatically, “I do.”
“And now, that we have regulation, rates should be put
upon a paying basis, is that your opinion?” he was asked.
To which his answer was, “ Yes.” +

The figures regarding the earnings of the Santa Fe which
the Commission publishes in support of its refusal to allow
the proposed advance in rates indicate that this line was
not in a relatively bad condition financially. And the
London Statist, which must be taken as an authority in no
way prejudiced against the position of the railways said
in an article in the issue for December 3, 1910, in regard
to the general financial condition of the American railways
at that time:

No one who acquaints himself with the condition of the
American railway industry can fail to be impressed by the
strong position it has now attained. . . There is practically
no comparison between the physical conditions of the railways
to-day with that of ten years ago. The main lines of the
country are now furnished with very heavy rails, are pro-
vided with strong bridges, have easy gradients and moderate
curvatures, all of which render travelling much safer than
it used to be. The employees have derived great advantage
from the new order of things, and in the past ten years have
secured much higher rates of wages and conditions of labor.
The return upon capital has also appreciably increased, and
their improved credit has enabled and is enabling the railways
to raise the additional capital required to deal with the grow-
ing traffic without difficulty—a matter of no small importance.

The ratio of the operating income to the property invest-
ment, as shown in the figures for the eastern railways, was
not, to be sure, any greater in 1910 than the previous

+20 1. C. C. Rep., 318.
60 RAILWAY MONOPOLY—RATE REGULATION [60

high-water mark of 1906, but it was not appreciably lower
and the appearances were not strong at that time that it was
about to fall off seriously in the near future. In short, it
is evident that the statements of the railway men, as quoted
by the Commission, claiming a more remunerative rate than
they had been able to secure before the legal prohibition of
rate-cutting had built up their monopoly status, are a true
outline of the policy of the managers. As the Commission
says:

We inquire again, Why was not such a higher rate imposed
long ago? The answer is, We could not maintain it; the pres-
sure of shippers and carriers was too strong. May we not ask
one more question, Why then do you seek it now? And should
not the answer be, Because we think we can get it. We are
united in mind and the law will safeguard our right to it.
The reasonable rate was the one that could be secured. That
definition remains as the carriers’ guiding star.*

That the Commission was right in its view of the case in
refusing the advance in rates and that the carriers were
asking too much does not necessarily follow from the fact
that they wanted more than they got under competi-
tion. It is a well-known fact that competition in the rail-
way field may reduce earnings much below that limit of
fairness which is supposed to rule in other lines of business
where competition operates naturally. But that such was
not the case taking the situation as a whole, that the rail-
ways of the United States, previously to the legal restric-
tions on rate-cutting, had been earning too little, is disproved
by the record of the enormous growth of our railways
throughout this period. Investors did not put their money
into railways to satisfy a passion for gambling. They in-

120 I. C. C. Rep., 356.
61] WHOLE-RATE SYSTEMS 61

vested because it was profitable for them to do so. The
railway enterprise bids for investment in the open market
for funds in competition with other lines of enterprise, and
the result has been a phenomenal expansion of the trans-
portation facilities in this country. As Mr. Dunn, Editor
of the Railway dge Gazette, says in a recent book, compar-
ing the privately owned system of the United States with
the government system of other countries:

Under private ownership, the development of the railways
of this country has gone forward at a rate which, until recent
years, has not been equaled in any other country. The capa-
city of the railway trackage and equipment provided in pro-
portion to both area and population is not surpassed in any
other country; and while there are sometimes shortages of
facilities for hauling freight traffic, these are not peculiar to
this country. Similar shortages occur on some of the other
leading private and state railways of the world.t

This is a comparison by a well-informed authority and
one favorably disposed toward the railway interests. And
the comparison is made with other countries where the lines
are operated by governments which have no other restraints
than economic limitations to prevent them from expanding
their service, countries where, the railway management and
the government being one and acting for the public interest,
the service has been expanded without being hampered on
account of rate restriction by a government commission.
These railways, being owned and financed by the state, have
been pushed in some instances, by the use of public credit,
into regions which were unprofitable for years, if judged
from a private economic point of view. And yet the
American railways, being financed in the open money mar-
ket, in competition with other possibilities for investment,

1 Dunn, Government Ownership of Railways, p. 376.
62 RAILWAY MONOPOLY—RATE REGULATION [62

where the investor had reasonably good knowledge of the
profitableness of his investment, have, unless very recently,
expanded more rapidly than the railway systems of any
other country. What better test could be found as to the
sufficiency of the railway income during this time of ex-
pansion?

No doubt the railway men in their zeal for pushing their
work feel that the expansion might nevertheless have been
still greater. But the history of our railroading shows that
expansion may be too rapid. On the stimulation of a boom,
railway building may be carried farther than the needs of
other business for the average times between the booms.
Such an expansion can only end disastrously. Provided
that their activities be held in check by the Commission, it
is natural and fortunate that the railway managers push
their expansion as fast as they may. Since the Commission
has become a rate-restrictive body, such a tendency on the
part of the railway interests will prove of advantage to the
country in counteracting the natural tendency of any body
of men to push restriction toward an extreme. But during
the period when the railways were independent of such re-
striction, the income was sufficient to warrant an expansion
which has kept pace with the country’s needs.

If this be so then when we consider the position of the
Santa Fe in its brief in the Western Advanced Rate Case,
we naturally conclude that the railway managers, while not
wholly unmindful of the public interest are yet mainly
actuated by their own. They say: ‘‘ The case of the Atchi-
son, Topeka & Santa Fe Railway Company is that American
railway rates never have been high enough and that the
public never has paid adequately for the service which it
has received.” *

1 Brief of the A. T. & S. F. Ry. in Western Advanced Rate Case.
63] WHOLE-RATE SYSTEMS 63

The conclusion must be that as the commission says,
“The reasonable rate was one that could be secured. That
definition remains as the carrier’s guiding star.” The rail-
ways while not unmindful of the public, put their own
interests first. Their tendency is to raise the rates so as
to retain only the more lucrative part of the business while
at the same time making this more lucrative. This tendency
to off-set expansion is becoming greater as the railways are
less subject to the law of decreasing costs.

This is the reason why we must have commissions with
authority to restrict the rate-making powers of the traffic
managers. In addition to their authority to deal with dis-
crimination between shippers, the commissions have for
some time had the power to restrict the rates even when
there was no question of discrimination. The reason for
this is the social necessity to off-set the monopolistic price-
making power which economic forces and the law of the
land have given to our systems of transportation.

Such being the case, on what principles should govern-
ment regulation proceed in its dealing with the regulation of
systems of rates? Where the relative advantages or dis-
crimination between the shippers is of less relative import-
ance than the question as to the reasonableness of charge as
between the railway interest and the shipping public, what
principles must govern?

There are two principles which bid for acceptance, the
principle of cost and the principle of value of service. Each
of these has its advocates; each quite different meanings, and
each, as will be seen, has its place in the theory of rate
regulation.

The theory of cost has been very vigorously attacked.
The railway men used to claim that cost had nothing to do
with rate-making; but recently they have learned that it is
a most useful principle with which to defend themselves.
64 RAILWAY MONOPOLY—RATE REGULATION [64

against the zealous commissioners. Moreover, the two
arguments which have been most potent against the cost
principle lose their force at the present time and for the
question in hand. It has been claimed that cost figures
could not be computed, that the data for the application of
this principle could not be found. The day when this
argument could be effectively used, except for the cost fig-
ures of particular elements of traffic, passed with the ap-
plication of the accounting methods inaugurated by the In-
terstate Commerce Commission. Cost figures are continu-
ally being used by the carriers in their defense and have
had especial significance in the cases involving an attempt
to increase schedules of rates as a whole, as in the great
cases of 1910-11 and the recent five-per-cent cases. These
cost figures may lack precision as yet, but it is hoped that
the valuation work of the Interstate Commerce Commission
may greatly improve the situation. The other great argu-
ment against cost is one that does not apply to the specific
problem on hand, but which will be discussed later, namely,
that regulation on a cost basis means that the cost of each
element of the traffic should be worked out and the rate made
strictly. in accordance therewith. For the present the discus-
sion is confined to what should be the guiding principle in
the regulation of schedules of rates as a whole, leaving, for
the present, the question as to the proportion of the burden
which each element of the traffic should bear.

President Ripley, to quote him again as an able exponent
of the railway man’s attitude, says, “I think they (the com-
mission) should consider the value of the service first and
foremost and leave the cost and the value of the properties
to altogether secondary consideration.” *

The Interstate Commerce Commission also at first ac-

120 1. C. C. Rep., 340.
65 | WHOLE-RATE SYSTEMS 65

cepted the value of service as the true principle of rate-
making. As they said in their first annual report: “ Such
method of apportionment would be best for the country
because it would enlarge commerce and extend communi-
cation; it would be best for the railroads, because it would
build up a large business, and it would not be unjust to
property owners, who would thus be made to pay in some
proportion to benefits received.” ?

It should be noticed that in the first stages of its work the
Interstate Commerce Commission was dealing principally
with the question of rates on particular commodities, and
judged these by comparison with other rates by the criterion
of value. They have not confined themselves to the view
expressed above in their dealing with whole-rate schedules
and rates whose reasonableness was to be judged aside from
the question of comparative advantages to shippers.

For a view at the other extreme of the question, Commis-
sioner Thorne, who is very well known at present in the
railway world, may be quoted:

If you do not take cost of service as a basis, but adopt
value of service to the shipper you are taking a basis that
becomes impossible for practical application. The value of
service on one railroad to the shipper depends upon how much
he can get the same service done for by somebody else, or else
upon the improvement in the value of what he has to sell.
When the railroads are all united as they are at the present
time value of the service without competition is the difference
in what it costs to haul stuff by railroad compared to what
it costs to haul stuff by wagon.?

This statement is evidently addressed to the point in
view, viz., the mere question of fairness between the rail-

1 First Annual Report of the I. C. C., pp. 30-32.
2Letter of November, 1911. (Private correspondence.)
66 RAILWAY MONOPOLY—RATE REGULATION [66

way and its patrons. The inference is that the value of the
service can be measured only by the improvement in value
of the commodity by virtue of the services performed on it
by transportation, or by measuring the cost of the next best
substitute. These are in principle criteria by which we meas-
ure economic value. But are they of any use at all in rate
regulation?

Considering first the improvement in value from the
transportation. This reduces itself to the railway rate be-
tween the two places. The price of wheat is higher in New
York than in the West by the charge for shipment. Of
course, since New York stands in great need of wheat or
its products, this charge might be placed at a higher figure
than that at which it now stands, and still wheat would
move. The demand for wheat is elastic. It would not en-
tirely cease to move with a higher price, but, as we have
seen is the general rule, the amount carried would decrease
with the increase of the charge for carriage. What, then,
is the value of the service of carriage? It is manifest that
the possible value is an unsettled quantity. There are con-
sumers to whom the possible value of a limited amount
would rise to famine prices. Even these persons would use
more if the price were less, and there are those who could
never pay the higher prices at all who do consume largely
at lower prices. There are even uses to which wheat might
be put which are cut off at the present prices. One might
eat two sandwiches instead of one for lunch. It is very evi-
dent that there is a series of potential values for any eco-
nomic good the supply of which is subject to variation.
This series of potential values makes up what is known as
the demand curve for the article or service in question. It
is along this series of possible values that monopoly may
push up its price till the amount demanded so falls off as to
decrease the actual profit. In so far as transportation
67] WHOLE-RATE SYSTEMS 67

charges make up the price in question it is at this upper
limit along the demand curve that the monopoly charge is
fixed, and it is at this point that a monopolist estimates the
value of the service. It is the only definite point along the
series that is determined by the consumers or by their de-
mand for the goods in question. It is the point of maxi-
mum social ability to pay.

Manifestly this price is of no use to the regulating com-
missions. No well-informed monopolist would exceed this
limit; and if he charged less, the public would be only too
happy.

The other possibility for the measure of value of the ser-
vice is what is called the marginal value. This is the usual
economic measure of value. It is the value to the consumer
who is least able to pay and still does pay, or the lowest
possible use of the good or service to which it is actually
put; it is the lowest potential value in the service that comes
to be included among the actual transactions. Is this cri-
terion of any use to us for the question in hand? Clearly
it is not. It is about as much good as the formula: “ That
which is, is; that which is not, is not.” If the price be fixed
at the monopoly limit, the marginal value will be the same
as this price, for consumers will enter or leave the field,
according to their ability to pay, until the market be ad-
justed to the price. If the price be reduced, the marginal
value will follow it to the new level. To be explicit, if the
price be lowered, consumers will enter the field—or if the
price be raised, consumers will leave—until the last one in,
whose offer is always the marginal value, is just able to
pay the price as fixed. The demands of customers of the
railways, or, in other words, the market for the railway
service, only fixes the limits of profitable price and the
amount of service demanded at the price as fixed by the
railroads. The marginal value is the same as the price, and
68 RAILWAY MONOPOLY—RATE REGULATION [68

is measured and determined, within the above-mentioned
limits, solely by the price. If this be so, the improvement
in value due to the transportation, so far as it is at all meas-
urable, reduces itself to the railway rate between the two
places. Clearly, the rate is of no use to regulate the rate.

Now what is to be said concerning the other criterion, the
cost of the next best substitute? ‘Commissioner Thorne
puts this in the worst possible light, and at the same time
very clearly.*

It is impossible that the cost of carriage by wagon should
measure the value of railway service. The great bulk of
the traffic that now exists simply could not move at all at
such rates as wagon carriage would necessitate. It would
not exist. The relatively cheap transportation has brought
into being an enormous service whose value per unit of
transportation is nowhere near the charge which would
be necessary to maintain wagon transportation. Of course
no one argues that railway rates should equal wagon
rates, but such an extreme statement helps to show the im-
possibility of measuring the value of the service for rate-
making purposes by measuring the cost of a different means
of transportation.

It might be argued that a fair measure of the value of
the railway service to the public would be what it might cost
the public to supply the service itself; not necessarily to
build new lines, but to acquire and operate the old systems.
But it is very difficult to see how the standards of one sys-
tem could measure fairness for another entirely different
system of affairs. If we were to change to an entirely dif-
ferent order of operation it might very easily be that the
service, including the amount of the traffic, would materially
change. The change would probably not be at all so strik-

1 See page 56.
69] WHOLE-RATE SYSTEMS 69

ing as that which would be brought about were we to revert
to the pioneer wagon, but we could have no assurance that
it would be the same service that would exist. If this be
so, then we need not talk of measuring the value of one
service by the cost of another.

As matters stand we are committed to our present sys-
tem of privately owned and operated railroads. It is the
regulation of the charge for this service as it now exists, or
may exist under private operation with governmental regu-
lation, that we are considering. And we cannot, from con-
siderations of the cost of any other potential service, im-
pute any value to this actual service that will be of any
practical assistance to us as a criterion of the fairness of
rates on this actually-existent service. What we want to
know is what principle of regulation will be the best for our
present system of privately-owned railways, for what would
be fair in another system might be very unfair to them.
It would be very unfair to compel them to maintain the
present service at rates unremunerative to them just be-
cause a system financed and operated by the government
might give the service at lower rates. And on the other
side, if the rates under government operation would be
higher than at present, that is no reason why the rates of
our present system should be increased.

In short we have not discovered any criterion for just
regulation from either of these possible measures of value.
It may be possible, as we shall see later is the case, that
value is of great use in determining the justice of rates com-
paratively, when the question is as to the comparative bur-
den to be borne by different articles, but the value of the
service is such an indeterminate quantity that by itself it
can give us no solution of the question of regulation of
whole-rate schedules. There are only two points in the
series of potential values that are even toleraby definite, the
70 RAILWAY MONOPOLY—RATE REGULATION [70

point which will yield the greatest monopoly profit, and the
marginal value or the value to the least able of the actual
patrons. If the first of these be taken as the real value to
be considered then we'need not talk of regulation, the rail-
ways are as able as any regulative commission to ascertain
this, and it is to their interest to charge in accordance with
it. As for the marginal value, economically speaking, this
is the actual value of the service. It is at the margin that
we measure real value. But it is very evident that this point
on the scale is fixed simply at the rate whatever that may
happen to be. The only conclusion that we can make is
that value of service by itself can afford no criterion for
regulation, where the question is of schedules of rates taken
as a whole.

What, on the other hand, can be said for the principle of
cost? Is there anything definite about cost that will make it
available for the purpose in hand?

It may be seen by reverting to the discussion of the ques-
tion of the operation of the law of diminishing costs in rail-
ways that the element of cost is not definite. The cost
varies with the amount of the service. It may be less, or
it may not be less, with an increased traffic, but the chances
are very strong that a change in the volume of traffic will
make a change in the cost per unit of this traffic. In taking
a period of several years we find that the costs follow the
change in the volume of the traffic, yet within this period
the costs per unit would fluctuate widely. The amount in-
vested cannot fluctuate punctually with the fluctuations of
business. It can hardly decrease when traffic falls off, and
its increase cannot follow the increase in traffic at all closely
except as we take into consideration a period of several
years. Then, again, when we investigate practical condi-
tions, we find that in taking any large area into considera-
tion there are several lines handling the same service, which
71] WHOLE-RATE SYSTEMS 71

must necessarily be taken on the same terms by all, but the
costs on the different lines are not the same even at any
particular point of time. The cost of railway service is not
so simple or definite a thing that we can readily say whether
or not even systems of rates on traffic already in existence
conform to the cost. Moreover, if we should be able to fix
rates on the basis of cost, and if this should bring about a
change in the rate, there would follow a change in the
amount and volume of the traffic that would react on the
cost and necessitate a recomputation.

Is the problem then hopeless? Can we arrive at no solu-
tion of the question as to the criterion for regulation? It
is doubtful if we can ever find one single principle that will
solve the riddle. Just as in our ordinary competitive eco-
nomic life the price depends on both the supply and the
demand, so here we must take cognizance of both principles,
both the value and the cost.

But this does not mean that these two principles are of
equal weight in regulation or that they are equally work-
able as criteria. Neither does it mean that even in conjunc-
tion the two principles can be worked out in any very simple
manner. The value principle cannot be utilized simply by
considering the marginal value, for this depends directly
on the rate. We must rather proceed in this direction by
investigating what the traffic will bear, or, more explicitly,
how the traffic will bear the rate that may be imposed. The
matter of interest is not any particular value, which varies
from patron to patron and even with the same patron, but
the series of potential values. We want to know how much
the service will be used at the different points in a possible
scale of charges, how the amount of traffic will depend on
the rate. This, so far, is just what the railway manager
wants to know, only he wants to know how the traffic
varies with the rate in order that he may place the rate so as
72 RAILWAY MONOPOLY—RATE REGULATION [72

to secure the greatest net profit. The public wants to know
this relation so that the traffic may be built up, even at the
expense of the income, until the rate shall fit the cost to the
railway of handling that amount of traffic. Is this want of
the public just and reasonable, and is it workable?

The cost principle, disregarding the troubles of segrega-
tion for the different classes of traffic, is more workable
for regulation than the value principle. For any one class
of service the law requires that the charge must be the same.
So, taking this as a unit, all that we need do, all that we
can do, is to take the average cost of this branch of the
service, and this, while the amount of traffic remains con-
stant, is a simple quantity for all the items within the class.
But while this cost remains the same, the value to the
patrons varies within wide limits. The passenger traffic
between New York and Philadelphia is sufficiently constant
for the railways to know how many trains to provide and
how many cars for each. But who could say what the value
of the service is? It varies all the way from those who
look at the four dollars a long time before they buy their
ticket to those who would not forego the trip for perhaps
hundreds of dollars if there were no other means of trans-
port. “The reason that cost is more simple than value in
this case is that the patrons are far more numerous than
the railways. The railway costs may be a variable scale,
but so are the values to the patrons; and so we may say that
the values are more variable than costs, as patrons are more
numerous than railways. Costs vary somewhat about
normal, while values vary tremendously from the low-level
of shut-out would-be customers to what a very few could
pay were they forced to it.

And to stress this principle seems just and reasonable for
the very reason that it is the element which would be left
out unless stressed by the regulators. The element stressed
73] WHOLE-RATE SYSTEMS 73

by the railways is certainly not this; judging by their own
statements they would not consider this were they not
forced to in self-protection. Nor, as repeatedly stated,
could we reasonably expect them to do so. The public is
able to look after its own interests. It cannot expect the
railways to do so except as it is profitable for them to do
so. The public cares for the railways only as it is a ques-
tion of its advantage. And so the principle stressed by the
railways is that of value in the sense of what the traffic will
bear. What the railway men naturally have in mind is
what the ability of their patrons may be to pay. They have
been held in check in the past by the law of diminishing
cost, by competition, by regulation, and, if corporations
have consciences, by their consciences. But still this has
been, and is, their ruling principle. Is it not just and fair
then that regulation should emphasize the other element of
the two which have so far proved themselves necessary in
other economic fields? The application of the principle of
cost is but regulation of rates on the standard of that for
which the railways are able to supply the service.

As stated above, the operation of this principle would, if
the rate were originally above this level, reduce the rate
and so extend the traffic until the limit was reached in the
ability of the railway to provide the service at the pre-
scribed rate. Provision must be made for the fact that the
cost would change with the change in the traffic, and here
again we must know the extent of the influence of dimin-
ishing costs. But it seems no more unreasonable to suppose
that the ability of the railway to supply the service would
be more difficult to ascertain than the ability of the public
to bear the charge.

Does not the social interest demand the application of
this principle in regulation? That the railroads are public
servants is legally established, and acquiesced in even by
74 RAILWAY MONOPOLY—RATE REGULATION [74

the companies themselves. Their function is to provide the
service of transportation. If so, then certainly they should
provide the greatest possible service. Their service should
be limited only by their ability to provide it. The railways
exist for the public, not the public for the railways. Ex-
tension of the railway net, limited only by the ability of the
patrons to pay for it, is not our goal. Railway extension
must proceed as the public business demands it rather than
as it allows it. But the public business, being the ultimate
social end of transportation, the end for which we have
fostered the railways and allowed them to become monopo-
lies, should be held in check only by the ability of the rail-
ways to provide the service. And this ability of the rail-
ways to provide the service is what is to be worked out by
the theory of cost.

The enforcement of this principle by regulation is not at
all unfair to the railroads. It merely supplies by govern-
mental law what railway men and the public expected to
dominate by force of natural law. When the railroads
were being established, it was expected that they would be
subject to the price-restraining force of competition. The
result expected was as great service as possible for the price.
It was not the competition itself that was wanted at any
time. And experience has shown us that competition really
did not give us this in the railway field. Competition was
injurious to both the railway and the public interest, so we
have practically abandoned it. But we know the result we
wanted from it, and can obtain this result with more fair-
ness to the railways than by the use of competition. Cer-
tainly it is only fair, then, to allow the railways to abandon
competition and to secure if possible this result of the
greatest possible extension of business through the saner
method of regulation. And this principle of costs affords
a most useful limit to the activities of over-zealous com-
‘missioners.
75] WHOLE-RATE SYSTEMS 75

This theory of cost to the railways has been worked out
along the line of an attempt to allow a fair return to the
railways upon a fair valuation of their property. Of course,
in costs we must provide for all running expenses such as
labor and supplies. But these items are so easily ascer-
tained and so patently must be provided for, that they do
not require much discussion. To be sure they constitute a
large part of the railway costs and are a first lien on the
income and it must also be noted that, rising as rapidly as
they have been doing of late, they are playing a tremendous
part in railway finance. But they must be met; no one chal-
lenges that. There is no problem in theory as to that.
There is, however, a big problem as to what is the criterion
of the ability of the railway to supply the services of trans-
portation.

As stated above, the theory is being worked out as a ques-
tion of allowing the railways a fair return on a fair valua-
tion. To this, then, we turn. An attempt will be made to
sketch briefly the development of valuation and the prin-
ciples involved in it, and also to discuss what is the return
to which the railways are entitled, whether it be based on a
valuation of their property or on some other standard.
Whether or not they are entitled to a return as an earning
on a certain property valuation we may question very easily,
but, at least in view of the enormous work that is being
done on valuation, we must expect to find it a sufficiently
good criterion of railway ability to warrant a careful con-
sideration. And we also must attempt to discover what
part the value of service plays in the theory of rate regu-
lation.
CHAPTER II
VALUATION AS A CRITERION OF RAILWAY ABILITY

WE turn now to the consideration of the ability of the
railways to supply the service. This is the question of cost.
It is the question of the cost of the service as a whole
rather than the cost of carriage of particular elements of
the traffic. In fact we can for the present set this latter
phase of the subject entirely aside. We want to know how
far the regulating commissioners may go in principle in ex-
tending the traffic or service of the railways by means of
rate limitations without trenching on the rights of the
companies, or, what will be shown to be the same thing,
the abilities of the railways to supply the service.

As already stated, this is a question of cost. It may very
easily be that nearly one-half of the gross railway income
goes to labor, as claimed by the Pennsylvania Railroad.
But this element as well as that of fuel and other strictly
running expenses must be taken out of the gross income
before we arrive at the corporate income, the income on
which the railways themselves live and grow in order that
they may supply the service to their patrons. Such elements
as labor must unquestionably be provided for, and, if we
overlook the matter of more or less unavoidable wastes, we
may hold that in so far as they affect the problem at issue
their amount is no greater and no less than necessary. They
must be provided for before arriving at net corporate in-
come, and their amount is decided by economic laws which
it is not worth while here to call in question. But as to the

bearing of the other great division of the costs, that of the
76 [76
77] VALUATION AS A CRITERION 77

net corporate income which is due the railways, there is
great room for discussion.

If it were only a matter of deciding what was due to a
particular railway of known capital value under settled con-
ditions of traffic and interest requirements, this element
would also be simple. But such is in no way the case. It
is a question of corporate costs for the situation as a whole,
with a view to the fact that there are rival lines of different
ability in the same field, that interest requirements are not
settled, that traffic conditions are not only subject to change
but that what we want is that traffic should expand as
much as it may, and last but not least that the true capital
value of the lines is not as yet defined. Leaving for the
next chapter the discussion of the rate of return on the
property, and assuming that such rate of return may be
determined, let us now consider the problems as to the re-
lation of the value of railway property to the regulation
of the systems of rates, and the principles upon which the
value of this property is to be determined.

Much had been said against the policy of basing railway
rates on any valuation of the property concerned. But no
better criterion has been devised whereby it is possible to
avoid the monopoly advantage of the companies over their
patrons and to relate the rates to the corporate ability. In
fields of enterprise subject to competition, capital value is
measured by the earning power. Manifestly this criterion
of value is out of the question for making a valuation for
rate-regulation purposes. But even in competitive fields
the earning power is only one side of the question. If new
capital stock can be added, there is a very definite relation
between the estimation of value placed upon the vested cap-
ital and similar goods devoted to other uses. The earning
power limits the investment in any particular enterprise,
but the value is determined, not by the earning power in
78 RAILWAY MONOPOLY—RATE REGULATION [78

the particular use alone—unless possibly this be the least
profitable use to which the goods in question are put—but
by the earning power in all uses, and this value is measured
by the least profitable use to which the goods are put. It is
objected that property invested in the railway enterprises
is fixed in this particular business. This to a certain extent
is true. But it is none the less true that there is a constant
flow of goods, if not out of the railway enterprise, at least
from markets where other enterprises compete into the rail-
way use. There is a constant connection between railway
investment and the market for similar goods. If this be so,
it does not seem unreasonable to hope that a fair and work-
able method may be found of so estimating the value of
the railway property that the corporate ability may be cal-
culated with sufficient accuracy to afford a just standard
to which to conform the rates and extend the traffic of the
companies. Moreover, the principle of valuation for rate-
making purposes has been very widely upheld by the courts,
advocated by the commissions and even utilized extensively
by the railways themselves in questions involving the fair-
ness of rates.

The-task of making a valuation of the American rail-
ways is one of almost appalling magnitude, and the prob-
lems involved in the task are fully in keeping with their
setting. It is a situation in which Hercules would have
delighted when he was young and possessed the confidence
of the race. But we can no longer call on him; men solve
such riddles themselves now. The task involved is to
ascertain the value of 251,000 miles of railway, and since
we are not yet sure on what basis the valuation will be set-
tled, the value must be found from all points of view. The
courts have given no simple and definite criterion by which
the value shall be measured. The working-out of this
problem is still before the country, and, consequently, in
79] VALUATION AS A CRITERION 79:

the investigations all factors which may be considered or
form part of the final rule of measurement are to be found
out. Forty-six per cent of the world’s total railway mileage
must be measured with all the yardsticks that may finally
have a part in the standard of value.

It seems almost unnecessary to say that such a tremendous
undertaking would have been avoided if it had been sup-
posed to be possible to neglect it. The railway commis-
sioners who have been advocating this work and who have
been, and are, actually taking part in it are very practical
men of affairs. They are quite fallible and liable to error,
but no one could accuse them of entering this field for the
pleasure of idle speculation. These questions of regulation
have been forced upon the commissions in the execution of
their public duty. Some of them have been brought up by
the railways themselves; some have been forced on the
parties involved by the decisions of the courts; and some
simply have evolved in the general attempt to regulate the
transportation of the country on a basis which will be fair
to all interested parties. Valuation has been brought to
the front in all of these ways.

The importance of this valuation and of the methods
used in carrying it out can be more readily appreciated when
we see what immense issues are at stake. It has been esti-
mated that there are at least $15,000,000,000 worth of
railway property in the United States. That amount of
property is not a thing to be dealt with lightly. It not only
is a considerable portion of the national wealth but it is a
very vital portion. The railways have well been called the
arteries of the nation and when we undertake to regulate
such an important function we need to proceed very care-
fully.

It might be thought that in such an immense sum the
errors which would be made in valuation would have a
8o RAILWAY MONOPOLY—RATE REGULATION [80

rather slight significance. Many errors naturally will be of

is character, errors which are slight and which will neu-
tralize each other. But there are difficulties of a totally
different character; difficulties which bring in errors that
instead of being hidden by the size of the value involved
will rather be multiplied by it. Just here a single example
may be cited as illustrative of many such cases.

