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PART III
GOVERNMENT AND MARKETS
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Chapter 9
Antitrust: Economics, Law, and Politics

This chapter addresses elements of antitrust law, its enforcement, and selected underlying
economics concepts. Antitrust is broad and deep subject to which entire courses are devoted.
Instead of trying to condense this subject, the chapter focuses on four aspects of it. The first is the
law and its enforcement. The second is schools of thought about the role of antitrust and its
application. The third is elements of the economics of antitrust, and the fourth is the politics of
antitrust. The three schools of thought are the traditional or structural school, the Chicago school,
and the new industrial organization (IO) approach.
A lecture that goes beyond the chapter materials can be based on any number of the sources listed
in the references. The case law provides a rich set of material for a discussion of antitrust law, its
enforcement, and the underlying economics.
One point that might be emphasized is that the vast majority of antitrust cases are private (do not
involve the government as a plaintiff). These cases are typically filed by a firm against one of its
competitors or by a distributor or supplier against a firm. These suits are encouraged by the
opportunity to collect treble damages. Some legal scholars believe that treble damages generate
lawsuits that have the effect of discouraging competition.
A lecture also might emphasize the distinction between per se violations and the rule of reason as
illustrated by the reasoning in the Northern Pacific and Continental TV cases.
As an example of a vertical practices case, the attorneys general of 44 states filed an antitrust
lawsuit against Toys ‘R’ Us alleging that it conspired with Mattel and Little Tikes to limit the
quantities of popular toys distributed to warehouse and price clubs. Toys ‘R’ Us agreed to donate
$27 million toys and $13.5 million in cash to be used for toys and educational materials for children
in all 50 states.
A lecture on the schools of thought can be based on Figure 9-3. The figure is arranged so that one
can proceed item by item down the figure contrasting the structural, Chicago school, and new IO
approaches.
Another topic for a lecture is the merger guidelines that the Federal Trade Commission and the
Department of Justice issued. The revisions allow merging firms to show that the merger would
not hurt competition. This provision was expected to be applicable only in extraordinary cases.
The revisions also reduce the likelihood of a challenge to a merger if entry is likely into the
industry.
The chapter case The AT&T and T-Mobile Merger? deals with an important horizontal merger case
in which the government challenged a merger that AT&T believed would be approved. The
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company was so confident that it agreed to pay T-Mobile $3 billion in the event that the merger
was rejected by the government.
The chapter case The Microsoft Antitrust Case is an important case for the software, Internet, and e-
commerce industries. The case identifies the reasoning of the court about the conduct of a
dominant company in an industry in which there are network externalities. The case includes the
decision up to the balking by the states.
Antitrust in the European Union is considered in Chapter 15, including cases against Microsoft.
The section on the politics of antitrust indicates that antitrust law and enforcement are not just legal
and economic issues but are also political issues. Antitrust politics is largely distributive, so the
framework developed in Part II can be applied to it. The case The Malt Beverage Interbrand
Competition Act in the second edition of the book is concerned with a bill that would grant a special
antitrust exemption to the beer distribution industry, similar to that for the soft-drink industry.
Antitrust law continues to evolve through court decisions even when no new legislation is enacted.
The following describes a Supreme Court decision pertaining to the right to sue under the antitrust
laws and to the illegality of certain price fixing practices. In 1982 ARCO adopted a new pricing
policy in which it eliminated its credit cards and lowered the prices it charges its retailers for
gasoline. USA Petroleum, which competed with ARCO in California, Nevada, and Washington,
claimed that ARCO’s new policy caused it to lose $800,000 a month. USA Petroleum filed an
antitrust suit alleging that ARCO conspired with its dealers to fix prices at a low level. The courts
have ruled that price fixing is a per se violation of Section 1 of the Sherman Act, and USA
Petroleum sought to sue under Section 4 of the Clayton Act which allows private suits in the case
of violations of the antitrust laws. The chapter case Price Fixing in the Airways considers price
fixing on fuel surcharges for freight transport.
A federal district court in California rejected USA Petroleum’s right to sue under the Clayton Act,
holding that a suit could be brought only if the prices were predatory. A federal Court of Appeals
panel overturned that decision and held that USA Petroleum could sue since “price-fixing of any
kind distorts in a basic way the competitive process the antitrust laws were meant to protect.” The
Supreme Court, however, overturned the Court of Appeals in ruling that USA Petroleum did not
have standing to sue on the basis that a price-fixing conspiracy was a per se violation of the
Sherman Act. Writing for the 7-2 majority, Justice Brennan said, ‘“The antitrust injury
requirement cannot be met by broad allegations of harm to the ‘market’ as an abstract entity….
