ECONOMICS OF REGULATION ANDANTITRUST il 0) Introduction to Economic Regulation. Third Edition W. Kip Viscusi Jobn M. Vernon ‘What Is Economic Regulation? Joseph E. Harrington, Jr. ‘The essence of free enterprise is that individual agents are allowed to make their own de- cisions, As consumers and laborers, each person decides how much to spend, how much to save, and how many hours lo work, Firms decide which products to produce, how much to produce of each product, what price to charge, which inputs to use and from which suppliers to buy them, and how much to invest, In all modern economies, there is also an entity called ‘government, which decides on such things as the income tax rate, the level of national de- fense expenditure, and the growth rate of the money supply. Government decisions like these affect both the welfare of agents and how they behave. For example, raising the income-tax rate induces some individuals to work fewer hours and some not to work at all. Although an income tax influences how a laborer behaves, the laborer is left to decide how many hours to ‘work. In contrast, in its role as regulator a government literally restricts the choices of agents. ‘Mote formally, regulation has been defined as “a state imposed limitation on the discretion that may be exercised by individuals or orgenizations, which is supported by the threat of sanction"! ‘As has long been noted, the key resource of government is the power to coerce. Reg- ulation is the use of this power for the purpose of restricting the decisions of economic agents, In contrast to the income tax, which does not restrict the choices of individuals (though it does affect their welfare), the suinimum wage is a regulation in that it restricts the ‘wages that firms can pay their Isborers. Economie regulation typically refers to govemment- {imposed restrictions on firm decisions over price, quantity, and entry and exit. Economic regulation is to be contrasted with social regulation, which is discussed in Part Il ofthis book: ‘When an industry is regulated, industry performance in terms of allocative and produc- live efficiency is codetermined by market forces and administrative processes. Even if it so desires, a government cannot regulate every decision, as itis physically impossible for & government to perfectly monitor firms and consumers. As a result, market forees can be expected to play a significant role regardless of the degree of government intervention. For example, under airline regulation, the government controlled price but not the quality of service, Firms were induced to shift competition from the price dimension to the quality dimension, Even in & government-costrolled economy like the former Soviet Union, mar- ket forces were at work. Although production and price were set by the stat, the (effective) rmarket-clearing price was set in the market. Ifa good isin short supply, people will waitin line for it, The effective price to them is the price paid to the state plus the value of their ‘The MIT Press Cambridge, Massachusetts ‘London, England 1. Alen Stone, Region ads leratives (Washinton, D.C Congesional Quy Pres, 1982) 910258 Chapter 10 time spent inline, In equilibrium, people stand in line uni he effective price clears the markt Instruments of Regulation [Although economic regulation can encompass restrictions on a wide array of firm deci sions the dee key decision variables contolled by regulation are pice, quantity, and the umber of firms. Less frequently controlled varisbles include product quality and invest Control of Price Price regulation may specify a particular price that fms must charge or may insted restrict fim to senting price within some range. IF the concer ofthe government is with a regulated ‘monopolist sting price too high, regulation is apt to specify « maximum price that can be charge, For example, in 1989 the Federal Communications Commission (FCC) instituted rice cap to regulate ATAT's long-distance rates. If the regulated frm has some unregulated competitors, the regulatory agency may also be concerned with the regulated firm engaging in predatory pricing that is, pricing so as to fore its competitors to exit the market). In that situation, regulation is likely to entail a minimum price as well as « maximum price. In some cases, ke the control of oil prices inthe 1970s, regulation required that a speifie price beset More often than not, regulation specifies more than a single price. It can pot an entire rice stucture in place. The regulation of ATT in the intercity telecommunications market require the FCCio specify long-distance rates For diferent times of day and for differen days ofthe week. The specification ofa price structure as opposed to just a single price greatly increases the complexity of implementing economic regulation and can result in additional welfare losses, as we will observe, In practice, price regulation may be the means by which a regulatory agency achieves an imate objective of ming industry profit. A regulatory agency often sets price so thatthe regulated fim earns a normal rate of return This is standard practice in