Before studying economics, many people think that the government needs to be a watchdog guarding consumers against monopolistic abuses and price gouging. Once encountering the invisible hand the- ory, we might be more reluctant to intervene, how ever, because economics teaches us that competitive markets can lead to efficient production and pricing For the most part, governments in market economies today rely on the force of rivalry and competition— the carrot of profits and the stick of bankruptey—to . stimulate the private sector to behave efficiently. But the forces of competition carmot work effec- CHAPTER tively when competitors are absent or feeble“When there is excessive market power, government can take steps to promote competition. There are other market failures that may call for government inter vention. Sometimes people may not haye adequate information to judge product quality786 the gov ernment requires that drug companies demonstrate the safety and efficacy of new drugs, The govern- ment alyo regulates industries like banking and elec- » Promoting More tricity,‘thies to protect consumers from false adver- ‘ising and financial misrepresentation, and engages : Efficient Markets in zoning decisions which contrl the economic we t How can governments best promote efficient markets? How best to control market failures without hindering the powerful efficiency gains of unfet- tered market competition and rivalry? Sometimes, « the public interest compels regulation in a limited domain; at other times, economic regulation creates more problems than it solves, and governments are ‘well advised to deregulate a sector: Public policy in this area—focusing on regulation and ant Markets are a great surveyed in this chapter way to organize economic activity, but they need adult A. BUSINESS REGULATION: 7 supervision. THEORY AND PRACTICE ‘ David Wessel Federal regulation of American industry goes back more than a century to the founding of the Inter- state Commerce Commission (IGC) in 1887, The ICC was designed as much to prevent price wars and, ' to guarantee service to small towns as it was to con- trol monopoly. Later, fecleral regulation spread to banks in 1913, to electric power in 1920, and to com- ‘ munications, securities markets, labor, trucking, and air travel during the 1930s, In recent years, as we will ie see, the federal government has changed its course ieee by deregulating many industries. 341342 CHAPTER 17 + PROMOTING MORE EFFICIENT MARKETS In attempting to control economic activity, gow Ww and consumers. [ts rules are earns Commande ot market incentives, correcting a wide varteryof sie effecs or externall ally the main form of regulation has been a Histo digect approach, where governments issie command ‘auicontrol orders, In this approach, government command people to undertake or desist from certain activities through government regulation, For exam- ple, the government might require that businesses focate only in commercial areas or that they do not pour chemicals in rivers. Government commands to Gay cover a wide variety of areas, including not only pollution and zoning bat also informational report ing, labor standards on wages and hours, and many regulations specific to particular industries such as those using pesticides or producing new drugs Recently, economists have been instrumental convincing government to try a brand new form of regulation: reliance on market incentives. The best ex ample of the use of market incentives is the 1990 Clean Air Act, discussed in the next chapter. This bill set up markets for buying and selling “tradeable 1s permits’—in essence, licenses {0 pollute Such harnessing of market forces has the possibility of achieving regulatory goals much more efficiently than commancland-control methods. Regulation consists of government niles or market incentives designed fo control the price, sile or production decisions of firms TWO BRANDS OF REGULATION This customary to distinguish between two forms of regulation. Economie regulation involves the control of prices, entty and exit conditions, and standards of service. It is most important in industries natural monopolies, (Recall that a natural monopoly is a market in which the industry's output can be ef jently produced only by a single firm.) Prominent examples are regulation of public utilities (tele~ phone, electricity, natural gas, and water) as well as regulations in other industries (transportation, t dio, and TV). The financial industry has been heavily regulated since the 1930s, with strict rules specifying what banks, brokerage firms, and insurance compa nies can and cannot do. In addition, there is a newer form of regulation, known as social regulation, which is used to protect the environment along with the health and safety of” i wh WHY,REGULATE INDUSTRY? Regulation restrains the unfettered market power of firms. What are the leg ‘ments might choose to over in free markets? There are three major publicinterest justifications of regulation. The firsts to regulate firm ehiavior to prevent abuses of market power by mo- major reason is to imate reasons why gover de the decisions made nopolis or ligopolies. A secon¢ ened informadonal faifives, such as those which hout the characteristics of important products like drags or energyusing appliances. A third reason is to