In making a valuation, the various boards have usually
considered it necessary to allow for what is called contin-
gencies in addition to the other items of value. This item
of contingencies is provided for in a percentage added
beyond the other valuation, but just what percentage it
shall be is a matter of no small dispute. Professor Cooley
states in regard to this factor that “ Engineers in making
estimates usually allow ten per cent on the average’”.* Mr.
Jurgensen, chief engineer for the Minnesota Commission,
fixes this item at five per cent. Mr. A. I. Thompson, for-
merly of the Oklahoma Commission, and now of the Fed-
eral Valuation Commission, states that the records of the
companies demonstrate that this item ranges from one-
half of one per cent to two per cent.* Massachusetts, on a
conservative estimate, allowed two per cent on the total
value of the New York, New Haven and Hartford Rail-
road.*| Now when we apply this difference of percentage to
such a figure as $15,000,000,000 we see the seriousness of
the problem. The difference in method in this one item
alone would make a difference in valuation sufficient to pay
for the expenses of the valuation of our transportation
systems more than one hundred times. The difference in
procedure makes a difference between $150,000,000 and
$1,500,000,000. And when we find that there are other

1Cited from Proceedings of the Twenty-fourth Annual Convention
of the National Association of Railway Commissioners, p. 35.
81] VALUATION AS A CRITERION Sr

problems of fully as great importance which are still un-
solved and which leave railway regulation on very unsettled
and different bases we begin to realize the seriousness and
importance of making a very careful valuation on a sys-
tematic basis.

The problem of valuation has arisen from an attempt to
put the transportation of the country on a basis which will
be fair to all the parties interested. Judging by the utter-
ances of many of the commissioners it is a problem which
has been pressing itself with increasing force upon their
attention as they have been struggling to execute their
duties. Originally there was little or no idea of any positive
relation of railway rates to the value of the property. This
was very natural under what were practically frontier con-
ditions, in a period of such rapid expansion that we were
too busy to count costs. But the time came when the ship-
pers began to count the costs of shipping and thought them
too great. They thought that the railways were securing
too heavy earnings and that too on a capitalization far in
excess of what the actual value of the properties would war-
rant. The shippers were indignant, they were in earnest,
and they succeeded in inaugurating a campaign of govern-
ment rate regulation that amounted to restriction. The
railways had stated their rate policy as one based on “ all
the traffic would bear”. The policy of regulation now
inaugurated under the commissions has been described on
the other hand as being based on “ all the traffic managers
would bear”. Naturally enough this limit was soon reached,
if it be interpreted as all the managers would bear without a
struggle, and litigation began.

The regulation then assumed somewhat the shape of
what the courts would make the traffic managers bear—the
legal limit. This limit was found as an application of the
Fourteenth Amendment, the railways claiming that they
82 RAILWAY MONOPOLY—RATE REGULATION [82

were being robbed of their property, or, what was counted
to be the same thing, of an income on this property. This
introduces an interesting phase of railway defense under
the plea that the proposed rates were confiscatory, a plea
that has played a leading rdle, notwithstanding the very
hazy idea of the real value of the property involved.

The most famous decision that has been handed down
on this question is one that has been quoted so frequently
that we almost know parts of it by heart, that is the case of
Smyth vs. Ames, opinion by Mr. Justice Harlan: *

We hold, however, that the basis of all calculations as to
the reasonableness of rates to be charged by a corporation
maintaining a highway under legislative sanction must be the
fair value of the property being used by it for the convenience
of the public, and in order to ascertain that value the original
cost of construction, the amount expended in terminal improve-
ments, the amount and market value of its stocks and bonds,
the present as compared with the original cost of construction,
the probable earning capacity of the property under particular
rates prescribed by statute, and the sum required to meet oper-
ating expenses are all matters for consideration, and are to be
given such weight as may be just and right in each case. We
do not say that there may not be other matters to be regarded
in estimating the value of the property. What the company
is entitled to ask is a fair return upon the value of that which
it employs for the public convenience. On the other hand,
what the public is entitled to demand is that no more be
exacted from it for the use of a public highway than the ser-
vices rendered by it are reasonably worth.

Out of this decision has grown the principle of a mini-
mum standard below which the regulating commissioners
should not attempt to force rates. In it is laid down a more

1169 U. S., 46.
83] VALUATION AS A CRITERION 83

or less indefinite idea of that value of the property upon
which the railway is entitled to demand a “ fair return”’.
The court has been criticised for vagueness in its definition
of railway value, but it simply put into as definite form as
possible the principle of valuation as worked out up to that
time. And, fortunately for a regulative policy still in the
formative stage, and applied to varied and changing con-
ditions, it was left to the wisdom of subsequent commis-
sions and courts to determine what weight given to the
specified factors might “be just and right in each case”.
The decisions and opinions following this have taken ac-
count of these factors, and have been working out a system
of administrative procedure based upon them. And the
railways have found the decision an invaluable bulwark of
defense as establishing a limit beyond which restriction
could not go in its policy of “all the traffic managers would
bear’. Unfortunately, the commissions have not yet come
to an understanding as to what weight, if any, each and
every factor specified in the above opinion should be given
in determining valuation as a basis for railway rates.

The use of this principle of relating rates to returns upon
the value of the property grew up, as we have seen, as a
minimum norm in regulation. The idea has also been grow-
ing that the maximum allowed for rates should bear some
relation to the same norm. Perhaps the public had in mind
the ethical view expressed in the proverb, “ What is meat
for the goose is meat for the gander”. But the commis-
sioners appear to have been influenced originally rather by
the dual idea that their public duty called them to restrict
rates to as near this base as possible and that the force of
competition would, if applicable in this field, have the same
effect. The popular idea has been that the effects of com-
petition in so far as it has worked sanely, were salutary.
The commissioners held to the same view, and have worked
84 RAILWAY MONOPOLY—RATE REGULATION [84

on the theory that they should regulate on the principle on
which competition would operate if applicable in this field.
As regulation has progressed, they have hoped to build up a
system of scientific rate fixation, using the valuation of the
property as a basis. Naturally they have turned their at-
tention toward ascertaining the true valuation, and, finding
the data supplied by the companies themselves insufficient,
they have in some important instances made an official in-
ventory of the value of the property under their supervision.
In this matter the state commissions have taken the lead.

By the year 1909 eight of the states had already valued,
or started to value, the railway property. ‘These states
were, Minnesota, New York (confined to city lines in the
first district), Oklahoma, Oregon, South Dakota, Texas,
Wisconsin and Washington. Besides these, Nebraska had
shortly before passed a law authorizing the appraisal of the
physical properties of the common carriers, and appropria-
ting $40,000 for the purpose, and the state commission had
organized an engineering staff to proceed with the work.
The North Dakota Commission had made a recommenda-
tion to the legislature for a law to provide for physical
valudtion and for an appropriation to this end.

With regard to the Minnesota Commission it is stated
that,

With a view of establishing a solid foundation upon which to
construct, for the future, a fair and equitable basis of rates,
the commission began in June, 1906, an investigation of the
costs of reproducing the railroads of Minnesota, and, in-
cidentally, to secure all available information and data as
would aid in determining the original cost thereof.*

The Washington commission stated in 1909:

1Proceedings of the Twenty-first Annual Convention of the Na-
tional Association of Railway Commissioners, p. 70.
85] VALUATION AS A CRITERION 85

The principle item in the work of the Railway Commission
of Washington during the past year has been in closing up
the work of valuation of railroads in the state and the deter-
mination of rates based upon such values.t

Thus it is seen that by 1909 the work was well aavanced
in some of the states. A statement of the Valuation Com-
mittee of The National Association of Railway Commis-
sioners, however, shows the inadequacy of the work:

We believe that these values must be authoritatively es-
tablished before there can be such supervision and administra-
tion, both by state and national authorities, as will do the
greatest justice to both the carriers and the public. One of
the chief objects of our organization is to promote uniformity ;
this it seems impossible to accomplish without having a reli-
able valuation of the railway properties, and in the belief that
the Federal Government is better equipped to conduct this
work than are the several states.

Your committee recommend that action be taken to urge
upon Congress the necessity for having as soon as possible
a comprehensive and authoritative valuation made of all the
tangible properties of the railroads of the country under the
direction of the Interstate Commerce Commission.

This valuation to be made with a view to segregation by
state lines, then every state could avail itself of the valuation
for all purposes to which it could be applied.?

By the year 1912 the Federal Government had not yet
started the work of valuation, and up to that time the work
had been still going on in the separate states. The records
for the year show that ten state commissions had recently
made, or were then making, elaborate inventories and val-
uations of all the railroads in their respective states. Com-

1 Proceedings of the Twenty-first Annual Convention of the Na-
tional Association of Railway Commissioners, p. 167.

2 Tbid., p. 333.
86 RAILWAY MONOPOLY—RATE REGULATION [86

prehensive valuations to be used for rate making, as well as
for other purposes, had been made recently, or were being
made in twenty states. In many of these, there had been no
extensive or thorough inventories or appraisals undertaken.
In three of these states the valuations were made for short
lines in connection with certain litigation. In one state,
Texas, a comprehensive valuation was made about twenty
years ago. In two states, Michigan and New Jersey, elab-
orate valuations had been made shortly before solely for
taxation purposes. In one state, Massachusetts, valuation
had been undertaken solely for the purpose of investigating
the soundness of a company’s securities. In another state,
New York, several individual properties had been valued
for various purposes. And in Oregon several properties
had been valued, but not all.*

As for method and standards for valuation, there is little
agreement among the states. The Valuation Committee of
the National Association of Railway Commissioners for
Ig12 states:

At the present time great confusion exists in the methods
pursued by the different states. There are hardly two states
which have agreed upon the same rules. The actual effect in
dollars and cents, caused by slight variations in methods, is
quite remarkable?

One of the Mississippi commissioners stated in regard to
the work of his commission:

I cannot say that we have any specific plan by which we
reach the value of the same, basing the valuation according
largely to the earning power of the property. The valuations
are made more for the purpose of taxation, yet the earning

1 Twenty-fourth Convention of above, p. 46.
*Tbid., p. 36.
87] VALUATION AS A CRITERION 87
capacity of a railroad has something to do with rate-making.*

We note the work of the Oklahoma commission in con-
trast with this indefiniteness. This state is making a valu-
ation for any purpose for which it may be desired to use it.
It is first undertaken to find out the original cost of the right
of way, original construction and all betterments to date.
It is also required that the replacement value of the same
property be ascertained. The plan provides for the

allocation of property and accounts as between states; the
separation of state property and accounts between terminal
and line; the apportionment of both line and terminal property
and accounts between freight and passenger; the separation
of main line and branch line property and accounts, showing
the data for each main and branch line separately, both as to
line and terminal; and the apportionment of main and branch
line freight and passenger accounts, both line and terminal,
between intrastate and interstate.’

The Wisconsin commission has made a complete valua-
tion which is used for both rate-making and taxation pur-
poses. They say that the fair value of the property can
best be determined, as a rule, from such factors as the
original cost of construction and development, and from
the cost of reproduction of the same under conditions which
are normal, and when, in both cases, full consideration is
given to the depreciation that has taken place in the property
because of age, use, and other reasons.®

In the State of Washington practically all the railroad
property has been valued by the commission for rate-making

1 Proceedings of the Twenty-fourth Annual Convention of the Na-
tional Association of Railway Commissioners, p. 41.

2 Railway Age Gazette, July 3, 1914.
S11 W.R.C.R.1, 14 A. T. & T. Co. Com. L. 197, August 23, 1912.
88 RAILWAY MONOPOLY—RATE REGULATION [88

purposes, but on a principle rather different from the above.
In fixing the value of the railways of the state for rate-
making purposes, this commission ‘“‘ has made market value
the basis.” The commission, following the steps indicated
in Smyth vs. Ames, has considered cost, cost of reproduc-
tion, depreciation, the amount and value of stocks and
bonds, the population and density of traffic along the line, the
physical characteristics of the road and “every element
which the commission believed an intending purchaser would
consider.” *

Enough has been said to show that, while a great deal
has been done toward valuation, yet the Association’s Valu-
ation Committee is fully justified in calling the situation
confused even in the sphere of the state commissions. In
the sphere of federal regulation, nothing had been done
by the government to ascertain the true value of the prop-
erties until a recent date. And this need was felt.

The Interstate Commerce Commission in its opinion on
the proposed advance in rates in Official Classification Terri-
tory in I9II said:

The commission has been compelled to dispose of this case
upon the evidence available, but there is no testimony tending
to show the cost of reproducing these properties. It is plain
that a physical valuation would introduce into the calculation
a new element which might lead to a different conclusion.
Congress ought to authorize a reproductive valuation of those
railroads subject to federal jurisdiction. The interest of the
public ought not to depend upon a valuation made entirely by
the owners of these properties, no matter how honestly the
work may be prosecuted.?

Five years before this time, Senator LaFollette offered

‘Whitten, Valuation of Public Service Corporations, p. 45.
720 I. C. C. Rep., 243.
89] VALUATION AS A CRITERION 89.

as an amendment to the Dolliver-Hepburn bill the proposal
that Congress provide for a valuation of the railroads.
The amendment was, however, rejected by an overwhelm-
ing majority in the Senate. By 1913 the country’s ideas
in regard to regulation had so developed that the measure
being again introduced, was passed, not only without any
real opposition, but without provoking any serious public
comment. And now, after the preliminary preparations,
the Interstate Commerce Commission is fully launched upon
the work of making a valuation of all the railroad property
inthe country. A similar task of such magnitude has never
before been undertaken.

When Germany took over her railways she made no
such attempt to secure a capital valuation. The principle
of payment, simple and just under the circumstances, was
employed of giving the stockholders bonds yielding an in-
come equal to that which they had enjoyed from their
shares in the corporations. England, on the other hand,
when she endeavored to inaugurate a settled policy of regu-
lation, simply declared that all rates in force at the time of
the act were to be considered fair and just, unless proof
to the contrary could be established in regard to particular
rates, and all rate increases from that time on must be
proved to be necessary. But the United States is not pre-
pared to purchase its railways, nor is at all convinced that
its present schedule of rates is just and fair. In this phase
of regulation neither of these countries can give us any
material aid by way of example.

The greatest assistance comes from the experience of
the states which have undertaken this task of valuation, and
material help is being given by the railroads themselves. .\
great deal has been done in the way of blazing the trail
for the federal undertaking, but much yet remains to be
done in the way of working out principles, to say nothing of
go RAILWAY MONOPOLY—RATE REGULATION ere)

the great undertaking involved in the actual application of
these principles.

Since no one definite principle has been decided upon as
a basis for valuation, the Interstate Commerce Commission
is to work out all the elements which may be taken into
consideration. If it is eventually decided that original cost
shall be the final basis, wholly or in part, the findings of
this investigation are to show this factor in so far as it is
at all possible to ascertain it. If the decision results in
favor of the cost-of-reproduction or cost-of-reproduction-
less-depreciation these figures are also to be at hand. Ifa
combination of these factors is desired, we shall not be at
a loss there either. In short, the federal valuation is sup-
posed to ascertain all about the value of the railways that
we can want to use and can possibly find.

As already pointed out, the task is enormous. Late
statistics credit the United States with 251,000 out of
613,000 of the world’s total railway mileage.» Each and
every mile and piece of property is to be inventoried, and
its history worked out. And the undertaking is further
complicated by the instructions to value the property of all
common carriers subject to the Act to Regulate Commerce,
including telegraph, telephone, express, car-service lines,
pipe-lines, ferries and steam-ship lines.

The commission is given plenary powers to carry out this
work. Its instructions are to hire experts, take testimony
and administer oaths, and to make full investigation of all
records, books, papers and property. Penalties are pro-
vided against anyone hindering the commission in its duties.

Under Commissioner C. A. Prouty as Director, four de-
partments are organized, viz., engineering, accounting, land
and law. Of these, the work of the engineering department

1 Statistical Abstract of the U. S.. 1974, p. 263. Statistical Abstract
of Foreign Countries, p. 463.
gt] VALUATION AS A CRITERION gI

has made the greatest progress. Besides these departments
of the commission, there is the president’s conference com-
mittee, representing the carriers, which is associated with
the government forces. These committees are divided into
three groups corresponding to the three classification terri-
tories of the country, the eastern, the western and the south-
ern. They are endeavoring to formulate the standard
method of procedure for the guidance of the roads in col-
lecting their data, for the roads themselves are obliged to
assist the commission in a great deal of the work. Need-
less to say the committee will have the opportunity of pre-
senting the attitude of the carriers on many important mat-
ters that will arise.

The commission has divided its work into five districts,
each of which extends from the north to the south of the
country so that work can progress uninterrupted by the
winter season. For the engineering work there is a board
of five engineers each of whom is in charge of a district, but
with headquarters at Washington for the purpose of mutual
consultation. Besides these, there are five other engineers
each at work supervising in his own district. The head
engineers are men chosen for their wide experience in such
matters and under their charge the work in this department
is making considerable progress. Their work began on the
first of January, 1914, and within half a year from that date
the valuation was definitely under way on ten lines, and they
hoped to extend their work rapidly, aiming to complete the
work on 25,000 miles of line by the close of the fiscal year
on June 30, IQI5.

The accounting department is in charge of one chief
accountant who will supervise the work in all five districts.
There will also be a division accountant in direct charge of
the work in each district, which will be carried on in the
offices of the roads under survey. The land department
92 RAILWAY MONOPOLY—RATE REGULATION [92

will be organized on very similar lines. There will be a
supervisor of land appraisals in entire charge and a land
attorney in each district.

The law department is in charge of a solicitor and his
assistants. Their principal duties will be to study the cor-
porate history of the roads and to prepare this information
for the use of the other departments of the valuation work.
They are supposed not only to ascertain the history of the
present corporations, but the history of all underlying and
preceding corporations that have handled the same property
from the very beginning. They must as far as possible
make a detailed and specific history of every property from
its entrance on the field of transportation down to this pres-
ent time. Judging from former expressions of the com-
mission, this will be a very unsatisfactory undertaking.

Many matters of corporate history, however, can be as-
certained fairly closely. In the past the various spheres of
government from the federal down to the localities have
made large donations of land and money, as well as other
subsidies. These probably can be traced fairly accurately,
and it is intended that this shall be done. The amounts of
all these grants are to be ascertained and also what parts
have been disposed of and for what consideration. And
again, all property held for other purposes than that of
transportation is to be listed and reported separately. These
items, with an account of any and all concessions made to
the federal or other government, will be the chief matters
to consider from the historical standpoint.

The factors to be taken into account for the present value
are fully as comprehensive as the decision of Mr. Justice
Harlan in Smyth vs. Ames. Each piece of property is to
be listed and a complete inventory taken. This includes all
lands, right of way, terminals and constructions, all track,
rolling stock, bridges, tunnels, buildings, shops, offices,
93] VALUATION AS A CRITERION 93

equipment and machinery. Each piece of property is to be
listed as to its original cost, its cost-of-reproduction-new,
and its cost-of-reproduction-less-depreciation with an
analysis of the methods by which these several costs are
determined, and the reasons for the differences, if any. To
carry out this tremendous undertaking the engineering de-
partment is dividing its forces into two general divisions,
the roadway and track parties for everything on the road
except tunnels and bridges over sixteen feet long, and the
structural parties which are to secure complete information
regarding all structures such as bridges and tunnels over
sixteen feet long and all large buildings.

All this applies to a physical valuation. But in the past
it sometimes has been found necessary to consider other
factors which are generally spoken of as intangible elements.
These the commission is to investigate and report on separ-
ately so that we may have a complete account of all the
elements of value.

When the task of the commission is finished which will
not be for some years, we shall have a complete statement
of the property of each carrier as a whole, and its property
will be listed separately as to state lines. As will be noticed
this conforms to the recommendation adopted by the con-
vention of the National Association of Railway Commis-
sioners in 1909 and presented by them to Congress. All
the requisite data will be at hand for regulation on the
cost basis as far as the value of the properties is concerned.
This all having been done under one general supervision
and with opportunities carefully to consider all sides of the
question, it may well be considered fair and final in so far
as the element of time shall not prove a disturbance.

But even with all these facts at hand, much will remain
to be done unless happily a great deal of theory shall have
been cleared up during the process of ascertaining the facts.
94 RAILWAY MONOPOLY—RATE REGULATION [94

At the present time there is far from being unanimity as to
what standard in value shall be the determining factor in
rate-making. Some say that one element should be the
basis, others favor another, and it is often asserted that
not one but many factors must be considered. This, no
doubt, is to a certain extent true, but when it is shown that
different standards of valuation give differences running into
the hundreds of millions of dollars in the value of a single
road, we can hardly refrain from thinking that, before
we have a scientific system of rate-making related to the
value of the property, we at least must know what weight is
to be given to each factor used in the valuation. It is
scarcely satisfactory to say that this factor must be con-
sidered and that one or another not neglected. If we are
to have a stable system of rate-regulation, it must be settled
what weight is to be assigned each element, and under what
circumstances each particular factor is to be given the pre-
dominance. If the present value is greater than the original
cost, we must know which rule is to determine, or, if both
factors enter in, to what extent each has effective power?
Doubtless we should know all the possible factors of value;
but to avoid chaos we must know how we are going to use
these factors when we get them.

The various bases suggested for valuation are earning
capacity, commercial value, capitalization, the cost accounts
or book accounts of the companies, cost-of-reproduction-
new, cost-of-reproduction-less-depreciation and original in-
vestment or cost. Some authorities would add another
which they call “ fair value,’ but as the terms are used,
this latter expression amounts to practically the same thing
as what is more explicitly called cost-of-reproduction-less-
depreciation, and this again is termed by others less definitely
but more briefly, “ present value.”

Among these standards, the ones most seriously advo-
95] VALUATION AS A CRITERION 95

cated by courts and commissions are the original investment
and the cost-of-reproduction-less-depreciation. The other
principles may be considered, but as a rule they are only
regarded as side lights to be used in exceptional instances.

Market value is a basis which is usually roundly con-
demned as a criterion for rate-regulation. This may be
taken as the market value of the property as a whole, or it
may be piecemeal market value as shown in the selling
price of its stocks and bonds. Either way in which we may
take this it is very nearly the same as, or at least largely
dependent upon, the earning capacity. A certain element
in addition to the earning capacity may enter into the market
value on account of the influence of speculation and the
power which ownership may give over related concerns, but
on the whole these two principles amount to the same thing,
From one point of view, this would be the fairest way to
value any business. It is the value in exchange, and mod-
ern economics esteems this view of value higher than any
principle which smacks of the old-time conception of just
price. But when we attempt to use this as a basis for valu-
ation, where are we? We apparently are taking a beautiful
spin on a circle, for we seek to base rates on a value that in
turn is based almost wholly on rates. We lack the power
of competition to break the circle by introducing the element
of substitution of other capital goods.

The difficulty in using market value as the basis for val-
uation lies in the fact that the problem is complicated by
monopoly. The value of an article which is easily replace-
able by a similar one is quite different from what it would
be if it could not be duplicated. In the latter case we should
count the value at the high point to which scarcity would
force the utility. But if the article could be replaced at
will, no one would value it at a higher figure than that for
which he could replace it. The ordinary articles which
96 RAILWAY MONOPOLY—RATE REGULATION [96

we value fall into this latter category; they can be replaced
and hence are valued at the replacement figure, and in pro-
ductive goods this figure is the same as the capitalized earn-
ing capacity. Only in monopoly is there any serious infrac-
tion of this rule. It is just this monopoly advantage from
which the country is trying to free itself as far as possible
in railway regulation.

The matter might be allowed to rest at this, were it not
for the fact that such an able body of men as the Wash-
ington Railroad Commission has advocated market value as
a standard of valuation for rate-making purposes. Follow-
ing the steps indicated in Smyth vs. Ames, they have, as
quoted above,’ “considered the cost, cost-of-reproduction,
depreciation, the amount and value of the stocks and bonds,
the population and density to traffic along the line, the physi-
cal characteristics of the road and every element which the
commission believed an intending purchaser would con-
sider.” It is evident that this commission has considered
the differential advantages which one line possesses over
another, and capitalized this advantage. This will readily
be seen to be capitalizing not so much the earning power or
market value of a line considered by itself, as the superior
advantages which one line possesses over its least fortunate
rival, which is commonly called in economics the marginal
line. The poorest competitor may be valued at the cost of
its physical elements while the other lines in the field are
given the differential advantage in addition to such a value.
In very simple cases this scheme would very likely work
well, that is, where lines were rivals in only one simple field;
but, since this is seldom the case in railway practice where
a line may have one rival in its through traffic and another
in its local, it is doubtful whether this method of capitali-

+ Page 88, infra.
97] VALUATION AS A CRITERION 97

zation would prove satisfactory in operation. It would
seem to be much better to allow the more favorably situ-
ated line its advantage in higher rates of income and to base
the valuation of all on the same standard. This matter will
be taken up again in the chapter on returns.

The capitalization of the American railroads would seem
hardly to have as much right to consideration as a standard
for rate making as even the market value. The stock and
bond issues have been based upon the anticipated earning
power of the company, not on investment, value of property,
or even actual earnings. Hence they are not of much value
in determining the valuation, but they nevertheless have had,
and are having, quite a part in the regulation of rates. They
are not the property of the companies but the property of
the shareholders, be these speculators or investors. It is
doubtful public policy so to lower rates that dividends on
stock already issued would be reduced below a certain level.
Such a course would seriously handicap a company not only
in the issuance of new securities to provide for expansion
but even in providing the proper facilities to care for the
existing traffic. It would seem better, as a rule, that such
concerns be completely reorganized, or that restriction of
rates be delayed, if possible, until the time when the value
of the property was built up to equal the amount of the se-
curities outstanding against it. It may be true, as now ex-
tensively claimed, that, taking the situation as a whole, the
property value of the American railroads is fully equal to
their capitalization. But there is no certainty as to the re-
lation. And, unfortunately, the effect of reducing earnings
on stock which does not have honest backing is just as ser-
ious as would be the effect of reducing the earnings on a
fairly capitalized road. In careful regulation capitalization
must often be considered, as will be shown later. But since
this factor may have as great an effect if based on dishonest
98 RAILWAY MONOPOLY—RATE REGULATION [98

practices as if issued in good faith, and since it is based
frequently on speculative conditions, it can have no serious
influence on the subject of valuation.

The use of the cost accounts, or book accounts of the past,
is easily disposed of. These terms refer to the account
which the books of the railway companies themselves give
of the cost of the property. Their use as a basis can best
be judged by the words of the Interstate Commerce Com-
mission to Congress :

It is sufficient to refer to the well-known fact that no court
or commission or accountant or financial writer would for a
moment consider that the present balance sheet statement pur-
porting to give the cost of property suggests, even in a remote
degree, a reliable measure either of money invested or of
present value. Thus at the first touch of critical analysis the
balance sheets published by American railways are found to
be inadequate. They are incapable of rendering the service
which may be rightly demanded of them.*

Thus we have seen that neither the earning power, market
or commercial value, capitalization, nor the cost or book
accounts can be counted as more than an incidental help to
assist us toward another basis, or other bases, which shall
determine the valuation, nor can the cost-of-reproduction-
new be counted on as a sufficient criterion for the purpose
in hand. For one reason, this would be the valuation of
such a property as never did and never could exist. By the
time a property is completed part of it has already begun to
depreciate. Moreover, to value a property in running
order at its cost new, neglecting the fact of depreciation,
would be to act in defiance of the principles of accounting.
In any system run on sane accounting principles, the depre-

1 Proceedings of the Twenty-fourth Annual Convention of the Na-
tional Association of Railway Commissioners, p. 52.
99] VALUATION AS A CRITERION 99

ciation which must of necessity exist is provided for and
written off the accounts.

The other principles which are left, and those which are
the most seriously considered at the present time, are origi-
nal investment and the cost-of-reproduction-less-deprecia-
ciation. In one point, at least, these are quite alike: each
practically requires an inventory of the real property of the
railroads and each pays more or less attention to the in-
tangible values as well. Again, apparently the advocates
of each standard sincerely want to be absolutely fair to the
interests of all concerned, and not to confiscate any values
which they think rightfully belong to either party. As the
argument between them stands, the difference of opinion
seems to be largely one of ethics, that is, to whom do certain
items of possible value rightfully belong? Unfortunately,
our system of ethics seems to be unable to settle the ques-
tion, for each side of the controversy claims that its dic-
tum is just. Apparently, if ethical considerations are to
rule, they will need to be expanded to meet the exigencies
of the situation. Perhaps it would not be too much to say
that what will settle such a question, when old ethical con-
siderations are inadequate, will be a far-sighted expediency
that looks ahead to conditions as far as we can see them in
the light of economic theory and of practical examples in
this and other fields. Larger considerations may thus be
worked out that will include and piece out what is lacking
in the accepted standards.

There is another point in which these theories are alike.
Each looks to the other for additional light, but says that
in the long run it must be fundamentally determinative
itself. The courts, especially the Supreme Court, have
stood for the present value or the cost-of-reproduction-
less-depreciation, but they have always said that the factor
of original cost must not be ignored. On the other hand,
100 RAILWAY MONOPOLY—RATE REGULATION [100

the commissioners who have stood out most strongly, es-
pecially during the last few years, for the theory of original
investment have said at the same time that the present value
was of great importance in determining valuation. But yet
it is acknowledged that the theories are mutually opposed
in places, and when such is the case one or the other must
be determinative. Doubtless the railway world will heave
a sigh of relief if the time comes when it will be settled
which is to be the fundamental basis, or, if each is to be
employed, when one is to rule and when the other.

It may seem not to be necessary to define these two con-
ceptions of value. Unfortunately, there is great need,
owing to the vagueness of the usage, for such definitions.
As in every other complex field, the terms are used with
great flexibility, or, perhaps it would not be too strong to
say, looseness. The cost principle is perhaps defined best
by one of its able friends, Dr. Whitten of New York, who
says in his first volume:

Strictly speaking, actual cost means cost of original construc-
tion plus cost of additional betterments. It excludes all ex-
penditures for renewals and replacements including super-
session due to obsolescence or inadequacy. It includes only
construction, additions and betterments that are a proper
capital charge under approved accounting principles.t

For a definition of present value it is doubtful whether we
can find one better than that advanced by Commissioner
Eshleman of California and approved by Commissioner
Thorne of Iowa:

The engineers usually find the reproduction value new and
depreciate the property to the extent they find it has come

* Whitten, Valuation of Public Service Corporations, p. 82.
ror | VALUATION AS A CRITERION IOL

about, and call that present value. That is the general de-
finition of what they mean by present value.'