the egulstion of public ulities and has been used in other regulated industries such as the airline industry prior to its deregulation. Because frm profit is determined by a varity of fctors (with price being just one of hem), a regulatory agency may have a dificult time in achieving its goal of 'snormal ate of retum, Regulatory lg in changing price in response to new cost and demand onions can result in regulated frm euring citer too igh or too low a rate of return. Daring ibe inftonary period ofthe 1970s, rising input prices resulted in public utiles often caning a below nomal rate of return because the regulatory agency was slaw to adjust peice. Altematively, a regulated firm that experiences an novation ins production technology will Induction to Economie Regulation reap above-normal profits unl the regulatory agency realizes the cost function has shifted down and responds by lowering price. A detailed discussion of rateofcetum regulation is provided in Chapter 12. Control of Quantity ‘Restietions on the quantity of «product or service that i sold may be used either with or ‘without price regulation. From the 1920s up until around 1970, many oil-producing states, mong them Texas and Oklahoma, placed maximum production limits on erude-il prodive- tes, Although quantity was controlled bythe state, price was determined nationally or globally (though obviously these quantity contzos influenced the market price). Allermtively, «com ‘mon form of quantity regulation that soften imposed upon a common care is that it*meet all demand at the regulsted price” This requirement is used in regulating electric utes. ‘Finally, regulation may place restrictions upon the prices that frms set while leaving their quantity deision unregulated, For example, there were no quantity restrictions imposed when Titural gas prices were regulated, Because these regulted prices were et below their market- Clearing levels und firms were not required to meet ll demand, the obvious implication was shortages Control of Entry and Exit As we will se in our studies of economic regulation, the two critical variables that regulators have contolled are price and the numberof firms, the later through restrictions on enry and cnt, These variables are critical because price andthe numberof ims are Rey determinants of both allocative and productive efciency Entry may be segulated on several levels. First, entry by new firms may be contlled, 1s is typically done inthe regulation of public utes. A Key step toward deregulating the intercity telecommuniations market was the FCC’s allowing MCI to enter in 1969. MCI ‘vas the ist entrant in the markt since the industy'sreglation atthe tum of the twentieth century. Tinton to controlling etry by new firms, a regulatory agency may also control eney by ‘existing regulated firms, These markets may already be served by ober regulated firms or mity be unregulated markets. As an example ofthe later, the FCC placed restrictions on AT&T's cnt into the computer market inthe 1980s, The former case is exemplified by siline and trucking regulation, Their respective regulatory agencies made it very dificult for an existing, firm to enter a geographic market already seved by another regulated firm. AS a more recent cxample of entry restrictions, the Telesommunications Act of 1996 specified that «regional ‘Bll operating company isnot permited to offer long-distance telephone service its local telephone customers uni its local telephone market is deemed sufiintly competitive by the FCC.300 Chapter 10 ‘A bass for exit regulation is that megulation strives to have services provided wo a wider set of consumers than would be true in free market. Ataning this goal may ental res- lated fms serving unprofitable markeis and, hence, crete a need for regulations that focbid a reguleted fim from abandoning & market without regulatory approval. As we will see, restricting the decision to ext was an important issu inthe regulation of the silroad indasty. Control of Other Variables “Theessene of economic regulation isthe limitation of finn behavior regarding price, quantity, nd entry into and exit out of markets. Obviously, ims choose many ther decison vtiables. (One of these is the quality ofthe product or service that they produce. A regulatory agency may speify minimum standards for reliability ofa service. I an electri utility has regular blackouts, the regulatory ageney is Ukely to intervene snd require an increase in capacity in oder to impeave service raiabilty Although product quality may also be controled for ‘reasons lke product safety, economic regulation does not typically place serious restrictions One reson forthe minimal use of quality regulation is the cost of implementing it. To control any variable, the relevant economic agents have tobe able to agree on what the ‘variable is and what retietons are placed on it. In the case of price and quantity, this isnot Aiticul, The price is the amount pid by the consumer forthe good, which is relatively easy to observe. Futhermare, restrictions take the simple fom of numbers: a maximum price and @ ninimaum price. Similarly, the