A Historical Example of Bilateral Oligopoly: Baldwin Locomotive Works

Baldwin Locomotive













Baldwin, the largest producer of steam locomotives in the                 nineteenth century, faced problems typical of a dominant company in a bilateral oligopolistic industry.  Almost everything that               happened at Baldwin was conditioned by a highly cyclical, almost   unpredictable competitive environment.  A high level of business       risk followed from sudden, large fluctuations in demand. This         meant that Baldwin often had excess capacity with substantial         fixed investment, leading to a strategy based on economies of scope and not economies of scale.  Baldwin also depended on a skilled       labor force with firm-specific knowledge and experience that was    exposed to sudden and massive layoffs followed by the company’s   attempts to rehire the same workers.  It is hard to imagine a more    challenging competitive environment.                                                    

Baldwin was a large and dominant firm, accounting for approximately one-third of all steam locomotive production.  The buy side of the market was dominated by a small and increasingly concentrated number of railroad companies, which were some of the largest corporations in America in the nineteenth century.  The sources of market power of the locomotive builders were their specialization and flexibility in production, although some of the larger railroads - Baldwin’s largest customers - also built locomotives in their own machine shops.  The sources of market power of the railroads were their large purchasing power, technical knowledge of their “master mechanics” who ordered equipment, and knowledge of the optimal mix of equipment for their particular company.  In such an environment, Baldwin had market power because of its size and assembly expertise, but never enjoyed the market control of a mass producer of standardized products.  Market power based on marketing to final consumers was not feasible; railroad customers did not demand that railroads use Baldwin engines.

Every large railroad developed its own specifications and demanded customized equipment from Baldwin.  In addition, there was continuous technological improvement of the basic steam locomotive, often innovated by railroad technical staff.  As a consequence, Baldwin could never control the pace of design change.  The company could not totally incorporate mass production techniques because of constantly-changing customized design and finish.  On the other hand, by working closely with its customers over a long period of time, Baldwin probably had lower transaction costs than if its sales were arms-length market transactions.

This mutual dependence, along with railroads’ credible threat of internal production, usually gave the railroads a bargaining advantage when negotiating design customization and price with Baldwin.  But working closely with its largest customers, particularly the Pennsylvania Railroad, also increased the probability of Baldwin’s long-run survival. 

This symbiotic relationship between steam locomotive builders and the railroads worked as long there was no fundamental innovation in engine design and both sides benefited from continuous improvement in the steam locomotive.   The bilateral relationship would be much different in the later market for diesel engines in which General Motors controlled the technology and forced railroads to buy standardized products.

Baldwin’s management objectives were to minimize risk and maximize operating flexibility by sharing risk with suppliers through subcontracting out much of its parts production.  Since production was to order, Baldwin managed a “just-in-time” parts inventory system that minimized working capital requirements. When times were bad, Baldwin could delay payment to its suppliers and thus use them as a major source of working capital.  This was one way the company dealt with severe cash flow problems in economic downturns.

The company countered the potential loss of skilled workers after massive layoffs with high wages, skill development through apprenticeship training for employees and sons of employees, and the hope of higher income for long-term employees through a system of internal promotion and inside contracting.  Inside contracting, usually managed by long-term employees, put pressure on contractors to keep labor costs down.  This led to much more cooperative, less confrontational labor relations policies than those of other large-scale employers like Carnegie Steel.

Horace L.Arnold - "Modern Machine-Shop Economics." in Engineering Magazine, 11. 1896

Because of the complex nature of its production, Baldwin needed sophisticated internal systems to keep track of parts, subassemblies, and final production schedules.  The company substituted detailed cost and internal job flow information for management control bureaucracies.  While Baldwin did little internal product development, it was very quick in applying advances in product design and production technology.  But the company never “bet the ranch” on internal development of a radically new design of steam locomotives.

The long-term success of Baldwin, under highly uncertain market conditions, raises the issue of the limitations of the multidivisional form of organization.  Multidivisional corporations often do not stay focused on production of key product lines and the development of core competencies.  Rather, they are prone to the danger of more diversification than they can efficiently manage, with the related danger of diseconomies of scale.

When diesel locomotives became less expensive to operate and maintain than steam locomotives, Baldwin tried to adjust but its technology and skill base was too specialized to adopt the new technology.  Baldwin did innovate, designing and producing more powerful and efficient steam engines.  But to no avail.  Baldwin was doomed, another victim of “creative destruction.”

COMPANIES SIMILAR TO BALDWIN

A suggestive line of inquiry might be the similarities between Baldwin’s strategies and those of Japanese companies to minimize risk and maximize innovation in a highly uncertain and changing environment. Large Japanese companies followed similar strategies in the early phases of their industry growth. A big difference was that zaibatsu risk was reduced by the actions of the Japanese government and related financial institutions.

Probably the current companies most similar to Baldwin are capital goods companies that sell large, complicated systems.  Another suggestive analogy might be the similar strategies adopted by organizations such as financial software companies that build large, complex systems, such as SAP or Oracle. Any company that relies on employees with firm-specific skills and experience, including knowledge of the requirements of large customers, face many of the challenges that Baldwin did.



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