13-2-1 READING REPORT TEMPLATEQuestion 1What are t.docx

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3-2-1 READING REPORT TEMPLATE
Question 1
What are the 3 most important concepts, ideas or issues in the
reading?
Briefly explain why you chose them.
Question 2
What are the 2 concepts, ideas or issues in the article that you
are having the most difficulty understanding, or that are missing
but should have been included?
Briefly explain what you did to correct the situation (e.g.
looked up an unfamiliar word or a missing fact), and the result.
Question 3
If you could ask the author1 question, what would it be?
Why is this question important?
Lightly adapted from a Purposeful Reading Report by Geraldine

Van Gyn
The Timing of Railway Construction on the Canadian Prairies
Author(s): Frank D. Lewis and David R. Robinson
Source: The Canadian Journal of Economics / Revue canadienne
d'Economique, Vol. 17, No.
2 (May, 1984), pp. 340-352
Published by: Wiley on behalf of the Canadian Economics
Association
Stable URL: http://www.jstor.org/stable/134961
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The timing of railway construction
on the Canadian Prairies
FRANK D. LEWISand DAVID R. ROBINSON/
Queen's University
Abstract. It is generally agreed that railways were a
prerequisite to the Canadian 'wheat boom.'
In this paper we analyse the timing of railway construction in
south-eastern Saskatchewan
during the wheat boom period. A monopoly model is derived in
which a railway makes its
construction and pricing decisions on the basis of a rational
settler's response function.
Between 1898 and 1906, when the CPR had a monopoly, the
model closely predicts freight rates
and the timing of branch line completions. The increase in
branch line construction after 1898 is
explained partly by the decline in the railway's operating cost
and partly by the Crow's Nest
Pass Agreement. This agreement raised the value of CPR land
by setting long-term ceilings on
freight rates.
Le moment approprie pour la construction du chemin defer
dans les prairies canadiennes. On

est generalement d'accord pour dire que les chemins de fer ont
ete une condition necessaire
pour le boom du ble. Dans ce memoire, les auteurs analysent
les decisions quant au moment de
la construction des chemins de fer dans le sud-est de la
Saskatchewan au cours de la periode du
boom du ble. Ils derivent un modele de monopole dans lequel
la compagnie de chemin de fer
prend ses decisions quant a la construction et quant 'a la
tarification sur la base d'une fonction de
reaction des colons rationnels. Entre 1898 et 1906, la periode
de monopole du CPR, le modele
permet de predire 'a quel moment on devrait completer la
construction de certaines lignes
secondaires et quelle devrait etre la tarification. L'acceleration
de la construction des lignes
secondaires apres 1898 est attribuable en partie a la chute dans
les couits d'operation du CPR et en
partie a I'Accord des tarifs du Nid de Corbeau. Cet accord
elevait la valeur des terres du CPR en
imposant un plafond 'a long terme sur les tarifs.
INTRODUCTION
Economic historians have long been puzzled by the timing of
Canadian prairie
settlement. The Canadian Pacific Railway's transcontinental
line was completed in
1885, eleven years before the beginning of the 'wheat boom';
and it was not until after
1900 that there was large-scale settlement west of the
Manitoba-Saskatchewan
border. In a series of recent articles economic historians have

tried to explain this lag,
For their helpful comments we thank Alan Green, Knick
Harley, Marvin McInnis, and Gillian
Wogin. An earlier version of this paper was presented to the
Twelfth Conference on Quantitative
Methods in Canadian Economic History at Edmonton, 1982.
Canadian Journal of Economics / Revue canadienne
d'Economique XVII, No. 2
May / mai 1984. Printed in Canada / Imprime au Canada
0008-4085 / 84 / 340-352 $01.50 ?) 1984 Canadian Economics
Association
2017 19:21:49 UTC
The timing of railway construction / 341
and although no consensus has emerged on the causes of
settlement, progress has
been made. Marr and Percy (1978) point to large expenditures
by the Canadian
government to promote immigration and to the increase in
railroad mileage. Norrie
(1980) finds rapid diffusion of dry-farming techniques; and
Dick (1982) estimates a
gradual decline in the cost per acre of growing wheat. In

another recent paper, Lewis
(1981) develops a simulation model of prairie settlement. He
finds that settlement
advanced with the feasible region of wheat cultivation, the area
on which wheat
farming was profitable.' Increasing mean wheat yields accounts
in part for the
extension of the feasible region, but it is the construction of
railway branch lines that
has by far the larger impact.
In all these papers, settlement is analysed on the basis of an
exogenously given rail
network. Missing is an account of the railway's decision to
construct lines. To fill this
gap we develop a model that recognizes explicitly the
interdependence of the
railway's and settlers' decisions and treats the timing of
railroad construction as
endogenous. At the heart of our model is the hypothesis that
railway companies know
the response function of settlers. The firms, therefore, base
their construction
decision not on observed settlement but rather on their estimate
of future settlement
conditional on a rail line being completed.2 We apply our

model to south-eastern
Saskatchewan during a period when there was no interrailway
competition - the CPR
had a monopoly - and implement the notion of a settler's
response function by using a
simplified vesion of the Lewis (1981) model, which he tested
on the same region.
We begin by outlining briefly the pattern of early railway
construction in
south-eastern Saskatchewan. In addition to the transcontinental
line, the CPR
completed two lines prior to 1900: a branch from Moose Jaw to
North Portal on the
u.s. border and a section that connected Esteven and Souris,
Manitoba (see figure 1).
Neither of these lines, however, can be explained on the basis
of locally generated
traffic. They were through lines designed to provide a
connection to the u.s. market in
Chicago. Two colonization railroads that passed through the
region also were
completed before 1900: the Qu'Appelle Long Lake and
Saskatchewan Railway (QLL)
that extended north from Regina to Prince Albert, and the
Manitoba and North

Western Railway (MNW) that lay between Portage la Prairie
and Yorkton. Like other
colonization railways they were subsidized with large land
grants but were not
successful at attracting many settlers. In fact, the poor
performance of the
colonization railways led Hedges (1934) to conclude: 'more
interested in securing
land than in operating railways, their every move was
calculated to obtain the
maximum amount of the best land, with a minimum expenditure
of money and effort'
(69). In 1890 the CPR began operating the QLL, and when in
1900 it leased the MNW, it
secured a monopoly on rail transportation in Saskatchewan. Its
position was
maintained until 1905, when the Canadian Northern purchased
the QLL. Then in 1907
1 Lewis applies his model to one area in Saskatchewan: Crop
District 1 (1908-14 definition), a district
of about 16,800 square miles in the south-eastern corner of the
province.
2 In his book on the history of the CPR, Innis (1971) pointed
out the interdependence of the decisions
made by the railway and the settlers both with regard to the
timing of branch line construction and the
setting of freight rates. See, in particular, the discussions on
pages 129-30 and 172-9.

2017 19:21:49 UTC
342 / Frank D. Lewis and David R. Robinson
_ ~~~YORKTON ?SAE
s ' /5 l ~~35 M ILES TO 3 I NCH
STRASSBURG /
- - -QPATRICK
FREGINA,
N ARCOLA,- z~ U I - "
ESTE VA -PORTAL
LINES COMPLETED BEFORE 1898
- - - LINES COMPLETED FROM 1898 TO 1906
LINES COMPLETED FROM 1907 TO 1911
FIGURE 1 Rail lines: Crop District 1, Saskatchewan
the CPR'S monopoly was further weakened as both the
Canadian Northern and Grand
Trunk Pacific completed main lines through the region. In fact,
after 1907 the railway
industry in Saskatchewan is best characterized as an oligopoly,
and the monopoly
model that we develop in the next section no longer applies.

A MONOPOLY MODEL OF RAILWAY CONSTRUCTION
A railway is assumed to secure a monopoly in a region of the
frontier by constructing
the only rail line through that region. Although completion of
the main line may be
premature based on current traffic and any subsidies that the
railway receives, the
railway anticipates that profits from future branch lines will be
at least enough to
offset current losses.3 Once the main line is completed, the
firm's objective is to delay
3 Harley (1982, 797-805) has an excellent discussion of the
economic factors affecting the timing of
main line and branch line construction. Indeed, one
contribution of our paper is to formalize Harley's
treatment.
2017 19:21:49 UTC
the construction of branch lines until the net present value of
each of these lines is
maximized. Income from a branch line is assumed to come
from two sources: net
revenue from the rail traffic generated and rent on any railway

land that is served by
the line.4 Formally, the firm maximizes the net present value of
each branlch line with
respect to completion time and the freight rates that it charges
once the line is opened:
max rT {{[Pr(t) - Cr(t)]F[t,Pr(t)] + PR[t,Pr(t)] jdt
Pr(t), T
- [(r + 8)lr]pke-, (1)
where Pr = rail freight rate, Cr = railway's operating cost, F =
rail traffic generated
by the branch line, p = proportion of land owned by the firm, R
= effect of the line on
land rents, Pk = cost of constructing the line, r = discount rate,
8 = depreciation rate
of the line (this is assumed to be offset by maintenance and
improvements to the line),
and T = optimal construction time (from the viewpoint of the
firm). The first-order
condition for the optimal construction time is
[Pr(T) - Cr(T)]F[T, Pr(T)] + pR[T, Pr(T)] = (r + 8)Pk. (2)
The intuition for equation (2) is straightforward. It requires
that the railway construct
each branch line when the net revenue from rail traffic plus the

increased rent on
railway land equals the interest and depreciation on the road.5
The optimal freight rate
in each period is the solution to the following equation, which
is derived by
differentiating equation (1) with respect to Pr(t)
F[t, Pr(t)] + p{dR[t, Pr(t)J/dPr(t)} + [Pr(t) - Cr(t)]{dF[t,
Pr(t)]ldPr(t)} = 0.6 (3)
We derive both the rail traffic function, F, and the rent
function, R, from the
feasible region of wheat cultivation.7 In other words, we
assume that the railway
bases its freight rate and timing decisions on the assumption
that settlers will occupy
all land where wheat. farming is profitable. The margin of
wheat cultivation
establishes the boundary of this region. The boundary lies at
that distance from a rail
line where the exogenously given rnarket price of wheat equals
the cost of producing
the wheat and transporting it to market by wagon and rail:
P(t) = cw(t) + Pr(t) + Ph(t)-D[t, Pr(t)], (4)
where p, = price of wheat, c, = cost of producing wheat
(exclusive of land rent), Ph