measuability of quantity allows a regulatory agency to specify ‘esietons oni, However, quality is typically neither so well defined nor so easily observable. or example, the qulity of sirline service encompasses an array of variables, including on time performance, safety, on-board services, seat width, and luggage handling. In principle, ‘regulatory agency could attrpt to contro each of these variables and thus control quality, butt would be very coal to do so, In the case of airline regulation, these variables were not controlled except for minimal standards on safely. As a result, aislines competed vigorously ‘in tems of quality, Generally, economic regulation has not placed severe restrictions on the quality of products or services that rms offer with the notable exception of product safety. ‘Another variable that is sometimes (though infrequently) regulated is frm investment. In contrast othe other decision variables we have considered, regulation of investment entails government intervention ito the production press tht is a firm's ehoice of technology and inputs. A regulacory agency may intervene inthe capital decisions ofa publi wit ike tn electc utility ora loal telephone company. One significant example i state regulation of investment decisions by hospitals. Cerificate of Need programs require a hospital to obeain stale approval before undertaking certain investment projects, Te stated objective is to avoid duplicate elites, 301 ——_etrodetin to Beonomi Regulation [Brief History of Eeonomie Regulation Formative Stages ‘What is typically meant by economic regulation inthe United States began in he 187052 To {important event took place aound that time. First, a Key Supreme Cour decision provided the ‘basis for the regulation of monopolies. Second, forces were building in the eilroad industry ‘that would result in its being the fst major industry subject to economic regulation atthe Federal level. ‘Munn v. inois (1877) 1m 1877 the landmark case of Munn w Hlnois was decided. This case established thatthe state of llinois could regulate rates set by grain elevators and warehouses, As stated inthe opinion of the majority the important principle promulgated by this decision was that, propery does become clothe with public ineres when used i a manner make it of public conse- ‘quece, end affect the commanity alge, When, therefore, ane devote his propel to wei which ‘he bli as on intrest e, nee, grams to the publi aimee nha se, and must submit be ‘ontoled by the pli for the como goo, ‘Munn » Hlnois provided the foundation for regulation to be used to prevent monopolistic exploitation of consumers. Interstate Commerce Act of 1887 ‘Around the time of the Mun»: Hinois decison, the road industy was going through & turbulent period. Throughout the 1870s and 1880s the rallzoad industry was subject to spurts of aggressive price wars intermixed with periods of relatively stable prices (see Figure 5.8 ‘in Chapter 5). At the same time, the railroads were practicing price disecimination across different consumers, Those consumers who were charged relatively high prices (because of| ‘oltively inolatic demand) were calling for government intervetion, At the same time, the railroads were seeking government assistance to stabilize prices (perhaps near the monopoly Tevel). The result ofthese forces was the Interstate Conmerce Act of 1887, which created the Interstate Commerce Commission (ICC) forthe purpose of regulating ral tes. Although conly with later acts of Congress was the ICC given the necessary powers to regulate price, the Interstate Commerce Act represents an important landmark in congressional regulatory legislation, 2 Fora doasion fey (ici gue ie he 1805, M, H. Hom "ty Regan of Pole Sanice Capone Amuro sone Rein (Se 197) 965-8,om Ccsper 10 [Nebbia v. New York (1934) ‘A.common interpretation of Munn x Hlinois was that it was constitutional for govemment to regulate certain monopolistic indusves. stricter interpretation was that regulation could only be applied to public ulities, However, in its 1934 decision of Nebbiav. New York, the ‘Supreme Court otlned« much wider realm for economic cegulation, In tha case, the slate ‘of New York was regulating the eal price of milk. The defense argued that the milk industry tras competitive and could not be classified as a public uty so that there was no basis for state regulation. The majority opinion stated So frat the quirement of dv proces is concerned, and in the absence of otter consional Testtn, 2st is eto adopt whatever eeonomie policy may reasonably be deemed t promote public well an to eaforce tat policy by legislation adapted to its purpose. “The Supreme Court tore down any constitational bases to economic regulation as long as, in the sct’s judgment, suc regulation was in the public interest. ‘Trends in Regulation acy regulation focused on the reilroads and public utes lke eletricty, telephone (which encompassed both lel telephone and long-distance communications), and city transit. The ‘Massachusetts state commission began regulating such industries in 1885, but not until the period of 1907-1930 did most state