Chapter 10 - Examples of Bilateral Oligopoly

Chapter 10

BALDWIN LOCOMOTIVE WORKS:  A HISTORICAL EXAMPLE OF BILATERAL OLIGOPOLY

Baldwin, the largest producer of steam locomotives in the nineteenth century, faced problems typical of a dominant company in a bilateral oligopolistic industry.  A highly cyclical, almost unpredictable competitive environment conditioned almost everything that happened at Baldwin.  A high level of business risk followed from sudden, large fluctuations in demand from railroad companies. This meant that Baldwin often had excess capacity with substantial fixed investment. There were few opportunities for 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. But the market radically changed with the introduction of the diesel-electric locomotive. Baldwin and other steam locomotive companies could not compete with the new technology and went bankrupt. 

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 cooperative, less confrontational labor relations policies than those of other large-scale employers like Carnegie Steel.

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.

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

Many transportation companies – companies that produce airplanes, ships, or railroad equipment – are similar to Baldwin. The American companies most similar to Baldwin are capital goods and information technology companies that sell large, complicated systems to other large corporations. Corporations that offer oil field equipment and services fit this category.

Strategies adopted by organizations such as financial software companies that build large, complex systems for large corporate customers, such as SAP or Oracle, are similar to Baldwin's. These companies start with offering complicated systems and then work with the to customize them to meet a company's particular requirements.

A suggestive line of inquiry might be the similarities between Baldwin’s strategies and those of Japanese companies in keiretsu supply chains to minimize risk, coordinate strategy, and maximize innovation in highly uncertain and changing environments.  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.

The New York Times Discovers Bilateral Oligopoly

On Sunday, November 1, 2015, The New York Times ran an editorial titled “How Mergers Damage the Economy.”

The article begins by citing an article in the Wall Street Journal summarizing a study done by two finance profs that estimate “nearly a third of American industries were highly concentrated in 2013, up from a quarter of all industries in 1996.” Much of the editorial mentions a few of the recent proposed large mergers and goes on to list the possible evils from large companies merging.

But why do large companies merge?  One reason the article gives, without naming the concept, is bilateral oligopoly.  To quote:

     Mergers tend to lead to more mergers.  In the health care industry, big insurers like Anthem and Aetna say they need to get bigger to have more leverage in negotiations with hospitals and doctor’s practices that have become bigger through acquisitions in recent years.

Anthem attempted to acquire Cigna ($48 billion) and Aetna attempted to acquire Humana ($38 billion).  There would have been only three large health insurance companies (UnitedHealth is the third). Both mergers were blocked by the Justice Department and the courts. Instead, insurance companies are buying or signing exclusive contracts with pharmacy benefits managers, hospital chains, clinics, and other health care providers. 

Even without mergers, the five largest health insurers cover over 130 million people, about half of Americans with health insurance. 

Pharmacies make the same argument.  Walgreen’s, the country’s largest pharmacy, wanted to buy Rite Aid, the country’s third largest pharmacy.  This is an industry that has seen massive consolidation over the last few decades.  Walgreen’s argument to the government is the same as the health insurers.  They have to get bigger to be in a stronger position when negotiating drug prices with the huge drug companies and pharmacy benefits managers. CVS, the second largest pharmacy chain, wants to take it a step further. They have proposed to acquire Aetna. If successful, they will combine a pharmacy, a health insurer, clinics, and a pharmacy benefits manager.

Every sector of the health care industry makes the same argument. Hospitals are merging into regional health systems which dominate local and regional markets. Physicians are also joining local and regional groups.  As any one part of the health care supply chain consolidates, partly through mergers and acquisitions, their suppliers and corporate customers feel pressures to also consolidate.  In game theory, this is called an “arms race.”

Health care providers are consolidating because over half of all health care costs are paid by various government programs. Prices are set by negotiations with the government, not by supply and demand. With third-party payment, ultimate consumers can demand high levels of health care with no or low out-of-pocket costs.    

Corporate managers may not believe in the economists’ quaint ideas about competition but they understand the advantages of market power, the power to influence prices.  They believe they have to gain market share not necessarily to be more competitive in their own industry but when dealing with their suppliers and customers in increasingly concentrated industries.  If not, they believe they will be forced during negotiations to accept lower prices and profits.

Mergers and acquisitions continue to be a major corporate strategy.

Mergers and acquisitions in the United States have averaged over $1 trillion a year in the last five years. Globally, mergers and acquisitions are over $3 trillion a year, creating larger and larger multinational corporations.

The government bailed out the entire financial sector (and General Motors) during the last recession.  Rather than breaking up the big financial firms, the government allowed (or forced) them to buy other large firms. The number of banking companies is rapidly declining; mergers and acquisitions are creating large regional banking corporations.  The banking industry is now more concentrated than before the financial crisis.  

The article really doesn’t make a strong case for “how mergers damage the economy.”  Maybe the “damage” isn’t so great because of the “countervailing power” (a phrase from John Kenneth Galbraith, used in a different context) of a small number of large companies on both sides of a bilateral oligopolistic market. But health care mergers across industry lines, creating dominant companies in local or regional markets, reduces the "countervailing power" effect.

===========================================================

For the concept of bilateral oligopoly, see Chapter 8 - Bilateral Oligopoly.