4 Although railways seldom rented their land, land rents are
assumed to be capitalized into the value of
the land.
5 Since the annual cost of the line is constant, the second-order
condition is that net income is rising at
construction time.
6 In other words, the railway raises its freight rate until the
increase in revenue due to the higher rate is
just offset by a decline in income due to reduced rail traffic
and land rent.
7 Our approach is based on the Lewis (1981) model with two
simplifying assumptions. First, we
assume that wheat yield is the same across all wheat land.
Lewis assumed a normal distribution of
yields. Second, we allow wheat to be shipped from any point
along the rail line. Lewis required
wheat to be shipped from loading platforms that were spaced
about eight miles apart. Neither
assumption seriously biases the results.
2017 19:21:49 UTC
= wagon haulage rate per mile, Pr = rail freight rate, and D is
the distance from the
line in miles where land rent is zero (all prices and costs are
per bushel). Rearranging
equation (4) gives

D[t, pr(t)] = [Pw(t) - Cw(t) - Pr(t)]Ph(t)* (5)
If there is no overlap with other rail lines, each mile of track
serves an area of 2D
square miles.
Wheat production in the feasible region provides the basis for
computing the
increase in rail traffic:
F[t, pr(t)] = 2D[t, Pr(t)]Y(t)f, (6)
where y = wheat yield per acre, k is a factor that converts
square miles into wheat
acreage, and f is a factor that converts wheat production into
rail traffic (in wheat
equivalents). The increase in land rent is also based on the
output of wheat:
R[t, Pr(t)] = 2D[t, Pr(t)]ky(t) [ 2[pP,(t) - CW(t) - Pr(t)]1M, (7)
where m is a factor that converts rent on wheat land to rent on
all land. Note that since
rent per bushel of wheat varies linearly from 0 (at the margin
of cultivation) to pw -
Cw - Pr (at the rail line), average rent is 2(pw - CW - Pr).
Finally, substituting
equations (5), (6), and (7) into equation (3), we derive the
optimal freight rate to be
Pr*(t) = [fl(2f - pm)] {[1 - p(f/m)] [pw(t) - cj(t)] + cr(t)}. (8)
The derivation of the optimal freight rate can also be illustrated
diagrammatically.

In figure 2, A represents the demand curve for rail services and
B the railway's
average revenue curve, which lies above A if the railway owns
land in the area served
by the line. The firm maximizes profits by setting marginal
cost equal to marginal
revenue, based on the B curve. Note that if the firm owns all
the land (and adjustment
factors m and f are equal), the slope of A is twice the slope of
B and the firm acts as a
perfect price discriminator, setting price equal to marginal
cost. If on the other hand
the firm owns no land, it charges the monopoly price, 2(pw -
Cw - Cr).8
AN APPLICATION OF THE MODEL TO CROP DISTRICT 1,
SASKATCHEWAN
We now apply the model to the construction of branch lines by
the CPR in Crop District
1, Saskatchewan from 1898 to 1905. During the period the CPR
laid three sections of
track (see table 1). A 64-mile branch from Reston to Arcola
was completed in 1901; a
140-mile section of the Pheasant Hills branch, from Kirkella to
Patrick, was
8 Engerman (1972) discussed some theoretical issues
concerning the subsidies provided to u.s. rail-
roads. He pointed out that giving a subsidy in the form of a
land grant not only could lead to increased
railroad construction but also would result in lower freight
rates. In a recent PH D dissertation, Gillian
Wogin (1983) explores the relationship between freight rates

and land settlement policy in Canada.
She finds that land grants to the CPR induced the railway to
lower its freight rate from the monopoly
price to a more efficient level.
2017 19:21:49 UTC
Pr
PW - S
Pr*
A B
Cr
I MRB
0
F* F, F2 Rail traffic
F, = [2(pw - CW)kyf/Ph-
F2 = -4(pw cw)kyf2]1[ph(2f- pm)].
F* = [2(pw- w- Cr)kyf2]I[Ph(2f - pm)].
FIGURE 2 Derivation of the optimal freight rate

completed in 1904; and in 1905 the Reston-Arcola line was
extended 113 miles to
Regina (see figure 1). We analyse the timing decisions by
comparing the annual cost
of each section of track with the income that each section was
expected to generate
during its first year of operation based on the actual freight rate
(see equation (2); the
effect on the calculations of using optimal freight rates is
discussed below). The
capital cost of these lines was among the lowest of all track
laid by the CPR on the
Prairies - about $12,000 per mile.9 Multiplying by the sum of
the discount rate and
the depreciation rate of the road, put at 6 and 4 per cent,
respectively, gives an annual
cost of about $1,200 dollars per mile of track. 0 It is this
amount that we compare with
net income from rail traffic and land rents. To derive net
revenue from rail traffic, we
first compute the effect of each branch line on the feasible
region of cultivation. Net
revenue is simply the implied increase in the volume of traffic
times the difference
9 The extension of the Pheasant Hills branch from Strassburg
to Hardisty, for example, cost about
$20,000 per mile, and the 270-mile Moose Jaw Branch, from
Moose Jaw north-westerly to Macklin,
cost $18,000 per mile.
10 Depreciation is assumed to have been offset by maintenance

of track and structures. For all CPR lines
the ratio of the cost of maintenance to the capital value of road
and structures was about 4 per cent.
The capital value is derived by cumulating all the (deflated)
expenditures of the CPR on construction
and improvements (CPR, Annual Reports).
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TABLE 1
The cost of constructing branch lines in Crop District 1,
Saskatchewan
Year Distance Cost per milea
Line completed (miles) (1890-99$)
1. Reston to Arcola (Pipestone Extension) 1901 64 12,400
2. Kirkella to Patrick (Pheasant Hills Branch) 1904 140 12,000
3. Arcola to Regina (Pipestone Extension) 1905 113 12,400
4. Reston to Kaiserb (Wolseley Branch) 1908 122 12,200
SOURCES: CPR, Annual Reports, 1898 to 1908, appendices;
Urquhart and Buckley (1965), 292.
aAll construction expenditures are deflated to 1890-99 dollars
and compounded at 6 per cent to the year in
which the line was completed.
'This line was completed after the CPR lost its monopoly in the
district. It is included so that we can compare

the monopoly with the oligopoly case.
between the CPR'S freight rate and its operating cost. Finally,
net income is obtained
by adding to this amount the increase in land rent.
We illustrate the calculation for the Reston-Arcola section,
which was completed
in 1901 (see tables 2 and 3). In that year the extensive margin
of cultivation (D) was
11.8 miles from the rail line and the feasible region per mile of
track was 19.4 square
miles.11 Average wheat output per square mile (ky) was 1,690
bushels of which 78
per cent was marketed. 12 But wheat generated additional rail
traffic in the form of
other agricultural output, imported freight, and passengers.
This traffic provided 90
per cent of the revenue obtained from carrying wheat. We
assume, therefore, that the
CPR transported the equivalent of 1.48 bushels of wheat for
each bushel of wheat
produced. 13 The revenue derived from this traffic is based on
the CPR'S freight rate to
Fort William, which in 1901 was the Crow rate of 10.1? per
bushel. The CPR'S
11 From table 2, D = (Pw - C, - Pr)'Ph = (64.3 -47.5 -
10.1)/0.567. The region served by the
Reston-Arcola line was less than 2D square miles, because part

of the track passed just south of the
Moose Mountain Forest Reserve, an area unsuited for growing
wheat.
12 Lewis (1981, 529-30) estimated that 17.7 per cent of Crop
District 1 was suitable for growing wheat
and that mean wheat yield in 1901 was 14.94 bushels (case 3 of
his model). (Note that there are 640
acres in a square mile.) The proportion of wheat output
transported by rail is based on a comparison
of the quantity of wheat inspected with the quantity produced
over the period 1908 to 1911 (Saskat-
chewan, Department of Agriculture, Annual Reports).
13 A breakdown of rail traffic is available only by railway. To
obtain an estimate of the traffic trans-
ported on branch lines in south-eastern Saskatchewan we
selected a small railway that served a
comparable area. This was the Brandon, Saskatchewan and
Hudson Bay Railway, a sixty-nine-mile
line about sixty-five miles east of Crop District 1 that
connected Brandon, Manitoba to Bannerman,
near the U.S. border. Railway Statistics reports the tonnage of
grain and other types of freight
transported along this line. It is assumed that 84.2 per cent of
grain tonnage consisted of wheat. This
figure is based on output in Crop District 1 and a comparison
of output and grain inspections for all of
Saskatchewan - in converting bushels to tons the following
weights are applied: wheat: 60 lbs; oats:
35 lbs; barley: 48 lbs; flax: 56 lbs. We estimate that the ratio of

wheat and flour tonnage to the
tonnage of all freight was 0.586. Finally, assuming that 10 per
cent of railway revenue was generated
by passenger traffic, we obtain a ratio of wheat traffic to all
rail traffic of 0.527. Since 78.1 per cent of
wheat output was marketed, it follows that the equivalent of
1.48 bushels of wheat was transported
for every bushel of wheat produced. (These estimates are based
on 1908- 11 averages; see Canada,
Department of Railways and Canals, 1908-11; Saskatchewan,
Department of Agriculture, 1908-
11.)
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TABLE 2
Data on the prices and costs of wheat production in Crop
District 1, Saskatchewan (1890-99 cents per
bushel)
1898 1901 1904 1905 1908
Price of wheata 63.7 64.3 64.9 65.1 65.7
Cost of producing wheatb 48.8 47.5 49.5 49.7 46.6
Rail freight rate to Fort Williamc 10.1 8.6 9.0 7.9
Mean wheat yieldd(bushels per acre) 14.95 14.94 15.03 15.24