legislatures create public-service commissions. In addi- tion to federal regulation of railroads officially dating from 1887, regulation over interstate telephone service came with the Mann-Elkins Act of 1910, Figure 10:1 depicts the growth of regulatory lgisaton, Thee spurts of Legislative activity can be identified.” The fest to occured during the periods of 1908-1916 and 1953-1940, During thee years, and up through the 19705, federal regulatory powers were greally ex- panded to encompass lage nomber of vital industries inthe United States. The third burst, of legislative activity began inthe 1970s and entailed te partial or ful deregulation of many ‘ofthe regulated industries, This tend continued up to the 1990s, ‘The economic historian Richard Vieto has pat forth the intriguing hypothesis that these regulatory and deregulatry booms are de to 2 fundamental change in people's perception of how an economy and its government interact He atribute the regulatory wave ofthe 19308, to the downfall of faith in a Iiser-fire economy emanating from the Great Depression. ‘The deregulatory period of the 1970s occurred ducing a period of serious stagfation—high 3, tt an, Th Regula Suge of te 19704 nM Penge” in Eze Fay Pre ans Now Pps on ston ond Plies (Cage, ts MT Pros, 97 4: Richa HK. Vow, Cone Compton: Reuton on Dron Americ (Cambria, Ms ar tery re, 1950 es 303 Inoducton to Beonomie Regulation Numtor ot seis passed res Teb0- fe7e- 1050 1e80- 1940- 1980- 1960-1970 Taoo ‘oo ‘eve ‘wan T008 Toes 10891969 1979 gure 101 ‘Nuer a Econ ResoryLepisiv Acts owe cones othe Sty of Ameian Bsies Ti Gps Go James Fat "An Overview of iPro, Se eee son! James FG (oP Lina of GoterameatReprion (New Yk: Acai Pres 98 inflation and igh unemployment—which Vietor argues shook our faith inthe ability of the overament to provide a constructive influence on the economy. Though this hypothesis is speculative and has not been tested (nor i it lear how one could test it), itis both interesting and plausible. 1930s: Wave of Regulation ‘After the Nebbia'v. New York decision and inthe midst of the dire economic conditions of the Great Depression, a wave of economic reguletion took place over 1933-1940. At the state level, contol over the production of crude ol producers was being implemented by oil~ producing states. Atte federal lve, there were several pees of major legislation tht greatly ‘expanded the realm of economic regulation, 'A ist of these legislative acts is provided in Tuble 10.1, With legislative acts in 1935 and 1940, the ICC’s domain expanded from railroads tothe entire intestate surface freight transportation industry, which included trucks, water barges, and cil pipelines (the last goes back to 1906). The one key exception was ocean shipping, which was regulated by theepee 10 ‘tent er Ligne Act ‘Ney Cra ia nse Commerce Act Inca Commerce Commision 1810 Moki et 1316 siping 0 ‘Trmpration Ae 30 i paonag (iam Tes) ws asking Ac ou king Act. Comision At Federal Conmasintons Commision 35 Neto Carir et Paice Feder Power Canaiion Seo Bchnge et ‘ssa Eehange Cores ie (Chit Arcus Act Gl Aeros Boast anal Gar Act 0 “Tesperton Act Federal Maritime Commission beginning in 1936, Regulation of long-distance passenger transpotation was divided Between the ICC (siroads and buses) and the newly created Civil ‘Aeronautics Bourd (arin), To deal with the technologically progressive communications market, the Federal Com: ‘munications Commission was established in 1934 to regulate broadcasting and to take over the duty of regulating the intercity telecommunications market from the ICC. Although elee= tricity and natural gushed long been regulated at the state and local level, federal regula- ‘ion of interstate commerce with respect to these two energy sources was only established in 1935 (for electricity) and in 1938 (for natural gs). Initially, natural gas regulation only covered is transportation. Regulation of natural gas prices did not take place until the mid 190s. ‘The unsatisfactory performance of financial markets in the Great Depression was fol- lowed by a wave of federal legislation relating to the banking and securities industries. ‘Among other restrictions, the Banking Acts of 1933 and 1935 created the Federal Deposit Insurance Corporation, forbade commercial banks from paying interest on ordinary check- ing accouns, and, in what as been referred to as the Glass-Steagall Act, prohibited both commercial banks from participating in investment banking and investment banks from 2 ceptng deposits, The Securities Act of 1983 mandated disclosure of information by issuers of securities, and the Securities Exchange Act of 1934 created the Securities and Exchange ‘nvroduetion to Beonomie Regulation Commission, the main purpose of which sas to monitor the ectivities of the securities industry 1940s to 1960s: Continued Growth of Regulation Between the two legislative peaks of the 1930s and 1970s, legislative activity continued fon a modest but steady path of expansion of federal regulatory powers. Two sectors— nergy and communicstions—were particularly affected. Although cable television was intally let unregulated atthe federal level, it became subject to FCC regulation begin- hing in 1968. Until 1954 federal regulation of th oil and natural gas industries was only over pipelines and, atthe slate level, over production of crude cil, Because of a Supreme ‘Court decision in 1954, the Federal Power Comnmission began controlling the wellhead price of natural gas. Then the price of oil was regulated beginning in 1971. Foreshadowing the deregulation that was to come, the FCC permitted MCI to enter the intercity telecommusi- cations market in 1969. Tis action represented a crucial fist step in the deregulation ofthat market. 