Activity 5: A Question of Trust

Lesson Overview

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Virtual Lesson Modifcation & Slides

The purpose of “A Question of Trust” is to let students simulate the origins of the era of trusts in American economic history.  Acting as “captains of industry” they, too, will try to create monopoly power within their classroom oil industry.  Their experience will challenge the common belief that the era of trust formation was evidence that Adam Smith’s analysis of capitalism was flawed.  Students will discover for themselves that  trusts were actually an affirmation of Smith’s  theory that, in the absence of coercion, an “invisible hand” regulates the market in the interests of the consumer.  The incentive of profit was, in fact, so strong that efforts to create voluntary collusion inevitably failed in post-Civil War America.  Businessmen turned to the trust as a way to escape competition and enforce the collusive activities that the quest for profit had consistently undermined.

The three parts of “A Question of Trust” simulate three stages in 19^th century United States economic history and three different efforts by business to escape the constraints of competition. The first stage was characterized by direct attempts to avoid the effects of competition by collusion – through pooling and so-called “gentlemen’s agreements.”  As students will discover, and as history confirms, such efforts were doomed to failure because the lure of profit created overwhelming incentives to “cheat” on the agreements. Popular perception of the history of the railroads is rife with examples of robber barons in smoke-filled rooms scheming to victimize the consumer through pooling and rate-setting.  Less well understood, however, is the reality that such agreements were invariably undermined by the lure of profit.  A careful examination of the era of trusts reveals that the battle for profits was not between rapacious producers and helpless consumers, but among producers themselves.

Once they experience the difficulties of collusion in a competitive environment, students are better able to appreciate the lure of the trust organization for businessmen.  Rockoff and Walton describe the trust as follows:  “Under a trust agreement, the stockholders of several operating companies formerly in competition with one another turned over their shares to a group of trustees and received ‘certificates of trust’ in exchange.  The trustees therefore had voting control of the operating companies, and the former stockholders received dividends on their trust certificates.”(p. 385)  Why would anyone willingly turn over his stock to someone else’s control?  The trust provided the mechanism by which colluders could be prevented from “cheating” on the cartel.   History leaves us no doubt as to the success of the trust in centralizing business and securing monopolistic profit levels.  By the 1880s, trusts had been formed in many of the major industries in the United States.  However, as public knowledge and understanding of the purpose and effect of trusts grew, the demand for reform gathered steam.  The 1890 Sherman Anti-Trust Act was only the first in a series of laws designed to prevent trust-type agreements and re-establish a more competitive environment.

Video Demonstration:

Content Standards addressed:

History Standards (from National Standards for History by the National Center for History in the Schools)

Era 6:  The Development of the Industrial United States (1870-1900)

Standard 1:  How the rise of corporations, heavy industry, and mechanized farming transformed the American people.

1A:  The student understands the connections among industrialization, the advent of the modern corporation, and material well-being.

Therefore, the student is able to  Explain how business leaders sought to limit competition and maximize profits in the late 19^th century.

 Economics Standards (from Voluntary National Content Standards in Economics)

Standard 4:  People respond predictably to positive and negative incentives.

• Acting as consumers, producers, workers, savers, investors, and citizens, people respond to incentives in order to allocate their scarce resources in ways that provide the highest possible returns to them.

Standard 9:  Competition among sellers lowers costs and prices, and encourages producers to produce more of what consumers are willing and able to buy.  Competition among buyers increases prices and allocates goods and services to those people who are willing and able to pay the most for them.

• Collusion among buyers or sellers reduces the level of competition in a market.  Collusion is more difficult in markets with large numbers of buyers and sellers.