16.99
Wagon haulage rate per milee 0.567 0.567 0.567 0.567 0.567
aThis is the (quality-adjusted) trend price of wheat at Fort
William between 1898 and 1911 less 3? per
bushel for commissions and handling (Lewis, 1981, 525-6).
bLewis (1981) separated post-harvest costs, which were
assumed to depend on yield, from the other costs
of producing wheat. Here we combine the two types of costs,
but otherwise the cost estimates are the same
(524-5).
cFreight rates are given for each line in the year they were
completed: 1901: Reston-Arcola; 1904:
Kirkella-Patrick; 1905: Arcola-Regina; 1908: Reston-Kaiser.
The freight rates are based on the average
distance of each line from Fort William (McDougall, 1966).
dBased on case 3 of Lewis (1981, 530)
eSee Lewis (1981, 526-7).
operating cost of moving this wheat to Fort William was 7.0?
per bushel, implying
that net earnings per bushel were 3. 1 ?. Combining these
values, it follows that on the
Reston-Arcola section in 1901 net revenue from rail traffic was
$1,500 per mile of
track (0.031 x 1.48 x 1,690 x 19.4).
Net revenue from rail traffic understates the full impact of the
branch line on CPR
income, because the firm owned a large share of the land in
Crop District 1. In nearly
every township the CPR had been granted the odd-numbered

sections, less two
sections that were designated as School Lands. Since there are
thirty-six sections in a
township, it follows that 44 per cent of the land in the district
was owned by the CPR.
In 1901 the Reston-Arcola line increased the rent on wheat land
by $1,100 per mile of
track. 14 This estimate, however, understates the impact of the
line on all rents,
because agricultural land also was used to raise livestock and
to grow oats, barley,
and other crops. Adjusting for these rents and for the fact that
the CPR owned less than
half the land, we estimate that per mile of track the Reston-
Arcola line increased the
rent on CPR land by $850.15 Combining land rent with net
revenue from rail traffic
and comparing the sum with the annual cost of the line, we
conclude that, based on
our model, the CPR should have completed the Reston-Arcola
section prior to 1901. In
1901, the road imposed an annual cost of $1,240 per mile but
provided income of
$2,350: $1,500 from rail traffic and $850 as the increase in the
rent on CPR land.
The timing of the Kirkella-Patrick and Arcola-Regina sections
conforms much
14 R = rent per bushel x wheat output per square mile x
feasible region = -(p,-c-Pr) x 1,690 x
19.4 = 1,100.

15 The ratio of rent on all land to rent on wheat land, m, is
estimated to be 1.76. This is the Crop District
1 average for 1908-1 1 and is based on the value of all field
crops and the value of output generated by
some livestock (milk cows, other cattle, sheep). Saskatchewan,
Department of Agriculture, 1908-
11.
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TABLE 3
Annual costs and returns of Railway branch lines: Crop District
1, Saskatchewan (1890-99 prices)
Reston- Kirkella- Arcola- Reston-
Arcola Patrick Regina Kaiser
(1901) (1904) (1905) (1908)
1. Annual costa (dollars per mile) 1,240 1,200 1,240 1,220
2. Operating costb (cents per bushel - 7.0 7.2 7.4 6.9
cents per ton-mile in parentheses) (0.367) (0.342) (0.344)
(0.355)
3. Freight rate (cents per bushel - 10.1 8.6 9.0 7.9
optimal rate in parentheses) (10.2) (9.8) (10.0)

4. Area servedc (sq. miles per track mile) 19.4 16.5 17.1 6.2
5. Income from rail trafficd (dollars per mile) 1,500 580 700
180
6. Income from land rente (dollars per mile) 850 740 730 35f
7. Annual income/annual cost 1.90 1.10 1.15 0.18
aO.I x capital cost (see table 2 and fn. 10).
bOperating cost per ton-mile is based on the sum of the
reported costs of conducting transportation, motive
power (when given), and the maintenance of rolling stock. Also
included are depreciation and interest on
rolling stock, put at 5 per cent and 6 per cent respectively (a
low depreciation rate was applied because of
the high expenditures on maintenance). The value of rolling
stock was derived by cumulating all CPR
expenditures from 1885, and applying a 5 per cent depreciation
rate. The share of operating costs attributed
to freight is set equal to the share of income from freight.
Operating cost per bushel of wheat is based on the
distance to Fort William and a weight of 60 lb per bushel
(CPR, Annual Reports).
cBased on equation (5) and table 2. The results are adjusted
downward to take account of areas that are not
suited for wheat-growing and overlap with other rail lines.
d[pr(t) - cW(t)] area served y(t) kf, where k is 113 wheat acres
per square mile and f, the ratio of rail
traffic to wheat output, is 1.48 (see fn. 13).
e2[p(t) - C.(t) - Pr(t)] area served y(t) . kmp, where m, the ratio
of rent on all land to rent on wheat
land, is 1.76; and p, the share of land owned by the CPR, iS
0.44 (see fn. 15).
fSince nearly all land served by the Reston-Kaiser section

would have been in the feasible region without
the line, the effect on land rent is small.
more closely to the predictions of the model. These lines,
completed in 1904 and
1905, respectively, generated less income per mile of track
than the Reston-Arcola
section because they overlapped with other lines and hence
served smaller areas. In
1904, its first year of operation, the Kirkella-Patrick section
imposed an annual cost
of $1,200 but generated net revenue from rail traffic of only
$580 (see table 3).
Nevertheless, the line was completed at about the optimal time
because the shortfall
was more than offset by an increase in the rent on CPR land.
The timing of the Arcola-
Regina section was also close to optimal. In 1905, when that
line was completed, the
annual cost was $1,240 and net income, including land rent,
was $1,430. An
important implication of these results is that the land grants to
the CPR accelerated
branch line construction, even though they were mainly
intended to subsidize the
transcontinental line. Had the CPR owned no land, completion
of both the
Kirkella-Patrick and Arcola-Regina sections would have been
delayed. In fact, when
these lines were first opened, the CPR derived more income as
capitalized land rent
than as net revenue from freight and passengers.
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TABLE 4
Hypothetical costs and returns of railway branch lines (1890-99
prices)'
Reston-Arcola Kirkella-Patrick Arcola-Regina
A B A B A B
1. Operating costb 7.7 7.7 8.5 8.5 8.7 8.7
2. Freight rate 13.1 10.3 13.1 10.6 13.7 10.7
3. Area served 6.3 14.1 5.9 12.4 4.0 12.8
4. Income from rail traffic 850 920 680 650 500 640
5. Income from land rent 75 425 70 350 30 350
6. Annual income / annual cost 0.75 1.08 0.62 0.83 0.43 0.80
A = based on 1898 values.
B = based on 1898 values but assuming the optimal freight rate
in that year.
aFor the units in which variables are expressed, see table 3.
bIn 1898 operating costs were 0.403? per ton-mile (see table 3,
fn. b)
On the basis of our model, we accurately predict the timing of
two of the three rail
lines in our study but estimate that construction of the third,
the Reston-Arcola
section, was delayed. The Reston-Arcola section was completed
in 1901, when net

income provided by the line far exceeded its annual cost.
Surprisingly, however the
lag between the optimal and actual completion time was at
most two years. We
establish this by recomputing our results using data for 1898
(see table 4). In that year
the Reston-Arcola section would have generated net income,
including capitalized
land rent, of $925, which is only three-quarters of the annual
cost of the road. It was
optimal, therefore, for the CPR to wait until at least 1899
before completing the line.
In addition to explaining construction time, our model can also
help account for the
freight rates charged by the CPR. Between 1898 and 1905 the
CPR reduced its nominal
freight rates twice. In 1899 the freight rate to Fort William was
reduced by 3? per
cwt'6 in accordance with the Crow's Nest Pass Agreement.
Then in 1903 the
Manitoba Agreement lowered nominal freight rates a further 2?
per cwt. We have
compared actual and optimal freight rates on the three lines for
the years when each
line was completed. In 1901, for example, the optimal freight
rate to Fort William
from the Reston-Arcola section was 10.2? per bushel (see table
3), which is almost
identical to the actual rate - the Crow - of 10. 1?. On wheat
shipped from the

Kirkella-Patrick and Arcola-Regina sections, optimal freight
rates were 9.8? and
10.0? per bushel, respectively, in the years when those lines
were completed. These
rates are well below the Crow rates of 11.6? and 11.9? but are
close to the rates
stipulated in the Manitoba Agreement, which by then was in
effect. It should be noted
than land ownership by the CPR reduced the optimal freight
rate by about 1.5? per
bushel.
Our results indicate that, as a monopolist, the CPR followed a
close to optimal plan
with respect to both freight rates and the timing of branch line
construction. Next, we
16 Freight traffic in Canada was measured on the basis of
American units: 100 lbs per cwt and 2,000 lbs
per ton.
2017 19:21:49 UTC
combine our findings with those of Lewis (1981), to help
complete our explanation
for the timing of the wheat boom. In his paper Lewis showed
that in south-eastern

