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,