 Teacher Background

A major theme in the history of post-Civil War America is the concentration of business. Larger size had the advantage in many industries of increasing efficiency and lowering cost, but there is also evidence that businessmen were consciously trying to amass monopoly power, to free themselves from the constraints of competition.  While attempts to stifle competition were met by legal roadblocks, the trend toward bigness in industry continued.  That does not mean, however, that big business effectively escaped the “invisible hand” of competition.  Neither does it mean that Populist and Progressive government efforts to control business through the Interstate Commerce Act, the Sherman Anti-trust Act and its successors were responsible for the competitive atmosphere that exists today.  In fact, it was the changing nature of the competition that accompanied economic growth that eventually undermined the efforts of would-be monopolists.  As economic historians Hugh Rockoff and Gary Walton note in their History of the American Economy, “. . . the one great pre-1920 experiment in social control of business achieved little.  By the time a vigorous enforcement of the antitrust laws was undertaken late in the 1930s, it was too late to do much about the problem of bigness in industry.  But by then, it was clear that a kind of competition not envisioned by the framers of the Sherman Act protected consumers.  The fall in communication and transportation costs wedded regional markets into national and international markets, thereby reducing local monopoly powers.”  (p. 395)

The history of John D. Rockefeller’s Standard Oil exemplifies the changes in American business.  The petroleum industry began in the 1860s and was characterized by numerous small businesses.  In 1863, there were 300 petroleum companies in the U.S. and still almost 150 companies by 1870.  As one would expect, the industry was extremely competitive and was plagued by overproduction.  Some economic historians have estimated that in the early 1870s American petroleum firms had the capacity to produce about 12 million barrels, about twice the amount of crude oil they received and twice the amount of petroleum sold at the market price of approximately $4/barrel.  Not surprising in such a competitive atmosphere, attempts to collude were unsuccessful and the rate of business failure was very high. Standard Oil, formed in 1869, was efficient, well-managed and well-capitalized.  As a result, it was able to acquire and absorb many small refineries.  Increasing size allowed Rockefeller a favorable position with the railroads, which offered rebates, further cutting his costs and increasing his competitive edge. By 1878, Standard Oil controlled about 90% of U.S. refining capacity.

Even this size did not make Rockefeller feel immune to the effects of competition, and in 1879, he entered an agreement in which three trustees began to manage the properties of Standard Oil of Ohio.  In 1882, the trust was expanded to include 40 companies, the value of the properties placed in trust set at $70 million.  Even after successfully absorbing most of the existing competitors, Rockefeller sought escape from competition in the formation of a trust, and the oil trust he set up remained highly effective until forced to dissolve by the supreme court of Ohio in 1892.

The third (and optional) part of the activity introduces students to the impact of a late 19^th century / early 20^th century development that paralleled the rise and fall of the trust – the movement toward government regulation of particular industries.  Students discover that government efforts to stabilize industries by setting “fair” prices fail because they inevitably result in overproduction, leading to the need for further regulation to restrict levels of production (which then results in the high prices and short supply we fear from monopoly).  The optional round of the activity also sets the stage for student study of the 20^th century phenomenon of industries “capturing” the regulators.  While historical evidence suggests that the earliest regulator, the Interstate Commerce Commission (ICC), was successful in securing benefits for the users of railroads – the shippers and passengers – more recent examples show its propensity to reflect and promote the interests of producers at the expense of consumers.  Such capture is characteristic of 20^th century regulatory efforts.  Public utilities, airlines, and trucking enterprises offer more contemporary examples of regulatory commissions filled with people whose background and knowledge base made them sympathetic to the industries they regulated.   Industries’ ability to use the regulatory process for their own benefit was further increased as the representatives of industry became more adept in “clothing in the public interest” their arguments for rate increases or supply restrictions.  Perhaps the most pointed evidence of this phenomenon is in recognizing that the protests against deregulation and calls for re-regulation come most often from the affected industries themselves.

(Source:  Walton, Gary M. and Hugh Rockoff.  History of the American Economy.  Fort Worth:  The Dryden Press, 1998.)

Activity Guide

Key Concepts:

Incentives

Profit

Market power / monopoly

Competition

Materials:

Company Balance Sheet-1 per team

Production decision cards-40 to 50 cards per game

Production decision worksheet-1 per student

Demand Forecast (overhead transparency)

Market Demand (actual)  (overhead transparencies, 1 each of 3)

Production tally (overhead transparency)

Prizes for $300 companies (candy)

Grand prize for the most profit

Procedures:

1. Form 6 companies of 4-6 students.  (If necessary, increase the company size, but do not increase the number of companies.)  Explain that all are oil companies, selling their products in the same market.  Mention that, while there are certainly others who are capable of making a large investment and entering the market, at this point in time there are only 6 companies who do all of the petroleum business nationwide.
   • The goal of each company is to make as much profit as possible.
   • There will be prizes for all companies earning more than $300 profit and an additional prize for the company that earns the most profit.
2. Distribute a Company Balance sheet to each team. (Students may be allowed to name their companies, or you can assign them numbers 1 through 6.  Direct them to enter the team name or number at the top of the balance sheet.)  Direct students’ attention to the beginning balance for their team. This is the money they have to start production.  The beginning balance for each team is $150.  (Teacher note: In reality, of course, company size varies, but students tend to interpret different balances as a manipulation of the activity by the teacher.  Start with a uniform balance and discuss the impact of varying size in the debriefing.)  In each round of the game, students must decide how much to produce, knowing that production costs will be subtracted from the company’s account balance.  Any revenue made from the sale of the units produced will be added to the company’s account balance.
   • In each round of the game, each firm must decide how much to produce.  In making their decisions, teams should consider:
     • the cost of production – $30/unit,
     • the amount of money they have on hand (production costs must be paid up front); and
     • the anticipated demand for the product.
   • Decisions must be made on the basis of consensus.
3. Display the Demand Forecast overhead and explain that it represents the best available information, based on past experience and knowledge of current conditions, about the amount of oil that consumers are willing to buy at various prices.  While there is no guarantee that actual demand will be exactly the same as the forecast, the forecasts have been highly reliable in the past.
   • Distribute the Production Decision Worksheet and use the overhead transparency to guide the class through the problems.  (Answers: $90,$75, $225, $115, $140, $70 loss)
   • (Teacher Note: Resist the temptation to skip this step.  Don’t assume that because you have good math students, they’ll figure it out.  It’s not the arithmetic, but the vocabulary of the procedure they need to practice.  Doing the worksheet at the beginning allows students to concentrate on decision-making during the simulation.)
4. Distribute a Production Decision Card to each company. (Company names can be entered on the blank line of the card.) Remind students that the goal is to have the biggest balance at the end of the game, and that they must have at least $300 to earn any prize.  (Teacher note:  Do NOT tell them how many rounds will be played,  as this knowledge changes the strategy necessary to win.)  Leave the Demand Forecast transparency on the overhead.
   • Allow companies time to discuss the problem and determine the amount they wish to produce in Round 1.  Announce that there is to be no communication among teams.
   • When a decision has been reached, the company records on the Production Decision Card the number produced. Collect the cards and tally the total production on the board or overhead.
   • Remind companies to subtract the total production cost from their balance sheets.
5. Display one of the Market Demand overheads (choose randomly).  Total the production for all companies, and read the market clearing price from the Market Demand schedule.
6. Instruct students to multiply the number produced by the market price and add the revenue to their company balance.  Instruct teams to figure out how much profit they made and to consider strategy for round 2.
7.  Distribute new Production Decision Cards and play round 2 using the same procedures as in Round 1.  Again, allow no communication among teams.
8. Before beginning Round 3 announce that there will be a social/business gathering at the home of the president of company #2 and that each company is invited to send a guest.  (It will probably not be necessary to coax students into sending someone to the meeting, as many will have figured out the advantage of collaboration.  However, if some companies seem uninterested, simply say that in the early history of U.S. economy there were businessmen from competing companies were not restricted from talking business among themselves.)
9. After the “social gathering” (about 3-5 minutes), direct representatives to return to their companies.  Stop all communication between companies. (Teacher note:  The reason for stopping communication is to prevent coercion.  If students have made an agreement to limit production, they may try to “enforce” the agreement by sending company members to monitor the actions of other companies and to threaten or use persuasion to enforce the agreement.  It is a better approximation of reality if they do not have access to the deliberations of other companies.)  Distribute the Production Decision Cards and proceed with Round 3.
10. Decide whether or not to play a 4^th round.  (Teacher note:  Monitor students’ reactions to determine how many rounds of the game to play.  It is only necessary to play long enough to get collusion and then breakdown of the collusive agreement.  For example, students should see the advantage of collusion by round 3.  If, however, you feel that they are still exploring options, play the third round without collaboration and set the social gathering before round 4.  Similarly, be aware of student response in the rounds after the social gathering.  If students do not collude as a result of collaboration, do some debriefing after the payout in that round.  Then allow collaboration in the next round.  If students agree to restrict supply and all companies uphold the agreement, proceed with another round until a team or teams discover the advantage of not restricting supply when all other companies have agreed to do so.)
11. Call a time-out, promising to continue the game in a few minutes.  Discuss the following questions with the class as a whole:
    • What was the strategy of the team that made the most money?
    • Which team made the least?  What was your strategy and why did it fail?
    • Did it help to talk with other teams?  Why? How did you decide how much to produce?