Others speak of this basis as cost-of-reproduction-less-depre-
ciation, which is really seen to be the same as the above.
Others again speak of fair value as present value, but this
term seems to be adopted as one that is broad enough to
include various items which may be considered fair, and
hence lacks definiteness.

As stated before, the two bases for valuation aim to con-
sider practically the same items. It may therefore be well
to go into a more detailed discussion of these items of pos-
sible value under either principle.

One of the most important elements in railway property
is the land on which the lines and terminals are built. No
one familiar with the railway affairs of the United States
needs to be reminded of the vast areas devoted to our great
systems of transportation. The amount of land so in use
at the present time is great, but we are told that it will have
to be much greater before the country is fully equipped
with lines of communication. If the value of this land is
to affect our freight and passenger tariffs, as apparently it
must, it will be generally admitted to be of vital importance
that a careful valuation of it be made and that this valuation
be on principles that will meet the demands of the essentially
dynamic conditions of present-day transportation. The
valuation must be placed, as far as possible, high enough
to allow for proper railway expansion and at the same time
no higher than absolutely necessary for this expansion in
order that the growth of the other business of the country
shall not be hampered any more than is necessary.

There are several well-defined problems in connection

1 Proceedings of the Twenty-fifth Annual Convention of the Na-
tional Association of Railway Commissioners, p. 307.
102 RAILWAY MONOPOLY—RATE REGULATION [r102

with this part of the valuation. Here is the great tilting
ground between the champions of the so-called present-value
principle on the one hand and those of original cost on the
other. The problem is complicated by the fact that a very
great deal of the land used by the railways has been donated
to them. It is further complicated by the situation where
land purchased by the companies must frequently be paid
for at much higher rates than similar land sold to individ-
uals. From these conditions and others arise the questions
as to whether the railways shall be allowed an income on
land given to them by the public and by private individuals ;
whether they shall be allowed an income on the unearned
increment on land; what methods shall be adopted in find-
ing the actual present value of the adjoining land; and
whether a multiple shall be added to this present value, and
if so, how much of a multiple.

When we stop to consider that the amount of land given
to the companies has been greater than the entire area of the
German Empire, we cease to wonder at the conflict between
the advocates of the rival principles. It would make a
difference that could be felt whether our system of trans-
portation should pay rent on a land area equal to Germany
or whether this should go rent-free. But by no means all
this land is now being used for transportation purposes. It
was given as an inducement to the promoters to build the
roads, and was given partly as right of way and partly in
the form of land reservations suitable for settlers and specu-
lators, which latter portions were largely disposed of in one
way or another. No one questions the right of the com-
panies to sell the last mentioned lands at a profitable figure,
nor does any one question that both forms of land grant
were made as an inducement to carry out the enterprises.
But very many do question the right of the companies to
fix rates to cover earnings on the present value of these
103] VALUATION AS A CRITERION 103

land gifts for right of way. This seems reasonable in the
light of what can hardly be questioned, that no idea of
such relation was entertained by either party to the original
transaction. The right of way was given for transportation
purposes, as a requisite for the service. No one seems to
have thought that later the donor would be charged for the
use of his gift. But, even if it had been known that an
income on this land would later be demanded, it is doubt-
ful if it would have stopped the donations. We find that
in Canada the fact that the Canadian Pacific is charging
for the use of donated property has not had this effect.
And again, why was it right for the companies to sell
the lands given for other purposes than right of way at a
profitable figure if they should be denied the right of all
earnings on the right of way which was just as truly given
to them as an inducement to go into the enterprise? In
fact the right of way has virtually been sold just as truly
as the other portion of the land grants. The latter has
been sold by the corporations, the former has been sold, or
at least the securities based upon it, have been sold by the
original stockholders of the enterprises. The original
owners have in many instances at least sold their securities
and pocketed the money. Their investments may be in en-
tirely different fields at present. They are the ones who
have received the value from the donations. In what way
is it fair then to demand restoration, or what amounts to
the same thing, from the present shareholders?

The questions of the unearned increment on land and that
of the right to present value on donated land go together.
To show the magnitude of the stake, two examples may be
cited, as given by Commissioner Thelen of California in
discussing the question:

In the Minnesota Rate Case the original cost of the terminal
104 RAILWAY MONOPOLY—RATE REGULATION [104

properties of the Northern Pacific Railway Company in the
State of Minnesota was found to be $4,527,228. The Master
allowed a return on $17,315,869. The original cost of the
entire system was found to be something over $312,000,000,
but the cost of reproduction new, which the Master took as a
basis, was over $452,000,000. The difference of $140,000,000
represented principally the unearned increment of land and the
value of donated lands. In the Western Advance Rate Case,
decided by the Interstate Commerce Commission on February
22, 1911, the Burlington claimed a return on a present value
of $530,000,000. Commissioner Lane found that the original
investment was only $258,000,000, and that approximately
$150,000,000 of the Burlington’s claim represented the in-
crease in land values.

And again, Professor Ripley’s comment on another case
may be quoted.

Carried at only $2,000,000 on the books—such being the ori-
ginal entry—the real estate of the Illinois Central was ap-
praised at $34,000,000 in 1900.?

Referring to the contention of the Burlington for a re-
turn on the unearned increment, Mr. Lane says in the
opinion quoted above,

If this is a precise expression of what our courts will hold to
be the law, then as we are told there is certainly the danger
that we may never expect railroad rates to be lower than they
are at present. On the contrary, there is the unwelcome
promise made in this case that they will continuously advance.*

That there is a tremendous increment of value in many

1 Proceedings of the Twenty-fifth Annual Convention of the Na-
tional Association of Railway Commissioners, p. 265.

2 Pol. Sci. Quar., vol. xxix, p. 586.
820 I. C. C. Rep., 340.
105] VALUATION AS A CRITERION 105

cases is beyond dispute, but to call this an unearned incre-
ment is, perhaps, rather begging the question. The custom
has grown up of calling an increment of value not definitely
assignable to the efforts of any owner an unearned incre-
ment. Moreover, we have the idea that earnings are and
always have been, confined to what we call a fair return.
There is ample opportunity for fallacy here. To begin with,
earnings limited to a so-called fair return are not the usual
phenomenon in frontier conditions. And our railways
were built up on practically frontier conditions. People do
not, as a rule, go into business under such conditions with
the hope of only a moderate rate of interest on their money.
The risks are great; the profits must be too. Fortunes were
lost as well as made in the early days of the railroad busi-
ness. Speculators in every field went into their businesses
for high stakes, and the fortunate majority won them.
Why not the railroads? The railroads had their share of
failures. If they secured the usual rate of return in the
frontier days, they took everything they could get, profits
and increment. And if they did, it was but a fair division
between the railroads and the farmers. In frontier days it
is only the richest cream of business that attracts invest-
ment. Moreover, the profits from the increased values have
been capitalized and in many cases sold. As in the case of
the donated land, those who received the benefit are in
great part not the present owners.

It may be asked if it is wholly fair to call this an unearned
increment. In many cases the railroads were given the right
of way and alternate sections of land within a certain dis-
tance from the line. These sections had been valued at
$1.25 per acre before. After the railroad was constructed
the remaining half of the land within the region was sold
for $2.50, making the value of the half in the hands of the
public as great, at least, as the former whole. The railroad
106 RAILWAY MONOPOLY—RATE REGULATION [106

made the difference in value, whether it earned it, or not.
The same principle is true all over the country, whether the
land is donated or not—the land in the vicinity of the lines
increases in value. In fact this was the purpose of the dona-
tions—increase in the value of the land or of the business
carried on in the country served by the roads. True, there
could not be the increase in value without the farmer and
other developing entrepreneurs, but these receive their share
in the increment in the property which they hold. Do not
the railways have a part, and a large one, in increasing the
values? Why then should they not have the benefit in so far
as the increment affects their own lands?

Even if it be admitted that the railway owners of the past
have the right to this increment in land values, this does not
necessarily argue that they must be allowed rates to cover
all future increases in value. The frontier days are gone,
and with them the period of real risks for the railway busi-
ness. ‘Even an inventor is not allowed the profits on his
patent for an indefinite period. Some one has said that, if
this were allowed, the inventor of the cotton gin would prob-
ably have absorbed half of the wealth of the country. Many
able men question the right of the railroads to the increment
of land value in the past, and even the Supreme Court has
not definitely decided in their favor in regard to this. Cer-
tainly when we come to the question of future increments,
there is ample room for argument. This will be more fully
discussed in the general argument as to the choice between
the rival principles of original cost and the cost-of-repro-
duction-less-depreciation.

If present value be the principle used, the actual present
value of similar nearby land must be ascertained. When
original cost is the criterion, the same problem is likely to
arise in the case of newly-built lines. It is quite certain
to arise if there should be any question as to the reasonable-
107] VALUATION AS A CRITERION 107

ness of the price paid for the land, for the advocates of the
principle of original cost do not aim to encourage extrava-
gance. On first sight it might seem to be a simple matter
to find these values in question; it is by no means as simple
as it looks. Oftentimes sales are not sufficiently frequent
in the immediately surrounding country to give any accur-
ate idea of the market value of the varied land in use by
the railroads. Again, when sales are made, it is difficult
to separate the value of the improvements on the land from
the actual land value itself. There are two methods of
ascertaining such values, the sales method and the tax
method. The sales method has been used very extensively
by different states. It is undertaken by this method to
ascertain the actual considerations paid in bona fide trans-
actions during recent years for adjoining tracts of land.
In one state, for instance, they took all actual transfers for
three miles on each side of the center of the track, cover-
ing four years’ time. The tax method is used in Wisconsin.
They obtain the assessed value per acre of land similar to the
railroad right of way, and divide by a factor representing
the ratio of the assessed value of the land to the true mar-
ket value. This factor is computed from records of real-
estate sales and is designated as the assessment ratio; for
it is a notorious fact that the actual figure at which real
estate is taxed is not the real value, but it generally bears
about the same ratio to the real value in the same part of the
country. Doubtless this assessment ratio will not vary
greatly when such a large number of instances are utilized
as is generally the case in railroad valuation. Hence while
sales may not be frequent enough in certain regions to give
accurate data, yet by means of this ratio the value may be
found from the assessment figures. By one or both of these
methods it ought to be easily possible to ascertain the fair
value of property at any desired distance from the railway.
108 RAILWAY MONOPOLY—RATE REGULATION [108

But ascertaining the value of contiguous real estate does
not settle the value of the railway property in question.
After the actual present value of the adjoining land has been
found, it is claimed that a sum must be added to represent
what it would cost the railroad to secure that land for rail-
road purposes. This includes the severance damages, re-
moval of buildings, etc. If the line be built right through
the middle of a man’s farm, the company will have to pay
a considerable sum for damages, besides the actual value of
the land per acre. Again, when it is known that the land
is needed for railway uses, the owners will frequently de-
mand a much higher price than would be asked in an ordin-
ary sale, and the company must either pay this excess or else
as much or more in litigation. It must be conceded that in
many cases the railways now actually do have to pay more
for acquired land than the actual present value of contiguous
property. But while quite a multiple must be added in
some cases, this is not always the case, and when it does
occur, it is offset by the fact that the land which a railroad
usually buys is land in a country where transportation facili-
ties are not abundant; hence the normal price is below the
general level of land where a railway is in actual operation.
In short, the multiple is absorbed by the increment.

The amount of this multiple and the extent of its use
are matters of great dispute. It is stated that in Wis-
consin an allowance is made to cover severance charges,
damages, and other elements entering into the cost of ac-
quiring land for railroad purposes. A multiple of one and
one-half has usually been applied to the market value of
railroad land in cities, and in rural districts a multiple of
two and one-half or three has been used for this purpose.
These multiples are based on investigations of actual condi-
tions governing the purchase of right of way in Wisconsin,
and other states. It is said that in Kansas and South
109 ] VALUATION AS A CRITERION 109

Dakota at the present time the multiple ranges from two
to five, the average being about three outside of the towns.
On the other hand Commissioner Thelen, of California,
says that “ exhaustive investigations conducted by the Cali-
fornia Railroad Commission show with reference to the
railways so far examined that it has actually cost these
railway companies an average of approximately 1.33 times
as much in the case of country lands and an average of ap-
proximately 1.28 times as much in the case of city lands to
acquire their land as the average market value at the
time of similar land in the vicinity.” *

In spite of the claim that the companies must pay some
multiple to acquire land this multiple is frequently denied
them. In the Minnesota Rate Case’ Mr. Justice Hughes,
of the Supreme Court, says,

Assuming that the company is entitled to a reasonable share
in the general prosperity of the communities which it serves,
and thus to attribute to its property an increase in value, still
the increase so allowed, apart from any improvements it may
make, cannot properly extend beyond the fair average of the
normal value of the land in the vicinity having a similar char-
acter. Otherwise we enter the realm of mere conjecture.

There are also some states which claim that this multiple
should not be used, because where the railroad company is
building through territory in which the railroad is actually
needed the company is not generally required to pay any
multiple or severance damage. And Mr. R. A. Thompson,
formerly engineer for the Texas and the California Com-
missions, and now of the Federal Engineering Board for
Valuation, while disputing the extent of the actual use of
such multiples, adds an interesting point. He says:

1 Proceedings of the Twenty-fifth Annual Convention of the Na-
tional Association of Railway Commissioners, pp. 65, 271.

2 Page 762.
110. RAILWAY MONOPOLY—RATE REGULATION [110

Contiguous lands have greatly increased in value since the
advent of the railroads. It would appear highly illogical to
advocate that these increased values should be multiplied by
three, or even by one and one-half, and used as a basis for
taxing the railroads on the one hand, or taxing the public on
the other, by permitting indebtedness to be issued against it,
the interest on which the latter must pay.

It would be interesting to know what part of the total
value of the railways pertained to the land. At the present
time it is impossible to do more than guess at the propor-
tion, for this depends so much on these vexed questions of
the multiple and the unearned increment. In the Minne-
sota Rate Case the total reproduction value of the Northern
Pacific Railway’s property in land, including percentages
for engineering, superintendence, legal expenses, contin-
gencies and interest during construction, amounted to more
than thirty-seven per cent of the total. This looks rather
large, but Commissioner Thorne draws attention to the
fact that the net value of the lands in this same property,
outside of terminals, and leaving out the multiple for sev-
erance charges, as well as the other above-mentioned
charges, amounts to only two per cent of the entire value
of the property in question. On the same basis, the origi-
nal cost of the terminals would be rather less than six per
cent of the same total value. These figures show at once
the uncertainty and importance of these problems, though
it must not be lost sight of that many of the items men-
tioned above in the thirty-seven per cent of the total value
are usually accounted for under different headings than that
of land value. The land outside of terminals would jump
here from two to four and one-half per cent and the ter-
minals from less than six to perhaps thirteen per cent under
the multiple claimed, making a total of some seventeen and

1 Proceedings of the American Society of Civil Engineers, Jan., 19tt.
111] VALUATION AS A CRITERION Lil

one-half per cent in all land values based on original cost.
It can readily be seen that Mr. Thorne is right in this case
when he says that “ the question of the unearned increment
does not overshadow the problem of the land multiple ”.*

In addition to the various phases of the question of the
land values there are three other broad divisions of the
railway assets, construction, equipment and the so-called
intangible values. Any one of these deserves an extended
discussicn but space forbids more than a brief mention of
the vital features.

In the Minnesota Rate Case, mentioned above, while the
terminal properties cost $4,500,000, the amount allowed
for the construction items of clearing, grading and grubbing
was $12,331,541. And the amount for ballast alone was
some $300,000 more than the present value of the land out-
side of terminals when the question of multiple was disre-
garded. Judging from these figures one would consider
that the element of construction was considerably greater
than that of the actual land values, and the statement is
made by Professor Bemis that ‘“ there are other unearned
increments that in most valuations are more important, far
more important, than the land question’’.? Prices of ma-
terials for both construction and equipment have risen
greatly in this last period of rising prices, and at the same
time the price of labor has gone up. But these facts are
offset, at least partially, by the increased efficiency in many
lines of work.

Unfortunately, though the above figures will show the
importance of this part of the valuation, very little has been
written on the matter of construction and equipment as
compared with the question of land values. It would ap-

1 Proceedings of the Twenty-fifth Annual! Convention of the National
Association of Railway Commissioners, pp. 290, 291.

2 Ibid., p. 317.
I12 RAILWAY MONOPOLY—RATE REGULATION [112

pear from facts that may be gleaned that excess of present
value in one branch of the property over the original cost
was offset in great measure by the opposite state of affairs
in other branches. Thus, though wages have risen, the
price of excavations and fills has fallen per cubic yard on
account of the advent of more modern machinery. But in
some other spheres, not only have wages risen, but labor
costs per unit of finished material have risen as well. And
in the matter of equipment, we find the tendencies are not
uniform, either. The present cost of passenger equipment
per seat has increased, on account of increased space per
seat, higher prices of material and more luxurious service.
On the other hand, while the cost of locomotives has in-
creased, on account of their increased weight and size, the
cost per tractive pound of hauling capacity has decreased.
Similarly, the cost of freight cars has risen, but their cost
per unit of capacity has fallen.*

As already brought out, there is, in the matters of con-
struction and equipment, a problem of increment of value
over first cost as well as in the matter of the land values.
To be sure, this is offset in these cases very largely, 1f not
entirely, by the fact of depreciation.

In the matter of construction the increment of value
comes very largely from what is known as adaptation, or
solidification of road-bed. If a road-bed were to be con-
structed new it would be some time before it would be in a
state of as great efficiency as that of an old settled track.
And this adaptation is due not alone to the effect of time.
It is the result of a considerable cost that must be laid out
on it during the first few years. As Mr. Riggs.? of Michi-
gan, says,

1 Proceedings of the Twenty-fifth Annual Convention of the Na-
tional Association of Railway Commissioners, p. 287.

? Riggs, The Valuation of Public Service Property, p. 147.
113] VALUATION AS A CRITERION 113

There can be no reasonable objection to adding to the contract
prices for grading, ballasting, etc., a reasonable amount to cover
not so much the seasoning and settling of the new roadbed as
the actual money disbursed in work on this new roadbed during
this first three or four years of operation in order to bring
it up to the proper operating condition. A very considerable
part of the money spent on “ maintenance of track” for the
first few years after a new line is built is in reality deferred
construction cost.

It would appear, however, that what expense was actually
added on account of this element was provided for under
the heading of maintenance, and hence fell under the head-
ing of running expenses rather than that of capital charges.
If so, Mr. Thompson, of Oklahoma, is right when he says
that allowance of this item would be capitalizing operating
expenses.”

The element of appreciation in value in this, as well as
in other matters affecting the value of the equipment and
construction, aside from what is provided for under main-
tenance and improvement charges, is very indefinite. Some
such items of property may be worth more now, in the sense
that it would cost more now to produce them at presetit
higher prices. These matters are so similar to the factor
of depreciation—the main difference being that one is posi-
tive while the other is negative—that in the matter of ac-
counting they partially neutralize each other, and may best
be allowed for at the same time. For example, in the case
of the settling of the road-bed, the actual depreciated con-
dition is modified by the fact of settling; the road does not
depreciate so rapidly in the first few years as it does later.

The factor of depreciation is one that should be allowed
for, in both construction and equipment, in any physical

1 Proceedings of the Twenty-fourth Annual Convention of the Na-
tional Association of Railway Commissioners, p. 50.
114 RAILWAY MONOPOLY—RATE REGULATION [114

valuation. If we were able to use the amount of the invest-
ment as a criterion of value, the matter of depreciation
might not disturb us. In such a procedure, the depreciation
of old elements is compensated for by the addition of new.
But when we are dependent upon an appraisal of the exist-
ing property, on the basis of either original cost or present
value, for the purpose of ascertaining its value we must take
cognizance of the fact that certain elements of the property
are partly used up. It is, of course, a patent fact that the
equipment and certain elements of construction of any road
are in a depreciated condition. Before a new road is fully
stocked its first equipment will be partly worn out. A road
under ordinary running conditions will have machinery in
all stages of wear and obsolescence, for depreciation is due
not only to wear, but as well to superannuation on account
of new inventions, or what is known as functional deprecia-
tion. To take a simple illustration, suppose a street car
line whose cars were usable for ten years had one hundred
cars in stock which had been acquired at the uniform rate
of ten cars a year. Obviously the cars would, on the aver-
age, be half worn out, and consequently the value would be
placed at one-half the cost new. Whether the cost would
be computed at present prices, or at original cost, is the point
in dispute between the different principles of original cost
and present value. The problem of depreciation is, of
course, not nearly so simple as the above example, for it is
a difficult engineering problem. However, it is principally
an engineering problem rather than an economic problem.
Economics must allow for the fact of depreciation, the en-
gineers must work out the ratios.

The percentage of actual depreciation as found by the
state valuation boards varies somewhat, as might be ex-
pected. But it varies surprisingly little when we think of
the extreme variation in some other items and the appar-
115] VALUATION AS A CRITERION 115

ently different states of maintenance of the various roads
throughout the country. Mr. Witt, of Kansas, says, “Well-
maintained road is almost invariably about 85 per cent con-
dition”. He also maintains that all appraisals which have
come within his notice are within one per cent of that figure.
Mr. Swain, of Massachusetts, reporting on the New York,
New Haven and Hartford, puts the depreciated value of
the grand total at about eighty-six per cent of the cost of
reproduction new. In the Michigan appraisal of 1900 it
was about eighty per cent, and in the Wisconsin appraisal it
was eighty-two and one-half per cent. These figures would
denote that, while Mr. Witt’s idea of eighty-five per cent
within an error of one per cent is too narrow, the actual
figures do not vary widely from this mark.’

In the statement of the land value of the Northern Pacific
Railway, as given above, are found the items of engineer-
ing, superintendence, legal expenses, contingencies, and in-
terest during construction. These items with others such
as discount on bonds, solidification of road-bed and working
capital are usually discussed apart from the land itself. At-
tention has been called already to the matter of the solidi-
fication of road-bed and to the wide divergence of method in
dealing with the question of contingencies. Somestates allow
a considerable percentage for this latter item, others disre-
gard it entirely, and apparently no two agree. The same
statement would be very largely true if applied to these other
items just spoken of; there is absolutely no unanimity of
opinion in regard to their treatment. And yet these matters
are important and are a part of the value, whether from
the standpoint of original cost or that of the so-called pres-
ent value. In many cases too great amounts may have been

1 Proceedings of the Twenty-fourth Annual Convention of the Na-
tional Association of Railway Commissioners, p. 68.
I16 RAILWAY MONOPOLY—RATE REGULATION [116

ascribed to these costs, but costs they are in almost every
case and they should not be neglected in a fair valuation.
Then, again, the subject of purely intangible value is a
matter of much dispute. The most prominent items here
are franchise value, value as going concern and strategic
location. To these may be added others such as early years
of unproductiveness, organization and good-will. These
are frequently all lumped together as franchise value.
There is no unanimity of procedure in regard to these any
more than in regard to the slightly more tangible elements
spoken of above. The general opinion in regard to the
actual franchise seems to be that, if it has had an actual
cost, this cost should be allowed. A franchise may have
been bought and paid for legitimately; if so, while not an
element of physical value, it is, nevertheless, quite truly an
element of cost that should be included in a valuation. The
other items, which are sometimes called in general the fran-
chise values, would naturally follow the same rule. The
value of the railway is not simply that of the physical items
which go to make it up any more than a man is simply flesh
and blood and bones. It means something to have the bones
all put together and in working order. So, it means some-
thing to have the earth and steel and wood of the railroad
organized into a system. It has cost money, and what is
more, as will later be shown to be very important, organi-
zation does cost money in all new roads and extensions of
the old ones. But why should we go further than original
or present cost of these matters? To go any further in as-
signing value would be to allow value for the monopoly ele-
ment, which we are seeking to eliminate, or to value the
earning capacity, which has been seen to be useless for our
purposes. It would seem to be a fair conclusion to say that
as far as these matters cost, they would have influence in
competitive enterprises, and should be allowed for in valua-
117] VALUATION AS A CRITERION 117

tion. If original cost is the principle adopted, let them be
rated at what they actually cost. If the principle of repro-
ductive values be adopted, let them be put down at what
they would cost under present conditions.

Large as some of these items are which have been con-
sidered there is another which well deserves the important
place of the last to be discussed before weighing the rela-
tive strength of the arguments for original cost and cost-of-
reproduction-less-depreciation. This is the matter of sur-
plus. It may be argued that this is not an item of cost, and
hence does not deserve a place in the matters which must
be considered no matter which criterion we adopt. But,
whether this has been a matter of cost to the investors or
not, in so far as it has been invested, the part of the prop-
erty so purchased has been a cost to someone, the stock-
holders, or the corporation, or even the patrons. If we
are to base rate regulation on the value of the property, we
must consider this very large share of the assets. In fact,
this problem alone gives great impetus to the movement to
base valuation on the original cost, this being taken as the
original investment by the shareholders themselves.

Commissioner Lane said for the Interstate Commerce
Commission in the Opinion on the Western Advance Rate
Case :*

It is to be borne in mind that it has been American Railroad
policy to maintain the property fully, in a constantly improved
condition, both as to roadbed and equipment, out of current
revenue. The carriers, even under the rules of the commis-
sion obtained only during the last two or three years, are
given the widest latitude as to the charges that shall be made
against the maintenance accounts. Notwithstanding the un-
questioned liberality of the policy of the railroads toward
themselves in charging maintenance expenditures to operating

+20 I. C. 'C. Rep., 332.
118 RAILWAY MONOPOLY—RATE REGULATION [118

expenses, the carriers of the United States have accumulated
unappropriated surplus amounting to $800,642,923, whereas
in 1899 this surplus, as given in the books of the carriers, was
but $194,106,367. In ten years, with an increase in rate of
dividend and increasing maintenance charges and a vastly in-
creased fixed charge for interest, these carriers had accumu-
lated a surplus of $606,536,556 or an increase of 312 per cent
of 1899, while the mileage had increased only 36 per cent.

Turning to the other great case decided at the same time,
the Opinion regarding advances in Official Classification
Territory, by Commissioner Prouty, we find it stated:

The president of the Pennsylvania Company testified that
since 1887 his company had put into the Pennsylvania lines east
of Pittsburg $262,000,00c0 from earnings. During all that
time this company had also paid to its stockholders munificent
dividends. Now, to whom belongs this $262,000,000, a sum
which according to the statistical report of the Pennsylvania
Railroad Company to this Commission for the year ending
June 30, 1910, equals nearly two-thirds of the total cost of
construction of the 2,123 miles owned by that company?

Suppose this Commission were required to fix a value upon
the Pennsylvania lines east of Pittsburg. Could any distinc-
tion be made between this sum which has accrued from the
operation of the property and what has been paid in from
other sources?

We are not required at this time to express an opinion upon
that point. What the claim of the railroads will be when the
matter finally comes to an issue is well shown by a question
which was asked upon the argument and answered by that
attorney who was urging most strongly the right of the rail-
road to accumulate a surplus for this purpose:

Question. The popular idea seems to be that these prop-
erties ought to be physically valued, and that the rate should
be determined by the value of the property so fixed. In that
case, would the surplus be entitled to be appraised as a part of
the value?
119] VALUATION AS A CRITERION 11g

Answer. As of the date that such a valuation takes place,
the property as it stands belongs to the stockholders. That
has been in accordance with the policy of the Government,
and it would take a change in the policy of the Government to
change that legal situation. So I think the valuation would
necessarily be on the property as it stands.

Ing I.C. C. Rep., 382, 417, the Commission, in considering
the financial condition of the Lake Shore & Michigan South-
ern Railway, said: +

“The Lake Shore & Michigan Southern, on June 30, 1901,
owned a majority of the capital stock of its competitor, the
New York, Chicago & St. Louis Railroad Company, a major-
ity of the capital stock of its connection, the Pittsburg & Lake
Erie Railroad Company, almost one-half of the capital stock
of the Lake Erie & Western Railroad Company, and $11,-
224,000 of the capital stock of the Cleveland, Cincinnati,
Chicago & St. Louis Railway Company, besides smaller hold-
ings in other companies. These stocks had been acquired, in
addition to the payment of dividends not less than 6 per cent,
for many years, out of net earnings. During the year 1902
it purchased, apparently out of surplus, $4,728,200 of the
capital stock of the Indiana, Illinois & Iowa Railroad Company,
the entire capital being $5,000,000.” ?

Enough has been quoted to show the enormous amount
of the stake. Apparently this question would overshadow
that of either the donated lands or the unearned increment,
if they were taken separately. And if we add all these items
together, it will readily be recognized that it makes a tre-
mendous difference whether the ruling principle in valuation
be the original investment of the shareholders or the cost-
of-reproduction-less-depreciation. At this point there is a
split in the original cost theory. As we have said before,
if the matter be regarded as a valuation of the property

120 I. C. C. Rep., 260.
I20 RAILWAY MONOPOLY—RATE REGULATION [120

used by the railroad to serve the public, we certainly ought
to count up the cost of the total assets, and we should not
find that the property bought out of surplus was any cheaper
than any other property. The only question is as to who
paid for it.

The railroads, of course, assert that they paid for it, and
that out of money which they might as well have handed
over to their shareholders in dividends in so far as the
public is concerned. Since the railroads were subject to
rate regulation during this time, and charged what they
were allowed to charge, they claim that it is immaterial to
their patrons whether the net income was all paid out in
dividends or reinvested in the extension of the property.
The result might have been the same in either case. Had
there been a law against the investment of surplus as capi-
tal, the money could easily have been paid over to the share-
holders to be reinvested by them. The difference would
have been that the shareholders would have had a greater
number of securities but of less value per share. But the
shareholders might not have reinvested in railway shares.
They might have invested in bonds, and then the railways
would not have been in as strong financial position; or they
might have invested the money in other enterprises entirely,
and then the patrons would not have had the facilities that
they now have. Of course, the railways would not claim
that the net income was more than necessary, and that the
rates charged the public might have been reduced. Why
should they? They were not charging more than the traffic
would bear according to their view of the case. And be-
sides, the rates, being subject to regulation, were allowed
as reasonable.

