David R. Henderson  

Rockefeller's Railroad Rebates

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I had always wondered why John D. Rockefeller would get rebates on railroad shipments, not of his own oil--that I understand--but of his competitors' oil. Such rebates were called "drawbacks." Here's the answer that Michael Reksulak and William F. Shughart II propose in "Of Rebates and Drawbacks: The Standard Oil (N.J.) Company and the Railroads," Review of Industrial Organization (2011) 38:267-283.

The rebates that were granted to Standard Oil were not garden-variety quantity discounts routinely extended to a customer whose business reduced the railroads' costs of preparing bills of lading, submitting invoices, and collecting payments. As emphasized earlier, Rockefeller undertook on his own account myriad investments that benefitted the railroads directly; rebates represented one way of compensating Standard Oil for value given. Drawbacks, on the other hand, seem to be a different story. Why should
Standard Oil be paid a mutually agreeable sum for every barrel of oil shipped on the same railroad by its competitors? One answer is that by helping to reduce the average cost of rail transportation in the ways we have documented, Rockefeller conferred a positive externality on his rivals, reducing the railroads' average cost of handling their shipments as well. Drawbacks were a way for the railroads to share those gains with the company that was responsible for them. Moreover, given that it was a common practice for all shippers to exploit a rebate that had been granted by one railroad to "shop around" for an even larger discount off the published tariff from another, drawbacks plausibly also had the advantage of being more difficult for competitors to discover and use as bargaining leverage.

This last sentence explains why Rockefeller would want "drawbacks" but not why the railroads would grant them. It's true that the railroads wouldn't want the shippers "shopping around," but hiding rebates granted to Rockefeller wouldn't have changed that. The way to prevent shippers from shopping around is to refuse to grant rebates and make that known, which, I gather from the article, is what the railroads were doing. So the drawbacks are a separate issue. The previous part of the quote above--about internalizing a positive externality--is clever and plausible but I'm not fully convinced. What do you think? Not just your bottom line but your reasoning that gets you to that bottom line.


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david writes:

The answer is in the "moreover" bit - the option of secret defection normally undermines price collusion. There is always at least one party besides the defecting seller that knows the secret price defection, namely the buyer, but normally the buyer's interest is in lower prices.

So the buyer cannot be relied on to enforce the collusion agreement - unless he is given a stake in the supernormal profit generated (notice then that this buyer obviously can't be asked to pay the colluded price - only other non-enforcing buyers do).

Hence the secret rebates (which allow Rockefeller to avoid the colluded prices) and then the drawbacks (which align his incentives with the joint colluding entity).

Notice that because the size of the rebate and the drawback was exactly the same, Rockefeller could ship oil from different company names for the same price. He could thus use his infamous network of bogus independent companies and still accrue the same incentive payment, so the railroads could not defect by trying to offer non-monitoring buyers different prices. They would not know which one was Rockefeller's, and Rockefeller would not need to tell them, since SIC received all the payments anyway.

It's ingenious.

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