    • Why did you agree to set production levels?  What was the impact on the market of such an agreement?  What was the impact on your profit?
      • This is an important opportunity to reinforce to students that producers do NOT set prices; the market does.  The only way that producers can impact the price is to limit production.  Students should answer that setting production levels kept the price high.  The result of limiting production is that only the consumers willing to pay the higher prices will get the product.  The result for the producers is a greater level of profit on each unit produced.
    • Did agreeing to set production levels work?  Why?  Why not?
      • It probably didn’t work – in the sense that the incentives were such that the agreements broke down.  For any single producer, there is overwhelming temptation to produce more when everyone else has agreed to produce fewer.  Of course, all producers face the same temptation and the usual result is that everyone produces more and the price falls.  IF, however, the agreement to reduce production could be enforced, it would result in higher prices and profits.
    • How did the profit motive, the desire of companies to make profit, act as an incentive?  What behaviors did this incentive encourage?
      • The profit motive encouraged the production of additional units at the higher price.  Thus, it isn’t surprising that many producers “cheated” on the gentlemen’s agreement to limit the amount produced.
    • How does the creation of a cartel affect consumers – both in terms of product availability and in terms of price?
      • An effective cartel makes less of the product available to consumers and causes consumers to pay higher prices.  (Note that the operative word here is “effective.”  In the absence of an enforcement mechanism, most cartels are not effective beyond the very short term.)
    • Predict what happens- in the short run and in the long run – in markets that do NOT prohibit collusion among producers.
      • If collusion is not prohibited, producers will be drawn to the practice.  In the short run, this will lead to restricted production and higher prices.  In the long run, the profit incentive will cause the collusive agreement to collapse and greater production and lower prices will result.
12. Return to the game.  Announce that we will “start over” and each company will, again, have a $150 starting balance.  Distribute a new Production Decision Card to each team and display the demand forecast on the overhead.  Ask students from companies that are not faring well, or from companies that tried to uphold the collusive agreement, how they feel about the actions of the other companies.  Since the agreements on output were violated by one or more teams, there will likely be accusations of  “cheater,” “back stabber,” and “liar.”  Explain that the history of “gentlemen’s agreements,” as they were called, is exactly what they experienced in earlier rounds of the game.  Turns out that the “gentlemen,” motivated by profit, weren’t always so gentlemanly.
    • Point out that no company, at this point, has earned the $300 profit necessary for the prize.
    • Appoint a vocal member of one of the companies to host an “industry discussion” of the best way for them to deal with this problem of low profits.  (Remember that until the later part of the 19^th century, it was not illegal for companies to collude.)
13. After the industry discussion, allow companies to meet briefly to determine who will attend the next social/business dinner.
14. Announce the social/business dinner and invite representatives to the front of the room.  When representatives arrive at the dinner, deliver the trust proposal telegram and have one of the representatives read it aloud.  Allow representatives to discuss the proposal briefly and then send them back to their companies to discuss whether or not they want to join the trust.
    • Note:  It is important that students not regard the telegram as a hoax or an attempt to trick them.  Assure them that the offer is genuine and that the gentlemen making the offer are known and respected businessmen.
15. If the company decides to join the trust, the production decision card is exchanged for one of the green  trust certificates.
16. Display the demand forecast and play another round of the activity.
    • If all companies have joined the trust, simply announce that the trustee has decided that each company will produce one unit, resulting in a price of $125/unit.
    • Instruct each company to subtract $30 production cost and add $125 revenue.
    • Ask each company to decide whether or not they want to stay in the trust.
    • Continue enough rounds that all companies reach the $300 profit level and earn one of the “prizes” (candy).
    • If one or two companies decide not to join the trust, ask them to fill in their production decision cards and turn them in before you announce the decision of the trustee.
      • Announce that the trust has decided to produce only X units in this round. (To find X add the number of units produced by the non-trust companies and subtract it from 42 – the number of units necessary to drop the price to $25/unit.) Further, announce that because of the advantages of operating as a trust , they’ve been able to reduce production cost to $25/unit.  In order to sell what they’ve produced, the other companies must meet this price.  (Note that the price is below production cost and will result in a loss for all non-trust companies.)
      • Instruct each trust company that they may just transfer their balance from the previous round to this round because the cost of production and the selling price are equal so no profit or loss is made.
      • Instruct each non-trust company to subtract $30 for each unit produced and add $25 for each unit sold.
      • There are several options at this point.  You may offer the non-trust companies the opportunity to join the trust before the next round, or you may announce that the process of undercutting will continue and the non-trust companies are put out of business.  Once you have only trust companies left, you may continue to play rounds until all companies reach the $300 “prize’ level.
    • If most of the companies choose not to join the trust, you may use this example in the debriefing to show how difficult it is to get competitors to join together to collude – reinforcing Adam Smith’s theories on the power of competition.  At the time of the activity, however, ask several of the companies to join the cartel just for the purposes of the lesson and then play out the simulation as indicated above.