Low prices benefit consumers regardless of how those prices are set, and so long as they are above
predatory levels, they do not threaten competition. Hence, they cannot give rise to antitrust
injury.’”1 2
1
ARCO v. USA Petroleum, No. 88-1668.
2
It is important to note that none of these rulings addressed the merits of the case itself. They only pertained to the
right to bring a private antitrust suit.
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Cases
Price Fixing in the Airways
This episode may have begun with an innocent telephone conversation lamenting the rising cost of
airline fuel, but such conversations can lead to illegal acts, as presaged by the quotation from Adam
Smith at the beginning of the chapter. As recognized by Smith price fixing is harmful and is
viewed as per se illegal by all three schools of thought. The Chicago school might be skeptical
about the ability of the colluding parties to sustain their collusion, but convictions for collusion and
price fixing are sufficiently common that such skepticism should be viewed as a reminder rather
than a belief that collusive activities always fail. That is, it is important from a public policy
perspective to recognize that cheating on cartel arrangements can occur, but there are enough
convictions to demonstrate that it occurs. The ease with which firms can fix prices varies across
industries, as does the incentive to do so. The incentive may be strongest for homogeneous
products, and the ease may be greatest when there are few competitors. Freight and passenger air
service seems to meet both conditions. What is not observable is how many cartels have not yet
been discovered, and how many have disintegrated without having ever been identified.
The economic costs of price fixing are straightforward to identify. Price fixing restricts
competition resulting in higher prices and hence lower consumer plus producer surplus. That is,
consumers lose more than producers gain because some economic activity is foregone because of
the higher price of air freight. The quotation from the producer in Australia illustrates this.
Collusion could also occur on non-price dimensions, although this seems less common than
collusion on prices.
What is not known in this case is who in the airlines knew of the price fixing. The airlines claimed
that the price fixing was done by lower level managers and that the top executives were ignorant of
the price fixing.
The leniency programs of OFT and the DOJ are helpful for exactly the type of situation described
in the case. The programs provide an incentive for executives who learn that their companies have
been price fixing to inform the authorities—before an executive in another of the colluding
companies does so. The companies are basically in a prisoners’ dilemma, since they have an
incentive to inform the authorities if they have some doubt that another party may do so. This
situation is actually somewhat more complicated than a standard prisoners’ dilemma because the
colluding managers may not have an incentive to go to the authorities (since they are likely to be
fired and face civil or criminal charges), but other managers who learn about the price fixing do
have such an incentive.
When a company informs the antitrust authorities under a leniency program, the leniency pertains
only to government actions. The price-fixing companies are subject to civil lawsuits for damages,
as indicated in the case.
Individual managers involved in price fixing are subject to criminal charges, and if found guilty can
be sentenced to prison. This was the result in the lysine price fixing discussed in the chapter.
Companies can also be charged with a criminal offense.
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In this case British Airways appears to have been the initiator of the fixing of fuel surcharges for
the Atlantic routes. What is not known (to me) is whether BA was also the initiator of the price
fixing on the Pacific routes.
The motivation and rationale for those managers who carried out the price fixing is not clear. One
possibility was to just avoid a competition in fuel charges. Another possibility is that the managers
may have feared that adding different surcharges might set off a new round of price competition of
freight shipments. This would be of particular concern if the allegations made by the Ryanair CEO
were true.
It is also useful to explore the incentives for a manager to engage in price fixing from an ex ante
perspective. That is, identify the gain from successful collusion, and compare that to the expected
loss if the collusion is detected. The expected loss is the probability that the collusion will be
detected multiplied by the fines, civil and criminal judgments, and reputation damage from being
caught.
Discussion questions:
1. Why did this price fixing occur?
2. What is the harm caused by price fixing? Did this price fixing of fuel charges actually harm
competition if the airlines were competing on freight prices?
3. What are the personal and company risks associated with price fixing?
4. As an executive with British Airways suppose you learn that managers have been
“coordinating” fuel surcharges with other airlines. What would you do? Do you notify
OFT immediately? What do you do about the managers who have been involved with
fixing the fuel surcharges? Suppose their supervisor had learned of the “coordination” and
ordered it stopped but had not notified you. What should you do with respect to the
supervisor?
5. What management processes would you institute to make sure that price fixing does not
occur in the future?
6. Should you investigate to determine if the allegation by Ryanair is true or false?
Update: In July 2009 during a trial of 3 former and 1 current British Airways employees, it was
revealed that Virgin Atlantic CEO Steve Ridgway had been involved in the price fixing that had led
to British Airways guilty pleas. Ridgway said, “I apologize unreservedly for my involvement in
this case. I have fully co-operated with the competition authorities since their own enquiries began
in 2006. Although I did not have any direct contact with BA in relation to passenger fuel
surcharges I regret that, on becoming aware of the discussions, I did not take steps to stop them.”