Saskatchewan large-scale prairie settlement had to await the
completion of railway
branch lines. In this paper we show that the reason branch line
construction did not
take place earlier was that prior to 1899 branch lines would
have generated less
income per year than the annual cost of the lines. After 1899
conditions changed and
the laying of track became the profit-maximizing course to
follow.
Two factors contributed to the increased profitability of
prospective branch lines:
the Crow's Nest Pass and Manitoba agreements and a decline in
the operating costs of
the CPR. We have shown that the Crow and Manitoba
agreement rates were close to
optimal; however, prior to 1899, when the Crow agreement
came into effect, the CPR
charged much higher freight rates. An immediate question
arises: why did the CPR
wait for the implementation of the Crow's Nest Pass Agreement
to lower its rates? We
offer the following answer, first suggested by Gillian Wogin
(1983). When settlers

purchased land from the CPR, the price that they paid was
determined not by current
wheat prices and costs of production, but rather by expected
future prices and costs.
Without the Crow's Nest Pass Agreement or one like it, settlers
expected that once
they purchased the land, the railway would raise its freight rate
in order to extract
more monopoly rent. This meant that the lowering of current
freight rates would have
had little effect on the capitalized value of CPR land, which led
to suboptimal pricing.
It was only after the CPR was in a position of precommitment
that reductions in freight
rates would significantly affect land prices and thereby
increase the income from
branch line construction.
The Crow's Nest Pass Agreement may have been a necessary
condition for branch
line construction, but it was not a sufficient one. Even if the
CPR had charged the
profit-maximizing freight rate in 1898, it would not have been
optimal to construct

either the Kirkella-Patrick or the Arcola-Regina line (see table
4). In fact, even the
Reston-Arcola section would have generated just slightly more
income than its annual
cost. The problem was the CPR'S high operating cost. Recently
Alan Green (1983) has
compiled evidence showing rapid technological change in the
railway sector during
the 1890s and early 1900s. Data on the CPR'S operating costs
are consistent with his
results. From the 1890s to the period 1900- 10 operating costs
fell from 0.4? to about
0.35? per ton-mile. 17 This reduction may seem small, but it
had a big impact on the
margin between freight rates and operating costs. 8 Green has
not identified the
sources of railway productivity change in Canada, but Fishlow
(1966, 626-31), who
also estimated large increases in total factor productivity for
u.s. railroads during this
period, points to the increased size of locomotives, their
increased motive power per
unit weight, and the higher ratio of load to dead weight in
freight cars. These changes
may have affected Canadian railways as well. On the Canadian
Prairies, moreover,
improvements in productivity not only led to reductions in

freight rates; they also
contributed to the extension of the rail network.
17 Operating costs are derived from the CPR, Annual Reports.
See table 3, fn. b.
18 In 1905, for example, the freight rate on the Kirkella-Patrick
branch exceeded operating costs by 1.4?
per bushel. But had operating costs been at their 1898 levels,
this margin would have been reduced to
0. 1? (given the 1905 freight rate).
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Our monopoly model, which accounts well for railway
construction between 1898
and 1905, is no longer appropriate by 1907. In that year the
industry became an
oligopoly, as the CPR, Canadian Northern, and Grand Trunk
Pacific all competed for
traffic. The oligopoly case has been analysed by Harley (1982)
for branch line
construction in the u.s. mid-west. Harley argues that once a
railway loses its
monopoly, or if an oligopoly agreement breaks down, a

construction boom will
occur. Fearing pre-emptive railway construction by
competitors, firms now build
lines whose net present value is positive, whereas in the
monopoly case they wait until
the net present value of each line is maximized. The story
Harley tells for the u.s.
mid-west also fits Crop District 1, Saskatchewan. After 1907
there was a construction
boom in which all three railways participated; moreover, the
branch lines completed
during this boom were certainly built before their present
values were maximized. In
1908, for example, the CPR line from Reston to Kaiser (see
figure 1) imposed an
annual cost of $1,220 and generated income of only $215 (see
table 3). Surprisingly,
however, the collapse of the CPR monopoly in Crop District 1
had little effect on
settlement, because enough branch lines had been completed
prior to 1907 to bring
nearly all land into the feasible region of wheat cultivation
(Lewis, 1981, 523). Track
laid after 1907 was for the most part redundant, in that it had

almost no effect on
settlement.
CONCLUSION
As Lewis (1981) showed with a model based on the feasible
region of wheat cultiva-
tion, settlement advanced not with the CPR'S transcontinental
line but rather with the
construction of railway branch lines. It is, therefore, the timing
of branch line
construction that is the focus of our paper. We first develop a
monopoly model of
railway construction that makes use of the Lewis approach. We
than analyse three CPR
lines built in south-eastern Saskatchewan between 1901 and
1905. We find that the
CPR completed each section of track at about the time that
maximized its net present
value. In fact, as late as 1898 it would not have been profit-
maximizing to lay any of
the three sections. The Crow's Nest Pass Agreement, which
came into effect in 1899,
was important in raising the profitability of prospective branch
lines. Since the
agreement set long-term ceilings on freight rates, it increased
the capitalized value of

CPR land by promising settlers low future, as well as low
current, freight rates.
Productivity change in the railway sector was even more
important. It lowered
operating costs, reduced (optimal) freight rates, and extended
the feasible region of
cultivation per mile of track. This led to increased rail traffic
and land rent, which
made the construction of new rail lines profitable.
We now return to the first issue raised in this paper: the long
period between the
completion of the CPR'S transcontinental line and the start of
large-scale settlement.
We think that the reason many economic historians have been
puzzled by the long
delay is that they have been posing the wrong question. Rather
than ask 'why did
settlement begin so late?' they should have been asking 'why
was the transcontinental
line completed so early?' On the basis of our model we can
provide a partial answer.
With the completion of the transcontinental, the CPR
established a monopoly on the
2017 19:21:49 UTC

provision of rail services throughout much of the Prairies. The
value of this monopoly
was the expected net present value of the future branch lines
that it built. The cost of
establishing the property right to these future returns was the
present value of
expected losses due to premature construction. Of course huge
government subsidies
substantially reduced net construction costs and contributed to
even earlier
completion of the line. With the exception of the land grants,
however, it is unlikely
that these subsidies had much impact on the timing of
settlement.
REFERENCE S
Canada, Department of Railways and Canals (1909-12) Railway
Statistics, 1908 to 1911. In
Parliament of the Dominion of Canada, Sessional Papers
(Ottawa)
Canadian Pacific Railway Company (CPR), Annual Reports,
1885 to 1911 (Montreal)
Dick, Trevor (1982) 'Mechanization and North American
prairie farm costs, 1896-1930.'
Journal of Economic History 42, 199-206
Engerman, Stanley L. (1972) 'Some economic issues relating to
railroad subsidies and the
evaluation of land grants.' Journal of Economic History 32,

443-63
Fishlow, Albert (1966) 'Productivity and technological change
in the railroad sector, 1840-
1910.' In Conference on Research in Income and Wealth,
Output, Employment and
Productivity in the United States after 1800. Studies in Income
and Wealth, Vol. 30 (New
York: NBER)
Green, Alan (1983) 'Productivity and technological change in
the Canadian railroad indus-
try.' Paper delivered at the Canadian Economics Association
annual meeting, Vancouver
Harley, C. Knick (1982) 'Oligopoly Strategy and the Timing of
American Railroad Construc-
tion.' Journal of Economic History 42, 797-824
Hedges, James B. (1934) The Federal Railway Land Subsidy
Policy of Canada (Cambridge,
MA: Harvard University Press)
Innis, Harold A. (1971) A History of the Canadian Pacific
Railway (Toronto: University of
Toronto Press)
Lewis, Frank D. (1981) 'Farm Settlement on the Canadian
Prairies, 1898 to 1911. ' Journal
of Economic History 41, 517-25
Marr, W. and M. Percy (1978) 'The government and the rate of
prairie settlement.' This
JOURNAL 11, 757-67

McDougall, John Lome (1966) 'The relative level of Crow's
Nest grain rates in 1899 and
1965.' Canadian Journal of Economics and Political Science 32,
46-54
Norrie, Kenneth H. (1980) 'Cultivation techniques as a
response to risk in early Canadian
prairie agriculture.' Explorations in Economic History 17, 386-
99
Saskatchewan, Department of Agriculture (1907-12) Annual
Reports, 1905 to 1911 (Regina)
Urquhart, M.C. and K.A.H. Buckley, eds (1965) Historical
Statistics of Canada (Toronto)
Wogin, Gillian (1983) 'The wealth-maximizing behaviour of
the Canadian pacific railway:
lands, freight rates, and the Crow's Nest Pass Agreement.' PH
D dissertation, Carleton
University
2017 19:21:49 UTC
Contentsimage 1image 2image 3image 4image 5image 6image
7image 8image 9image 10image 11image 12image 13Issue
Table of ContentsCanadian Journal of Economics, Vol. 17, No.
2, May, 1984Front MatterStagflation and Productivity Decline
in Canada, 1974-82 [pp.191-216]Intertemporal Choice and
International Trade [pp.217-231]Production Possibilities and
International Trade with a Public Intermediate Good [pp.232-
248]The Infant-Export Industry Argument [pp.249-269]Tariff
Policies in a Small Open Spatial Economy [pp.270-282]The
Real Interest Rate: A Multi-Country Empirical Study [pp.283-
311]The Inflation Tax and the Value of Equity [pp.312-
326]Long-Term Interest Rates and the Price Level: The

Canadian Evidence on the Gibson Paradox [pp.327-339]The
Timing of Railway Construction on the Canadian Prairies
[pp.340-352]Parable and Realism in Production Theory: The
Surrogate Wage Function [pp.353-368]A Study of the Cost
Structures of the Canadian Intercity Motor Coach Industry
[pp.369-385]"Trade, Industrial Policy, and Canadian
Manufacturing" by Richard G. Harris (with the Assistance of
David Cox): A Review Article [pp.386-398]Reviews of
Booksuntitled [pp.399-401]untitled [pp.401-403]untitled
[pp.403-407]untitled [pp.407-411]Back Matter [p.412]
Economic History Association
Some Economic Issues Relating to Railroad Subsidies and the
Evaluation of Land Grants
Author(s): Stanley L. Engerman
Source: The Journal of Economic History, Vol. 32, No. 2 (Jun.,
1972), pp. 443-463
Published by: Cambridge University Press on behalf of the
Economic History Association
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Some Economic Issues Relating to Railroad
Subsidies and the Evaluation
of Land Grants
THE federal policy of granting land in aid of railroad construc-
tion in the mid-nineteenth century has been the focus of
many heated discussions. Both praised and attacked by
contempo-
raries, it has remained a lively issue in the pages of history
books and
in journal articles. Several 'land-grant legends" have
developed, re-
ferring to different problems in the evaluation of these
measures. At
issue have been the question of the justification for land grants,
the

value of the benefits provided the railroads, and the
determination of
whether the government aid did provide net benefits to society
as a
whole. While the "land-grant legend" has been frequently
buried, it
has invariably been resurrected in one guise or another.1 In
large
measure this state of affairs has been due to the failure to
specify
fully the problems under discussion, and to approach
systematically
their resolution.
This article will not attempt to resolve these issues, but rather
will
be concerned with a better specification of exactly what should
be
under discussion and what approaches seem useful at this stage.
It
will discuss the following questions in turn: (1) Why should a
subsidy be granted and what is the most appropriate form for
the
subsidy? (2) What was the value of the land-grant subsidy? (3)
What was the size of the optimum subsidy to encourage private
In the course of several drafts of this paper I have incurred a
number of intel-
lectual debts. Helpful comments on earlier drafts were received
from Michael Edel-
stein, James Ferguson, Carter Goodrich, Frank Lewis, Peter
McClelland, Donald
McCloskey, Lloyd Mercer, Sherwin Rosen, Richard Thaler, and
Harold D. Woodman,
and from the members of the University Seminar in Economic
History at Columbia