contect externalities ike poltution—this isthe sub- ject of social regulation, studied in the next chapter Containing Market Power rhe traditional public-interest view of economic reg- ulation is normative: that regulatory measures should be taken to reduice excessive market power. More specifically, government should regulate industries where there are too few firms to ensu rivalry, Government should regulate industries par ticularly in the extreme case of natural monopoly. An important example of a natural monopoly is Jocal water distribution. The cost of gathering water building a waterdistribution system, and piping water into every home is sufficiently great that it would not pay to have more than one firm provide local wa Service, so this isa natural monopoly, Sometimes water service is provided by the government; more often, it c vigorous is provided by a regulated privately owned water company ‘Another type .of natural monopoly can occur when there are economies of scope, which arise when a pumber of different products can be produced more ‘efficiently together than apart, A prominent exam ple of econoinies of scope is computer software Many software programs incorporate additionalWHY REGULATE INDUSTRY? features as they evolve. For example, when con. sumers buy software to prepare their federal income taxes, the CD-ROM usually contains several other modules, including a link to a Web page, govern- ment documents, and a tax preparation manual This shows economies of scope because the different ‘modules can be mor¢ inexpensively produced, pack: aged, and used together than separatel A inal component of natural monopoly, particw larly prevalent in network industties, isthe require- ment for standardization and coordination through, the system for efficient operation. Railroads need stan dard tack gauges, electrical transmission requires load balancing, and communications require standard codes so that different paris can “talk” to each other: We know fiom our discussion of declining costs in earlier chapters that pervasive economies of scale are inconsistent with perfect competition; we will see oligopoly or monopoly in such cases. But the point here is even more extreme: When there are such power fil economies of scale or seope that onky one firm can su vive, we have a natural monopol Why do governments sometimes regulate nat. uural_monopolies? They do so because a natural polist, enjoying a lange cost advantage over its potential competitors and facing price-nclastic de- mand, can jack up its price sharply, obtain enormous monopoly profits, and create major economic ineffi ciencies. In the early 1990s, cable television compa- nies exploited their local monopolies in providing multiple channels with high-quality pictures by raising prices sharply. This provoked Congress and several siates (0 enact legislation regulating the prices set by these companies, Studies indicated that this price reg- ulation was ineffective and may actually have raised prices in some categories, Consequently, in the 1996 Communications Act, Congress changed its mind and lifted price and entry controls, with the idea that {greater competition would be more beneficial for con- sumers than price controls. In cartier times, regulation was justified on the du bious grounds that it was needed to prevent cuttiroat or destructive competition. This was one argument for continued control over railroads, trucks, airlines, and buses, as well as for regulation of the level of agricultural production, Economists today have lite sympathy for this argument. After all, competition with increased efficiency and low prices is exactly what an efficient market system is designed t0 ensure, 343 Remedying Information Failures [Another reason for regolaion is that consumers have inadequate information about product, For exam- ple, testing pharmaceutical drugs is expensive and Sciemiticaly complex. The government regiates drugs by allowing the sale of only those drugs which are proved “safe and eifcacios.” Government aso prohibits false and misleading advertising, In both Eases, the government isattempting to correct forthe market's fre to prove information efficient ‘One area where regulating the provision of in- formation is partieully critical ix financial markets. When people buy stocks or bonds of private eamps nies, they are placing their fortunes in the hands of people about whom they know next so nothing, Be- fore buying shares of IBM or Z¥X.com, Twill exam ine their nancial statements 0 determine what their sles, earnings, and dividends have been. But can I know exacily how they measure earnings? How can I be sure that they are reporting honestly? This ivshere goverment regulation of financial markets steps in, Most regulations of the financial in- dlusiry serve the purpose of improving the quantity and quality of information so that markets ean work better: When a company sels stocks or bond inthe United States, tis required to ise copious docu- mentation of its current financial condition and future prospects. Companics’ books must be certi fied by independent auditors. Government require- mentsare sometimes reinforced by th companies listed on the New York Stock Exchange must comply with an even tougher st of accounting regulations Occasionally, particularly in times of speculative fremzies, companies