He added, “Since 2006, I have ensured that a thorough and far-reaching competition law training
program has been put in place at Virgin Atlantic so that everyone understands the serious nature
and true extent of competition laws and so that this does not happen again within our team.”3
Virgin Atlantic and Ridgway escaped prosecution by revealing the price fixing to the authorities.
3
Wall Street Journal, July 14, 2009.
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As of March 2011, 21 airlines had paid $1.7 billion in fines for price fixing and 19 executives have
been charged. Four executives have gone to prison. No major U.S. airlines have been charged.
The AT&T and T-Mobile Merger?

At one level this is a complex case involving competing claims, competing nonmarket strategies,
and broad benefits and costs. At another level it is a simple case in which an already highly
concentrated industry could become even more concentrated. Concentration analysis, however,
may not be so straightforward in this case, since the wireless communication market cannot sustain
a substantial number of firms due to network effects. That is, there are efficiencies in networks that
should drive the number of suppliers down to a very small number, which could be 2 or 3. Another
complicating factor is whether if the merger is abandoned, will T-Mobile be able to remain a viable
competitor or will it wither away and sell its assets piecemeal along the way?
AT&T obviously understood the concentration concerns but sought to justify the merger on
efficiency grounds. It argued that the capacity that would be obtained would allow the company to
expand quickly its network to provide service to 97 percent of the population. More importantly, it
argued that substantial efficiencies would be achieved and innovation would be stimulated. The
relation between size and innovation is not obvious from economic theory or empirical studies, so
AT&T would have to show how innovation would be increased. The support of Silicon Valley
Internet firms and venture capital firms for the merger provides some indication that there may be
innovation implications, but those endorsements could also reflect the desire to have an expanded
AT&T network as soon as possible. AT&T would also have to identify the specific efficiency
gains and how those gains would be passed on to consumers.
AT&T argued that there lots of other carriers as well as new entrants such as LightSquared with
national network ambitions. The effect of these carriers and entrants on the market was, however,
tenuous at best. (LightSquared subsequently declared bankruptcy.)
To support the merger, AT&T launched a broad scale nonmarket strategy to enlist endorsements
and support. The company was able to obtain endorsements from Silicon Valley firms and private
equity funds, NGOs, governors, members of Congress, and the principal union. Some, such as the
CWA, were clearly self-interested parties. The CWA had already bargained with AT&T over the
unionization of T-Mobile’s workers.
The opposition to the merger was broad and vocal. The opposition used the media, lobbied in
Congress, and presented their arguments to the FCC. Most of their criticism focused on the
concentration in the market and the inevitable costs resulting from a duopoly. The “digital divide”
argument of the Minority Media and Telecommunications Council did not dissuade the critics.
The opposition’s nonmarket strategies included two components intended to delay any possible
approval of the merger. First, the opposition sought to intervene at the state level. Second, it asked
for FCC hearings.
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The opposition also focused on pockets of concentration in urban markets where concentration
could “jump dramatically.” AT&T responded with a new filing in which it proposed fix-it
measures to deal with specific concerns. It also proposed giving up some spectrum in some areas.
Another relevant factor in the decisions of the FCC and the DOJ is whether T-Mobile is a viable
entity if Deutsche Telekom continues not to invest in it? The only possible acquirer is Sprint, and it
certainly cannot afford $40 billion. However, if T-Mobile’s viability is in question, then its market
value must be substantially lower than $40 billion. The minimum value of the company would be
its salvage value—what it could get if it sold its spectrum and other assets. An acquisition by
Sprint at a lower price is conceivable.
Despite the nonmarket strategies mounted by both sides, the concentration issue is likely to be the
most important factor in the decisions by the FCC and the DOJ.
1. What factors will be the most important in the decision of the FCC about transferring
spectrum as a result of a merger?
2. What factors will be the most important in the decision of the DOJ regarding whether it will
attempt to block the merger?
3. How compelling are AT&T’s justifications for the merger?
4. How effective is AT&T’s nonmarket strategy?
5. How effective are the nonmarket strategies of the opponents of the merger?
6. Was it wise for AT&T to agree to a break-up fee of $3 billion?
7. What decisions will the FCC and the DOJ make?
Update: In August 2011 the DOJ filed a lawsuit to block the merger. AT&T pledged to
vigorously defend the merger in court. The FCC also expressed concerns about the merger. The
situation became more complicated in November 2011 when the FCC chairman announced that it
would require a hearing, like a trial, before an administrative law judge on the economic benefits
and costs of the proposed merger. This would be the first hearing by an FCC administrative law
judge in 8 years. At the least the requirement of a hearing would delay the merger, and it could
block it.