University. I have also benefited from conversations with
Lance Davis and Douglass
North (and from their Institutional Change and American
Economic Growth), as
well as from many discussions on related issues with Robert W.
Fogel. Detailed com-
ments on style and substance by Paul David and the editor were
most useful in the
preparation of the final draft.
1 For the most recent such burial announcement, see Eric E.
Lampard, "United
States: Periodical Literature," Economic History Review, XXIII
( 1970), 411-16. Lamp-
ard does have enough insight into the academic mind to add a
skeptical "but we
shall see," clearly expecting attempts to keep the corpse alive.
443
2017 19:20:20 UTC
444 Ermerman
investment? (4) How can the social desirability of the land-
grant
policy be determined?2
In the historical literature relating to land grants, the rationale
for a subsidy paid to the private builders of railroads follows
from the
concept of "building ahead of demand," to use the

Schumpeterian
phrase. Carter Goodrich, in his detailed studies of
governmental aids,
has used the term "developmental construction" to describe the
same
phenomenon. The image conveyed, which comfortably fits into
the
rationale for government planning, is that of an area unsettled,
but
presumably awaiting settlement and requiring governmental aid
to
undertake the initial transportation construction.3 In more
formal
economic terminology, the argument is that a change in the
supply
of transport services would encourage settlement, affecting the
de-
mand curve for the services of the railroad. Western settlement,
then,
is regarded as not only a function of the passage of time, but a
response to the availability of the means of transportation.4
The empirical relevance of the concept of "building ahead of
demand" is rather difficult to test since it depends upon the lag
(or
lead) of settlers in response to the announcement of
construction.
The difficulty is suggested by the fact that the most famous
illustra-
tions of the concept in the literature were actually quite
successful
investment projects from the builders' point of view, and
success
2 The general preoccupation here will be with land grants to
the transcontinental

railroad systems. The grants from the federal government can
be divided roughly
into three categories: aids to transcontinental systems, to
midwestern regional rail-
roads, and to southern Reconstruction railroads. The shares of
total land granted
were approximately 77, 15, and 8 percent, respectively,
justifying the emphasis on
the former. However, the revenues of the Midwestern regional
railroads (in the un-
discounted current dollar accumulations shown in the Public
Aids volume) were
almost 2/2 times larger per acre than those of the
transcontinentals, and amount to
31 percent of the total of net proceeds shown, as against 66
percent for the trans-
continentals. Allowing for the difference in timing of sales, the
importance of the
regional land grants vis-a-vis the transcontinentals is even
larger. U.S. Office of
Federal Coordinator of Transportation, Public Aids to
Transportation (Washington:
G.P.O., 1940), II, pp. 107-11.
3 Within the economic development literature this problem has
been dealt with
in Tibor Scitovsky, "Two Concepts of External Economies,"
Journal of Political Econ-
omy, LXII (1954), 143-51. The central problem, one of
possible failure in the signals
given by the price system, is attributed to the lumpiness of the
investment project,
not to technical externalities in the customary sense of that
term.
4 For this reason the problem of investment decisions in the

presence of "building
ahead of demand" is not quite the same as that discussed in
Yoram Barzel, "Invest-
ment, Scale, and Growth," Journal of Political Economy,
LXXIX (1971), 214-31.
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Railroad Subsidies 445
came without any time lag.5 What Fishlow describes as
anticipatory
settlement can be logically construed under the name of
"building
ahead of demand," since, although the chronological sequence
sug-
gests that the settlement preceded transport change, in fact it
was
the expected development in transport that encouraged
settlement.6
More generally, "building ahead of demand" can be used to
describe
most investment projects, particularly those which lead to the
marketing of new goods and services, though the concept is in-
frequently cited as the basis for subsidy except in the transport
case.
This suggests that other characteristics of the railroad
investment,
not "building ahead of demand," underlie the case for
subsidization.
It will be useful, therefore, to briefly run through a check-list

of
the general cases in which economists can justify the payment
of a
subsidy. These can be classified by the cost characteristics of
the firm
receiving the aid (constant, increasing, or decreasing), as well
as the
degree of perfection or imperfection of capital markets in
which the
builders obtain the funds for construction. All rationales
involve
some form of externalities-benefits of the project which cannot
be
captured by the investors through normal market practices, or
systematic discrepancies between private prices and "true"
social
benefits.8 I shall first discuss the case of perfect capital
markets in an
5 As Nathan Miller points out, the toll rates charged by the
Erie Canal yielded
a profit from operations, and provided a development fund for
the state. Nathan
Miller, The Enterprise of a Free People: Aspects of Economic
Development in New
York State During the Canal Period, 1792-1838 (Ithaca:
Cornell University Press,
1962). "Building ahead of demand" seems more a logical
statement-that a particular
area could not be settled without a transport form-than one
which should be
chronologically interpreted. However implications for the
governmental role do follow
depending on whether the tracks precede or follow settlement.
In the latter case,
investors, already owning land, would be willing to finance the

railroad to capture
external effects on land values. This, indeed, is a typical
pattern for the U.S. as well
as for England. In the former case the problems of forming a
coalition may be
more difficult and thus require intervention by a higher level of
government.
6 See Albert Fishlow, American Railroads and the
Transformation of the Ante-
Bellum Economy (Cambridge: Harvard University Press, 1965),
ch. vi. It has been
suggested (by Harold D. Woodman) that this encouragement is
what Jenks had in
mind when he referred to the "railroad as an idea." Leland
Hamilton Jenks, "Rail-
roads as an Economic Force in American Development," THE
JOURNAL OF EcoNoMIC
HISTORY, IV (1944), 1-20.
7 We shall restrict the discussion of decreasing costs to those
instances based upon
economies of scale internal to the firm. The case of the
decreasing cost industry,
with all firms having increasing costs, is thus excluded as not
being part of the
historical debate.
8 Another explanation of some cases of government
construction and ownership
has been provided in John Bell Rae, "Federal Land Grants in
Aid of Canals," THE
JOURNAL OF EcoNoInc HISTORY, IV (1944), 167-77. Early
discussion of aids to
canals raised the prospect that they would be so profitable that
all taxpayers should

2017 19:20:20 UTC
446 Engerman
industry consisting of increasing or constant cost firms. This is
done
merely for heuristic purposes, since most would regard the
railroad
case as one of decreasing costs.
Externalities generated by the railroad improvement can be
sub-
divided into two varieties. The first refers to benefits obtained
by
demanders of railroad services in excess of the price paid for
these
services. The benefits are thus not captured by the railroad in
the
form of revenues and increase the wealth position of the users.
Mercer, in his measurement of social benefits, evaluates the
un-
captured benefits accruing to passengers, to interregional
shippers,
and to settlers within the area of construction.9 These benefits
could
be captured by the railroad via a perfectly discriminating
pricing
policy, charging each individual the maximum price he would
be
willing to pay for transport services. This would internalize as
rail-

road revenue what would otherwise have been an unpaid for
benefit
for others. Internalizing this external benefit could be effected
either
by a discriminatory rate structure or, for those in the area of
settle-
ment, a policy permitting the railroad to sell the land on which
bene-
fits accrue. Similarly, the uncaptured benefit would be
internalized by
permitting settlers to build the railroad, making it irrelevant
whether
they benefit from higher land value or higher railroad returns.
It
must be noted, however, that in the constant or increasing cost
case
the project could be undertaken even if unpaid benefits were
not
captured, since it is possible for the firms in the industry to
make
normal profits with customary uniform pricing rules. The
division of
the infra-marginal surplus need not affect the investment
decision.
However, it could affect the output decision of the railroad, if
it were
a monopoly provider of the service. In that case internalizing
the
externality would lead to the socially desired output, which
need not
occur under non-discriminating monopoly pricing and non-
railroad
ownership of land. This argument to justify railroad land
grants,
however, is not found in the literature.

The second variety of externality used to justify subsidization
of
increasing cost industries arises in cases in which non-users of
the
service obtain some of the benefits. The classic case, of course,
relates
be permitted to benefit, and not just a select few. Private
ownership, with an auction-
ing off of the franchise rights, could have achieved these
results.
9 Lloyd J. Mercer, "Land Grants to American Railroads: Social
Cost or Social
Benefit?", Business History Review, XLIII (1969), 134-51, and
Lloyd J. Mercer,
"Rates of Return for Land-Grant Railroads: The Central Pacific
System," THE
JOURNAL OF EcoNOMc HISTORY, XXX (1970), 602-26.
2017 19:20:20 UTC
to the infant industry. This form of aid could be justified if
there were
external benefits not captured by the firm but accruing to
others in
the economy.'0 In part, the subsidy goes to firms or individuals
who
benefit from the infant's learning. These benefits take the form
of

lowered costs of production, and thus represent a net benefit to
the
economy. This particular aspect of the infant industry
argument-the
spillover of learning from one project onto others-has not
custom-
arily been used to justify railroad subsidies. Another rationale
for
subsidies, which can be regarded either as an option demand by
potential users or else a type of benefit provided to non-users
of the
railroad which cannot be captured in the course of operations,
is also
infrequently invoked." In these cases, even if returns from
operations
yielded insufficient profits, external benefits (for example, a
national
defense desire to have the railroad available if needed; a
patriotic
goal of having many railroads) would justify aid to
construction,
making the return from all demanders sufficient to justify the
project.
Another argument for subsidies, of a traditional economic
source
but one seldom found in the historical literature, is that the rate
of
discount applied to future incomes by the private sector is too
high
relative to the "true" rate of social time preference. Some
subsidy to
investors is necessary to increase private investment (of which
the
railroads would presumably be a particularly profitable type).
Inso-
far as the social discount rate was below the market rate,

whether due
to inappropriate intergenerational foresight or some form of
market
imperfection, a subsidy to encourage all investments would be
socially desirable, but by itself this does not provide any
necessary
argument for a differential subsidy to be provided for railroad
con-
struction.
In each of the three cases in the preceding paragraph a subsidy
might be necessary to justify investment by private individuals.
In
its absence the discounted future revenues could fall below the
discounted future costs. In none, however, do we see a typical
situation of "building ahead of demand," as the term is
normally
10 This is a necessary, but not a sufficient, condition. For a
discussion of this
argument see Murray C. Kemp, "The Mill-Bastable Infant-
Industry Dogma," Journal
of Political Economy, LXVIII (1960), 65-67.
11 For example, the Union Pacific legislation cited "postal,
military, and other
purposes" as a rationale for government aid. (Option demand
refers to the desire
to have the service available for potential future use, even if
there is no demand
at present, as could be claimed for the case of future military
usefulness. National
pride from a large, modem railroad network is another benefit
which would not be
captured by private pricing policy of the customary sort.)