Many who are not railway men regard the matter quite
differently. They must admit that the property is there
and that it had its full share of cost. But they say that the
121] VALUATION AS A CRITERION 12

cost was not to the shareholders, for they had a compensa-
tion reasonable for shareholders in a public agency. They
claim that the cost was to the shipping public, in that the
payment was made out of what they paid for the service.
The argument is that this surplus is a sum that is held in
trust by the railroads and should not be the basis for charges
in the future. The railways, having originally charged
enough for what even they seemed to think an ample divi-
dend, in fact imposed a tax in addition sufficient to collect
this enormous surplus which was in reality an overcharge.
That it was not declared an overcharge at the time is no
evidence of its fairness. People are sometimes overcharged
without being aware of it. If the rates really were more
than reasonable, there is a good argument against the rail-
roads charging a return on what they formerly filched from
the unsuspecting public.

The policy towards the surplus may well be different as
regards past aggregations and those of the future. As re-
gards that already collected, and leaving till the comparison
of the general argument between original cost and present
value the questions of practical expediency, we may say
that the policy of not allowing this factor to count in val-
tiation rests on questionable theory. It rests, for one thing,
on an extreme organic conception of both the shippers and
the investors. In fact, if we refused to allow this surplus
of the past to be counted in the valuation we would be tak-
ing from present owners of railway securities what past
owners filched from past patrons and we would be return-
ing this, in the shape of capital goods to be used without
charge, to the present patrons of the railways who never
paid anything to this surplus. It is a bit difficult to see how
this would mend metters. The probabilities are, judging
by the history of the financial dealings of the railroads that
the benefit from this surplus never seriously affected the
122 RAILWAY MONOPOLY—RATE REGULATION [122

rank and file of the shareholders, even in the past. Those
who controlled railway finance saw to it that the common
stockholders who were not insiders suffered as little as pos-
sible from the evils of sudden riches from the increased
value of stock, when it became known that a lump of sur-
plus had been added to the companies’ assets. We could
hardly put the present directors in jail for the practices of
the captains of high finance in the past. And why it would
be more fair to mulct the present stockholders for what past
insiders got while the public was asleep, is difficult to see.
Whether it would be feasible to try to benefit the present
patrons for what may have been an overcharge on past busi-
ness is a matter that must also be left to later pages.

It would be out of place to go extensively into the ques-
tion of future policy regarding the matter of surplus just
here. It is claimed that an amount should be allowed for
surplus as a foundation for credit, a guarantee fund against
disaster and a reserve out of which improvements and ex-
tensions may be made. It is claimed that improvements
such as track elevation, passenger stations, and safety ap-
pliances, which are supposed to be of a non-revenue pro-
ducing character should be made out of surplus. Aside
from the fact that, as soon as this surplus was actually laid
out in physical property, the railroads would be very likely
to include this in the valuation on which they demand a fair
return, it is a very doubtful economic policy to do what
would virtually make a tax on present business for the bene-
fit of future patrons. To a certain extent this is necessary,
but it should not be done without careful consideration.

It is thus evident that there are many elements of value
in a railroad property and that there are many differences
of opinion in regard to the measurement of these values.
Many of these differences, probably it would be safe to say
most of them, would disappear if the controversy between
123] VALUATION AS A CRITERION 123

present value and original cost were settled. The great
problem now is as to what weight each of these rival prin-
ciples shall have in valuation. It is quite generally con-
ceded now that one or the other of these must be determin-
ative except in exceptional cases. Each also has its right to
a hearing on the cost-of-service principle.

Enough has been said in the discussion of the particular
matters of the elements of land value and the surplus to
show the immense difference between the results of the two
lines of argument. And sufficient has been said as to
the merits of the two principles in these particular matters.
But the decision as to the particular items depends upon the
relative merits of the two general principles. Decide the
question between the principles, and the question as to these
particular items will be automatically adjusted.

The objection may easily be raised that it is not a vital
question which principle of valuation be adopted, that in
either case fairness will be worked out in the matter of the
return allowed on the valuation. It might be immaterial
whether we allowed a return of five per cent on a valuation
based on the so-called present value or one of ten per cent
on an original cost of the amount of half the present value.
The same argument has been used on the question of capi-
talization, and it is generally conceded that it is a matter
of concern whether the stock is watered or whether it has
full real value behind it. Minor differences may be adjusted
in the rate of return, but, in question of valuation, it is an
important matter for the guidance of railway investment
and for public sentiment which base be used. Not only
might economic friction distort the working out of the
proper result, if the wrong base were adopted, but the ques-
tion before us is on which of these bases a return should be
rated as a fair return on railway capital.

In the earlier. days of this movement to regulate rates on
124 RAILWAY MONOPOLY—RATE REGULATION [124

the ability of the carriers to supply the service, the tendency
was to look with favor on the principle of cost-of-repro-
duction or the cost-of-reproduction-less-depreciation. It
was known that stocks were highly watered, that the capi-
talization was far in advance of what the investment had
been. And yet capitalization stood in the way of regula-
tion when there was no knowledge of the fairness of this
capitalization. It was recognized that no dependence could
be put on any accounts of investment that were available.
The nominal capitalization was held to be unreasonable as
a criterion for regulation. Public opinion was in favor of
holding the railways down to a return on what it would
cost to reproduce the properties as they existed. But re-
cently people have been awakening to the fact that, with
the increment in value of property that has been going
merrily on and the reinvestment of surplus, such a valua-
tion was liable to show that, under the pressure of these
movements, the water which had been abundant was prac-
tically all squeezed out. There is even a slight uneasiness
that the result might show that by this time the properties
would cost more to reproduce than the amount they are
capitalized for. This is a finding with which the shippers
do not care to be confronted, and now they generally claim
that what the railroads should be allowed to earn returns
on is only what they originally put into the business. If it
cannot be ascertained just what was originally put into the
properties at least this can be estimated with a fair degree
of accuracy.*

Mr. Whitten says in his latest comprehensive book on
the subject,

Prior to 1912 there were many cases in which the courts and

1 Proceedings of the Twenty-fifth Annual Convention of the Na-
tional Association of Railway Commissioners, p. 275.
125] VALUATION AS A CRITERION 125

commissions while nominally at least considering various ele-
ments of value, as a matter of fact apparently made cost-of-
reproduction-less-depreciation the controlling factor. In re-
cent years there has been a tendency to modify the reproduc-
tion method so as to bring it nearer to actual cost and to em-
phasize the importance of the necessary cost as a factor in
determining value.*

In the face of the many things that are said against the
accounts of the original cost, it may be thought an impossi-
bility to use this as a basis. The original investment by
the security holders, or the cost of the original property,
is a matter that would be almost impossible to ascertain.
But the opponents of original investment avoid this diffi-
culty. As Commissioner Erickson, of Wisconsin, says,

The books and records of a utility is not the only place where
a basis for determining the original cost of the property may
be had. The original cost of the property is mostly repre-
sented by the cost of the property actually in use at the time.
From a complete inventory of this property such as must be
had in order to determine the cost of reproduction, and which
shows the year when each part of it was put into service, and
from facts giving the market prices of material, equipment,
labor and services of all kinds, and of other needed elements
for these years, it is possible to compute the original cost of
the existing property with as much accuracy as its cost of
reproduction may be ascertained. When in addition to these
facts full information is also available showing the size, loca-
tion, growth and character of the plant and the kind of services
it furnishes, the true original cost can often be more correctly
obtained through these and other similar methods than in any
other way.”

1 Whitten, Valuation of Public Service Corporations, Supplement,
p. 817.

2 Erickson, “Relations between the Valuation and the Rate of Re-
turn Thereon,” Proceedings of the Twenty-fifth Annual Convention of
the National Association of Railway Commissioners, p. 438.
126 RAILWAY MONOPOLY—RATE REGULATION [126

One of the principal arguments for the adoption of the
original-cost principle is that the capital put into railway
enterprise is a fixed investment; that capital is devoted per-
manently to the enterprise. If this be so, then, it is argued,
the value of the property has no cause to change with the
changing value of the property around it. When a railway
is constructed, it is practically impossible to turn the land
back into the market again. In many cases it is practically
ruined for other purposes. If the land is utterly removed
from the general market why should the general market
prices affect its valuation? An illustration is given of a
railway running through a fertile valley and laying claim
to a valuation similar to that of surrounding lands, though
it has not paid as much originally. Then the boll weevil
gets into the crops and ruins the selling price of the farm-
ing land. It is pointed out very emphatically that the rail-
way would not be anxious to change its rates to accord with
this kind of a change of value. The railways will not be
so ready to note a decrease in value in the contiguous prop-
erty as they are an increase. If this happen to a section
of a through line that gets most of its business from
other parts than the section affected, it will be to the rail-
way interest to keep up the valuation. It will not make a
reduction in value for local traffic, its value will be affected
without any action on its own part or on the part of
the commission. Its rates may remain the same, but its
value will fall off just as much as the value of the property
held by its agricultural neighbors and this independently, or
even in spite of regulation. Though its rates remain stable,
its traffic will decrease, and consequently its returns and
hence its value. What is a mining railway worth in an ex-
hausted mining region? Obviously as much as the ex-
hausted mines. True, the capital is fixed, if by capital is
meant the capital goods. But the capital value of a railway
127] VALUATION AS A CRITERION 127

rises and falls, or at least certainly falls with any permanent
fall in the value of the property of those upon whom it is
dependent for patronage.

Another argument is voiced in the rather extreme state-
ment of-a commissioner that “if the present or the repro-
ductive value theories are carried to their logical conclu-
sions, rates will become so high that no one can pay them’’.*
Surely this cannot be meant in the extreme form in which
it is stated, for no one could possibly think, while we are
dependent on our railways for the transportation which is
truly the vascular system of our economic life, that rates
could approach the prohibitive margin and land values still
keep on rising. Even the most confirmed pessimist, if his
eyes be open, must see that there is here a limit beyond
which transportation rates cannot soar without reacting
upon the land values not only of other property, but of the
railway property as well.

However, while rates can never be so high that no one
can pay them, yet they may rise so high as to be oppressive.
It is to guard against this that the cost-of-service basis is
being advocated for: general rate schedules. The attempt
is to make rates as low as the ability of the railways may
allow, in order that the other business of the country may
have the freest possible opportunity to expand. Such may
not be the case, and such is certainly claimed not to be the
case, if the railways are to be allowed a full return upon
the unearned increment of their property and the property
bought out of surplus earnings. Certainly the railways
must have a fair return on their investment, but are the
railways chartered to act as speculators in land values?

The original investment principle is not being advocated
with any idea of confiscating lawful vested interests. It is

1 Proceedings of the Twenty-fifth Annual Convention of the Na-
tional Association of Railway Commissioners, p. 280.
128 RAILWAY MONOPOLY—RATE REGULATION [128

being advocated as an ethico-legal idea. It is regarded as
only just and fair that the shareholders of a line receive a
fair return upon what they have actually and judiciously
invested. When it is objected that a private citizen is en-
titled to the unearned increment on his land and the present
value on all his goods, it is very forcibly pointed out that
the status of the private citizen is entirely different from
that of a railway. Private business is not subject to rate
regulation at all. Commissioner Thelen, of California, has
made an excellent argument on this, advancing the prin-
ciple that the relation between the railways and the people
is that of agent and principal. He argues that it is only as
an agent of the public that the railways have the power of
eminent domain. He then applies the following principle
of agency:

It is a well established principle in agency that an agent
acting within the scope of his authority is entitled to be re-
imbursed for the money which he honestly and judiciously
expends for the benefit and account of the principal, together
with a proper compensation for his services. As a general
rule, it is a breach of good faith and of loyalty to the principal
for an agent to deal with the subject matter of the agency so
as to make a profit out of it for himself in excess of his law-
ful compensation. If such a profit is made, that agent may
be held as a trustee and may be compelled to account to his
principal for all profits and advantages acquired by him out
of the relationship. Applying these principles to the relation-
ship between the public and the public utilities, it seems clear
that the public utilities are entitled to a reasonable return upon
stich money as they honestly and wisely expend for the public.
but that they should not be allowed a return on the increased
value of the property used in the agency.

1 Proceedings of the Twenty-fifth Annual Convention of the Na-
tional Association of Railway Commissioners, p. 273.
129] VALUATION AS A CRITERION 129

Going further, he makes the agent assume losses from
injudicious investments, but would guarantee him against
the competition of a possible cheaper or more efficient
property, if his original investment was made honestly and
wisely. So it is only half a game of heads you win, tails I
lose, for the companies. To be sure, the risks are not so
great in the transportation business now as formerly. But
to a layman in the subject of law it would seem as if the
very fact of making the agent assume the risks of invest-
ment, with protection only from possible rivals would de-
cidedly modify the relation between the agent and its prin-
cipal. If the agent buys the property at his own risk it
ought to be with the chance of an increase, as well as with
the chance of a decrease of value. There may easily arise
many cases, if not at present, at least if we meet with a
period of falling prices, in which investments made with
ordinary wisdom decrease in value. Such examples as
were mentioned above, cases of the boll weavil injuring
property values and with them the traffic, of exhausted run-
out mining regions, or even of railway property bought in
cities which have not kept up their promise of growth, all
show what may happen even in periods when prices are on
the rise. If prices fall, examples may be more abundant.
It would be very hard to guarantee even investment made
in property with reasonable honesty and foresight. Even
to maintain the rates at a standard level might not protect
the railway interests. Certainly we could not consider
guaranteeing the investment in equipment against the ad-
vent of new inventions. That would not be to the public
interest, nor is it the policy of the commissions. The com-
missions are quite ready to force the adoption of new in-
ventions even though it be at considerable cost to the rail-
ways.

There appears to be some weight in the proposal that the
130 RAILWAY MONOPOLY—RATE REGULATION [130

railways be protected against the competition of a possibly
cheaper route. To a large extent the railways are being
protected against the advent of rivals, and this is of im-
mense advantage to them. They are not in the position of
those who invest in real estate with a likelihood of many
rivals entering the field. The railways are given what prac-
tically amounts to the undisputed control over their field.
And yet even here there are limitations. And, should very
much more efficient means of transportation be discovered,
it would be useless to talk of guaranteeing the investment
that had been made in good faith. The only way this could
be done would be to buy out the roads in such a case; and
this would be practically out of the question. It will be
objected that this is a purely speculative objection, that there
is no likelihood of any invention revolutionizing transpor-
tation except what may grow up in the railroad business
itself. There may never be anything that will wholly super-
cede railway transportation, though electric traction may
condemn thousands of dollars worth of workable property
to the scrap heap. But just this last few years, while this
movement for depriving the railroads of the increment in
value in their property has been becoming popular, a sys-
tem of transportation has come into being, not merely with
public permission, but by government action, that is a
cheaper and more efficient route for a very appreciable part
of the traffic formerly carried by the railroads. It is said
that the Panama Canal is likely to come into competition
with the transcontinental railways for twenty per cent of
their business. Such a striking object-lesson shows that it
is doubtful if public policy would for a moment save the
agent from the destructive competition. Certainly the usual
economic law which lets the fittest survive would not guar-
antee the investment, nor is it to be expected that public
opinion would do so. While the principle was working in
131] VALUATION AS A CRITERION 131

one direction it would be popular. Nevertheless, as shown
above, the railways are protected to a very large extent
against the advent of rivals, and they are not so easily as-
sailed by rivals as are investors in more open economic
fields; consequently their risks are less. And in so far as
these risks are diminished by the relation of the public, the
principle of agency is carried out.

Ethical arguments might also be advanced on the other
side of the question. But it would be difficult to find an
argument that would settle the question. In the matter of
ethical considerations, it is as a certain character in litera-
ture often said of various subjects: There is much to be
said on both sides. Our ethico-legal conceptions do not fit
the case. They have grown up in a different economy.
And the underlying principles of justice need to have light
on the situation before they can act. We are dealing here
with an expanding economy, and the question is as to what
share of the expansion belongs to the railroads and what
part to the public in general. Justice demands that neither be
deprived of what it has fairly acquired, if it be possible to
avoid it, but it does not say when additions are made to the
common fund that is the share of each in the expansion.

Starting from the conception that neither be deprived of
what it has fairly put into its enterprise, that the railways
be allowed full right in their investment at least, and that
the shippers shall not have their shipping rights decreased
if it be at all possible to avoid it, what can we find as to the
division of the expansion which has been taking place and
which we hope will continue? As has already been shown,
the railways exist for the general business of the country.
They are not an end in themselves. Railway expansion is
necessary to provide for the traffic, but it is not even desir-
able that it exceed the requirements of the traffic. If the
railways are allowed sufficient earnings to warrant and se-
132 RAILWAY MONOPOLY—RATE REGULATION [132

cure this expansion, there can be little doubt but that it will
be generally conceded that justice is done them. More
than enough would stimulate over-expansion, and would be
inexpedient as well as unjust to the shippers for whom trans-
portation exists, for it would hamper their expansion.

Two important facts deserve emphasis. One is this fact
of expansion. Our railways have had phenomenal expan-
sion, and must have still more. They have added line to
line, and property to property. New lines have been built,
sometimes to be absorbed by old, and sometimes to become
independent systems. In early days, much of the needed
land was donated. For many years it has been bought, and
at constantly increasing prices. As matters stand, different
roads in the same field have acquired their land on vastly
different terms. Then again, in spite of the fact that this
country has about four-ninths of the total railway mileage
of the world, we are far from the point when we can cry,
enough. Even the populous East is not oversupplied with
transportation facilities, and will doubtless need more before
the population ceases its expansion. If this be true of the
East, what of the West? It has been claimed that while at
present we have at least $15,000,000,000 invested in rail-
ways, it would not be extravagant to look for a necessity
for at least three or four times that amount before expan-
sion stops.

The other fact to be noted is that the railways of the
country are, as a whole, so intimately bound up with each
other that rates on one line can only be made in a certain
close relation to the rates of the other railways. Not only
do railways compete for service between the same points,
but the markets which they serve, though they may be
separate, nevertheless compete, and hence the rates in dif-
ferent regions cannot be made in defiance of each other.
As Commissioner Prouty says:
133] VALUATION AS A CRITERION 133

The greater part of the business of the railways of the United
States is subject to competitive conditions of one sort and an-
other which are largely controlling so that the rates of one are
necessarily bound up with those of another.

What then must be the ruling principle for valuation
under such conditions of expansion where the rates on the
different lines must be closely related to each other? Let
us first examine the question of the property which is al-
ready in the hands of the railways; property that has been
built up before this conflict between the different principles
of valuation gained prominence, and property built up as
largely in the absence of competition as the will of the public
could command. Needless to say, under such circum-
stances, the railways have acquired property as it seemed to
them that it would be profitable, with no thought of restric-
tion to original cost. And again, under competition as it
once existed, and as the public has hardly ceased to try to
make it exist, the growth of our railroad systems must of
necessity be quite largely by the building of new and inde-
pendent lines.

Could our railway system expand under these conditions.
if allowed merely what is understood as a fair return on
the original cost? Take for example a district served by a.
line built some years ago on free right of way, that had
bought terminal properties at very low cost before the cities
were built up, and that, before regulation was inaugurated,
had invested a considerable surplus in necessary equipment.
With the development of the region another line became
necessary to provide for legitimate business interests.
Would this new line be a possibility if regulation insisted on
basing rates on a fair return on the original investment?
It is certain that a new line would find it very difficult to

1 Railway Age Gazette, Feb. 13, 1914, p. 322.
134 RAILWAY MONOPOLY—RATE REGULATION [134

enter the field expecting to charge more for the same ser-
vices than the old line. Even if they were to serve exactly
the same district, this would be impossible with any hope
of success for the new venture. And if the function of the
new line were partially to open up new fields, the case would
be still plainer. The traffic is less in new fields and the rates,
if anything, must be lower than in old fields in order that
the traffic may be stimulated. The outlook would be that,
if regulation had been adopted so adjusting rates that the
income should only be a fair return on the money invested
by the security holders as actual out-of-pocket payments,
there would be no second company. Rates based on the
original cost of the first company would not tempt capital
into the new venture where everything must be paid for at
present value. It is a very grave question whether capital
would go into a venture that had even so little risk as rail-
roading has at the present time, with the prospect of noth-
ing more at best, than a so-called return on its own original
investment. Certainly it would be impossible to get capital
for a new line if the rates for the region were fixed at a fair
return on the original cost of an older line built when land
was either much cheaper or could be had for the asking.
Of course, this applies not only to the return on land invest-
ment but on all other forms of investment with which a
new line must equip itself when entering the field. If the
price of construction work or of equipment has risen, the
only terms on which new investment can be expected is that
rates for the region be based on present prices of all these
necessaries for the new line. In other words, if a new line
is hoped for, the rates of the old line must be sufficient to
cover the present value of the old line, for this would as a
tule be the best working criterion of what it would cost to
construct the new property.

It would be hopeless, as seen from the statement quoted
135] VALUATION AS A CRITERION 135

from Mr. Prouty, to base rates on the old line on its cost
and those on the new line on its cost at the same time and
in the same region. In order for the new line to exist, the
rates for the region must be high enough to cover the new
cost. Would there be any advantage, then, in counting the
valuation of the old line at its original cost and allowing
for the difference, when making rates to be worked out in
a higher rate of return? Obviously this might be done.
But if the rates were to be the same in either case, it could
hardly be any advantage to the shippers for the railway to
have a high rate of return on a low nominal valuation. It
would probably even be a disadvantage, for it would be a
great source of worry and grief of mind to many who could
never be brought to see the reason for it. The result would
probably be a popular feeling that the railways of the coun-
try were earning far too much, and consequently there
would be a great deal of trouble caused to the railways, a
great deal of useless embarrassment. It might be argued
that, if the two lines considered were rivals only in through
traffic, it would be of advantage to the local trade of the
road built at the lesser cost that its valuation be based on
the cost. It would not be necessary for the local rates to
cover present value just because this was essential for the
through traffic. But since the local rates on the newer
road must pay this higher rate, owing to the principle
of the competition of markets, it would be a doubtful eco-
nomic policy to base even local rates on one line on present
value and on another line in the same general field on a very
much lower original cost. What one part of the region
would gain the other would lose, and it would be the one
that could least afford it that would be the loser. The new
line would need the benefit of local traffic more than the old
one would, and it would be hard to build it up under such
uneven circumstances. The through traffic of the new line
136 RAILWAY MONOPOLY—RATE REGULATION [136

would be unduly burdened. To make this line profitable,
its through rates must be higher than they otherwise would
be, and consequently, as this line would be the pace-setter
for rates, the region would have a greater burden than it
would if the rates and traffic were more evenly divided as
a result of the valuation being based on the same standard
in each case. And in addition to this difficulty in fixing val-
uation on the prices of totally different periods of time, in
the case of two lines in the same region there is a perhaps
greater difficulty in the fact that different lines come into
rivalry for traffic, not in one single phase of the traffic but
in many. A line will share business with one rival in one
part of its traffic and with others in other parts of its traffic.
It may share through traffic with one line and local traffic
for part of its length with another, while the rest of its
local may be with still another. The outcome would be a
great mixup of rate-making if costs at different periods of
construction were the determining factor in the making of
rates. It would probably be very difficult to find any area
of appreciable extent on which rates could be based on the
prices of the land-donation period, even in so far as the val-
uation is concerned.

It is true that a great deal, probably by far the most, of
our construction work of late years has been done by ex-
tension of the sphere of established companies. But this
does not interfere with the fact that a tremendously im-
portant part of our railway development from the begin-
ning up to this time has been under such circumstances as
outlined above. New roads have been built as separate
units. And while the land for the first lines was donated,
the land for other lines which followed, and were a neces-
sity to the development of the country, has been bought,
and bought at ever-increasing figures as time has gone on.
That this has been a necessity can be seen at once by im-
+37 VALUATION AS A CRITERION 137

agining the conditions that would exist if all the railway
expansion had waited for the development of the lines in
existence fifty years ago. Certainly the railway map would
look different to-day had the development come only in this
jmanner, and one need hardly fear being accused of rash-
ness in hazarding a guess that the railway network would
have been much smaller than it actually is had this been the
rule. Not only are we indebted to this building of separ-
ately financed lines for our present railway facilities, but
this has been the policy of the public that has been pushing
the matter of regulation. The public has endeavored to
maintain all the features of competition possible. It has
been opposed to concentration as well as monopoly. Anti-
trust acts, anti-pooling restrictions and various other de-
vices to offset the evils of monopoly have stood in the way
of the economic advantages of the amalgamation of the
railway interests; such amalgamation might allow expan-
sion into new territory on the financial backing of the es-
tablished lines.

The result is that we have a system that could not have
grown up under a system of rate-making allowing only
what is understood as a fair return on what the security
holders originally put into the enterprise with the actual
additions for betterment as paid for by new subscriptions.
And we could not now go back and base rates on the origi-
nal cost of those roads which acquired a major part of their
property in the early days. To attempt to do so would be
to attempt an impossible system of rate-making. The newer
and more expensively propertied roads set the pace for rate-
making valuation, as in the Spokane Rate Case. It may be
that in some regions lines have not been so recently built as
to necessitate valuation based on value completely up to
that of the present general market. But since the original
cost of the early lines is so far eclipsed, and the actual cost
138 RAILWAY MONOPOLY—RATE REGULATION [138

of even the more recently constructed lines is so difficult to
ascertain, we may reasonably conclude that, for the invest-
ment up to the present, it would be much the better policy
to count the present value as the fair valuation. Any dis-
count from this could be allowed to work out in what would
be a small difference in the rate of return.

If our transportation system could not have grown up
under the principle of original cost, it would hardly seem
feasible to go over to this principle for the system that now
exists. If it could not have developed on the principle, how
could such an intricate railway system be maintained on it?
It is argued that railway property, once it becomes railway
property, is fixed as such. Land once adapted to this use
can hardly be expected to return to other uses. The great
argument against valuation on the same principles as gov-
ern the price of property in the general market is the lack
of transfer of property between the railways and the gen-
eral market. The attempt has just been made to show that
there is no lack of such transfer in one direction; that there
has been such a transfer in one direction as to be determin-
ative. Such a one-sided transfer of property is the only
possible state of affairs in any enterprise which is continu-
ally expanding, and which pays for its property in the gen-
eral market. The railway does not want to sell land if it
can earn a fair return on what it has to offer to the public.
But if the railways should be cut down to a return merely
on the cost of property bought years ago which would sell
for many times that figure to-day, they might want to sell.
If the terminal properties were scaled down from millions
to a few thousands, the railways might sell their city prop-
erties for other uses and let the cities provide for the han-
dling of the goods as far as terminal facilities are concerned.
The land covered by the Grand Central Terminal is no more
unfit for other uses than is that covered by the Woolworth
‘building.
139] VALUATION AS A CRITERION 139

As already brought out, to allow a valuation for past ac-
quirements on only what was paid long ago would be looked
on as confiscation from the standpoint of the present secur-
ity holders. A very important part, if not the majority, of
the stock of the railroads has changed hands since they were
built. The increment of land value, whether earned or not,
has been added to the accepted value of the stock, or even
covered by bonds, and passed on by sale to other owners.
Surplus over the dividends paid has been invested and the
value added to the value of the stock, or made the basis for
new bond issues, and simply put into the pockets of the
former owners by another hand than the one they would
have used had it been devoted to dividend payments. The
present owners have paid for all they got. The profits have
gone to former owners and insiders, doubtless principally
the latter. And the value of the land donations has gone
the same way. They are no more a source of profits to the
present owners then they were of loss to the original donors.
The latter counted the donations as payment for the rail-
ways which they got, just as anything else they bought and
paid for, and the former paid for what they own just as
much as for the land bought from the farmers to-day. It
cannot be claimed that we must guarantee the basis of all
stock sales. That would be worse than trying to guarantee
all original investment. Unfortunately, there are many
securities issued and sold that regulation must overlook in
so far-as their selling price is concerned. But sales based
on a valuation, indefinite though it has been, that has been
freely allowed by the courts and advocated by the commis-
sions and the shipping public as long as it was supposed to
be to the public advantage, are surely sales that the buyers
have had reasonable grounds to have confidence in. Not
to stress the ethical phase of the subject, let it only be
noticed that there would be great danger of a serious effect
140 RAILWAY MONOPOLY—RATE REGULATION [140

on the future market for railway securities. To go back
on a principle of valuation so long maintained against the
railroads would be likely to have a most depressing effect
upon the home security market and might be classed abroad
with State repudiation.

The conclusion in so far as the valuation of railway prop-
erty up to this time is concerned is that the principle of pres-
ent value, or cost-of-reproduction-less-depreciation should
rule. And it should rule in so far as all items, whether
land, constructions, and equipment or non-physical elements
that have cost and must cost, and are needed for present
traffic requirements are concerned. Let the slate be cleared,
allowing, for the past, the so-called unearned increment,
and allowing the valuation on the actual property bought
out of surplus earnings. It will do us no good to remember
that half a century ago certain promoters were given tre-
mendous tracts of land—unless we want to tax their de-
scendants. But there seems to be little reason for allowing
a large multiple for land condemnation in addition to the
present value of the land. When we see how small the
multiple actually is in the long run, and that, when paid, it
is not paid generally on the value of lands contiguous to rail-
way property, but on land at a considerable distance from
existing sytems and hence cheaper than what is actually con-
tiguous to operating lines, we see the reasonableness of the
decision of the Supreme Court in the Minnesota Rate Case,
where the multiple was completely denied. Exceptional in-
stances may occur, but, as a rule, justice would seem to be
done the railways if they were allowed the present value on
their property without the multiple at all. And as for the
suppositious cases where the original cost is greater than
the present value, unless it be feasible for this difference to
be amortized, as is so frequently done with the discount on
bonds sold below par, it would seem much better, as a
141 | VALUATION AS A CRITERION 141

rule, to count this in with the risks of enterprise, and allow
the promoters to pay for the lack of wisdom or worse in
their investment. Such cases will probably be so rare under
the present trend of prices that they can easily be cared for
on the individual merits of the case, and will not prove a
serious disturbance to the general rule of the justice and
expediency of the principle of the present value as a basis
for the valuation of the railways in so far as they have al-
ready been established.

