Joseph Schumpeter, one of the leading economists of the early twentieth century, argued that many midwestern railroad projects “meant building ahead of demand in the boldest sense of the phrase” and that “Middle Western and Western projects could not be expected to pay for themselves within a period such as most investors care to envisage” (Fishlow 1965, 165-167). The implication of Schumpeter’s argument was that government aid to the railroads was necessary to open the West.
Schumpeter’s argument was a conjecture based on common sense. Albert Fishlow specified and tested the Schumpeter thesis rigorously, drawing the praise of fellow economists (Fogel 1967, 296; Desai 1968, 12). Fishlow reasoned that if railroads were built in unsettled regions, the demand for the railroad’s services must have been low initially, with prices below average costs. As settlement occurred, the demand curve would shift upward so that average revenues would eventually exceed average costs. This provided him with three tests: (1) government aid should be widespread; (2) profit rates initially should be less than profit rates in alternative investments and should grow as the railroad aged; and (3) the number of people living near the railroad should initially be low compared with the number living near eastern railroads. On all three tests, Fishlow’s findings failed to support Schumpeter’s assertion that the railroads were built ahead of demand. Government aid to the railroads was often minimal, directed simply at getting a railroad already under construction to go through one town rather than another. Profit rates often started out relatively high and then fell over time. And the number of people living near the railroads when they began operations was typically similar to the number living near railroads in eastern rural areas. (Economic Reasoning Proposition 5, evidence matters, often because it contradicts what appears to be “common sense.”)
What could explain such a paradoxical result? After all, it seems self-evident that farmers wouldn’t move into an area before the railroads and that railroads couldn’t be built until the farmers were in place. How could the market coordinate economic development in the Midwest? Fishlow discovered what he called “anticipatory settlement.” Farmers and businessmen were well informed about the new territories being opened up by the railroads. They moved into a region, cleared the land, planted crops, and opened up ancillary businesses while a railroad was being constructed. By the time it was completed, crops were waiting to go to market. Fishlow concluded, however, that “a similar set of criteria casually applied to post-Civil War railroad construction in states farther West suggest that this constituted a true episode of ‘building before demand”’ (1965, 204).
The work to determine whether or not Fishlow’s tentative answer was right about the post-Civil War’s transcontinentals was done by Robert Fogel (1960) and Lloyd Mercer (1974).87 Using Fishlow’s criteria, they showed that indeed, the railroads were built ahead of demand; they had relatively low initial profit rates, and their profit rates grew over time. Finally, Fogel and Mercer tested for another interpretation of the notion of the railroads being built ahead of demand. Did the transcontinentals eventually earn high enough profit rates on operations to justify private investment without government subsidy? Alternatively stated, was their average rate of return (excluding revenues from land sales) over several decades above or below average rates of return on alternative investments? Mercer’s findings showed mixed results. The Central Pacific and the Union Pacific (which formed the first transcontinentals) and the Great Northern (the last) had private rates of return above rates on alternative investments in the long run. Had private investors anticipated this result, they would have been willing to finance the railroads without government assistance. Three others—the Texas and Pacific, the Santa Fe, and the Northern Pacific—did not. These findings show that the postbellum transcontinentals were all built ahead of demand, in the sense that initial profits were low. The necessity of government subsidies for the three high profit railroads could be questioned, because in the long run, these railroads made enough extra profits to compensate investors for their low early returns.
World History