17. Discuss:
    • How did the efforts to collude in this round compare to those of earlier rounds? The efforts to collude were successful.  Profits were assured and the group was able to control supply so as to achieve the greatest profit margin.
    • Why were you able to maintain the collusive agreement in this round? In effect, the creation of a trust provides a way to “enforce” a collusive agreement.  When stock certificates were exchanged for trust certificates, the trustees controlled the votes of all the companies whose stock they held.  They could conduct business as if there were one company instead of many.  They didn’t have to worry about anyone breaking the agreement, or “cheating,” because no one was able to do so as long as the trustees held controlling shares of stock.
    • Explain to students that the previous round of the game helps us understand the rise of trusts in the late 19^th century.  When businessmen discovered that their gentlemen’s agreements didn’t hold up, they developed the trust – a method of doing business that allowed them to enforce the collusion that created monopoly power.  A trust was created when the owners of stock in competing companies handed over their stock to a group of trustees and received certificates of trust in return.  The trustees, now in control of the stock of all the formerly competing companies, ran them as if they were one company – a monopoly.  In return, the holders of the trust certificates received a share of the dividends.  Trusts were very profitable because they successfully centralized control of entire industries, and by the 1880s the production of many, many products – including sugar, meat, whiskey, lead, salt, rubber, and kerosene to name a few examples – was controlled by trusts.
    • What’s different about the trust relationship necessary to uphold a gentlemen’s agreement or pool, and the trust relationship necessary to maintain a successful 19^th century trust?  There was no ability to enforce a gentlemen’s agreement.  Peer pressure or a sense of honor or commitment to other men (who were, in fact, your competitors) was the only thing holding the agreement together.  It proved to be very weak glue – especially in face of the lure of additional profits.  The trust agreement turned competitors into partners, and removed the possibility that one partner could cheat the others.  It was certainly easier to “trust” in that situation; there was no risk.
    • If collusion wasn’t illegal, why did businessmen have to resort to use of the trust in order to gain market power? Because the possibility of earning additional profits by cheating on the trust agreement proved to be an extremely powerful incentive.
    • By what means did trusts maintain high profits in an industry?  (Teacher note:  It is important that students realize that trusts did not  have the power to “set” prices.  They caused increases in prices, and therefore profit, by restricting output.)
    • Note:  If you are ending the activity at this point, don’t forget to distribute prizes to the teams that earned them.
18. (Optional) Distribute another Production Decision Card.  Announce that the passage of the Sherman Anti-trust Act has made the trust form of business organization illegal.
    • Solicit reactions from the businesses.
    • Ask for predictions about levels of output, prices, and profit.
    • Suppose the industry included companies of various sizes.  On which companies would the new legislation have the greatest impact – the big companies or the smaller companies?  Why?
    • How should the companies deal with this change?  How can we make the business environment “fair?”
    • Announce that in the interest of fairness and compassion, you have decided to set up a commission to oversee the industry and make decisions for the good of the whole. The commission has decided to set a “fair” price but to leave up to the businesses the decisions about the amount to produce.  Announce that since you understand that there are costs in the production of oil, you want to set a price that allows everyone to stay in business.  Solicit suggestions for the price. (Ultimately, set the price at the target price they were trying to achieve in their earlier collaboration.)
    • (At this point some students may point out that with the price set but no restriction on quantity there is still an incentive for teams to produce more and that there will be over production.  If students make this observation, acknowledge their suggestion and say that we’ll use this round to test their hypothesis.)
19. Collect the Production Decision Cards, noting on the back of the cards the order in which they were turned in.
    • When all cards have been collected, direct companies to subtract their production costs from their balance sheets.
    • Display the demand schedule on the overhead, pointing out the number that will be purchased at the fixed price.
    • Note that the units will be sold in the order they were produced, until the market quantity is met.  Determine which companies earned revenue and how much.  Direct them to add any revenue earned to their balance sheets.
20. Discuss:
    • Does the setting of “fair” prices by the government help or hurt the businesses?  Explain.  (Setting prices by government commission helps some businesses, but only those that are able to sell their product at the set price, not all businesses in the industry.  Prices set above the market price generate overproduction because they send the wrong signals to producers.)
    • In order to ensure levels of profit that stabilize the industry and allow all the producers to remain in business, what must the government commission do? (The important point here is that to control price you must also control the quantity produced or there will be over production.  Thus any regulating agency or body will have to pay attention to both aspects, price and quantity to stabilize the situation.)
    • Based on what you saw in the activity, do you think consumers are better off when the government regulates markets and trade? (Consumers are hurt because many who would buy the product at a lower price are unable to do so.  In addition, resources that could have been used to produce other things that consumers want are being wasted on the overproduction of the set price product.)
21. At this point the teacher should revert to the last round that there was no intervention and ask which teams made over $300 and which team made the largest profit.  Distribute any prizes to teams that earned $300 at some point in the game.