Though the claim has been made that the principle of val-
uation for the property already invested in railroading
should be the value of the property were it in the general
market at the present time, yet this is by no means under-
stood to mean that for the future railway values must nec-
essarily expand to keep pace with the cost of reproduction.
In fact the most powerful arguments for the principle of
cost-of-reproduction-less-depreciation lose their force when
future expansion of values is considered.

This does not mean at all that a period of cessation from
railroad expansion is anticipated. Conditions are not at all
likely to become static in the railway world; they are likely
to be fully as dynamic as ever for some time to come. As
already noted, the United States will need at least four
times as much investment in transportation as the present
figures show, before the country will be fully equipped.
But we may not have a program of expansion by the method
of launching new independent lines. If we accept railway
monopoly as a fact, an economic necessity, then while not
allowing it its ordinary burdensome rate-making powers we
may allow it the monopoly privilege of control and opera-
tion with freedom from competition of new lines entering
the field. This means that our expansions may be by the
enlargement and extension of already existing systems.

This may not, at first sight, promise to make any radical
142 RAILWAY MONOPOLY—RATE REGULATION [142

difference in what basis will be necessary for the valuation
of the future. But a careful view of the case will show a
very important difference between the two programs of ex-
pansion.

Expansion by the method of the projection of new inde-
pendent lines is like the classic economic illustrations of the
farmer extending his cultivation of grain to less fertile
fields. The profitableness of each field is an entirely separ-
ate consideration. The fields may be owned by different
farmers. It makes no difference. The farmers cannot in-
crease the productivity or profitableness of the fields in use
by adding other less fertile ones to cultivation. The change
warranting expansion to the less fertile fields must come
from an expansion of the demand allowing a price that will
make cultivation on such fields profitable. This expansion
will necessarily give an added profit to the owner of the first
fields, but it is a profit that can come only through the med-
ium of an expanded demand. Even though both a new and
an old field are owned by the same farmer, it will not be to
his profit to cultivate the less fertile field, till he can make a
profit on it independently, unless the addition of the new
crop increases the marketability of the old. Even though
the addition of the new crop might increase the marketabil-
ity of the old, a new farmer could not be expected to culti-
vate a new field until the new field was, through rising
prices, profitable by itself. An enlarging demand would be
very profitable for old farmers, but, unless the cultivation of
new fields made the products of the old more marketable
and the new fields were brought under cultivation by the
same men, the cultivation could not be extended farther into
the less fertile fields than their independent profitableness
would warrant. Both economic combination and help from
one unit in the marketing of the products of another would
be necessary to prevent the least fertile being the price-setter
for all.
143] VALUATION AS A CRITERION 143

So in railroading; so long as additions are made by inde-
pendent lines, the latest unit, or the one provided with the
most expensive land and such other commodities as are ris-
ing in price per unit of transportation, will be the line that
sets the pace for the rates.

But, to return to our farmers, if we have combination of
new and old land in the hands of the same farmers and if
the addition of the crops on the new fields is of material as-
sistance in marketing the products of the old, we have a dif-
ferent state of affairs. By means of increasing their output,
they may be able to secure great economies in marketing.
If this is possible it will pay them to bring new fields under
cultivation that would be unprofitable if operated independ-
ently. In so far as the cultivation of new fields increases
the profitableness of all the fields, it will be to the advantage
of the farmers to extend their cultivation farther than they
would under the previously supposed case. Under this
former case, the margin of cultivation would be extended
only in so far as the income from the new field alone paid
for the new outlay of capital on it. Under the present
method, new capital would be laid out on new fields so long
as it resulted in a net increase of the income from all the
fields sufficient to warrant this investment. In other words,
it must only be seen to that the income as a whole is suffi-
cient to warrant the investment of capital as a whole.

Returning to the railroads, let us see how this principle
works out.

When an established railway system considers building a
branch line, does it wait till it thinks that the receipts of the
new line on the mere traffic carried over its own tracks will
pay for the new investment? Certainly not. The branch
lines are known as feeders for the established systems. A
great deal of the profit from these feeders comes from the
added traffic which they make on the older sections of the
144 RAILWAY MONOPOLY—RATE REGULATION [144

systems. If the traffic actually handled on the branch were
barely sufficient to pay interest on bonds that would cover
the cost of the new line, it would not pay an independent
company to construct it. But if at the same time traffic
originated on this line that would be carried at a profit all
over a large railroad system, it would certainly pay the old
system to build the new line. It would pay it to build the
new line at less return from its own individual receipts than
would pay the interest on its construction bonds. The busi-
ness of the separate lines does not stand or fall by itself.
An increase of traffic on any line increases the traffic on
neighboring lines. The building of a new line means the
addition of traffic to older established systems. It is not
like a system of farming where the crop on each field must
be considered as a separate unit that must be profitable in
itself. It is like a system of farming where the profitable-
ness of all the crops and stock holds together; where grass
must be raised for the stock, and stock must be kept to pro-
vide fertilizer for the orchard. The business carried on in
a railway system is to a large extent all one organic unit.
Investments are not made with a view solely to the profit
on the particular property in which the money is laid out in
the particular instance. Money is spent on ventures that
will increase the business of the whole system sufficiently
to warrant its investment. The business of the whole must
be sufficient to provide an attractive return on the invest-
ment as a whole. The investment will naturally be in-
creased to the amount warranted by the returns anticipated
from traffic demands.

Does not this mean that, if the future expansion of our
railways may come about by the development of the present
system instead of by building separate new lines, the basis
for rate-making may be the actual future investment, with
perhaps a little leeway to cover expansion over more ex-
145] VALUATION AS A CRITERION 145

pensive territory? And may not the expansion come about
in accordance with the same principle?

Surely expansion might come about by this method if the
public would remove its objection to railway combination ;
an objection that does not seriously prevent monopoly, so
far as it is spent in trying to stimulate railway competition.
It would probably be impossible to ascertain how much of
the expansion of this last few years has come about in
this manner. Owing to the practice of inter-holding, and
the formation of what are in reality subsidiary companies,
it is hard to distinguish new companies from what are in
reality forms of the old ones. But the amount of expan-
sion that is known to have come about through the building
up of the great systems of late years would easily lead to
the conclusion that, were this practice fully accredited in
the public estimation, we could depend on this program for
the necessary railway expansion. Even new lines of con-
siderable extent, and built into new territory as needed,
would increase the profitableness of the present existing
systems. We hardly need new lines faster than it will be
thus profitable for the old lines to build.

By the statement that the basis for future valuation may
be the actual investment, is meant that, after making due
allowance for the property at present devoted to transpor-
tation, at such a valuation as would allow for its present
value as outlined above, in the future we may simply add
to this the amounts of actual new investment. This would
allow for the necessary railway expansion of the country
by the expansion of the existing systems. If it be objected
that, while the companies were earning a bare return on
what they already had invested, they could hardly be ex-
pected to buy new property at higher prices for the prospect
of a slow addition of traffic at old rates, it must be answered
that the rate of return must be sufficient to attract capital
146 RAILWAY MONOPOLY—RATE REGULATION [146

under such conditions. Nor would this rate of return be
any greater than what would be necessary for the so-called
marginal line, or the most expensively built line, if this
were independent of a large system, in order that it might
operate and expand as its business demanded. But further
discussion of this and the influence of the unearned incre-
ment on the rate of return must be left to the chapter on
the net return.

This rule for valuation for the future would not involve
anything that could rightly be called confiscation. It would
be a generally understood program, and would be accepted
as a settled fact by investors. Certainly it could work no
hardship to future investors. They would invest on known
terms. The returns would be according to the expectations
of their investment. Neither could it work any hardship
to those who would buy the stock of previous investors.
They would buy the stock of former security holders with
a view to future earnings just as those who would invest in
new securities. The only ones who could suffer would be
those who held stock when the program was changed to
the basis of the principle of actual investment. These
might suffer if they received too small returns when de-
prived of future increment. If so they would suffer in the
shrinkage of returns on stock which they retained and in
the shrinkage of capitalization based on such change if
they sold their shares. It could be argued that, even though
a certain amount of such shrinkage should occur, it would
only be an instance of restrictive regulation scaling down
anticipated profits. Such things are almost bound to hap-
pen. If the real social good demands such restriction, it is
not held to be unjust. Such things are part of the regular
risk in investment in public utilities. And if the valuation
allows full present value for all investment up to the time
of a definite inauguration of the other principle, there can
147] VALUATION AS A CRITERION 147

be no real confiscation. Anticipated profits in public utili-
ties could hardly be counted as property. Moreover, it is
very doubtful if the expectation of the increment of prop-
erty value has had any serious influence on the investment
in railroads of recent years. If it did influence the invest-
ment, it should be to decrease the amount of dividend re-
quired per unit of capital value. An increase of capital
value would count as part of the return. But investors in
railway stocks do not count on any certain rise in the price
of the securities as a part of the earnings on the invest-
ment. It would be difficult to find any case where the rail-
ways discussed the earnings in which they counted the un-
earned increment as part of the returns of the enterprise.
Since there seem to be no serious arguments in the way
of computing the valuation in so far as it changes from the
present value of the property actually in use at present on
the basis of the actual investment, the question is as to
whether or not it would be expedient to do so. The prob-
lem as to whether or not it would be a saving to the ship-
ping public to cease allowing the so-called unearned in-
crements has had sufficient discussion already to intimate
that there would be such a saving. But this phase of the
matter cannot be closed till after a careful consideration of
the problems of the return. The question as to feasibility
or convenience, however, is one that presents little or no
difficulty. One of the greatest objections to the principle
of cost-of-reproduction-less-depreciation is the difficulty
of applying it and keeping it in operation once it is ap-
plied. It is continually being said that neither the Federal
valuation nor any other valuation made on this basis would
be useable, for, by the time the valuation was finished,
the first part appraised would need to be revalued. Such a
valuation neither stays at a constant figure nor does it vary
according to any schedule that could be computed. It
148 RAILWAY MONOPOLY—RATE REGULATION [148

would be necessary to continually keep revaluing, and even
then we could never be really up-to-date with the figures.
But, on the other hand, once we have a valuation deter-
mined and standardized, it would be a very easy matter
with the methods of accounting now in force, to keep it up
to date on the principle of actual investment. All that
would be necessary would be to add the new outlays to the
valuation of a line or system as standardized. Once the
work of the Federal Valuation Board is completed the ac-
counting methods enforced by the Commission would pro-
vide for the future.

If once the general principles could be decided, the var-
ious elements of value would naturally be decided quite
easily. But yet there would be a few points that would
require particular consideration. One of these is the matter
of future surplus. The railways claim the right to a sur-
plus that may be laid out in unprofitable property, such as
the grade crossings demanded for public safety. If this
should be allowed on the express conditions that the value
of this property should never be added to the amount used
as a basis for rate-making, the claim does not require dis-
cussion here. And the question as to the expediency of sup-
plying such needs for the future out of the rates imposed on
the present, together with the question of building up a
surplus to tide over lean years and give greater basis for
credit, belongs rather in the discussion of the return.

In so far as the valuation of property already in the rail-
way enterprise is concerned, it would seem best, as a rule,
to disregard the matter of the multiple. As was seen, this
has been very generally compensated for, to the extent
that it has actually been paid, by the increased value of the
property. But if future increments of property value are
not to be allowed in the valuation, such multiples as must
be paid to secure necessary land must be allowed in the
149] VALUATION AS A CRITERION 149

future estimation of value. They must be paid, and hence
their cost must be provided for, or the land could not be
bought.

Similarly, all intangible elements must be allowed for in
so far as they are real and necessary charges. Extravagant
charges may not be counted in, but all reasonable outlays
must have their share in the computation. Fortunately, if
future expansion be by the extension of old systems, such
matters as loss from early years of unproductiveness, once
they are settled for in the past, will be minimized as a prob-
lem for the future.

Fairness, expediency and convenience would seem to
argue for the adoption of the principle of present value as
the standard for the investments of the past, and for the
principle of actual investment in addition to such a valua-
tion as the standard for the future. Whether or not such
a policy for the future will actually secure more favorable
terms for the shippers can be decided more definitely after
discussing the question of the fair return.
CHAPTER III
Tue Farr RETURN

Tue Supreme Court of the United States said in the case
of Smyth vs. Ames: “ What the company is entitled to ask
is a fair return upon the value of that which it employs for
the public convenience.”

This oft-quoted decision has been accused of vagueness,
such vagueness as to make it valueless. Certainly the term
“fair return” denotes nothing very definite to our minds;
it seems impractical. But it is a very great question if the
critics, with the material available at the time, could have
framed a better answer to the question. Those who ask
that a definite rate of interest be laid down must be ignor-
ant of the problem before us. When we think of the num-
ber of questions involved in the problem, the conclusion is
forced home that not only was it out of the question with
the evidence then at hand to lay down a settled rate, but it
is also improbable that such a thing will ever be possible. As
shown in the preceding pages, these problems are essen-
tially dynamic, they deal with changing and developing con-
ditions.

The problem is not so simple as that of finding the rate of
return upon the valuation of a completely isolated line and
under settled business conditions. Business conditions are
not settled. A legal rate of interest might be fixed as a maxi-
mum, but the market rate of interest is a thing that changes
continually, sometimes widely from day to day. We must
account not only for these random business changes but for

150 [150
1st] THE FAIR RETURN 151

the longer time cyclical and secular variations as well.
Moreover, when we speak of a fair rate, we must not for-
get that that means fair to the public as well as to the rail-
way corporation. It should also be remembered that fair-
ness is very largely an ethical conception and that the ethical
conceptions worked out for simple conditions may need a
great deal of development before they are adequate for
these complex problems. Again, the question of surplus
may involve a tremendous difficulty in the calculations, to
say nothing of the complications that the increment of capi-
tal values is likely to involve, perhaps even if omitted from
the criteria for future valuations. The changes in the pur-
chasing power of money make another disturbing element.
The different jurisdictions of the Federal authority and the
States also enter in with the demand for a fair return in
each, and the cost-of-service principle calls for a fair return
in the various divisions of the traffic, such as the freight
and the passenger. While all these things are to be ac-
counted for, it must always be kept in mind that we are
dealing with a railway system that should expand fast
enough to provide for the expansion of traffic, and that
rates should not be unnecessarily high lest the traffic be
hampered on that side; nor must we do anything to unduly
discourage movements for better service and more efficient
management. A careful consideration of this list of ques-
tions, which could easily be enlarged, should have a calm-
ing effect upon the critics who look for the problem to be
settled by a decree of the courts.

As a problem in rate regulation the one before us is an at-
tempt to limit monopoly profits which unnecessarily restrict
the amount of the business transacted. In the ordinary busi-
ness of the country competition does the work which regu-
lation attempts to do in the field of these natural monopo-
lies. It is a principle apprehended by all that monopolies
152 RAILWAY MONOPOLY—RATE REGULATION [152

usually reap rich harvests. The complaint generally made
in such cases is that the patrons are being robbed. This
may be true, but it is even more important, in the field under
discussion, that many prospective patrons are entirely de-
prived of the service, and much business that would be
possible is kept from actual transaction. The monopolies
skim the cream, and leave the milk to be thrown out. As
already pointed out in an earlier chapter, the attempt to
adjust regulation to the cost of the whole service is an at-
tempt to extend the service so that as many prospective
patrons may be served as the ability of the railways may
allow. This idea rather than any movement to deprive the
companies of profits is the reason for restriction of monop-
oly returns on railway property.

Accurate data are not available for the returns of the
railways in the early days of the business. There was no
established basis on which to calculate any rate of return
except the stocks and bonds. Judging by these, the returns
varied within rather wide limits. In many cases large for-
tunes were made, and yet most of the transcontinental roads
have passed through receiverships, and some of the roads
of the. country have been bankrupt several times. In a
period when there were so many failures, it was but fair that
profits, when they were made, should be large. It was not
only fair but necessary, if capital was to be turned into such
a business in a time of great risk, that the returns in the
successful ventures should be high. No one would enter
such an uncertain business without the hopes of large re-
wards for success. The fair return in those days was large.
Not only on account of the risk must returns have been
high to be fair; it was a period of rapid business expansion,
and in such times the profits of entrepreneurs are large; it
was also a period of frontier conditions when natural
wealth could be acquired for only the price of reclaiming.
153] THE FAIR RETURN 153,

Under such circumstances it was but right that the railways
which played a large part in the reclaiming should receive
a substantial share in the profits.

A very large share of the returns to the early investors
in the railway enterprise in the past came in the form of
increasing values in the property which had been received
in the form of bonuses, or had been purchased at com-
paratively little outlay. Frequently the stock was either
sold for a mere pittance or else issued as a bonus to those:
who bought the bonds on which the railway was financed.
But now the water has been squeezed out of the securities
by means of the increased value of the properties. In many
cases securities were taken up by the market at prices that
in no sense represented money laid out in the property,
prices that it has taken years to back up by actual property
values. Had the price of the securities started and kept
pace with the actual property values, the increment in value
would have appeared in an increasing price, and this in-
crease in price would have amounted to a part of the re-
turn enjoyed by those who held the securities during all
this period. But the abilities of salesmanship of the pro-
moters and insiders has been such that at the time of the
original promotion and during later reorganizations the
price of the securities has been based on anticipated earn-
ings. Consequently the benefit of the increment of capital
values has gone to those promoters and insiders perhaps.
years before it has actually appeared in the property. The
result has been that a great deal of this profit has been di-
rected rather to profits of entrepreneurs, promoters and
insiders than to a return on capital as such. And this is.
not as iniquitous as it may seem to many. It may be that
many things that were accounted honest business in the
earlier days of the enterprise would put the actors in jail,
should the same things be done to-day. But there was a
154 RAILWAY MONOPOLY—RATE REGULATION [154

great deal of profit in those days that belonged rather to
the promoters as entrepreneurs than to capitalists as in-
vestors. The man that made the New York Central into
one system performed a service for society that deserved a
return entirely separate from the capital which he had in-
vested. And the men who were obliging enough to receive
the gifts of land and other donations for the consideration
of supplying railways to the frontier regions performed a
service which appeared to the other parties to the transac-
tions as worthy of the reward . One region vied with an-
other in making these donations. It was the only condition
the public saw on which they could get the desired service.
The price was high, but it was paid cheerfully enough for a
time. And these high profits were largely entrepreneurs’
profits that were required to induce men of the needed quali-
ties to push the enterprise to a successful issue.

But the frontier days are passing into history. Dona-
tions ceased some time ago, and speculative risks have
largely disappeared with the standardization of railway en-
terprise. The salaried officer holds the place of the entre-
preneur. The returns now are supposed to be divided be-
tween.such salaries and the returns to those who invest the
capital. The days of easy profits to the successful have
very largely passed. Competition holds the returns down
in the ordinary fields of business, and government regula-
tion has undertaken to perform the same function for the
railways in order that the other branches of industry may
not be at a disadvantage.

Government regulation involving interference with the
return is a matter of long-time standing. As early as 1876
the Supreme Court was asked to decide on a case where a
legislature had undertaken to so regulate the rates. At that
time the court considered that it was purely a matter for
the legislature to handle if they so chose. Later the idea
155] THE FAIR RETURN 156

was adopted that the court had a right to interfere with
‘such restriction if the legislatures undertook regulation that
deprived the railways of a return on their property. At
first this was looked upon as any return, later it was held
that in general a fair return should be allowed on property
carefully invested. In some cases the court has decided
upon particular rates for specific circumstances, upholding
er enjoining rates fixed by the legislatures or commissions,
but never has it decided upon any rate of return which
should apply in general.

Among the rulings of various courts and commissions
there is a great variety of opinion registered. In many
cases definite rates of return have been fixed for the par-
ticular instances, but the rate held to be reasonable in one
case may be held to be confiscatory under some circum-
stances, or unreasonably high under others. When a rate
has been determined, it is always with reference to the par-
ticular circumstances in hand and is never made as a gen-
eral rule. Mr. Whitten says in his volume published in
1912 that “the decisions of 1911 indicate that the Federal
courts are now inclined to allow higher rates of return than
formerly.” *

The courts, however, do not contend that in every case
there must of necessity be a return upon property invested.
Such is the rule which obtains under ordinary conditions.
Unusual conditions demand special consideration. Mr.
Justice Brewer said in the case of Reagan vs. Farmer’s
Loan and Trust Co.:

It is unnecessary to decide, and we do not wish to be under-
stood as laying down as an absolute rule, that in every case a
failure to produce some profit to those who have invested their
money in the building of a road is conclusive that the tariff

1 Whitten, Valuation of Public Service Corporations, p. 689.
156 RAILWAY MONOPOLY—RATE REGULATION [156

is unjust and unreasonable. And yet justice demands that
every one should receive some compensation for the use of his
money or property if it is possible without prejudice to the
rights of others. There may be circumstances which would
justify such a tariff; there may have been extravagance, and a
needless expenditure of money; there may be waste in the
management of the road; enormous salaries, unjust discrimin-
ation as between individual shippers, resulting in general loss.
The construction may have been at a time when material and
labor were at the highest price, so that the actual cost far
exceeds the present value; the road may have been unwisely
built in localities where there is not sufficient business to sus-
tain a road. Doubtless too, there are many other matters
affecting the rights of the community in which the road is
built as well as the rights of those who have built the road.*

The courts have generally considered the fairness of the
rate towards capital already invested in the business. The
commissions, on the contrary, have, as a rule, considered
the rate which will induce capital to enter the field.
The Master in the case of Columbus Railway and Light Co.
vs. City of Columbus refers to the latter viewpoint as the
administrative standard, but holds that the judicial standard
for testing the constitutionality of an ordinance must be
based on the narrower grounds of prevention of actual con-
fiscation.?

Enough has been said about the necessity for the expan-
sion of our railroads to show the need of attention to the
interests of the investors. It would not be good policy to
guarantee any particular return on, or even the profitable-
ness of, each investment. There may be cases of ill-directed
investment where there will be no return. But yet the re-
turn in the field as a whole must be sufficient to offset such

+154 U. S., 362, 412. 2 Page 50.
157] THE FAIR RETURN 157

risks and make the enterprise attractive to prospective capi-
tal. A return cannot be demanded on the plea of invest-
ment, but investment cannot be looked for without the
prospect of an attractive return. Looked at from the stand-
point of the public, the return is what warrants future in-
vestment, rather than something which is due to capital
already in the business. Even the courts admit that vested
interests may be neglected under higher considerations. The
ordinary competitive conditions show the same principle.
Since capital may be ill-directed, the mere fact of invest-
ment does not necessarily mean a return. But a prospective
return upon future investments is an absolute necessity that
a business may live and especially that it may expand, and
the main criterion by which prospective investors judge is
the profitableness of the capital already in the enterprise.
There are risks of failure, but these must be offset by the
advantage of the whole situation. The ultimate object for
which the return must suffice is the attraction of future in-
vestment, but the means by which we estimate this is the
return on what is already in the business. What we are
after is not so much a fair return as it is an expedient re-
turn, using the term expedient always to mean a far-reach-
ing expediency. Legal and ethical fairness in detail is yet
to be worked out for this field. No higher criterion is at
hand than the highest social good. Individual interests are
subservient to social interests when they conflict. The ulti-
mate end must be to attract sufficient capital without at the
same time overburdening the traffic.

Mr. Whitten expresses very clearly the principle that seems
to be the most applicable here. He gives, among other pos-
sible standards, “‘ The rate of return adequate to induce in-
vestment in a new enterprise at the present time.” *

! Whitten, Valuation of Public Service Corporations, p. 705.
158 RAILWAY MONOPOLY—RATE REGULATION [158

The National Securities Commission said in its report to
the President :

A reasonable return is one under which honest accounting and
responsible management will attract the amount of investor’s
money needed for the development of our railroad facilities.
More than this is an unnecessary burden. Less than this
means a check to the development of traffic.

The Wisconsin Railway Commission says:

It is absolutely necessary that the wages paid should be high
enough to attract competent workmen, superintendence and
management, that the interest paid on the capital legitimately
invested should be sufficient to attract the necessary capital into
these enterprises ; and that the speculative or other gains should
be high enough to induce employers to enter these industries
as co-ordinators of the other factors of production therein,
and as assumers of all risks and responsibilities that are in-
volved in their operation. From these facts there is no escape.*

One of the greatest complications of the question arises
from the fact that any settled rate schedule will give dif-
ferent rates of return to the different railways in the same
field. ~This is not a situation which is peculiar to the rail-
way industry. Even under competitive conditions all busi-
ness units do not receive the same rate of return. It may
be true that the tendency is towards such a state of affairs,
but the tendency works out very incompletely. The normal
level towards which returns gravitate is the normal or com-
petitive rate of interest. Yet even in the farming business,
where the different advantages are largely neutralized by
differences in rent, some farmers make a very comfortable
living, and save money, where others only make enough for
wages and interest: and again others fail even to make a

14 W.R. C., sor.
159] THE FAIR RETURN 159.

living. The same is true in other branches of competitive
industry. By reason of differences in management and by
reason of unforeseen changes in the demand for the products
turned out, some succeed well, others do not make interest
on their fixed capital and others again fail entirely.

The railway enterprise shows this state of affairs with
great clearness. It is necessary that the rates for the same
traffic be substantially the same for all lines in the same field,
yet this makes it but the more certain that the earnings on
these lines will be unequal. The railways cannot cut rates
against each other. The very maintenance of the service
depends on a standard rate schedule for all. But under
these standard rates the earnings of one line may be barely
sufficient to pay operating expenses while another may be
paying large dividends. The necessity for mutual interde-
pendence of rates is set forth with admirable clearness by
Mr. Prouty of the Interstate Commerce Commission :

The greater part of the business of the railways of the United
States is subject to competitive conditions of one sort or an-
other which are largely controlling so that the rates of one
are necessarily bound up with those of another. Nearly every
station at which considerable quantities of traffic originate or
are delivered is served by more than one railway. It is pos-
sible, for example, under present switching absorption tariffs
in force at the city of Chicago to reach any point within the
limits of that city at the same rate by any line which reaches
that city. The same is true in substance of the city of New
York and the great industrial district of which New York
is the centre. It is also true that while two given points may
each be served by but two railways, a great variety of routes
between those points can be found by choosing different inter-
mediate carriers. For example, lumber from almost any point
of production in the South can reach Chicago by a variety of
routes through Ohio river gateways. Now while it may oc-
casionally happen that the rate by one route is different from
160 RAILWAY MONOPOLY—RATE REGULATION [160

that of another, broadly speaking the rate by competing lines
is the same.

He says further :

A certain amount of traffic is strictly non-competitive. What
proportion this may bear to the whole I have no idea; the per
‘cent would be small.*

Rates must almost always be made with a certain definite
relation to each other, and in general the rates for the same
service must be the same. To this fact must be added an-
other of equal significance. No two railways, generally
‘speaking, supply the same service at the same advantage.
By reason of more advantageous routes, better management,
greater density of traffic, or other advantage, one road will
be almost certain to have a greater net profit from supplying
any service than its rival will have.

The Interstate Commerce Commission, in its decision of
the Five Per Cent Increase, given July, 1914, states:

The net corporate income for the fiscal year 1913 of the
‘carriers in official classification territory, comprised in the 35
systems, averaged 8.07% upon their outstanding capital stock,
and ranged from 24.93% earned by the Central Railroad of
New Jersey, to a deficit of 13.74% on the stock of the Cin-
cinnati, Hamilton and Dayton.

The same body expresses both facts under discussion in
its decision in the Spokane Case:

It is well understood that rates by all lines to Spokane from
a given eastern destination must be the same. We have al-
ready held that in establishing a reasonable rate the strongest
line should not alone be considered; the necessities of the
weaker line must also be taken into account. In the applica-

1 Railway Age Gazette, Feb. 13, 1914.
731 1.C. C. Rep, p. 362.
161] THE FAIR RETURN 161

tion of this principle it is evident that a rate might be fixed
which would pay a very moderate return by one line and a
very handsome return by the other. Under the operation of
these rates the Great Northern, by reason of its cheaper con-
struction and its easier operation, might accumulate a surplus
while the Northern Pacific did not.?

From these two general facts, it is evident that under the
same conditions the rates of return on different lines in the
same general territory will differ. The schedule of tariffs
must be substantially the same for all rival lines, but the
resulting rates of income may differ widely. What bearing
does that have on the subject of an expedient return?
Manifestly, if an expedient return be any fixed percentage,
when one railroad earns this its rivals will be earning too
much or too little. Is it then a hopeless task to solve the
riddle?

This is, as stated above, practically the state of affairs
that obtains in the general economic field. Rival businesses
have a differential earning capacity, and it depends upon
the prosperity of the business as a whole with what mem-
ber of this series of rivals the rate of return will warrant
the expansion of its business. A firm that is earning
enough to pay all expenses, including interest and wages
of management, will be in a position to acquire more capital
and extend its business. As the business possibilities in-
crease, such a firm will be able to meet the demand for ex-
pansion. Any business continually earning less than this
must eventually fall out of the race. If the weakest member
of the series is earning enough to pay expenses, as above,
the business as a whole is prosperous, and will be able to
meet all demands in the growth of the market for its pro-
ducts. If more of the rivals than those who are in bad

115 I. C. C. Rep., 415.
162 RAILWAY MONOPOLY—RATE REGULATION [162

financial condition through mismanagement or exceptional
misfortune earn less than these necessary expenses, the
business as a whole must decline. If, through unusual de-
mand for the product, the poorest competitor is enabled to
earn more than enough to keep going, then, under competi-
tive conditions, others will surely enter the business till the
poorest one of the enlarged series gets only his necessary
expenses. Or, again, the profits in the general field may be
such that all those in the field who are efficiently managed
and wisely located will be kept in a prosperous condition,
and other well-managed businesses may be able to enter
the field as the demand grows; and yet during this expan-
sion those that are really ill-directed will have to give place
to their betters.