2017 19:20:20 UTC
448 Engerman
used. For example, the second, option demand, allows for a
situation
in which private profits from operations by themselves never
justify
construction. And the first category of cases (in which the
externality
is in the form of an analogue to consumer surplus) neither
relates to
"building ahead of demand" nor does it even provide an
argument for
subsidy. With non-decreasing cost curves an excess of total
benefits
over privately captured benefits is not a basis for subsidy.
Railroads, however, are generally considered to compose a
decreas-
ing cost industry, with high initial capital costs and low
variable costs
per unit of freight carried. A line through a specific geographic
area
can thus be a "natural monopoly," though a monopoly whose
de-
mand curve will be affected by other networks which approach
its
geographic limits. This natural monopoly, which can be
established
legally by government franchise, poses two different issues in

the
analysis of price and output decisions. The first concerns the
decision
of whether the investment should be undertaken by a private
entrepreneur, even when provided an exclusive franchise.
Investment
would occur, when price discrimination was not permitted, if
the
marginal revenue curve intersected marginal cost at an output
level
for which the demand curve was above average cost. This,
however,
would mean too low a level of output would be produced, since
there
would be units for which the marginal cost of shipping was
below
marginal benefits. Thus the second problem in the case of the
natural
monopoly is the production of the socially optimum output.
Under
the cost conditions described, some form of subsidy would be
necessary to get the private entrepreneur to provide the socially
appropriate output. The subsidy would not reflect "building
ahead of
demand," in the usual sense of the phrase, and it would have to
be
made in a manner that eliminated the social cost of the
monopoly
pricing decision. Thus, in the natural monopoly case, a subsidy
would
be paid, not for the purpose of inducing investment, but to
induce
the private sector to produce the socially optimum output. And
as
long as the cost conditions existed, a subsidy could be justified
as a

permanent feature.'2
There is an extensive literature concerning the appropriate form
of
12 If paid annually, the subsidy would continue over the life of
the investment.
However, it could be paid in a lump sum of sufficient present
value and with suffi-
cient regulatory constraints to induce proper behavior over this
lifetime. Regulation
by itself could be used to eliminate monopoly profits, but this
would not provide the
socially optimum output.
2017 19:20:20 UTC
pricing and subsidy policy to be pursued in such cases.13
Proposed
alternatives include discriminatory pricing, a two-part tariff
(lump-
sum payments to cover fixed costs plus payments of marginal
cost
for shipping), or some general lump-sum tax and transfer
scheme.
While the form of subsidy is usually considered to be a cash
payment,
it is interesting to examine the characteristics of a land grant as
a
form of subsidy. If the only reason for the increased value of

the
land granted is cheapened access to transportation, the
discounted
price of the land would be equal to the excess of the fare that
could
have been charged on each commodity unit sent to market
above the
fare per commodity unit actually charged.14 At issue is who
captures
this surplus. If the only change due to the railroad was lowered
fare
per unit shipped (and either the lands were previously held or
were
sold by the government at an unchanged price) the landowner
would
receive the benefit in the form of higher wealth. However, if
the
lands were sold by the government at an auction, the taxpayers
would capture this excess, while if sold by the railroad, the
railroad
would capture it. The purchaser of land might be indifferent to
the
identity of the seller, but it would have some effect upon the
pricing
policy of railroads. If the government captured the incremental
rent,
the railroad would maximize profits by monopoly pricing of
fares.
This would lower the rental value of land below its optimum,
but
would yield maximum railroad profits. If, however, the railroad
first
owned the land and was in effect selling the land to purchasers
in
addition to charging for freight shipped, profit maximization
would

occur at optimum social output.15 The land grant permits the
railroad
to act as a perfect price discriminator, capturing the rent in its
pricing of the asset sold rather than on the shipments, which
could
13 See the classic article by Alexander M. Henderson, "The
Pricing of Public
Utility Undertakings," Manchester School of Economics and
Social Studies, XV
(1947), 223-50. For a recent approach that fits in the social
decision-making process
with the pricing discussion, see James M. Buchanan, "A Public
Choice Approach
to Public Utility Pricing," Public Choice, V (1968), 1-17.
14 The usual assumption is that, within any small area, the
demand curve faced
by producers for export is perfectly elastic at the "world" price
less the costs of
transport, and the supply of imports is also perfectly elastic, so
that lowered trans-
port costs do not affect the "world" price.
15 It is assumed that the railroad keeps the implicit contract
concerning rates
that it makes when selling the land. Actually, it would pay for
the railroad to sell
at a promise of low rates, but, once the land is sold for the
higher price, to raise
freight rates to the monopoly level. Note that unexpected rate
wars could then
provide landowners with windfall profits.

2017 19:20:20 UTC
450 Engerman
then be priced at marginal cost. Total railroad profits are
maximized
when both land and freight transport are sold and this form of
price
discrimination yields the appropriate social output."' Thus the
land-
grant subsidy could lead the railroad to produce the appropriate
output, whereas any other form of aid would require separate
determination of optimum output and subsidy payment."7 This
sub-
sidy would be paid by taxpayers to railroads, with settlers pre-
sumably not benefiting.'8
The final set of issues to be discussed concerns the argument
that
the reason for subsidy was to provide some method to offset
private
evaluations of the riskiness, or uncertainty, of projects."' This
is
apparently the best justification for subsidy in the railroad
case. It
may be that the mean expectation was of a normal return from
opera-
tions, but that because of uncertainty considerations investors
de-
manded a risk premium before undertaking investment in a
private
project. Since bankruptcy in operations was always a
possibility, this

consideration could deter investment financing of a privately
owned
project. If it is considered socially desirable that investments
of high
expected value but of high risk or uncertainty be undertaken (a
mat-
ter that has provoked debate in recent years), several types of
policies are available to the government. First, actions could be
16 Land grants, with the alternate acreage provision, might still
allow for the
correct output, with taxpayers obtaining part of the "benefits."
There is a problem in
evaluating the railroad pricing policy to maximize profits when
the grant is for only
one-half the adjacent land and when price discrimination is
precluded. The output
in this case, however, should be closer to the optimum output
than it would have
been in the absence of the grant.
17 As will be discussed in more detail below, the land-grant
policy would make
the railroad anxious to accelerate settlement, but that does not
mean that it would be
willing to part with land at less than its full value for a given
fare structure. There
would be no advantage to the railroad in foregoing those
potential profits, nor is
there one for society unless there is another decreasing cost
component involved.
18 These decreasing cost considerations raise several issues for
the interpretation
of state failures to cover costs in earlier years, particularly in
the canal era. There

was no need for canals to be paying ventures, since some
subsidy to cover fixed costs
would have been desired, at least for certain pricing policies,
and there are circum-
stances under which financial failure would have been the
appropriate policy. In
the analysis of canals undertaken by Harvey Segal the freight-
rate used per ton-mile
is less than half the resource costs per ton-mile, consistent with
(among many other
things) declining average costs. Harvey H. Segal, "Canals and
Economic Develop-
ment," in Carter Goodrich, et al., Canals and American
Economic Development
(New York: Columbia University Press, 1961), pp. 216-48.
19 The imperfection could also have taken the form of a
savings constraint, with
the ordering of investments by social profitability differing
from that by private
profitability. Then a government subsidy could be necessary to
provide the appro-
priate ordering by social profitability. For the nineteenth-
century United States, with
international capital inflows, this case seems of limited
interest.
2017 19:20:20 UTC
undertaken that do not affect the expected value of projects,

but
that reduce the private risk of loss. These actions could entail
government guarantee of securities (making investment riskless
to
the non-local private sector), or the use of government rather
than
private security issues to finance investment.20 The latter
method
was used to finance several land-grant roads, with the federal
government providing securities in exchange for railroad
issues. The
government securities were sold to private investors, with the
rail-
road making payments to the government out of profits. The
frequent
use of this type of financing suggests that capital market
conditions
were crucial in determining the extent of the government role.
A second device to induce investment would be to provide a
non-
related subsidy which would not increase the expected value of
the
transportation project to investors, but would raise the expected
income for the package as well as reduce the risk of investor
loss by,
in effect, diversifying the portfolio. The subsidy could, for
example,
take the form of an asset of value being offered in conjunction
with
the railroad security. Thus a bank charter issued to an
improvement
company would have this diversification outcome, as would a
grant
of land in an already settled area.21 Similarly a cash grant

would
clearly increase expected value. (In all these cases the
additional
asset would have a return that would be uncorrelated with that
of
the railroad, so that the investment package would also be
made less
risky.) The United States land grants, however, promised a
higher
expected return without a large reduction in risk. In the case of
land
adjacent to the proposed line, the subsidy return would be
highly
20 The Public Aids data indicate that the use of government
aids was more a
function of capital market considerations than of externalities.
A large portion of
aids was not taxpayer financed, but consisted of a swap of
government securities (fed-
eral, state, and local) for private securities. For example, of the
total loans and
subscriptions described, almost 90 percent entailed government
payment in securities
rather than in cash or in kind. Of the much smaller total of
outright contributions,
over 40 percent were made through securities, not cash. (The
use of securities as
opposed to cash was more frequent on the state than on the
local level.) The same
reliance on security issue rather than taxpayer finance was
characteristic of the canal
era as well. Harvey H. Segal, "Cycles of Canal Construction,"
in Goodrich, Canals,
pp. 169-215. To evaluate fully the costs of such policies,
therefore, it is necessary