1970s to 1980s: Wave of Deregulation “The decades of the 1970: and 1980s were characterized by extensive deregulation (see “Table 102). In 1977 fully regulate industees produced 17 percent of the U.S. Goss National Product, By 1988 this figure had been reduced to 66 percent’ In the area of transport ‘ion, several pieces of legislation over 1978-1982 deregulated ailines (Airline Deregulation ‘Act of 1978), railroads (Staggers Act of 1980), tucking (Motor Carrier Act of 1980), and passenger buses (Bus Regulatory Reform Act of 1982). In communications, enty regula- tion of the intercity telecommunications market was tom clown over the course of several decisions that ranged from the FCC's Specialized Common Carrier Decision in 1971 t0 the breakup of AT&T in 1984 a¢ a result of the U.S. Justice Department’ antes case [Also ducing this period, cable television was deregulated atthe federal level. Finally oi! price controls were lifted by Presideat Ronald Reagan in January 1981; patial deregule tion of natural gas prices had begun in 1978. Only in 1989 were naturalges price controls removed. [Regulatory Policy in the 1990s [Asis evident in Table 1043, the deregulatory wave that began in the 1970 largely eontin- ted into the 1990s, In recent years the deregulation of interstate and intrastate tucking. was ‘5 citfrd Wison, “Ezononic Deep: Dye of Recarag for Micromass” Jou! of Economic ssc 1 Sept 1993 126983Ths pope prover ompecnensve say he diced 26 reseed fer feo desi.306 Chapter 10 Introduction to Beonomie Regulation Table102 ‘tate10 Major Esnmie Dereguaoy Inatine, 1971-1989 sh oder amon Regula at Dressy Iii, 190-1957 Yer Iniaie Your Inte Provision: im ‘pein Conon Cae Don FCC) ol Rete De Tad oar rien oes site open ke ple Inswrnce Corprtion _itveton fe lg buns, esd conn for bnking aes wn Domes ties pale (FCC) eee Ting FDIC's byt eis uniared epestos 10s Auton of xed kara fs (SEC) 199 Cable Televison Replat cable TVs 19% ReleoaéReiminton nd Reform Act Soon ‘7 ‘ic Cago Deel Act fod Competion Aa 197 ‘Aldine Dergulmion Act, 1992 Bey Py Act ‘Opes up wise capetisonty ging FERC auto rier Neral Gar oly At Deegan of tlt et sto (FCC) Urgensina exempt Pt Series) 1990 Motor Care Reform Act Honshed Goods Tanspeaon Act Sager Ra Ast epost Itunes Deceuauos ad Monetary Conl Act. Intemational Air Tampon Competion Ae Deregulation of cable evo (FCO Deregaliton outer press eqipmen a enkaced serie (RCC) econ of rei and eed petaleum rod eee ere) Devegultin of ado CO) vos we Bus Repro At tn St evn Depry nto Act at etter 988 Spee contrition (ae Tluon Deeplon Act ‘Sing ac 1988 “Trting aot ining rights 1st Se of Cora “lina fies dete FCC) 188 roy es on xa nel (FERC) Prope ee een 900) 1999 Natural Gas Welln Deon Act of 1989 ‘Source Updo Eronamic Raper of he Preis, any 199, ‘completed, Loosened regulatory controls allowed competition to exert itself in the trans= ‘mission of natural gas and the generation and distribution of bulk power. Entry restrictions {in banking—which prevented banks from having branches in more than one state and, in some sates, prevented a bank from having more than one branch—were largely elimincted by state legislatures. Contrary to this deregulatory tend, cable television rates have oscl- tated between being regulated and deregulated, and the landmark Telecommunicatons Act of 1996 is considered to be a mixture of regulation and deregulation. With regard to the ‘Cialyinegte ule ot tes common can of dete power Isr FERCOMe 36 Regie pilings tuber tele nd wasgraton of aa gs 1993 Elininaton of te repsition of ear ‘eepone es 19) Neve Rates At‘ uta strons eted otrskng res 1994 Rlle-Nel neste Cited mth aoa eel the miso of ani resto a Banking sno rshing ese level, Ercy ne 10s Tring ny andl resigns inne ki ston opin Ren Ae vos 1CCTemiaten A Ait CE : ‘emconmuncion ‘Daun TV nit intone phone cops i Act +o enter long distance telephone, mandated eqas) aocess to locel ‘sephone sens Renaved inpefiments competion inthe wheal ak ower 199 FERCOnersa8 “Towledgmens Ts elope of te wan il by mages fn Randy Kner Pal Macho, ‘Thoms ale Mose wd So felon. Terese sox apps. Tey ree eponiie fay ero future, the primary architect of siline deregulation, Alfted Kahn, sees us ata point of 90 return: evo f equa ptiy wl ee cone oan Te pt kod we huts ‘My etan ose te th fal lor pen vi ool ake sole we sated oral ihr son Tiss ese on on xeon aera tctng omc mae he eon ofS ening ae wiser an sono ib wor of coal command om T Aifed.Kata, Dereon Looking Back and Looking Foran” learn Replation? Sune 930) 35-54