Is not this latter condition that in which an expedient re-
turn is enjoyed by the enterprise in question? In general,
in ascertaining the expedient return, we must of necessity
take cognizance of the whole situation. In the railway field
no one line offers a wholly individual problem. All the rail-
ways in the field and the future needs of the traffic must be
considered. If the tariffs are so fixed that those established
railways that are located to provide for the demands of the
country’s business and are well managed get return enough
to keep them prosperous, and at the same time other simi-
larly well-directed lines may be built as there is effective
demand for them in the development of trade, can we not
say that the railways in question are getting an ample re-
turn? If they are getting more, it would seem to be at the
inexcusable constriction of the possibilities of traffic. May
they get less and still be getting enough? Is not the return
sufficient if it warrants the proper maintenance and develop-
ment of the systems already established, and at the same
time makes profitable the building of new lines by the sys-
tems already in operation instead of by independent com-
163 | THE FAIR RETURN 163

panies? It must be brought to mind that this rate of return
may not be so high as the requirements for the extension
of new lines independently. Not only is the traffic less dense
on new lines, but their cost is as a rule greater. Their prop-
erty must be bought at constantly higher figures as the coun-
try becomes developed. If they must be allowed to be profit-
able for only the traffic actually carried over these new
lines, their construction must be delayed till the traffic de-
mands in the section are heavy. But, as we have already
noted, these new lines mean added business for the older
systems with which they connect. And if they are con-
structed and financed by these older systems, it will be
profitable for these systems to push the construction, for
the sake of this added traffic to the whole, when the new
lines would be unprofitable by themselves. It is quite pos-
sible that there would be instances when new companies
might be able to compete for the opportunities of new con-
struction even when the rule was that no influence be ex-
erted against the consolidation of lines. But if the public
would accept the principle of railway consolidation and put
nothing in the way of the extension of the companies, the
contention is that the principles which would be operative
under such a program could be made the rule. If new com-
panies could enter the field profitably, let them do it. If the
old companies neglected their opportunities for expansion,
doubtless the opening would be seized by others. But why
not make the ruling principle that all the well-directed sys-
tems should earn sufficient to maintain themselves and ex-
tend their activities into new fields as needed for the sake
of the return thus added to the whole system?

It is manifest that, in the situation as portrayed, some of
the roads or systems will get a higher rate of return than
others. Some will get more than what would be necessary
for them to be in a prosperous state if they were to be con-
164 RAILWAY MONOPOLY—RATE REGULATION [164

sidered alone. There will be one or more others that will
be in technical language, at the margin; they will only earn
enough barely to get along and meet the traffic require-
ments. There may have been some mismanaged, or not
rightly placed to meet the requirements of traffic, and these
may not be able to escape reorganization. But the rule
will be two or more railways serving each general field, the
least favored of which gets just enough to meet require-
ments—a fair return—and the others will have a larger
rate of income.

There seems to be no way in which this extra or differ-
ential return can be denied the more favorably situated
road; and, as we shall see later, there is a real advantage in
the fact that such a differential must exist. Some have
advocated that the differential be taxed to the point of con-
fiscation, but this would in no way affect the amount of
the rates, and hence is not a question for discussion here.
It is a matter of concern for us, however, that this differ-
ential should be no higher than necessary. The necessary
differential is the difference between the most expensive
route and the more favorable routes. Right here is another
point in favor of the consolidation of lines and growth by
extension of established systems. We have already dis-
cussed the advantage of this system in so far as the acquisi-
tion of property is concerned. There are other ways in
which economies may be achieved by the same system. Not
only by the acquisition of expensive lands may a railway
be a more expensive route; by lack of density of traffic, of
favorable routing and of the finer points of efficient man-
agement a railway may be less favorably situated than its
rivals. Such routes, if independent, would bid for the place
of the least favorable lines, and might have to be awarded
the place of marginal or determining lines. But if these
lines were absorbed into larger systems, the business which
165] THE FAIR RETURN 165

originates or ends on them may be sufficiently remunerative
to the main line for it to be profitable that they be run by the
system on terms that would make it impossible for them to
continue in business separately. If they were not a part of
the system, the system would gain from the business coming
in from their lines at no expense or outlay on its own part.
In this way an independent branch line brings in an unearned
increment of traffic to the main line with which it connects.
If the branch line is a part of the main line financially, then
the business is largely one organic whole, and the traffic on
one part of the system increases the profitableness of the
rest of the system. Following out this plan many lines
that would be weak by themselves may profitably be oper-
ated by the established systems, and hence drop out of the
list of those which would be marginal or rate-determining
lines. It is as if the rate system rested on uneven ground
the highest points of which determined the height of the
rates. Leveling the highest points into the hollows allows
the rate system to be lowered by just so much. The gen-
eral level of the ground is the same; and so is the total rail-
way cost. But since the highest points determine the rate
level this process at once lowers the rates and diminishes
the differential earnings. This is a method of diminishing
the differential returns that materially reduces the neces-
sary height of the rates. To the extent that consolidation
has been accomplished, this advantage has already been
achieved.

Some enthusiastic railway investors may object that this
is unfair to the railways. If the railways, in spite of public
opinion, succeed in consolidation, they might be allowed
the advantage arising therefrom. At least why deprive
them of what the public apparently would have to pay ti
consolidation did not exist? The answer might be made
that no patent exists on consolidation. The railways did
166 RAILWAY MONOPOLY—RATE REGULATION [166

not discover it. There is no reason why they should capi-
talize it. Consolidation and monopoly are natural necessi-
ties in the railway enterprise. The advantages arising from
this fact should be distributed according to the same prin-
ciples which rule the other phases of the situation. If the
public creates the corporations and protects them from the
harrowing effects of destructive competition, the railways
are placed in a position fully as favorable as the general
business situation in other fields. However, this is another
reason why the public should tolerate and even foster rail-
way combination. Railway combination, under regulation,
allows lower rates at the expense of unnecessary differential
earnings.

The question now arises as to what is to be considered
the marginal or rate-determining line. Since a route once
established cannot be removed from the field as would be
the case in many other industries the question is far from
simple. If in other enterprises a concern falls below the
point where it can obtain a profit from the prices set by the
free demand and supply, it must be reorganized or go into
bankruptcy. Since the price in the field under discussion 1s
set artificially by the commissioners, these men must decide
which lines shall be kept above the margin of bankruptcy.

Vested interests cannot claim that those lines which are.
or have been, sufficiently mismanaged to cripple their re-
sources must be kept above that margin. Neither can they
claim that lines that are disadvantageously located must %¢
kept in the profit-earning class. These may to a certaiu
extent be useful, but they may be too expensive luxuries for
society to afford on those terms. They cannot demand
rates that will make them prosperous without reorganiza-
tion; they must be content with the pickings. Overcapital-
ized lines cannot demand to set the pace for railway rates
in order to pay interest on their water. With expanding
167] THE FAIR RETURN 167

business conditions and careful management, such lines may
in time recover, but meantime the public should not, eco-
nomically speaking, pay for the wastes of mismanagement.

What then determines which road is to be allowed the
position of the rate determiner? This is probably the most
knotty question in the whole field. Even theoretically it is
almost impossible to lay down definite general principles
here; and the problem may be further complicated by ques-
tions of broader public expediency than the dicta of railway
economics.

What would determine this question in the field of free
competition? It can safely be said that the demand for the
service or product determines the margin of production; at
least it is safe to say that the demand is what warrants the
extent of production. And this demand is simply the ex-
pression of the element of value. Are we then in seeking
for the cost of the service driven around a circle to the value
of service principle? The answer is that we are driven to
the point where the two elements intersect each other. Cost
and value of the same product are each variable matters. In
the general economic field, the rule is that the cost increases,
as the products are increased beyond a certain point. This
may be disputed in the railway field, but it cannot be denied
that, at the very least, cost does not decrease at anything
like the same rate as that in which the value decreases as
any particular service is multiplied at any particular time
and place. A time must come, as the particular services are
multiplied, when the value will just equal what it costs to
produce these services. But this applies particularly to the
handling of traffic in a particular locality and period of
time. We are especially interested just now in the whole
railway line as a unit of service rather than in the units of
traffic. And we are looking at dynamic rather than static
conditions. The question is not just as to what are the de-
168 RAILWAY MONOPOLY—RATE REGULATION [168

mands for railway service under settled conditions, as to
how the demand for service will vary at a particular time
and place with a change in the charge. This latter variation
in demand is merely a shifting of the point where the
supply cuts a settled demand schedule. What we have to
deal with is a state of affairs where the whole demand
schedule is moving. The demand for transportation service
is growing, and the appearances are that it will grow, inde-
pendently of changes in the rate of charge. As this demand
grows, greater railway facilities must be provided; new
lines must be added. And new lines must be added, whether
by new companies or old systems, at ever-increasing costs.
As the margin is extended, new land must be acquired at
ever-increasing cost; and unless some unlooked-for change
occurs, this will mean that the traffic cost per unit of trans-
portation will not fall off, but will likely increase. Cer-
tainly, as Commissioner Lane says, if the railways are to be
allowed a return on the unearned increment of the future,
we must expect that rates will rise and not fall.* And it
is also certain that, if expansion should come by the addi-
tion of independent lines, this cost would increase as the
margin was extended. We have then a demand that is
growing so that the traffic facilities must be increased
whether the costs are increased or not, though at any par-
ticular time the business which is the result of this demand
will fall off with any increase of the charge. There is a
continued trend of expansion in the demand, but the amount
of business actually varies with the rate of charge. As
shown in a previous chapter, there is a limit in the rate of
charge beyond which the business will so decline as to de-
crease the returns from the transactions. On the side of
supply, the cost of running lines into newer territory, we
have a curve of costs that will very probably rise as the

+20 7. C. C. Rep., 340.
169] THE FAIR RETURN 169.

margin is extended. The charges cannot fall below this
curve of the cost. It would be possible then to extend the
margin of railway expansion so rapidly that the necessary
charge to cover the increased cost would rise so high that
the returns from the business actually transacted would fall
off in spite of the natural rise in the potential demand. This
would prove disastrous. Not only would it seriously affect
the railway world, but it would be likely to induce general
financial depression, if not panic. The theoretical degree of
railway expansion that would be desirable would be just
enough to balance the movement for expansion in the
natural demand for the service. Too rapid railway expan-
sion would, by raising the cost too high, restrict traffic ex-
pansion. Too little railway expansion would restrict the
traffic by lack of facilities. A balance should be struck that
would allow the greatest possible development of the traffic
which is the legitimate function of the railways.

It is not an easy matter to carry out the demands of such
a theoretical balance. It needs the careful foresight of the
combined genius of the railway managers and the commis-
sioners. And to this end everything possible should be done
to make the interests of the railway men and the public
which they serve identical. Possibly the greatest help in
this direction would come, not from restriction of monopoly
control, but from actual encouragement of railway consoli-
dation. To the extent that there is competition, there is a
tendency to supply facilities to take business away from, or
to keep it from going to, rivals. When business cannot be
acquired at the expense of a rival, the only incentive to ex-
tend the facilities will be to provide for actual new traffic.
If new enterprises were prevented from entering the field
to supply the needs for expansion, the result might be too
little of such provision. But if public policy should go only
so far as to encourage consolidated expansion, the way
170 RAILWAY MONOPOLY—RATE REGULATION [170

would still be open for independent capital to enter the fields
neglected by established systems. Without encouraging a
system that would tend to bring on an extension of facili-
ties not warranted by the demands of new traffic, it
would seem highly probable that, by properly gauging
the rate of return on the investment, railway building
could be stimulated to keep even pace with the ex-
panding demands of the traffic. There is great reason to
hope that, if the matter of a proper rate of return is care-
fully worked out, the question of the extension of the mar-
gin will be attended to quite adequately by the railways
themselves. It would be to their interest to provide for
profitable traffic. If we could only be certain what was the
proper rate of return on the marginal line under given traffic
demands, it would appear that if the commissions deter-
mined what line or system of the existing net should be
held to be the marginal or rate-determining one, the ques-
tion of the extension of the margin would solve itself. The
problem is to find this proper rate and what unit of the ex-
isting railway net should be the rate-determining line.

In the Spokane Case already referred to, substantially
this was done. There were rival lines competing for the
same traffic at the same rates of tariff. The commission
judged that under all the circumstances the Union Pacific
need not be considered in the estimate, as its business to
Spokane was only a side issue. The other two lines were
considered to be necessary for Spokane business. These
two did not have equal advantages; where one could make a
profit, the other could not. And yet the weaker was de-
‘manded by the traffic conditions in that particular field.
Hence rates were so fixed that, as regards that part of the
traffic which it handled, the weaker road could live and
prosper. This example shows that the principle can be put
into operation in regulating lines which are going concerns.
171] THE FAIR RETURN 171

In this case one road was excluded from the determination
of rates in that field, even though it was a well-conducted
line. In the recent Five Per Cent Case a view of the whole
situation was taken, and the determining margin was so
placed as to exclude certain lines that, on account of mis-
management, were not considered as fair criteria for the
fairness of rates. There seems to be no great difficulty
here. All lines which are necessary for the existing traffic
and are fairly capitalized and carefully managed are in-
cluded in those above the margin, and the weakest of these
would naturally be the marginal or rate-determining line.
If, then, expansion to meet trade demands may come from
the development of the existing systems, and if the proper
rate of return to warrant such expansion can be ascertained,
the problem before us seems capable of solution.

The situation is that in almost all districts of the country
there are several rival lines or systems. Of all those which
must be kept in good running condition without reorganiza-
tion, the weakest is the one which sets the pace for the
tariffs. A certain so-called fair return must be allowed to
this line; the others will get more. But the fact that the
others get more does not make the tariffs any higher. To
lower the tariffs would deprive this marginal road of its
fair return and, by causing it to go out of business, would
deprive the shipping public of needed facilities for the trans-
portation of their goods and the traveling public of their
service. The question, then, for the rate regulator is as to
what is the fair or necessary return for this weaker or mar-
ginal line.

If we had a settled rate of interest for all capital, this
might be expected to meet the requirements of the case.
But we do not have such a thing, nor if we had, would we
be sure that it would, in the face of railway conditions, be
sufficient to attract the necessary money to the line in ques-
172 RAILWAY MONOPOLY—RATE REGULATION [172

tion. However, a settled rate of interest is out of the ques-
tion; we not only must suit the return to the particular
enterprise, but we must also allow for temporary, cyclical
and secular changes in the general market rate.

The minor fluctuations in the rate of interest are not a
cause of much trouble. They offset and balance each other.
The causes of difficulty are cyclical and secular changes.

It is a well-known fact that even the steadier rates of in-
terest vary widely from year to year. One year they will
be high; two or three years later they may have materially
declined. So far we have not analyzed these changes suffi-
ciently to be able to account for them, much less to predict
them with any degree of accuracy. But yet in rate fixation,
which usually applies for a term of several years, care must
be taken to allow a return that will cover the average of the
changing conditions. To this end a surplus should be per-
mitted to accumulate in good years, to offset the evil years.
If rates are fixed to allow only the average rate in a good
year, the railroads will find themselves in difficulty when
hard times come. It is claimed that this is partially the
trouble back of the late five per cent cases. One fact that
helps to make this problem easier should be noted in passing.
Earnings are the product of rates and the amount of the
traffic; and in good years, when interest is high, the traffic
is larger and hence railway earnings are higher. It will be
remembered from an earlier discussion of this relation be-
tween the density of traffic and the net earnings that though
a continued increase in density might not give greater net
earnings covering a period of years, yet the expansion of a
business boom would show itself in an immediate increase
in the returns.

The secular changes produce rather a different situation.
They cannot in any sense be averaged. Cyclical changes, as.
the name indicates, bring the rate back to the starting-point
173] THE FAIR RETURN 173

and they do this within a time that will allow a view of the
cycle; a few years completes the phase. Secular changes
may strictly speaking be cyclical, but if so, the cycle is so
long that we cannot tell whether conditions will ever come
back to the starting-point or not. For the practical pur-
poses of rate regulation, these changes may as well be as-
sumed to follow a straight line without return to the
place from which they started. These secular changes in
the rate of interest are worked out in the change in the
purchasing power of money. It may be safe to say that
they appear also as the change of valuation of the property
when the valuation follows the principle of present value,
for then the railway value follows the general trend of the
market. If the principle of present value be adopted as the
rule for the valuation of all property already invested, it
may be assumed that the investors have received compen-
sation for the change in interest from what it was at the
time of their investment. The correspondence between the
change in the interest rate and the change in property value
may be very rough, but the latter would be a sufficiently
good covering for the former to provide for the interests
of those who invested in the past. If for future policy the
actual investment be adopted as the basis for valuation
special attention must be paid to provision for such trends
of the interest rate. No attempt can be made to guarantee
the rate of interest for the future that existed when the in-
vestment was first made; railway investors must take such
changes as they arise, as do the investors in other fields.
But steady trends of prices will affect the rate at which
capital will freely enter the enterprise.

The risks of the enterprise also affect the necessary rate
of return. In other fields entrepreneurs are satisfied with
the prospect that only the moderately successful should be
fairly prosperous if there be a chance for excellence to win
174 RAILWAY MONOPOLY—RATE REGULATION [174

profits enough to offset the risks and losses of failure. It
is a game of speculation in which the merely fit survive, the
unfit perish, and excellence reaps the fatter harvests. This
would be the case in the railway field under the conditions
as considered. Those who had made unwise ventures or had
mismanaged would be weeded out; the ones barely worthy
to persist would be allowed to stay and expand; and those
who, by foresight or for other reasons, had hit upon a for-
tunate location and had managed the business rightly would
be rewarded for their abilities. Here is seen the actual ad-
vantage, even to the public, of the differential return to the
more fortunate lines or systems. If no one were allowed to
earn more than the so-called fair return, the risks of being
below the margin with no hopes for extra-marginal profits
would deter investors from putting money into the rail-
roads. But if success is allowed the reward of the differ-
ential return, investors, who are always hopeful of success,
will run the risks of failure. If no line is allowed more
than the marginal fair return, this return must be greater
than it would be were the differential allowed. The differ-
ential reduces the fair return to a minimum. Consolidation
and freedom from competition will also operate in this same
direction. The freedom from risks which goes with monop-
oly will tend to make investment attractive at a lower actual
rate of returns. And as pointed out before, combination
not only gives greater freedom from risk but smaller differ-
ential returns on the more fortunate lines. Consolidation
cuts down the differential, but at the same time decreases a
certain need for it.

The question of incentive to efficient management and
economies of operation has its answer anticipated in the
preceding remarks. The rival lines are in competition, but
only in the sense that at the standard rates they are bidding
together for traffic by the inducement of better facilities.
175] THE FAIR RETURN 175

They are competing for better relative position in the dif-
ferential series of lines. The line that offers the best facili-
ties gets the largest share of the traffic, and hence a larger
share of the profits and a greater differential return than its
rivals. And the line that, by efficient management, is most
economical gains thereby larger profits from the gross earn-
ings. Unless a line has a very serious handicap in its rela-
tion to its rivals, it may reasonably hope to improve its
condition by efficiency, economy and good service. Even if
the marginal line it may hope to move up from the foot of
its class and leave this less enviable position to a rival.
Thus the differential earning capacity is a benefit to the
public rather than an evil.

The element of risk and the incentive for better manage-
ment being provided for in the differential situation, what
is the proper rate of return for the marginal line that will
induce a sufficient investment in the enterprise to meet the
requirements of expanding traffic? What is the proper
principle according to which the return should be estimated ?
Several criteria have been offered to solve this question.
The best discussion is given by Mr. Whitten in his volume
published in to12:

(1) A fair rate of return at the time the original investment
was made. The pioneer who undertakes the manufacture of
a new commodity expects if successful to secure for a time
what are practically monopoly prices and monopoly profits.
His chief reward comes during the period before his success
has induced others to follow his example. There is practically
no legal authority for this standard.

(2) A rate of return adequate to induce investment in a
new enterprise at the present time. This rate prevails in
competitive industry. This seems to be the standard that
finds most favor with the state regulatory commissions, (e. g.
Spokane Case). On the other hand the courts have usually
176 RAILWAY MONOPOLY—RATE REGULATION [176

adopted a rate of return lower than that which would be
produced by the application of the above standard. In Colum-
bus Railway and Light Company vs. City of Columbus the
special master refers to this as the administrative standard but
holds that the judicial standard for testing the constitution-
ality of an ordinance must be based on narrower grounds of
prevention of actual confiscation.

(3) The market rate indicated by the income basis on
which the securities of the company are bought and sold.
‘This corresponds to the rate of return that would make the
market value of the securities substantially equal to the ac-
tual investment. It is the rate of return that would make
the market value of the property substantially equal to the fair
value of the same for rate purposes. The question is what
return do actual investors at present demand when purchas-
ing the stocks and bonds of the company. There is no direct
judicial precedent for the use of this method in a rate case.
It seems probable, however, that some such mental process as
this has influenced the numerous decisions of the courts
holding 5% or 6% a fair return or at least as a non-confiscatory
return.*

Closely in line with the third standard suggested by Mr.
Whitten is one suggested by Professor Bemis in regard to
public-service corporations. He says:

In the case of a large, old, and well-established enterprise
like the Chicago Telephone Co., the proper test would appear
to be such rate of return as would render possible the sale
‘of additional stock and bonds when needed from time to time
for extensions. In other words, the rate should be such as
to keep the securities at par, or slightly above. The market
for the securities of a well-known company is highly com-
petitive. If investors are willing to buy stock on a 6% basis,
and the company insists upon paying 8% dividends, the in-

at Whitten, Valuation of Public Service Corporations, pp. 702-7.
177 | THE FAIR RETURN 177

vestors will quickly run up the price to such an amount, say
13314, as will net the investor only 6% on what he pays for
the stock. We may argue that the business is such that the
investor ought to have 8%; but the investor, having his own
ideas on the subject, insists upon buying on a 6% basis, or
whatever may be the actual market quotation. The problem
before us now is not so much an ethical problem of what a
company ought to receive, as it is what return, as a matter
of fact, will tempt the investor to furnish the money needed
for the growth of the business. If the lesson of the stock
market point to 5% on bonds and to 6.5% to 7% on stock
as sufficient for this purpose in the case of the Chicago Tele-
phone Company, then such rate of return is reasonable.*

Manifestly, if this line of reasoning were applied to the
railroad situation, allowance would have to be made for
the fact that the securities do not always correspond closely
to the value of the property as it would be allowed by any
valuation board. It might be possible to make this allow-
ance, and utilize the suggestion of Professor Bemis. Once
the value of the property was ascertained, the ratio of the
value of the outstanding securities to this standard valuation
could be established, and, instead of keeping these securities
at par, they could be maintained at this ratio to the standard
valuation. It would be a slightly cumbersome method, but
it might secure the results for which Professor Bemis
argues, the same results, in fact, as those which are aimed
at under the third standard suggested by Mr. Whitten,
vig., the return which the purchasers of securities demand
on the money they invest.

The first standard suggested by Mr. Whitten might apply
to a municipal utility, but it is not what we are looking for
in the railway field. It would be impossible to segregate

1 Report on the Investigation of the Chicago Telephone Co., sub-

mitted to the Committee on Gas, Oil and Electric Light by E. W.
Bemis, October 25, 1912.
178 RAILWAY MONOPOLY—RATE REGULATION [178

the earlier investment from that of the present and give one
a different return from the other. Just because a part, pos-
sibly a small part, of the total was invested earlier at a
higher rate than the present necessities demand is not a
sufficient reason that all future investment must be allowed
such a return. On the other hand, if the original invest-
ment had been made at a lower rate than the present would
demand, it would be impossible to finance the present needs
on the terms of this standard. Neither is the second stan-
dard thoroughly suitable to the case in hand. As we in-
sisted in the discussion of the valuation, why make the
necessities of a hypothetical situation the criterion for the
treatment of an actually existent situation that is quite dif-
ferent? Moreover, this criterion involves a principle which
we have been arguing against. The attempt has been made
to show that what we want is really not the establishment
of new enterprises at the present time, but the extension
of those already in existence. The return necessary may
be quite different under the different principles. The return
necessary for a new enterprise would likely be appreciably
higher. If so, why allow it? Doubtless one reason why
the commissions have argued for this standard—which may
be more applicable in the case of municipal utilities—is that,
contending as they do for the principle of original cost in
the valuation even of property invested in more favorable
times, they see the necessity for a decidedly generous rate
of return.

We return to the third standard suggested by Mr. Whit-
ten, the same as that advanced by Professor Bemis, with
the modification demanded by the disparity between the par
value of the securities and any reasonable valuation of the
property. This standard demands a return which the pur-
chasers of securities require on the money invested in the
development of the established systems. And a very rea-
179] THE FAIR RETURN 179

sonable criterion is proposed to measure this requirement.
The proposal is to allow such rate of return as would keep
the market value, as shown in the sales of the stocks and
bonds, substantially equal to the fair value of the property
as established under accepted principles of valuation. The
purchasers of new issues of securities must share equally
all the advantages and disadvantages of the former security
owners. They will enjoy exactly the same return as goes
to the old securities on their market value. And the return
which goes to the old securities on their market value is
what the investors show to be the necessary rate of return.
This does not mean that the securities must be kept at par.
It only means that they must be kept at the ratio to par
which would make the sum of their values equal to the
standard valuation. No difficulty should arise here as fre-
gards stock. If the company were capitalized at twice its
real value, the stock would be rated at fifty; and new stock
would be worth the same, would sell at fifty, and receive an
income on such a value, which income would be one-half
what the market would allow on property worth the full
hundred. This ought to work quite smoothly if the prin-
ciple adopted for future valuation be the actual investment,
the investment of money. A difficulty would be experi-
enced if the bonds were held below par, as they must even-
tually be redeemed at par. The discount on bonds sold
below par must be made up in some manner. It would
certainly appear as though such bonds as have been hon-
estly and wisely issued against the property should be kept
up to par value, and, if so, sufficient returns on the property
should be allowed to secure this end. It must be remem-
bered that all this applies to what has been termed the mar-
ginal or rate-determining system; once this system is se-
lected, the return on the other systems does not directly
affect the rates. The conclusion as to this system tends
180 RAILWAY MONOPOLY—RATE REGULATION [180

towards such a return as would allow the wisely issued
bonds to be maintained at par and the stock at such level as
the ratio of its par value to the real property value would
warrant. In this way the return on the present property is
made the criterion for the necessities of further investment.

The discussion would be quite incomplete unless notice
were taken of the compound question whether or not, in
order to ascertain the proper return for the railroads, a
valuation of the property is actually necessary, and if so,
whether or not it would make any difference if this valua-
tion were placed at a high or low figure, so long as due com-
pensation for this be made in the rate of return. May we
not avoid the expensive and troublesome valuation alto-
gether, and simply allow a return sufficient to provide the
necessary funds for expansion? Is it essential, if valuation
be made, on which principle it should be carried out; would
not the unfairness be eliminated in working out the return?

The answers to these questions go largely together.
There seems to be no other way than by the means of val-
uation to ascertain what would be sufficiently large earn-
ings to attract the necessary new funds. Reasons have
been shown why the capitalization cannot be used as a cri-
terion for rate of earnings. And if this also be thrown out,
there is nothing left to refer the earnings to asarate. They
would simply be earnings ina lump sum. Unless some new
system of accounting be devised, some valuation, whether
based on capitalization or other standard, is necessary, if
for no other reason than as a guide to the companies in
the extension of their business and to the investing public
in their purchase of securities. Valuation on some standard
or other is necessary as a measure of railway ability to
supply the service. And the attempt has been made to out-
line what system of valuation does show this railway ability.
It is important, for the sake of the investors, that the return
181] THE FAIR RETURN 181

be based upon a valuation worked out on a principle that
really shows forth this standard. It is fully as important
for the shipping public, in order that they may have the
greatest possible facilities for their traffic at the least pos-
sible cost. It is important for all, in order that the dis-
trust, suspicion and uncertainty which have marked the
situation up to the present be removed. If once it be settled
on what basis the railways shall be allowed to earn a return,
there seems to be little question but that investments can be
secured on better terms, and the actual rate of return will
be lower.

There is another reason for valuation, and one based on
principles which will properly relate the value of the rail-
way property to the general markets. The law requires
that a so-called fair return must be allowed in each sphere
of the railroad’s activities, the state as distinguished from
the interstate. There is also more or less necessity for the
same distinction between the earnings on local and through
trafic. And the only way in which it may be told whether
a proper return is being secured in each of these spheres is
by knowing what value of property is devoted wholly or in
part to each of these phases of the business. There seems
to be little question as to the desirability of valuation on
sound principles, at least until some still undiscovered
theory of earnings is brought to light.

It may be questioned here whether the fact of allowing
or not allowing the so-called unearned increment for future
valuations will affect the problem of the necessary return
at the margin. It may be argued that to leave out this in-
crement in the valuation means that the rate of return will
be changed by just so much; that nothing will be saved by
disallowing this in the value, for it will appear in the return.
Investors in other fields are receiving the benefit of this in-
crement of capital value. Then since the railways are
182 RAILWAY MONOPOLY—RATE REGULATION [182

financed in competition with other enterprise, it is reason-
able to suppose that what other enterprises get the railroads
must be allowed to get. The truth of the situation
seems to be that the influence of the increment in capital
values works only one way in the railway field. In
a field in which there is no friction or leakage of any
kind, the increment affects the situation in two ways.
When it is once established in the capital value, the
capital demands higher return. But while it is com-
ing in, it is a part of the return, and under free compe-
tition diminishes the rate of return which must be obtained
in the shape of earnings. A steady rate of increase in prop-
erty is just as good as a similar amount of earning on the
property. In periods of expansion land is invested in for
the increment of value rather than for the rental at the time.
In fact, a great deal of land is held in the cities at a positive
outlay for taxes in order that a profit may be realized from
the increment in capital value. But nothing is heard of this
side of the question in the pleadings for greater railway re-
turns. Nothing is heard of the increment until it is a thing
of the past and the attempt is made to include it in the capi-
tal value as a basis for a higher amount of return. What
becomes of this value while it is being accumulated; or who
gets the benefit of it as it comes in would be difficult to say.
At least it does not seem to be counted in the rate of return
enjoyed by the security holders. Why then should it be used
as a basis for higher returns once it has been capitalized?
If it were actually counted while it was a part of the return,
it would make a difference on the rate of return allowed
from earnings. It would diminish the necessary earnings.
But there is no evidence to show that it has this effect.
Possibly one reason for this is that it is uncertain whether
it will ever be allowed as a part of the capital on which
earnings in the future will be rated. Whether this is the
183] THE FAIR RETURN 183

case or not, it certainly seems as if the unsettled principles
of valuation and the return thereon were very disadvan-
tageous to the end of securing the greatest facilities at the
lowest rates of charge. The roads insist upon the principle
of the higher standards of value, while the investors fear
the application of the lower standards.