wil bend or even break the rules. This happened on a large scale in the late 19906 and early 2000s, particularly in communica- tions and many neweconomy firms. When these ilegal practices were made public, Congress passed anew law in 2002; this lav made i legal to ie to an ndependent boatd co over: fee aecoutants, and provided new oversight pow- ters to the Securities and Exchange Commission (SEC), Some argue that this kind of law should be welcomed by honest businesses: tough reporting standards are beneficial to financial markets Because they reduce informational asymmeties between buyers and sellers, promote trust, and ene courage financial investment. auditor, established344 ” Dealing with Externalities Government regulation can also be justified when, there are externalities. The classic example of regu- lation of this type, which we analyze in the next chapter, is antipotiution measures. But there are other interesting cases. One pervasive example is l- cal zoning regulation, which limits how landowners can use their land. Most zoning regulations specify whether a plot of land can be used for residences, stores, or industry and how big the buildings can be ‘What is the justification for zoning regulation? Alloxeing a junkyard ina quiet residential area, for in- stance, would generate externalities that might harm everyone in the neighborhood. Similarly, « 50-story office building in a neighborhood of 2story homes might overwhelm the local transportation system and other neighborhood services. ‘The economic impact of zoning can be huge. Be- ing able to build a 50story building on a plot of land, as opposed to a 2story one, can dramatically affect the value of the land. That's why zoning is perhaps the most important ype of regulation undertaken at the local level of government. INTEREST-GROUP THEORIES OF REGULATION So far we have been looking at the normative pul interest justifications for government regulation, We should recognize, however, that regulation creat profits and thereby produces interest groups which have vested interests in the regulatory outcomes. Sometimes, because of the interaction between regu- Iation and politics, regulation has the perverse result of restricting entry into the regulated industry, and, thus actually raising prices and profits for established, companies.! Hence, a regulated industry may lobby in favor of continued regulation, in order to keep out competitors and keep profits high. Economists who emphasize the anticompetitive aspect of regulation make the following argument: ‘You say that regulation is in the interest of cons and workers. Don’t believe it. Rather, regulation is designed to boost the incomes of producers by The germinal work i this arca was by George Stigler of the Univers’ of Chicago, who won a Nobel Prize for this and ‘ther contibutions: The Chieago Scot hae een high in- ‘venta in is view that government intervention ta the e¢aw. ‘omy often does more harm than good, CHAPTER 17 + PROMOTING MORE EFFICIENT MARKETS limiting entry and preventing competition in the reg- ulated industey, Any gains to constimers or workers tare purely incidental The historical record shows that there is much truth to this view. For example, numerous economic studies have shown that regulation often keeps prices high. For many years, tucking companies and airlines had to get permission before lowering prices or enter- ing new markets. Other types of regulation also have the effect of limiting competition, For example, high standards for new drugs mean that the process of get- ting regulatory approval is lengthy and expensive ‘That keeps out many smaller companies which cannot afford the years of testing that a new drug requires. ‘An example of a regulatory program benefiting the industry at the expense of taxpayers came in the savings and Ioan industry. The federal program of deposit insurance was established in the 1930s to help restore confidence and prevent bank panics. By the early 1980s, however, it became clear that the program was poorly designed. It provided a gover iment guarantee on bank deposits without ensuring that banks behaved prudently with the insured deposits. Deregulation of industry here meant less intensive bank examination. Banks often would pay high interest rates to attract deposits and then use the money to make risky loans and investments and to pay high salaries to their executives. When the banks began going bankrupt, the government had to pick up the tab; losses mounted to the hundreds of billions of dollars, Because of intense lobbying and generous campaign contributions, appropriate government action to stop the wasteful practices was delayed for years until Congress acted to curb the ‘worst abuses in 1989. Who were the major beneficia- ries of the corrupt regulatory regime in the banking industry? Primarily bankers, banks, and bank stock- holders. Who were the losers? The taxpayers © PUBLIC-UTILITY REGULATION OF NATURAL MONOPOLY A traditional economic argument for regulation is to prevent monopoly pricing by natural monopolist Let us see exactly how regulators control excessive price increases of monopolists. Recall that a natural monopoly is an ind way of organizing production is through a single firm. Figure 17-1 shows the way the AC, MC, and it dustry demand curve might look for a natural