to know more about the details of canal and railroad debt
payments to governmental
units.
21 The former method is seen in New Jersey's aid to canal
construction, discussed
in H. Jerome Cranmer, "Improvements Without Public Funds:
The New Jersey
Canals," in Goodrich, Canals, pp. 115-66. The latter is found in
Canadian land-grant
policy, which left the railroad greater flexibility in choosing
land than occurred in
the United States, permitting land to be selected which was far
removed from the
location of construction.
2017 19:20:20 UTC
452 Engerman
correlated with the return from the operations of the railroad. If
it
was felt that the pace of settlement was such that insufficient
traffic
would be generated, making the railroad an undesirable
investment,
the expected future value of land would be low. The addition of
an
asset, with a return positively correlated with expected return
from
operations, thus might not sufficiently enhance the desirability
of

the package, which suggests why land might have been a rather
ineffective method of overcoming the market's feelings
concerning
risk, and explains why the land-grant feature apparently did not
raise the valuation of securities issued.22 Land might have
been
politically the cheapest way to provide a subsidy, but it was
clearly
not economically the most efficient. If the problem was
"building
ahead of demand," or building before the private investors
thought
the time was ripe, the form of subsidy selected was
inappropriate.
The case for railroad subsidization is not an easy one to make
with
the use of the conventional economic models. The best
rationales are
those based upon imperfect capital markets, in which investor
uncertainty must be overcome in order to raise private
investment
funds, or upon the existence of a decreasing cost firm. In the
former
case, however, Fogel has pointed out that land is not the
preferred
method of financing construction. The case for a land subsidy
can be
best made for the decreasing cost firm, in which internalizing
the
externality in the form of land values results in the appropriate
out-
put decision. However, land grants of the type used (land
adjacent to
the railroad line) were not efficient in the promotion of the ap-
propriate investment decision. Moreover, neither of the two ra-

tionales mentioned in this paragraph describes "building ahead
of
demand," at least as that concept has been conventionally
described.
II
In order to evaluate the efficacy of government land-grant
policy,
the value of the subsidy which was provided must be
determined.
A heated debate in the Mississippi Valley Historical Review in
1945
22 In the case of the transcontinental and other land-grant
railroads, the issuance
of bonds backed by the grant was delayed, often until almost a
decade after the
grant was bestowed. For example, the Union Pacific did not
issue land-grant bonds
until 1869, and the Southern Pacific until 1871. Stuart Daggett,
Chapters on the
History of the Southern Pacific (New York: Ronald Press,
1922), and Robert W.
Fogel, The Union Pacific Railroad: A Case in Premature
Enterprise (Baltimore: Johns
Hopkins Press, 1960).
2017 19:20:20 UTC

was centered on this issue.23 The proposed evaluations run
from the
cost of government acquisition to the actual selling price (and
that
without any discounting). The issue has recently been
discussed by
Mercer, who argued 'that "the value which the land had, before
the
building and operation of the railroad, was a subsidy.... The
value of
the land grant beyond this was the capitalization of the stream
of
unpaid benefits which would accrue to the land owner when the
railroad was in operation."24 This distinction between the
value the
land had before the railroad and its value afterward was
justified by
arguing that the former amount was presumably the price the
government would have received if it had sold the land to the
railroad owners, while the latter was "but a capturing by the
rail-
road of part of the otherwise unpaid benefits it produced." This
position is similar to the view taken by Colonel Henry and
other ad-
vocates of the railroad position in the 1945 articles. The
argument
about the valuation of land grants has generally been conducted
on
the assumption that there was perfect foresight about the course
of
future land values. Whatever historical validity this assumption
has,
making the assumption permits one to focus on several
important
analytical points in the debate.

The basis of the Mercer argument is that the land would have
had
some value in the absence of a railroad, and it is at this price
that the
particular entrepreneurs would have been able to acquire the
land
from the government.25 After construction (or, more
accurately,
announcement) the land values would increase. This increase
(at-
tributable to the transport improvement) would represent the
value
of a benefit to which the promoters were entitled. Implicit in
this
argument is that there was only a single interested purchaser
buying
land from the government at a non-railroad price, and therefore
able
to benefit from the increase in value which the railroad brought
about (since the government had been willing to sell at the non-
railroad price). It should be noted that, in general, the
capturing of
all benefits by entrepreneurs is not considered desirable or
necessary
for proper investment decisions, but putting that objection
aside for
23 See Robert S. Henry, et al., "The Railroad Land Grant
Legend in American
History Texts," Mississippi Valley Historical Review, XXXII
(1945-46), 171-94 and
557-76.
24 Mercer, "Land Grants," p. 140.
25 Presumably if purchased in small parcels, and without

anyone else being aware
of the purpose of such purchases.
2017 19:20:20 UTC
454 Engerman
the moment, the argument overlooks some of the mechanics of
the
actual subsidy process. There rarely existed a monopoly of
informa-
tion on the part of only one group of promoters; in many cases
there
were several groups of entrepreneurs competing for the
franchise
rights to build the same or comparable lines. Rather than a
purely
bilateral situation existing between promoter and government,
the
government was in the position of a monopoly provider of land,
offering land to competing promoters. What the government
had to
offer was a package consisting of an exclusive franchise and
land, and
the bidding (in the form of bribery, etc.) among entrepreneurs
set
the value of the package.26
This is not to deny that the increased land values were due to a
railroad; it is to suggest that if several entrepreneurs were
willing to

undertake construction, the benefits cannot be attributed to the
railroad actually built by one particular group of promoters.
The
owner of the exclusive rights, the franchise, was the
government, and,
by establishing the proper pricing policy for land, the
government
could obtain the incremental benefits for the taxpayer. The
difference
between pre- and post-railroad values would then accrue to the
government, and not to the private promoters. The bid price for
a
franchise plus land would be sufficient to yield a normal return
to
promoters from the package. We can visualize two possible
cases.
First, if the franchise had value-expected profits from
operations
were positive the price paid for land would have been the
expected
selling price. However, if the franchise, with whatever
conditions
imposed, had a negative value, the price bid for land would
have
been the expected selling price of land less the expected loss
from
railroad operations, so that the bid for the complete package
would
have provided for a normal return. Given a sufficiently high
value of
the land in the absence of a railroad, the promoters would have
made
a positive bid for the package including the franchise. Thus the
maximum value of the subsidy attributable to the land grant
would
be the selling price of land, while the appropriate valuation of

the
land would be the post-railroad price of land.
While the argument based upon perfect foresight is of interest,
it
obscures some elements of difference between land and other
forms
of subsidy. One difference, the correlation with project risk,
was
discussed above. Another issue, often obscured in the
literature, con-
26 Vide the legislative battles for rights to franchises.
2017 19:20:20 UTC
cerns the allocation of the risk relating to the subsidy between
the
government and the investors. There was risk in regard to the
relative
price of land, as well as its absolute price. One difficulty in
determin-
ing the allocation of risk is that we don't know how the
quantity of
land granted was decided. A cash provision would be certain in
absolute amount, but since it would be affected by changing
price
levels, it would be uncertain in purchasing power. The land
grant
presumably was meant to yield a certain cash income to

investors,
and it might be argued that the independent variable was this
cash
equivalent, with the quantity of acreage set to yield this
amount. To
allow for uncertainty, it might be that a larger quantity was
provided,
thus yielding a larger certainty equivalent for the subsidy.
Until more
is known about this expected value, and the acreage
adjustment, no
statements about the distribution of risk between stockholders
and
the government are possible. The usual assumption (made
above)
that the risks were borne by the company may not truly reflect
the
subsidy intended by the two parties.
The other uncertainty concerning the land grant, which affects
the
estimation of the value of the subsidy and the risk borne, arises
because the Civil War land grants were given at a time when
the
price level was expected to decline. The Civil War inflation
was
considered an aberration which would be overcome in the
ensuing
years of peace. The choice between a subsidy in cash or one in
kind
would be affected by these price level expectations (and adjust-
ments of risk could be made as described above). The risk of
price
changes could therefore be borne by either party. The subsidy
paid

in land is akin to a subsidy fixed in terms of constant
purchasing
power, since the asset value would adjust to changing price
levels
to yield an anticipated increment in terms of real goods. To
provide
a similar sum via a cash subsidy there would have to have been
a
scale written in allowing for the expected price level changes.
If,
however, the grant was intended as a specified cash amount,
irrespective of the price level, then the falling price level
reduced
the value of the grant, since the payment of a cash sum would
have
left the railroad better off than the payment in kind.
There is one further issue concerning the cash value of the
subsidy
to which Mercer and others have devoted some attention. This
is
the relationship between the cash value of the subsidy provided
and
the cost of construction. If the value of the grant (properly dis-
counted) was sufficient to meet the cost of construction,
investors
2017 19:20:20 UTC
456 Engerman
would be perfectly levered, in that they would be able to get by

with
zero investment, providing no risk capital in exchange for their
future income.27 However, Mercer shows that land grants
raised the
private rate of return by a relatively small amount. As Mercer
(and
Cochran before him) points out, the confusion in the literature
on
this point results from the failure to consider the substantial lag
in
land sales behind construction.28
By using the ex post data calculated by Mercer in his
evaluation of
the contribution of the land grants to increasing private returns,
it is
possible to say something about the value of the land grants to
the
Central Pacific and to the Union Pacific. As Mercer points out,
in both
cases the return from the grant, properly discounted, was low
relative
to the costs of construction, and thus could not be used as a
source of
bond issue to finance all the costs of construction. His
estimates can
also be used to calculate the maximum value of the land-grant
subsidy. This maximum would be the value of the net proceeds
from
selling the land. The present value in 1862 of the subsidies to
the
Central Pacific and the Union Pacific was under $1 per acre (in
1869
dollars), totalling under $40 million. In current dollars this
would be
equal to less than 10 percent of the federal budget in the year