One other reason may be emphasized against the adoption
as the policy of the future of a principle increasing valuation
by more than the actual investment. As has already been
noted, the business on a railway system is practically an
organic thing. The traffic which originates in one place
makes the rest of the system more profitable. Similarly,
the securities are all part of the same system. The earn-
ings of the new investors cannot be higher than those of the
old. It may be necessary that the new property get a slightly
higher rate of return than the old. To allow it an increased
income corresponding to the increase in property values
would be tantamount to allowing the unearned increment on
all the property. If the new property stood by itself, this
would be necessary and the owners of the old would have
their earnings increased by just so much. But if the new
and the old owners were shareholders in the common lot,
there would be no necessity for such an increase in the rate
of return. A slight increase in the returns for all the shares,
if combination were a fact, would cover the necessities for
expansion onto higher-priced land just as well as a large
rise, in the case of the earnings on an independent new
line. The unearned increment need not be allowed on all
property; only on what has actually been purchased at the
higher figures. Expansion of consolidated systems would
leave out the necessity for the unearned increment on all
property, and allow the railroad system to be pushed to a
higher margin.

The conclusions which are ventured on this question of
184 RAILWAY MONOPOLY—RATE REGULATION [184

the proper return to the railways as publicly regulated
monopolies are as follows: The return should be based
upon a careful valuation of railway property, the so-called
intangibles as well as the physical elements. This valuation
should follow the principle of the cost-of-reproduction-less-
depreciation for the property invested in up to the time when
the valuation is standardized and the rule for the future
established. After establishing such a valuation for the
property on hand, the principle for the future should be to
maintain this valuation at the figures worked out—provid-
ing for the replacement of worn-out elements—and to add
to this amount what from that time on is actually invested
in the enterprise. In the light of the facts ascertained by
this valuation, it should be decided which system in the field
operates at least advantage while still socially necessary
and managed with reasonable care, and on this system what
is counted as a necessary return should be allowed. This
necessary return is what is necessary to warrant investment
in needed betterments and extensions of the system, and
may be judged by the marketability of the securities at their
proper ratio to the valuation of the property. It is hoped
that this plan would provide expansion of our railway net
as the expansion of traffic warrants it, but no faster. And
rates based on such a plan, while fair to the railways, would
not unnecessarily burden the shipping public or unduly limit
the expansion of traffic.
CHAPTER IV
REGULATION OF PARTICULAR RATES

REGULATION, to be complete, must cover the adjust-
ment of particular rates. It is not sufficient that the system
of rates as a whole should be so regulated that a proper re-
turn and no more be earned by the railroads. The rate
structure as a system should be based on the ability of the
railroads to supply the service, but the work of the com-
missioners does not end there. Regulation of the rates.
charged by the railway monopolies, to repeat, should con-
sider the proper relation of the particular rates to each
other and to the return demanded by the enterprise. As
Commissioner Erickson, of Wisconsin, says:

A rate schedule to be fair and just should not only yield
the required amount in revenue, but each particular rate in
it should have a proper relation to all the other rates. That is,
the charge on each article or shipment should cover the cost
of transportation and contribute its just proportion of the:
interest on the investment. This proportion in turn depends
upon the cost of transportation and on the value of the service
or of the articles shipped.*

The system of regulation being worked out by the com-
missioners under the name of the cost system, while not de-
pending wholly upon costs as the criterion of fairness, never-
theless says that the first thing to be considered is the cost
of the particular class of service in determining the fairness
of the rate upon this class. For this end, of course, they

1 American Economic Association, Publications, Third Series, 1908,

p. 96.
185] 185
186 RAILWAY MONOPOLY—RATE REGULATION [186

are réquired to ascertain the approximate cost of each such
class. As Commissioner Staples, of Minnesota, says:

In order to fix rates upon the cost basis, it is necessary to
determine the approximate cost per unit of traffic as well as to
weigh these costs for each class of the traffic in proportion
to the value of the articles contained in each of these classes.*

And Commissioner Erickson says:

That part of the cost which should be borne by the freight
traffic is distributed between the various classes and com-
modities on the basis of cost, and this cost per unit of trans-
portation is then weighted, so to say, on the basis of the value
‘of the articles transported.’

Thus we see the necessity of ascertaining the cost per unit
of transportation on the various classes of traffic in order
‘to put the principles of the commissioners into operation.
But we are told that no method has ever yet been devised,
or is likely to be devised, by which the actual cost of trans-
porting any particular commodity can be ascertained.

In this connection Professor Ripley may be quoted:

‘So many expenditures are incurred indiscriminately on behalf
‘of the service as a whole—being an indispensible condition for
operation of the property at all—that no logical distinction of
expenses even as between passenger and freight is possible.
That being so, how futile it is to expect to be able to set off
the expenses due to any particular portion either of freight
or passenger.®

Mr. Carl C. Wright, General Solicitor for the Chicago
and North-Western Railway Co., says:

' Proceedings of the Twenty-third Annual Convention of the Na-
‘tional Association of Railway Commissioners, 1911, p. 33.

2 Letter of December 15, 1911. (Private correspondence.)
* Ripley, Railways; Rates and Management, p. 70.
187] REGULATION OF PARTICULAR RATES 187

No definite means or accepted method of determining cost
charges as related to each commodity has been found. Our
road has, like other railroads, been striving to find some ac-
curate basis for determining cost charges in relation to each
commodity for its own information. I have not yet thought
that we had any data which are sufficiently clear or conclusive,
or which can be successfully supported, in use in determining
the rates. It must, of course, depend upon very many arbi-
trary divisions and, as there are so many items of cost which
are apparently indefinite and in regard to which it is imprac-
tical to measure them in dollars and cents, no definite state-
ment can be made, and perhaps never will be made.*

Following out the same line of thought, Mr. Peabody,
Statistician of the Atchison, Topeka and Santa Fe Railway
System, says:

No method has as yet been devised, nor is there any prob-
ability that any method will be devised, by which the actual
cost of transporting any particular commodity can be ascer-
tained, as distinguished from the cost of transporting any
other commodity. We are able to ascertain approximately
the average cost of transporting all commodities, but even that
affords no criterion for determining the reasonableness of
any rate.?

In spite of the criticisms launched against the principle
of segregating the costs of the particular services, the com-
missioners are not discouraged. They do not claim that all
the railway costs can be accurately allocated to the particu-
lar elements of traffic. But they do claim that a sufficiently
large proportion of the total costs can be allocated to be of
great value in the regulation of particular rates. And in
spite of their protests against this principle, the railway

1 Letter of November 25, 1911. (Private correspondence.)
2 Letter of November 25, 1911. (Private correspondence.)
188 RAILWAY MONOPOLY—RATE REGULATION [188

men, by its extensive use in their arguments against restric-
tive orders of the commissions, weaken the strength of
their objections.

Moreover, the attempt is not made to carry out the segre-
gation of costs to each particular service. It may cost more
to handle a certain kind of freight in the summer than in
the winter. But, unless in such cases of extra service as
icing, no attention is paid to these differences. Perhaps no
two shipments of the same class of goods over the same
routes would have exactly the same cost if the details of
each shipment were gone into. Certainly the value of ser-
vice of these different shipments would show considerable
variation, but no attention is given to these minutiae. Under
the law, as it exists, there is to be no discrimination between
members of the same class. Each shipper of the same class
of goods must pay the same for similar services under simi-
lar conditions. Hence we are not in any way called upon
to determine the actual cost of each particular shipment.
What must be done is to ascertain with a reasonable degree
of accuracy the average cost of each particular kind of ser-
vice. How broad this latter term, particular kind of ser-
vice, should be is a matter of dispute. In so far as this
depends upon the classification commodities, it is gen-
erally agreed that at present there is too much differen-
tiation. There are too many rates based upon such a dis-
tinction. The great reason against rating the differences
between the particular service within each class is that, in
order to avoid discrimination between shippers, it is essen-
tial that all members of the same class be treated alike. It
has been found that, if differences be allowed between these
shippers within a class, the principle will be abused. In-
stead of basing the difference on either cost or value, it will
very generally be based on favoritism, or the ability of the
patron to demand a preferential advantage. The law has
189] REGULATION OF PARTICULAR RATES 189

very wisely been made stringent against giving different
rates to patrons in the same class, and consequently there
is no use in trying to determine the differences in cost. It
is also considered that there is no great advantage in hav-
ing a very great multiplicity of classes. The result is that,
while, according to the advocates of the cost principle, it is
necessary as far as possible to ascertain the average cost of
shipment per unit of all traffic within each of these classes,
there is no need to go into differences within rather large
classes. The attempt of the commissioners is to allocate
the costs of these classes as far as possible and weight them
in providing for such part of the railway return as can not
be so allocated.

The greatest difficulty in the way of the segregation of
transportation costs lies in the fact that so large a propor-
tion of railway costs cannot be said to be due to the carriage
of any particular element. Many expenses accrue just the
same, whether any traffic is carried or not. The interest
on the capital, the taxes, and a large part of the maintenance
expenses are said not to depend at all on the amount of the
traffic. Another large part of the expenses can scarcely be
assigned to any particular part of the traffic; there are costs
that might cease largely if the traffic ceased; but it would
be very hard to determine which part of the traffic caused
them. The rails, if not used, would deteriorate to a cer-
tain extent. However, since a very small proportion of the
American rails rust out it seems quite safe to say that rail
expense is an element of cost that is due to traffic rather
than to a deterioration that goes on irrespective of traffic.
It is a much more open question as to the up-keep of ties
and ballasting and the general road bed; but judging from
the greater amount spent on these items by roads of
dense traffic, we may safely charge this element of cost to
general traffic wear. Buildings are another class of ex-
190 RAILWAY MONOPOLY—RATE REGULATION [190

pense that can only with difficulty be allocated to any par-
ticular phase of the traffic, except that we know quite largely
whether the freight or the passenger service causes the out-
lay. Then again, the salaries of some of the officers could
hardly be classed with any division, even in some cases with
freight as distinguished from passenger service. There are
many parts of the salary and wage expense, such as the
pay of the office men, the switch men and station men, which
can with difficulty, if at all, be assigned to any particular
element of the traffic. The general class of costs which do
not increase with increased business could hardly be ex-
pected to be allocated to any particular element of traffic.
Some of these, it is claimed, should not be classed as traffic
expense at all. Neither can the expenses which do increase
with traffic growth but only with general growth—as for
example rail expense—be assigned to particular elements of
the traffic. What is everyone’s business is no-one’s busi-
ness. Those costs which go on irrespective of whether
there is any traffic or not, and those which apparently are
not caused by any particular traffic, are called joint costs.

Besides these joint costs, all admit that there are costs
unquestionably assignable to particular classes of traffic.
The cost of purchase and up-keep of coal cars undoubtedly
belongs to the coal traffic. The cost of live-stock cars be-
longs to the live-stock business. And the maintenance of
the passenger accommodations pertains to the passenger
traffic. There are many elements of cost that can easily
be assigned to the particular class of traffic that has caused
them, so easily assigned that even a tyro in the art of ac-
counting could see where they belonged. And since the
cost principle does not propose to segregate costs to any
finer degree than the classes, it is assumed that all that it is
necessary to do with these costs is to average them per unit
of traffic within the class.
191] REGULATION OF PARTICULAR RATES IgI

Just what part of the railway cost is strictly joint, and
what part is easily assignable to particular elements of the
traffic, it would be difficult to tell. It is safe to say that
these two together would not make up nearly all the cost.
Besides these, there are many costs which cannot be so
easily allocated ; costs which some claim are joint and others
contend can be assigned to the elements of traffic by the use
of careful cost-accounting methods. A great difference of
opinion is expressed in regard to these costs. Professor
Ripley claims that probably over one-half of the expendi-
ture for freight and passenger business is entirely joint; '
if this be so, what must be the case in the divisions of the
freight business? But many other authorities, particularly
the commissioners, take an entirely different view of the
matter; they claim that, with the application of modern cost
accounting methods, the greater part of the costs can be
allocated. And, of course, the commissioners consider that
such part of the cost as can be allocated should be borne by
the particular traffic in question.

If we regard only instances of declining traffic or static
conditions where there is neither increase nor decrease, it
would be rather difficult to disagree with the objections
against apportionment of more than the bare movement ex-
penses to the various elements of traffic. If traffic is in-
creasing, we may be able to tell what elements occasion part
of the increased outlay besides the movement charges and
the cost of equipment strictly pertaining to particular traffic.
But if traffic is falling-off seriously, returns must be ob-
tained in any way possible. Equipment that may be used
for various kinds of traffic will be requisitioned under such
circumstances, for any use that can be made of it. But
such conditions do not attain prominence in this country.

1 Ripley, Rai'ways; Rates and Management, p. 69.
192 RAILWAY MONOPOLY—RATE REGULATION [192

There are periods of depression, but on the whole we have
steady expansion. And expansion of any element means
that if this continue, equipment must be provided for it,
and the outlay in office expenses and terminal facilities may
even need to be increased. In cases of increments of traffic
which do not appear to increase the joint expense, or neces-
sitate an increase of capital it is claimed that it is profitable
to haul them for little more than the bare movement ex-
pense. A famous example is coal. It is claimed that this is
an extra traffic which cannot be asked to bear any particular
share of the joint burden or expense. But how can this pos-
sibly be true in the case of the Pittsburgh and Lake Erie
and the Pennsylvania Railroad? Here a large part of the
traffic is coal, and it can hardly be doubted that it is the
presence of this traffic that thas necessitated the increase of
the capital to provide for quadruple tracks on certain sec-
tions of these systems. Moreover, each of these companies
is quite prosperous. This but illustrates a principle. The
business of our railroads is in a growing state. And in such
a state of affairs, each increment of traffic contributes to
the necessity for an increase of the joint expenses of the
road. The question is as to whether or not a cost account-
ing system can tell what this contribution is. One extra
passenger may not be noticed, but a regular addition of
fifty will necessitate another car, and maybe another brake-
man. The increase of business is continually causing
greater joint movement expense, and is even necessitating
the larger investment of capital. Since this is so, it does
not seem to be absurd to claim that to each class of traffic
corresponds a certain part of not only the movement ex-
pense, but the capital charges as well. The question re-
mains, can this part of the expense belonging to the differ-
ent classes of traffic be ascertained? If this can be done, it
should affect the rate, according to the views of the com-
193 | REGULATION OF PARTICULAR RATES 193

missioners. And the commissioners contend that such cost
accounting is a reasonable possibility. If they are right, it
is a comparatively simple matter to distribute such charges
and say what part each unit should bear in addition to its
fair share of the strictly joint costs.

In regard to the separation of expenses between freight
and passenger service, President Burr, of the Convention
of the National Association of Railroad Commissioners, in
IQII, said, in the annual address from the chair :

The first block of the primary expense accounts is “ Main-
tenance of way and structure accounts.” Practically only the
primary account, “ Repairs and renewals of buildings,” can be
kept separate by cost accounting methods. In the next block
of expenses, “ Maintenance of equipment,” all these expenses,
save those of, “ Work equipment,” can be by proper methods
of cost accounting, definitely located to freight or passenger.
It will be necessary for a large number of carriers to keep
track of engine repairs as between freight, passenger and
switch engines. This is done by some carriers, but not all. In
the next block of expenses, the “ Traffic expenses,” it is neces-
sary for the carriers to apply the principles of cost accounting,
and to determine the amount of energy expended in the traffic
department into freight and passenger business, respectively.
This can be accomplished by railroad companies requiring the
proper report as to the time expended by joint agents and
officials in each class of service. The next block of expenses
is “ Transportation expenses.” The bulk of these expenses
can be determined with great accuracy between freight and
passenger. Some few of the expenses, such as despatching
trains, operating interlocker, block, and other signals, and
crossing flagmen and gatemen may have to be divided upon a
more or less arbitrary, but perfectly obvious basis, not arbi-
trary in the sense of unreasoning assignment, but arbitrary
only in so far as to slight variations of factors upon which
they depend can be considered an arbitrary matter. The next
194 RAILWAY MONOPOLY—RATE REGULATION [194

block of expenses, “General expenses,” are susceptible of
division between freight and passenger, with a degree of ac-
curacy which is practical in all its points. The only block of
expenses, therefore, which requires more than ordinary care
in the division of its primary accounts is the first block of ex-
penses, “ Maintenance of way and structures,’ and even here
the operation which causes the wear or the destruction of the
facilities, which destruction it is necessary to renew or replace,
can be determined and application of the resulting factors
made.

President Burr also discusses the application of cost ac-
counting to other divisions of traffic. He maintains that
cost accounting is necessary to determine the proper ex-
penses to each State, the proper freight and passenger ex-
penses, the proper amount chargeable to interstate and intra-
state passenger, the proper amount chargeable to interstate
and intrastate freight, and to determine the expenses proper
to any class of traffic whether interstate or intrastate. He
then says:

These five questions are daily before some court or com-
mission of the United States, and it seems, therefore, abso-
lutely’ essential that cost accounting should be applied to all
railway accounts, and that if we are to determine these matters
justly and intelligently it must be so applied.

In the conclusion of his speech he says:

To state that there is an insuperable difficulty in determining
these matters is an insult to our intelligence, as well as to
that of our railway friends. The virility, resourcefulness,
and brains of this present generation have not fallen into
decadence.?

1 Proceedings of the Twenty-third Annual Convention of the Na-
tional Association of Railway Commissioners, 1911, pp. 24-27.
195] REGULATION OF PARTICULAR RATES 195

The Interstate Commerce Commission seems also to con-
sider it quite possible to allocate the costs to the different
services with a reasonable degree of accuracy. The two
great decisions given on the schedules of freight charges in
IQI1 are generally admitted to have been based largely on
cost, and the cost as it was distinguished between freight
and passenger service. Commissioner Lane said in one of
these opinions, the Western Advance Rate Case:

While we find the carriers contending uniformly that in the
making of a reasonable rate the cost of service is a practically
negligible factor, yet the contention is herein made that the
carriers should be allowed to increase their rates upon that
ground. In short, that addition to cost of service justifies in-
creased rates. It becomes of immediate importance, there-
fore, to learn what we may as to this factor in the problem.
That the railroads are not indifferent to this element is shown
by the fact that some of those of the highest grade keep such
figures. It would be remarkable indeed if, in this time when
all great business enterprises make analyses of costs, our
railroads should keep no such accounts.

When we have sought to learn the cost of railroad service,
a twofold answer has been made: (1) That rates were not,
and could not be, made with reference to cost, because some
traffic could and should bear a higher rate than other traffic ;
and (2) because it was impossible to allocate to the different
services rendered their proper share of expenditures. The
first of these answers we have considered above. As to the
second, it has been testified by an official of an important
carrier that it was entirely feasible to absolutely segregate
about 51 per cent of the cost of operation between passenger
and freight traffic; that about 29 per cent was subject to
some arbitrary division, but that for all practical purposes it
would be accurate; and that only the remainder, or twenty
per cent of the whole, had to be determined upon an arbitrary
basis. So that it was regarded as practicable by statisticians
196 RAILWAY MONOPOLY—RATE REGULATION [196

to leave but a very narrow “twilight zone” between the
actual cost of moving a ton of freight and the statistician’s
estimate; and this estimate, it was thought, would not vary
5 per cent from actual cost. This is readily apparent from
the fact that of the total operating expense on most of the
roads substantially 50 per cent is chargeable to “ conducting
transportation,” 25 per cent to maintenance of way and struc-
tures, and 25 per cent to maintenance of equipment. There
is no difficulty in segregating the cost of maintenance of
equipment as between passengers and freight. Likewise the
50 per cent under the head of conducting transportation is
easily segregated, excepting as to some station, yard, and
similar expenses, which constitute a small proportion of the
total. Thus practically 75 per cent of the entire expense is
taken care of. The expense of maintenance of way and struc-
tures can not be allocated, and this has to be divided arbi-
trarily. Moreover, that it is not impracticable to estimate cost
of railway service is evidenced by the fact that we have be-
fore us the cost figures of both the Santa Fe and the Burling-
ton lines.?

Other commissioners might be quoted to support the
same view, but enough has been given to show the trend
of thought among these experts. It is considered possible
to separate the costs of freight and passenger service with a
reasonable degree of accuracy. It is not claimed that there
is an absolute exactitude in this allocation of costs. It is
doubtful if economic laws when allowed to work naturally,
do so with any absolute exactitude. We usually find a zone
of indifference. So we should not be disturbed if we found
a similar twilight zone in artificial regulation. Suffice it to
say at the present time that very important decisions have
been rendered both by the Interstate Commerce Commis-
sion and by the various state commissions, where such

120 I. C. C. Rep., 357-8.
197] REGULATION OF PARTICULAR RATES 197

separation of the costs of the freight and passenger service
has been the underlying principle upon which the decision
stood or fell. Cases have been argued by the shippers on
this basis; the railways have used it in a great number of
their defences; the commissions have based regulation of
rates upon it; and the courts have sustained the principle.
But this is only a beginning of the question. The second
problem that must be solved, before even passenger-rate
disputes can be finally settled, is the separation of accounts
between state and interstate business. It has been said that
none but German metaphysicians would attempt to cope
with this problem. But since they are otherwise occupied
at present, America herself must solve this problem grow-
ing out of the artificial economic barriers supported by the
Constitution. Even though the commissions wished to
avoid the question and fall back on the value-of-service
principle, they would still be forced by the railway man’s
plea of confiscation to consider this troublesome point as in
the Minnesota Rate Case. By our constitutional principle
of the separation of powers, no state commission can pass a
ruling interfering with interstate business. This artificial
boundary cannot be overstepped. State business must stand
on its own feet. The railway must be allowed a fair re-
turn on its state business as well as on its interstate busi-
ness. As Commissioner Fairchild, of Washington, says:

Every time a state commission attempts to fix a rate and the
railroads do not desire to acquiesce in that, we are at once
taken into the United States courts on the proposition that
the railroad is being deprived of its property without due
process of law, and the question immediately arises which is
tried by the courts, “‘ What is the value of the property of the
railroad within the state given up to and used for the benefit
of state business? ”

The same commissioner gives as his opinion that the most
198 RAILWAY MONOPOLY—RATE REGULATION — [108

important element in making the division between state and
interstate, the most controlling element under all the cir-
cumstances, is the cost of the service.*

Commissioner Burr regards this as a less intricate prob-
lem in cost accounting than the divisions of the expenses
between freight and passenger traffic, his optimistic account
of which has already been quoted. His opinion is that
there is only a small percentage of operating expense which
must of necessity be joint to two or more States, these costs
occurring almost entirely in terminal and in the maintenance
of equipment items. Each of these expenses can be readily,
and should be, divided between the States according to the
factor of use applicable in each case.

In the discussion by the American Economic Association
in 1908 following Commissioner Erickson’s paper quoted
above, it was pointed out that, “ Rate making on a basis of
cost of service requires that the state commission should
separate intrastate from interstate traffic, and while to some
extent arbitrary, this can be done closely enough for prac-
tical purposes.” ”

It would seem from the statements of the various commis-
sioners that with the proper application of cost accounting,
this problem of separating state and interstate accounts
could certainly be solved as well as that of the distinction
between freight and passenger service. If these problems
can be settled, it is a comparatively simple matter to adjust
passenger rates with reference to the cost of the service,
and we would be in a fair way to the adjustment of freight
rates, or at least the determination of the cost element in-
volved in the rates.

1 Proceedings of the Twenty-first Annual Convention of the Na-
tional Association of Railway Commissioners, 1909, p. 313.

2 Publications of the American Economic Association, Third Series,
vol. ix, p. 102.
199] REGULATION OF PARTICULAR RATES 199

The next question to consider is the cost of conducting
each particular class of the service within these broader
divisions. The local must be considered as compared with
the through service. The relation of rates to distance must
be worked out. The comparative costs of transporting the
various elements of traffic must be determined. And to do
this we must find the cost of hauling traffic between the ter-
minals, and we must ascertain the terminal expenses. Rates
cannot be determined simply on the basis of cost per ton
mile. If all freight were homogeneous, or equally costly
to handle, we should have to find the cost per ton-mile for
actual carriage; that is, the share per ton-mile of engine
and car expenses for the up-keep of the road, the wages of
the men, and the earnings on all the property involved in
the movement of freight. All this is proportionate to dis-
tance, although it is relatively greater for local traffic than
for through traffic, the proportion depending, among other
things, upon the relative amount of the two kinds of traffic
on the road in question. Besides these movement expenses
there are the terminal expenses, which may be the same for
the same kind of freight moved one mile as moved one
thousand miles. These latter expenses are not affected by
distance, but are constant per unit of the same kind of
traffic. The cost of handling any unit of a particular kind
of freight includes the two elements, a constant terminal
cost and a movement cost depending upon the distance.

It is, of course, very evident that we here again encounter
the same difficulty of allocating joint costs. But we are
assured by Mr. Erickson that, upon a close and detailed
examination of the nature of the various items, it will be
found that in this case also the common expenses may be
fairly and equitably distributed.

Mr. Erickson shows roughly how these costs are deter-
mined in practice. He shows that to find the costs of mov-
200 RAILWAY MONOPOLY—RATE REGULATION [200

ing any unit of traffic, the costs per ton or per hundred-
weight, the best method by which to approach the matter
is to ascertain the cost of handling the loaded car. Freight
is ordinarily handled and moved in car-load lots. The ter-
minal charges can be pro-rated on the number of cars when
we allow for differences in size of cars, etc. These charges
appear to be a sort of weighted average for each car. “When
the cost per car, in turn, is pro-rated upon the gross weight,
or on the weight of both car and the load, we obtain the
cost per gross ton. The figures thus obtained furnish a
basis upon which the cost per unit of the terminal expenses
may be determined for light as well as for heavy loads.” ’
The actual movement expenses on the road are not much,
if any, more complicated. We must first ascertain the cost
of the broader divisions of traffic as a whole and then aver-
age this per unit, always remembering that the average must
be weighted. As shown above one necessity of weighting
the average per unit is the weight of the car; more strictly,
the proportion of the net weight to the gross weight. The
gross weight incurs the cost, the net weight pays for it.
Another matter necessitates the weighting of cost aver-
ages, in fact, to a good degree, takes it beyond the operation
of averages in that it produces actual expense. This is the
adjustment of the expenses between way and through
traffic. The former is, as a rule, the more costly. Way
freight trains stop at practically every station on their run
to unload or take on freight, and therefore make much less
mileage in the same time as through trains. In iact, the
latter usually make twice as much mileage in a given time
as the former. Then again they require more men to oper-
ate them and handle the goods. Starting and stopping in-
volves more wear and tear and fuel. And with it all, they

1 American Economic Association, Proceedings, 1908, p. 97.
201 | REGULATION OF PARTICULAR RATES 201

haul less net weight per car than through traffic. Investi-
gations have revealed that the movement expenses per unit
of traffic are often from two to three times as great for
way-freight as for through freight.

We are in the midst of our difficulties now. The prob-
lem of classification confronts us. No one seriously consid-
ers making a flat rate on all commodities. This is charged.
against the advocates of the cost principle, but it is a charge
that falls wide of the mark. It is erroneous on two counts.
First, the cost per unit of transportation is not the same on
all commodities. And, secondly, if the cost were the same,
the commissioners say flatly that they would not make the
rate the same, but would weight the charges according to.
the value of the goods or the demand for the traffic.

That the cost per unit is not the same for all classes of
goods is very evident to even the tyro. Who would say
that the cost per unit of ton-mile on steel rails, shipped by
the whole train load, and sent through to suit the conveni-
ence of the rest of the traffic, was the same as on freight
which is highly perishable and must be rushed through at
high speed in expensive refrigerator cars? Even the cost
of hauling coal and coke differ widely. The railroad that
accepts a consignment of coal at Pittsburgh for the West
knows by the weight at Pittsburgh that that is what it will
have to carry to the destination. But a load of coke which
must be accepted at the dry weight at Pittsburgh may be
very much heavier before it gets near the West, if the sea-
son is rainy. These are but samples of some of the more
obvious differences in the cost of transportation of differ-
ent commodities. There may be certain fundamental costs
per unit of traffic that are uniform for all classes of traffic,
but beyond these fundamental costs are very many addi-
tional costs that make the necessity in point of cost for our
commodity tariffs.
202 RAILWAY MONOPOLY—RATE REGULATION [202

This estimate of the costs of the various classes of
the freight traffic is not arrived at by means of a separ-
ate study of each such element. It could hardly be
denied that there are insuperable obstacles in the way of
such independent determinations of the costs of each ele-
ment. But it frequently is possible in large measure to find
the comparative costs of handling the separate elements.
And when the cost of the total service is known, it is not an
impossible task to estimate the costs of the particular ele-
ments by dividing the total costs according to the compar-
tive costs. Estimation of the costs of the particular ele-
ments of traffic has been carried out in numerous rate cases.
But this estimation has been made by the use of the com-
parative costs. As Professor Hammond says in his review
of the “ Railway Rate Theories of The Interstate Com-
merce Commission ”’:

Our review of the cases in which differences in the costs of
service have been cited by members of the commission as
reasons for differences in rates shows that the commissioners,
as well as the traffic officials of the various railroads, have
made much greater use of the cost-of-service principle than
their preliminary utterances would lead us to expect. It has
not been by means of a direct determination of the costs, how-
ever, that the commission has sought a solution. The method
followed, as we have seen, has been that of comparison. The
method of comparative costs does not yield absolutely accur-
ate results but it is sometimes sufficiently accurate for prac-
tical purposes and we must remember that economics, like law,
does not concern itself with trifles.?