Debriefing – Teacher Guide:

Tie the activity into the history of business concentration in the 19^th century.

1. What was the incentive for the business collusion that arose in the 19^th century?  The incentive was profit and the realization that higher levels of profit could be earned by restricting output.
2. Why were pools and gentlemen’s agreements generally unsuccessful? They were unsuccessful, ironically, for the very reason they were created.  The lure of profit – and the greater profit that could be made by producing more when other cartel members produced less – virtually guaranteed that such agreements, because they had no enforcement mechanism, would break down.
3. Why did business turn to the trust form of organization and how did that form solve the problem that pools and gentlemen’s agreements couldn’t solve?Business turned to trusts as a way to enforce the gentlemen’s agreements.  Once a trust was formed, individual owners no longer had the ability to “cheat” by producing more than the agreed-upon amount.
4. The rise of trusts has been used as an example of the failures of capitalism.  Make an argument that the rise of trusts supports Adam Smith’s contention that an “invisible hand” prevents the concentration of market power. Adam Smith never said that businessmen were “good guys.”  In fact, he clearly stated that they would try to collude.  His insight was in seeing that the market system, with its built-in incentive of profit, would cause the collusive agreements to collapse.  Trusts arose because attempts by late 19^th century businessmen to collude invariably failed.  In creating trusts – a legal mechanism to enforce restrictions on production – businessmen were in fact acknowledging the validity of Smith’s insight.
5. The outlawing of trusts coincided with the increased use of government regulatory commissions.  Based on the activity you experienced, predict:  When is the call for government regulation likely to come from consumers? When is the call for government regulation likely to come from competing businesses? Consumers are likely to call for regulation when the possibilities for informal collusion are greatest – when there are fewer producers, for example.  Producers are likely to call for regulation when the possibilities for informal collusion are fewest – when there are many producers or the industry is highly competitive.  In such situations, producers may find it easier to “capture” the regulator than to deal with the competitive pressures within the industry.
6. If you owned a business in a highly competitive industry, would it be to your advantage or disadvantage to have a government regulatory commission?  Who would you want to sit on the commission? Evidence suggests that highly competitive industries welcome (and even invite) regulation, seeing it as an advantage.  They want on the commission people who are knowledgeable about the conditions of the industry.  The prevalence of former industry people on such commissions tends to mean that they are not only understanding of but also sympathetic to the problems of that industry.