of the
first grant, 1862, and is a sum equal to less than one-half the
average
annual federal expenditures in the 1850's. A crude
extrapolation of
this subsidy value per acre to all transcontinental roads still
leaves
the entire program amounting to considerably less than one-
half
year's peacetime budget in the post-bellnm period.29
This relatively low valuation of $1 per acre does not hold for
other
lines. For example, the present value of the lands granted to the
Illinois Central in 1851 was about $10 per acre.30 However,
the
27 In that event the private rate of return, including income
from land revenues,
would have been infinite when measured from the date the
subsidy was received.
28 See Mercer, "Rates of Return," and Thomas C. Cochran,
"Land Grants and
Railroad Entrepreneurship," THE JOURNAL OF EcoNoMIc
HIsToRY, X (1950), 53-67.
29 The extrapolation of a $1 subsidy value per acre would
make federal land
grants equal to about one-fifth of the government investment in
railroads calculated
by Goodiich. Goodrich's estimate of the proportion of
government investment to
total investment, with his suggested addition of the value of
land to the total of
other aids, is misleading. The latter total does not really

provide an estimate of
the net amount of government subsidy, but rather of the total of
government cash
and security aids. Given the importance of the swapping of
private for government
securities, the proportion of taxpayer subsidy represented by
land grants would be
higher than the average subsidy implicit in the other categories
of aid. See Carter
Goodrich, "Internal Improvements Reconsidered," THE
JOURNAL OF ECONOMIC
HIsTORY, XXX (1970), 289-311.
30 Thus, relative to the size of the federal budget in the year
granted, the Illinois
Central grant was the most important of the land grants.
2017 19:20:20 UTC
lower valuation is more accurate for the great bulk of lands
provided
to the transcontinental, which received land where settlement
char-
acteristics were more similar to those of the Union Pacific and
the Cen-
tral Pacific than to the Illinois Central. The difference in value
per acre
between the Illinois Central and the transcontinental systems
reflects
not only differences in selling price per acre, but, more

importantly,
the fact that there was a much longer lag of sales behind the
date of
the grant for the latter. Whereas the Illinois Central had sold
almost
90 percent of its land twenty years after the grant, a similar
percent-
age was not achieved by several of the transcontinentals until
almost
fifty years after their grants were received.31 It is these belated
sales, rather than the use of selling prices, which make the
Public
Aids totals for the value of the subsidies too high. The long
time
taken to realize the proceeds indicates why the grants may have
been
of limited effectiveness. It might be argued that the lands were
arbitrarily kept from sale for prolonged periods, but the general
failure to enter into rental contracts would suggest that delays
in
title transfer of land in productive use were not frequent. Also
sug-
gestive of the probable absence of inefficient delays are the
heavy
railroad investment in advertising for settlers. And, as shall be
dis-
cussed below, there are reasons, such as railroad credit
provision, for
believing that the land sales were faster as a result of land
grants
than they otherwise would have been.32
III
The most recent study of land-grant policy concludes with a
justification of the program, on the basis that the ex post social

rate
31 For example, the Union Pacific had sold only 60 percent of
its land by 1890,
and the Northern Pacific, by far the largest recipient of land,
did not sell one-half
of its grant until early in the twentieth century. Twenty years
after the grant less
than 10 percent had been sold. While the Illinois Central was
atypical in both
selling price and pace of sale, most of the other midwestern
lines did achieve sales
of over one-half the land in their grants within about 20 years.
See Paul W. Gates,
The Illinois Central Railroad and Its Colonization Work
(Cambridge: Harvard Uni-
versity Press, 1934); Richard C. Overton, Burlington West: A
Colonization History
of the Burlington Railroad (Cambridge: Harvard University
Press, 1941); Poor's
Manual of the Railroads of the United States (New York:
Annual 1868- ); and
L. L. Waters, Steel Trails to Santa Fe (Lawrence: University of
Kansas Press, 1950).
It remains a mystery why the transcontinental took so long to
sell their land. The
lag is inconsistent with the perfect foresight assumption.
32 On the general question of the speed of sales by landowners,
see Robert W.
Fogel and Jack Rutner, "The Efficiency Effects of Federal Land
Policy, 1850-1900: A
Report of Some Provisional Findings," in William Aydelotte et
al. (eds.), Dimensions
of Quantitative Research in History (Princeton: Princeton
University Press, 1972).

Again, however, it is unclear exactly why the railroads did take
so long in selling
their lands, even if the sales were made at a more rapid pace
than would have
occurred if the government had been the seller.
2017 19:20:20 UTC
458 Engerman
of return on land-grant roads exceeded both the market rate and
the
social rate of return on projects abandoned as a consequence of
the
diversion of investment from them to the land-grant roads.33
There
are some technical problems with this definition, relating to the
as-
sumptions of capital market perfection and the existence of a
mono-
tonic relationship between private and social rates of return.34
Putting these points aside, it can be seen that Mercer's criterion
does
not really provide the test of the desirability of land grants that
has
been suggested most frequently. Mercer's criterion ignores the
dis-
tinction between the questions of whether the railroad should
have
been built and whether, given a positive answer to the first
question,
the building should have been aided by the provision of land

grants.
The second question raises the issue of whether the subsidy
was
optimal, rather than excessive, from the point of view of
taxpayers.
Mercer's test for the usefulness of land grants is that the social
rate of return, including the private return from operations and
the
increased incomes of the users of the road which were not
captured
by the railroad, exceed the market rate of return (the measure
of the
opportunity cost of capital). Strictly speaking, Mercer has
tested the
proposition that the railroads built with land grants were
desirable;
he has not explicitly tested the proposition that the land grants
themselves were desirable. In order to test the latter
proposition, one
should measure, not the marginal return on the funds invested
in the
railroad, but rather the marginal return on the funds invested by
taxpayers in influencing this particular investment decision by
other
33 Mercer, "Rates of Return." This is Mercer's second test,
which he considers
to be conclusive. The first criterion, relating to the short-fall of
the private rate of
return to investors below the market rate, is, however,
important for determining
both the desirability of a subsidy policy and the size of the
optimum subsidy. Mercer
does point out that his verdict "rests on the further conclusion
that land grant

policy hastened construction of the system." The sup port for
this judgment rests
on a statement made by Robert Edgar Riegel, which places the
acceleration at ten
to fifteen years. Robert E. Riegel, The Story of the Western
Railroads (New York:
Macmillan, 1926). Riegel's estimate is frequently cited, but is
clearly more an im-
pression (albeit an educated one) than the specific result of the
testing of any
hyothesis. Not everyone, of course, accepts this possible
acceleration of railroad
construction as necessarily a desirable condition for the
national economy. See, for
example, Frederick A. Cleveland and Fred W. Powell, Railroad
Promotion and
Capitalization in the United States (New York: Longmans,
Green, 1909), p. 253;
and Thomas C. Cochran, "Did the Civil War Retard
Industrialization?", Mississippi
Valley Historical Review, XLVIII (1961), 197-210, where it is
argued that the
economy would have been better-off if construction had been
delayed.
34 See Peter D. McClelland, "Social Rates of Return on
American Railroads in
the Nineteenth Century," (Unpublished, Discussion Paper 188,
Harvard Institute of
Economic Research, April 1971).
2017 19:20:20 UTC

members of the private sector. The latter return may have been
sub-marginal for two reasons. First, it may have led to an
investment
which was not socially profitable even though with the subsidy
it
was privately profitable.35 The investment would then have
created a
cost to society, the loss involved in drawing resources away
from
more profitable uses. However, historians have seldom argued
this
case. Their suggested test is not that of the waste of resources.
Most
seem to believe that the railroads themselves were socially
profitable.
But some believe that the subsidies were unnecessary, and
created
excess profits for their recipients. The subsidies were thus
transfers
from general taxpayers to railroad investors, a "giveaway."
There
may have been no loss to society, but there was a redistribution
among its members.36 Mercer's test would show that the land
grants
were socially desirable even in the second case. His criterion
would
treat subsidies in excess of the optimal amount necessary to
provide
for construction as efficient subsidies. It would thus accept
situations
in which firms that were privately profitable would be deemed
worthy of receiving subsidies.

What apparently has been of interest to historians is the
question
of whether the government paid the "optimum subsidy," that
amount just necessary to bring about construction.87 Concern
with
the prospect of excess subsidy is, of course, one reason why the
evaluation of the subsidy inherent in land grants has aroused so
much controversy. Mercer's tests ignore this aspect of the con-
troversy. His tests for the desirability of land grants should
have
included the following two parts. First, that the social rate of
return
exceed the market rate. Second, that the market rate exceed the
private rate of return on this particular investment, with the
subsidy
equal only to the difference needed to equate the market rate
and the
private rate of return to investors.
35 This would happen if land values were high without the
railroads and the
railroads added little to any intertemporal increase in value, or
if the aid took the
form of other profitable assets, permitting entrepreneurs to
obtain private profits
even though the railroads provided no net benefits for society.
36 If government expenditures were held constant, in essence
the transaction would
amount to an increased tax burden upon the citizens to pay a
certain sum to the
railroad investors, and since taxation was not lump-sum, some
distortions could occur.
37 For an application of this concept to a discussion of the
Canadian Pacific, see

Peter J. George, "Rates of Return in Railway Investment and
Implications for
Government Subsidization of the Canadian Pacific Railway:
Some Preliminary Re-
suits," Canadian Journal of Economics, I (1968), 740-62. Of
course, using the ex
post data developed by Mercer for the two American
transcontinental systems, the
"optimum subsidy' would have been zero.
2017 19:20:20 UTC
460 Engerman
IV
The various forms of social benefits anticipated from railroad
construction were mentioned above in the discussion of why a
subsidy policy was desired. Similarly the evaluation of social
costs
was considered, in part, in the discussion of the determination
of the
value of land grants. Yet these descriptions omitted some of the
relevant historical issues. Land-grant policy was but one of a
set of
governmental policies relating to the overall pace of western
settle-
ment. By the land-grant decision the government was affecting
the
speed of settlement of the western part of the continent.
Similarly, in
evaluating costs, it is necessary to consider alternative feasible

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