Such excellent testimony to the value and feasibility
of the cost principle in this connection is made by Commis-

1Hammond, Railway Rate Theories of the Interstate Commerce
Commission, pp. 68, 188.
203 | REGULATION OF PARTICULAR RATES 203

sioner Meyer of the Interstate Commerce Commission in a
paper which he read before the American Economic Asso-
ciation in 1913 that we cannot forebear quoting from it
rather extensively. After saying that ‘“‘ Perhaps the most
important single factor, now unknown, which will enter
into the consideration of railway rates in the future is that
of the value of the property ”’, he states:

A second factor equally fundamental with the value-of-the-
property factor, which I believe will be employed very much
more in the future, is that of the cost of the service. A very
great variety of statistical analyses have heretofore been made,
but systematic efforts directed toward the ascertainment of
the approximate cost of the service have, generally speaking,
been strangely neglected. A small minority among those deal-
ing with rate problems have long advocated it, but their plans
have been thwarted by the skepticism and unwillingness of a
persistent majority. There are those who have opposed the
development of statistical investigations along the lines of cost
because they assert the results are bound to be misleading and
unreliable. Others confess a fear that information of that
kind will be misused. Others declare that it will result in the
establishment of rigid distance tariffs, with attendant chaos in
the industrial world. Still others maintain the view that the
cost of the service has nothing to do with the rate either in
general or in particular. The combined weight and influence
of all these objectors has thus far been sufficient to obstruct
substantial progress.

It is a fact of common knowledge that so-called cost account-
ing has been applied to every important branch of industry
except steam railway transportation. A prolific literature
upon the subject has been produced within the last decade, and
competent specialists in all branches of business are prepared
to give these principles practical application. The railways
themselves have made limited application of the principles of
cost accounting to more than one-half of the railway mileage
204 RAILWAY MONOPOLY—RATE REGULATION [204

in the United States. They declare, however, that this has
been done for internal corporate administrative purposes
rather than with a view of assisting in the establishing of just
and reasonable rates. The difficulties of separating operating
expenses among the various branches of the railway business
are as apparent as the benefits of the final results are clear to
those who are willing to undertake the task. It is perfectly
obvious that controversy respecting the apportionment of
maintenance-of-way items, for instance, can never end. Is
this, however, sufficient reason for refraining from undertak-
ing a work which is so promising in beneficial results? There
exists surprising similarity in the methods employed by differ-
ent railway companies in apportioning certain common or over-
head expenses. This similarity appears to have been brought
about without previous conference and agreement and is ap-
parently the result of similar conclusions arrived at by men
working at the same problem independently of one another.

He then goes on to show the necessity for cost accounting
to arrive at proper and just solutions of such transportation
problems which are active at the present time as the express
business, the railway mail pay and the state passenger rate
cases.*

Thus we see there is abundant evidence for the conclu-
sion that the majority of the running expenses of the rail-
ways can, with proper cost-accounting methods, be allo-
cated to the various elements of the traffic. These are items
of cost that are caused by the traffic; the traffic is that by
which they exist. Besides these, there is another very im-
portant matter of cost, that for which the traffic exists,
namely, the profit upon the railway property in general, or
the fixed invested capital. It is not so easy to allocate this
part of the cost as it is the costs of operation. A small
part of this also can be immediately segregated, that profit,

1 American Economic Review, Supplement, vol. iv, p. 74.
205 ] REGULATION OF PARTICULAR RATES 205

namely, upon the property used peculiarly by the element of
traffic in question. For example, the passenger service must
pay not only for the wear and tear on its engines, cars, ter-
minals, etc., but it must also pay the interest upon all this
property devoted exclusively to its use. And, to quite an
extent, this can be carried to minor divisions of traffic, as
the patrons of the Pullman cars pay the added cost of the
Pullman equipment, and the dining-cars pay their own costs
and interest from their own earnings. But there is a cer-
tain total fixed capital invested in the business as a whole
upon which profits must be earned, irrespective of what
kind of traffic is handled. The interest on the securities
issued to cover the purchase of the right of way is a large
item, and an item that must be made up irrespective of the
differences of the traffic. This capital is entirely fixed; re-
turns must be obtained on it from the traffic as it may be
possible; no particular element of traffic is responsible for
any particular share. Then again there is capital that is
fixed from the standpoint of the investors in the sense that
it has been invested in the railway property, but it is in-
vested in property that is not permanent; it is permanent
investment only as a reinvested depreciation allowance
maintains the amount of capital in the business. As re-
newals are going on all the time this capital is not neces-
sarily fixed in any one branch of the service. The traffic in
each branch of the service must earn sufficient to warrant
keeping this capital in the equipment belonging to this ser-
vice, or it will be shifted to another branch of the service.
This is certain to happen if the company maintains proper
accounting methods. Consequently it is true that there
should be a very close connection between the earnings of
any particular branch of the traffic and the return necessary
on the equipment which handles it. The interest on securi-
ties covering the equipment for one branch of the service
206 RAILWAY MONOPOLY—RATE REGULATION [206

should not be paid by the earnings from another branch. If
any branch of the traffic cannot pay the interest charges of
its equipment, it stands to reason that any company main-
taining a cost-accounting system would decrease the relative
investment in such equipment. Capital may not shift in
large masses, but, as renewals and extensions are appor-
tioned, that branch of the service which is most profitable
will undoubtedly be increased in capital at the expense of
those less profitable. The return on all capital invested
is that for which the traffic is handled, rather than costs
caused by the traffic, as viewed from the standpoint of the
railways. But all such investment as is made in property
assigned to the use of any element of the traffic must just
as truly look to the particular elements of traffic for the
return as must the actual movement charges. Under proper
accounting methods much of the capital charge may be
allocated to the elements of service just as truly as the
running expenses.

The contention of the commissioners who advocate what
is known as the cost principle is that all costs—capital
charges and running expenses—which may be allocated to
the several elements of the traffic should be borne by the
element in question. Their conclusion seems very just.
Any other system of charges taxes one branch of the traffic
for the up-keep of another; a result that would be very
hard to justify. It would appear much fairer that each
element of traffic should bear its full share of such elements
of the cost as may be due to it. The different businesses
of the country would then be independent of each other as
regards their transportation costs, just as they are in other
costs of production. Each product would pay its own cost
and the laws of supply and demand would not be disturbed.
The result in the transportation charges would not be a flat
rate for equal distances on all commodities, but would be a
207] REGULATION OF PARTICULAR RATES 207

differential rate, compounded first of terminal and move-
ment charges. It would be further differentiated by the var-
iant elements of cost such as the distinction between local
and through traffic, in short, differentiated by all general
elements that make the cost per unit of transportation
greater or less.

We are told, however, that many articles of traffic could
not bear their full share of the costs. This statement un-
fortunately is made in line with the assertion that in the cost
principle we would have the same rates for all classes of
commodities, and consequently falls rather wide of the
mark. As pointed out, movement expenses are often two
to three times as great per unit for way freight as for
through freight. If this be so in this distinction of traffic,
certainly there would be quite a wide difference between
the real costs of shipment of different commodities. Fortu-
nately, the items that cost more to ship are those which it is
agreed are able to bear the relatively greater cost. Quite
possibly one reason why all admit that these commodities
can bear more charge is that they have had to and hence
it is proved that they can. The question is whether or not
the commodity in question can bear its full share of costs,
be this above or below the average, without causing the
amount of traffic to fall off.

It seems somewhat strange that in this light the commo-
dities said not to be able to bear their full costs are those
which apparently would not suffer a serious falling-off of
traffic at a fairly high rate. Many of the items mentioned
are either necessities or are commodities on which the tax
would be easily shifted and would be borne by the final con-
sumer. They are commodities on which our large roads
live and prosper. A notable example is coal, which is rising
in price independently of transportation costs; furthermore,
there is no decrease in its consumption, nor are the poor
208 RAILWAY MONOPOLY—RATE REGULATION — [208

suffering from cold more than formerly. It seems, on the
other hand, that this traffic must be quite profitable at pres-
ent rates, in spite of the fact that it is said that it must be
hauled for less than its share of the cost of service. At-
tention is directed here to the large proportion of traffic in
coal and the similar traffic in iron on our very prosperous
systems, the Pittsburgh and Lake Erie and the Pennsyl-
vania Railroad. One is reminded of the shopkeeper who
sold his goods below cost, but made money because he sold
so many of them.

Take again the example of sand for building. If this is
not already bearing its full share of the costs, what is to
hinder it doing so? Suppose that this rate were doubled.
Would the freight rate on the sand be sufficient appreciably
to discourage building? Or would the poor man use
fresh butter, or eat unsalted porridge, if the rates on salt
were advanced? And yet these are some of the commodi-
ties that we are told could not bear their full share of the
‘costs, were rates to be so fixed.

There are some cases where, to build up a new line of
traffic, it would pay any railroad to grant exceptionally low
rates in order to get a new business on its feet. It would
even pay the other members of the shipping public to en-
courage such a procedure. If this traffic would be able, in
time, to take an appreciable share in the up-keep of the
strictly joint costs, it would be socially expedient that it be
stimulated in its early growth by a rate even less than the
extra cost to haul it. But such cases are exceptions, and
should be so treated; they do not disturb the rule. Then,
again, there are other instances where a service may be
performed at less than what would be its normal cost. There
are cases where a line of traffic may be picked up to fill cars
returned from regular traffic, cars which otherwise would
return empty, and traffic that could not afford to pay for
209] REGULATION OF PARTICULAR RATES 209

the movement of the cars, were it not for the fact that they
were going anyway. In such a case, carrying this traffic at
a low charge really helps rather than taxes the standard
traffic. But if this back load increased so much that it be-
came larger than the standard load, the circumstances would
be materially changed. It would require its own special
service and car movement, and in such a case it could not
look to the other traffic to pay the lion’s share. Clearly,
while cases exist to quite an extent where it is expedient to
haul a certain traffic at a low rate, yet this is a principle of
charge that must be decidedly limited, or, instead of aiding
the rest of the traffic, it will be a tax upon the latter. And
moreover, many such cases are really not exceptions to the
rule. The traffic can, and does, pay for the actual cost en-
tailed by it. But while it is what may be called a subsidiary
traffic, it does not demand special equipment, and hence need
not have such costs rated to it.

The balance of argument and evidence goes to show that
the rule should be that each element of the traffic should pay
for all the costs that may be assigned to it by a careful ac-
counting system, and that the proportion of costs which
can be so allocated is not only larger than many would
have us suppose, but the outlook is that, as accounting
methods are improved and put into application, the sphere
of strictly joint costs will be continually reduced. There is
a large and growing proportion of the costs which should
be assigned to the particular elements of traffic, and form a
minimum below which the rates should not go except in
unusual instances. In addition to these assignable costs, it
is held that the strictly joint costs should be divided up
somehow on the principle of value. In addition to the dif-
ferential allowed on the principle of cost, there is another
differential added on the principle of value.

It should be brought to mind that no differential is al-
210 RAILWAY MONOPOLY—RATE REGULATION [210

lowed on the difference of value or of cost within the classes
of service. To allow such a differential would not only be
almost impossible of application, but it would be so very
liable to abuse that it it held to be illegal. When we turn
to the broad divisions of traffic, there seems to be little at-
tempt to differentiate on the principle of value. It appears
from the opinions handed down on the separation of ac-
counts between passenger and freight service that the at-
tempt here was made merely to ascertain, so far as possible,
the true expenses of each branch of traffic, and then to
divide up the remaining doubtful expenses and the interest
in the same ratio as that already worked out from the other
expenses, or to apportion them on the basis of the train
mileage. In fact, several methods have been tried, and it is
claimed that they work out about the same. We cannot
compare the value of the passengers versus that of the
freight, and it is only in a very general way that the value
of the two services may be compared as in the Wisconsin
decision in A. E. Buell vs. Chicago, Milwaukee & St. Paul
Railway Co. Should we attempt to establish such a divi-
sion as the freight versus the passenger on the wealth
or ability to pay of the ultimate consumers of the freight
and that of the passengers, the very probable outcome would
be that the differentiation would be in the wrong direction.
Instead of the wealthiest class of patrons paying the most,
they would pay the least. The freight charges are ulti-
mately paid by the consumers of the goods, and while goods
are consumed by all, yet the rule can safely be held to be
that these consumers as a class are not as wealthy as the
patrons of the passenger service. The simple reason is that
the people who travel most are above the average in means,
while the freight is ultimately used principally by the
masses. The freight is paid first by the middlemen, but it
is shifted to the ultimate consumer. This fact by itself
211] REGULATION OF PARTICULAR RATES 211

makes it easier to burden the freight traffic more than the
passenger. The rate is paid on the freight long before it
gets to the consumer; it is assimilated into the total price
of the goods, and the ultimate payer, not being present
when the railways are paid, gets but a poor opportunity to
object to the payment. He does not realize what elements
enter into the price of what he buys. But the passenger
pays for the ticket himself, and uses it himself. And he is
ready to object, and object strenuously. He can, more-
over, make his complaint heard more readily than the one
who bears the burden of the freight charge. The very fact
of his being relatively better able to pay makes him rela-
tively better able to register an effective protest. When a
differential beyond cost is allowed in this division of the
traffic, the tendency will be, both economically and politi-
cally, to make the less able pay more, rather than less, of
the joint burden. Consequently, it is socially expedient that
the element of value should be kept in the background in
the adjustment of the relative burden between the freight
and the passenger traffic. What elements of the cost cannot
be allocated by the principles of accounting may be appor-
tioned on a more or less arbitrary basis, following out the
lead which the cost principle gives. Then the ultimate
payers in the two classes will be likely to be dealt with:
more equitably.

The division between the state and interstate business is
also beyond the easy application of the principle of value,
and the division here that meets with most favor seems to
be the one based as far as at all possible on the cost of the
service and the relative amount of the property involved
in each service. Not so with the through versus local
traffic. Here, as in the case of the rates on different com-
modities, great attention may be paid to the relative value
of the different services. And the advocates of the modi-
212 RAILWAY MONOPOLY—RATE REGULATION [212

fied cost basis claim that this difference in value should
quite largely affect the proportion which each element of
traffic should pay toward the interest on vested capital and
other strictly joint burdens on the business as a whole. As
already quoted, “ The charge on each article of shipment
should cover the cost of transportation and contribute its
just proportion of the interest on the investment. This
proportion in turn depends upon the cost of transportation
and on the value of the service or of the articles shipped.”
Is not this as much as to say, let each element pay for what
expenses it incurs, let it pay for such part of the capital as
it can be judged distinctly to use, and let the remainder of
the interest on the vested capital and other strictly joint
charges be borne according to the unit of value, rather than
unit of weight or transportation?

And yet these statements as to the use of the value prin-
ciple in regulation are very vague. It might be supposed
that the value of the goods and the value of the transporta-
tion service performed upon them were identical, or at least
proportional. But these two values may be entirely differ-
ent. The price of the goods to the ultimate user may be al-
most entirely made up of the transportation charge, as in
the case of sand or other goods which cost very little at the
point of shipment, but cost an appreciable amount to trans-
port. On the other hand, the transportation charge may
enter very slightly into the ultimate price, as in the case of
jewelry and other luxuries. And doubtless what is meant
by the value of the goods is the price, for value is rated
at the margin of value, and this margin of value is the price.
Moreover it is not at all self-evident that the value of the
goods should rule. What the patrons pay the railways for
is not the goods themselves but the service of transporta-
tion performed upon them. This is but a part of the total
utility, the part which is found in place utility, and, as we
213] REGULATION OF PARTICULAR RATES 213

have seen, this has no definite relation to the utility of
the complete economic good.

The value of the service is also an indefinite matter. As
we saw in discussing the value of the service as a whole,
the value is quite indefinite, except as we mean marginal
value; and marginal value is simply the result of setting the
price (where competition does not enter the case). The
value of the service is the marginal value. And the mar-
ginal value is the price which is artificially fixed. Shippers
will avail themselves of the service up to the point of profit-
ableness under the rate as fixed. The marginal value is
useless in regulating the rate; to attempt to so use it would
involve a circle of causes and effects.

A better way to treat the matter is to say that the dif-
ferences that must be allowed in the rate beyond the dif-
ferences in cost should be based on the differences of de-
mand. The greater the demand per unit of any commodity
the more people are willing to pay for it. To be sure, the
demand varies with the price, but it is not just what the
price is. The real problem here, and apparently the solu-
tion of the problem of rate differentials is how the demand
varies with the change in the price or rate charged.

There can be no question but that the function of the
railroads is to supply the service of transportation. Since
this is so, the end should be to supply the greatest amount
of service possible. And to supply the greatest amount of
service possible, the rates must be adjusted with regard to
the comparative demand for the different services. For this
end the important thing is not so much what the demand
is at any one fixed price, but how the demand would vary
with a change in price. It is a well-known fact that the
demand for various articles and services varies quite dif-
ferently with the different articles and services. One ser-
vice will have a greater variation of demand with a change
214 RAILWAY MONOPOLY—RATE REGULATION [214

in price than another will. In fact, within reasonable limits
the demand for some services varies but little with a change
in price, while with other services the variation is great;
that is to say, the demand is elastic in the latter case. Does
that not give us the main part of the solution for the dif-
ferential division of the strictly joint costs?

The principle is that those services which have the most
elastic demand schedule, which fall off the most with an
increase in price, should bear relatively less than services
which will fall off but little in their use by an increase in
price. The end of the railway function and its regulation
is to serve the public as much as possible. As much of the
offered traffic should be handled as possible. Within rea-
sonable limits any kind of traffic will move to a certain ex-
tent, whether the rate on it be raised or lowered. But the
amount handled will vary with the rate imposed, and it will
vary more in the case of some traffic than in the case of other
kinds. In most cases, almost all cases, the amount handled
will fall off with an increase in price, and increase with a
decrease of charge. But the charge cannot be placed so
low that the railway will not get a fair return. The charge
is a necessity. Then let it bear on the different elements of
traffic so that they will have equal opportunities to expand.
And this result is not attained by an equal charge per unit
of transportation, or per unit of value of the goods handled.
The equality for expansion depends rather on the different
demand schedules for the different services; and the ser-
vices being the place phase of the ultimate utilities, the de-
mand schedule for the service is similar to the demand
schedule for the good in question.

There is a decided difficulty in arriving at the demand
schedules for these services or the goods into which they
enter. And yet it would seem to be possible to overcome this
difficulty within a practical degree of accuracy. Under mo-
215] REGULATION OF PARTICULAR RATES 215

nopoly price-making the variation in demand is one of the
chief elements in determining the level of price. As we have
seen, the monopoly price is set by raising the price to the
point where the falling-off in the business handled offsets the
increase in price per unit. This is done in the case of each
commodity. If this principle can be used to get the greatest
return for monopoly, it ought to be reasonably workable to
secure the greatest amount of business possible. It requires
a great deal of care to ascertain the demand schedules for
different commodities, and it cannot be expected that it can
be done to a point of very fine precision; but that is not nec-
essary to make a workable system of rate regulation. Such
a scheme of rate-making is truly in accordance with what the
traffic will bear. Let us not say that it is a system of what
the traffic will bear, for that has been used so much to cover
up the similar phrase, “all the traffic will bear’’, that it
might convey a bad impression. Let it rather be expressed
as a system based on the relative ability of the different
elements of traffic to bear the charge.

Just how does such a system work out? Take the example
of the comparison of any two classes of service. The com-
parative rate adjustment between the two could be said to be
worked out when any change in the rates, even though ad-
justed in such fashion as to give the same total return, would
diminish the amount of traffic handled in the two classes of
service. The reduction of traffic in one would be greater
than the addition of traffic in the other, while the change in
rate would not make a change in the total return. But we
would not rate the traffic in such a measurement simply on
the basis of a unit of transportation, but rather on the value
of the goods carried. The criterion would be the change in
the total value of the goods handled. It is not only that we
want more goods shipped. We want more value trans-
ported. It is worth more to society to have some goods
216 RAILWAY MONOPOLY—RATE REGULATION [216

shipped than it is others. And the best way in which we
can measure such comparative value is by the standard that
our ordinary price-setting mechanism puts upon them. The
differential accorded to value can be said to be awarded
to social advantage when any disturbance of rates that
would merely affect the relative burden on the different
classes would cause a diminishing of the traffic as measured
by the value of the goods to the consumers.

Just here comes in the weight to be given to the value of
the goods. Goods of low value might be able to bear a
high rate without any more diminishment of the traffic than
in the case of goods of high value. The goods of high
value might have an extremely elastic demand schedule,
while the traffic in the cheap goods might fall off but little
with an increase in the rate. But if they each had an elastic
demand, the variation in the traffic would be felt more
severely in the case of high-priced goods than in the case
of the cheap ones. The difference would of course be in
direct ratio to the price of the goods, as fixed in the ultimate
market. And since most goods have an elastic demand
schedule, the value of the goods has a very important place
in rate regulation.

This argument does not mean that we give up the cost
principle in so far as it can be applied. Both cost and value
principles are needed to make a fair system of rate regula-
tion. The background of cost is needed to work out the
return needed on the traffic as a whole, and the cost is
needed as the principal feature in the adjustment of rates
between entirely different spheres of transportation where
the comparative demand schedules can not be well worked
out, and where the admission of a differential on the value
side would probably lead to abuse or an exact reversal of
the principle. Cost is also needed as a minimum, in so far
as it an be ascertained, below which individual rates should
217] REGULATION OF PARTICULAR RATES 217

not be placed unless in exceptional instances. But, in addi-
tion to this, the value principle is needed as it is worked out
in the differential demands for the different classes of traffic
with possible changes in the rates.

Another question arises, as to whether the differential
due to demand should have as its base line the cost mini-
mum, or whether the rate as a whole should be worked
out on this principle and the cost minimum be used as a
necessary limit below which no rate should be allowed.
An argument could be raised on either side, but since it is
generally conceded that any class of service should be
handled if it pays what can be ascertained as its cost and
merely enough more to induce the railway to handle it, the
probabilities are that it would be best that the whole rate
should be apportioned according to the demand. The rates
would then vary upward from the lowest cost ascertainable
on any class of traffic to much higher rates on goods which
could bear the higher rates as well as the goods of less de-
mand could bear their low rates. And the difference be-
tween the differential rates so established and the particular
cost of the various elements of traffic would provide for
the costs which are strictly joint. The complete fair return
on the whole business would be made up, but the pressure
bearing equally on all would win a greater part of the burden
of the joint costs from the traffic which would be least af-.
fected by a high rate.

It would be exceedingly interesting to compare this theo-
retical view of the case with the actual rate situation in the
United States, but that would necessitate a work of greater
extent than what has already been attempted in these pages.
However, it is hazarded that the theory would fit the situa-
tion fairly closely. While the zone system would afford
spectacular examples of a more or less justifiable applica-
tion of the principle of setting certain portions of traffic
218 RAILWAY MONOPOLY—RATE REGULATION [218

aside as a class by themselves, the disturbing elements of
competition with outside carriers, such as waterways, by
their effect on the elasticity of demand for the traffic in ques-
tion, would correspond quite closely with this theory, and
the difficulties in regard to the different abilities of the var-
ious classes to bear the charges are provided for with as few
exceptions as is usually the case with any theory.
CONCLUSION

Tue thesis advanced in the beginning of this study was
that the railroad enterprise is properly a monopoly. Mo-
nopoly being generally considered to be an evil, the quest
has been to find principles upon which the railways may
be regulated to avert the evils of monopoly in our trans-
portation service. These evils are chiefly an unnecessary
maintenance of price and the consequent restriction of the
possible service. The undertaking has been to outline prin-
ciples of regulation upon which this price maintenance
and restriction of service may be minimized, and upon
which the rate-making basis may be made the ability of the
railroads to give the greatest and cheapest service possible
without violating their legitimate interests, instead of their
ability to win the greatest return for themselves.

An incidental principle has been brought out in the treat-
ment of this general question. It has been pointed out that
railway monopoly is not just a necessary evil to be toler-
ated lest we plunge into worse evils. Railway monopoly,
in so far as this means combination of control and financial
administration, is a positive social advantage beyond any
results which might be hoped for under a system of compe-
tition, even though competition were practicable in this en-
terprise. Under a competitive system, which might be im-
agined with the destructive effects eliminated, owing to the
necessary interrelation of the rates on all lines, the basis
for the rates would have to cover the lesser ability and
larger costs of many independent small lines. But under
the combination which rules under the monopoly system,

219] 219
220 RAILWAY MONOPOLY—RATE REGULATION  [220.

owing to the organic nature of the business and the mutual
helpfulness of the business on the various parts of the sys-
tems, the basis for the rates on a large system which would
include these weaker small lines would be the profitableness
of the whole system considered as a single unit. The re-
sulting rates would be considerably more moderate than if
raised to make profitable the business on each weak side line
considered by itself, as these were pushed independently
into new territory. The fact of concentration under monop-
oly has meant a great saving, a saving which in the long
run must work a great advantage to the interest of the
public as well as to that of the railways.

The only reason to fear monopoly in this sphere of our
economic life is that it may get so powerful as to be beyond
the power of public control, or that we may not be able to
work out principles and methods whereby we may keep
this line of investment on a parity with other investments,
having only its due share of the expansion and profits of the
country’s business. But the recent history of the question
should quiet our fears as to the impossibility of maintaining
the public control, provided we can work out the proper
principles of procedure; and these principles are not im-
possible of attainment. We can regulate the monopolies.

The need of applying regulation that will reduce the rates
and extend the service to the ability of the railways to sup-
ply the same is increased by the marked tendency of late
years for railroad business to depart from the sway of the
law of diminishing costs. Since the year 1906 the rail-
ways of the East have given evidence of comparative free-
dom from the operation of this law, and as this state of
affairs extends over the country, increasingly greater need
will be found for supplying by governmental authority the
incentive to keep the rates down and provide for expansion
of the traffic which formerly came in great measure from
the operation of this economic law.
221] CONCLUSION 221

The greatest difficulty in attempting to base rate regula-
tion on the ability of the railroads to serve comes from the
difficulty in determining which should be the marginal or
determining line. Under competition, as we ordinarily un-
derstand it, the determining margin is found by the en-
trance and exit of enterprises with the variations in demand
for the products of the business and the variation in ability
of the different enterprises to weather the storms of eco-
nomic life. But it is almost out of the question for a line
once established to be withdrawn from the business; the
right of way is condemned and the property ruined for
other uses. Fortunately we do not want a withdrawal from
the business. The need for railways is continually growing,
and we may expect it to grow as time goes on. The only
reason for railways being below the determining margin is
lack of foresight in establishing them where they are not
needed, or mismanagement. Lines so situated cannot be al-
lowed to determine rates for the transportation system at
large. If they cannot persist as organized under rates that
will be fair to other lines, they must be allowed to reor-
ganize on a new basis that will meet the conditions of the
country’s needs. But all lines which are placed with a view
to the needs of traffic and that have been carefully managed
must be allowed to earn a fair return, that they may keep
up their service and expand as the development of business
conditions warrants such expansion. The margin is an
ever-advancing margin, one that will keep pace with the
march of the traffic expansion that is continually going
on. And it is believed that this margin will advance to
meet the needs of traffic if a fair return be allowed on the
property already invested in carefully situated railway sys-
tems. This return is held to be sufficient when it allows a
sale of securities in the open market, in competition with
other enterprises, at rates which are proportional to the
222 RAILWAY MONOPOLY—RATE REGULATION — [222

amount of securities and the value of the property which
they represent. And the value of the property for rate-
making purposes, it has been maintained, should be rated on
the principle of the cost-of-reproduction-less-depreciation
for what has already been devoted to the business; but for
the future, dating from a valuation of existing property
on the above basis, all actual investment of capital should
be added to this established valuation, and the standard val-
uation of property should be this established valuation made
by the Federal commission plus such additions as will ac-
crue from increased investment. The argument is that, if
combination of the railroads be allowed, there will be no
need for the valuation to expand with the increasing value
of the surrounding property. The newly-purchased prop-
erty must be rated at the price necessary to obtain it, but the
old property does not need to follow such expanding values.

This is the principle of establishing whole-rate systems
on the cost of the service as a whole, though it differs more
or less from the widely variant views of the commissioners
who advocate the principle of cost. In addition to es-
tablishing the total-rate systems on the cost situation as a
whole, an attempt has been made to show how the individual
rates may be made to conform to such a system. The prin-
ciple advanced here is that the costs of the individual ser-
vices, in so far as they can be ascertained, and this is much
farther than some would allow, should be established as a
minimum for such rates; that the greater divisions of ser-
vices should have their contributions to the total cost di-
vided as far as possible on the basis of cost, but that the
rates on the minor divisions of the service should be dif-
ferentiated not only on the principle of cost but also on
the principle of demand, in order that the various divisions
of traffic may have an equal opportunity to expand ac-
cording to the elasticity of the demand for them. It is
223] CONCLUSION 223

hoped that in this manner the monopolies may be re-
strained from exercising the power ordinarily within the
reach of such favorably situated enterprises, that is,
the power to fix their prices so as to get as much
as possible out of their enterprise. The railroads are
the servants of the public, and while we want to be very
fair to them, we want the regulating principles to be such
that we may get the greatest possible service from them,
rather than they the greatest profit from us. It may be, it
probably will be, that we cannot thereby keep rates from
rising as the railroads expand, as their equipment grows
more crowded, and as their property includes more and
more of purchases made at greater prices. But it is to be
hoped that we may in such a way keep the rates down as
far as the ability of the roads to supply the service will al-
low. And this is as much as could be hoped for under a
system of government ownership or an ideal but imprac-
ticable system of competition.
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