In December 2011 AT&T abandoned its efforts to acquire T-Mobile and paid the break-up fee of
$3 billion to Deutsche Telekom.
The Microsoft Antitrust Case

The antitrust case is obviously very complex with major implications for the development of
several of the most innovative industries. The decision will be made in the institutional arena of the
courts. The trial has two components. The first centers on the facts relevant to the government’s
allegations. The second commences if the judge renders a guilty verdict and deals with the remedy
to be imposed. Then, there is the possibility or likelihood of an appeal. Judge Jackson had been
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scolded by the Court of Appeals in his decision ordering the separation of Internet Explorer from
the Windows operating system. He was not cautioned, however, and continued to speak outside the
courtroom. The Court of Appeals criticized him and removed him from the case.
The trial produced testimony that the DOJ argued showed abuse of power and which Microsoft
argued established neither monopoly nor conduct that was not customary in the industry. In
teaching the case, it would be useful to discuss the ways in which Microsoft’s conduct could be
anticompetitive. The discussion in the case about thwarting a competitor with a complementary
product and the use of exclusionary practices and tying could serve as the focal point. The
discussion could also focus on how Microsoft could target Netscape. For example, Microsoft could
license its operating system only to those PC manufacturers that agreed to use Internet Explorer or
not to use Netscape Navigator. A less drastic practice would be to offer Windows at a discount to
PC manufacturers that agreed to use Internet Explorer rather than Navigator.
In the rebuttal testimony an IBM executive testified that Microsoft had said that IBM would have to
pay a higher price for Windows if it continued to promote Lotus’s Smartsuite office software.
(Lotus is a division of IBM.) The IBM executive testified, “I was told that as long as you compete
against Microsoft you will suffer in terms of pricing and support.” As an example, the executive
said that negotiations with Microsoft regarding licensing Windows 95 dragged on until the day of
Microsoft’s rollout of the new operating system. IBM thus did not have time to put Windows 95
on its PCs, when consumers rushed to purchase computers with Windows 95. He stated that this
“impacted measurably on our business.”
The economic rationale for an antitrust case against Microsoft is that it has protected its monopoly
in operating systems through exclusionary practices, tying, and offering its own versions of
complementary products to extend its monopoly and to stifle competition (e.g., Netscape). This
conduct has implications for the current marketplace, but more importantly it can have implications
for the rate of innovation in the industry. That is, if Microsoft is allowed to use these practices to
drive competitors out of business, rivals will be hesitant to innovate for fear that they will be
overwhelmed by Microsoft’s conduct directed at their products. The loss in dynamic efficiency
and innovation could be much larger than any damage to the current market place. The DOJ did
not raise the issue of the impact of Microsoft’s conduct on innovation until the end of the trial, and
it was apparently not considered by the courts. The economics of the software industry is
considered in Chapter 13.
Microsoft argued that the AOL-Netscape merger rendered the government’s case moot. That is, the
merger and the alliance with Sun Microsystems showed that Netscape was not harmed and that
Microsoft indeed had a formidable competitor capable of using an Internet access site as a platform
for a variety of software applications. In addition to the argument that AOL-Netscape-Sun
represented a formidable competitor, Microsoft argued that the merger and alliance showed how
dynamic the industry was and how it was impossible to have a true monopoly. William Neukom of
Microsoft said, “The $10 billion merger of AOL and Netscape completely undercuts the
government’s case. Competition and innovation are stronger than ever in the software industry …
Consumers are seeing extraordinary benefits from Microsoft and the industry as a whole.”4
4
San Jose Mercury News, May 17, 1999.
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Microsoft thus argued that it did not have a monopoly and its practices were customary in the
industry. There is little to suggest that Judge Jackson gave this argument any weight.
Both Judge Jackson and the Court of Appeals concluded that Microsoft had a monopoly in
operating systems.
In the trial the government was successful in presenting evidence of abusive practices by Microsoft
and in discrediting some of the testimony of Microsoft executives. The government was less
successful in showing that consumers had been injured by those practices. This led some
commentators to argue that the government’s case was more about protecting Microsoft’s
competitors than about protecting consumers.
In a further embarrassment to Microsoft, during the rebuttal testimony Microsoft entered into
evidence data supporting the claim that Netscape’s browser was healthy and thriving. The DOJ
produced a recent e-mail from one Microsoft executive to others asking, “What data can we find
right away, showing that the Netscape browser is still healthy? The Government is introducing a
bunch of data showing Netscape headed down big time and Microsoft way up.” Internet Explorer
had approximately 85 percent of the browser market in 2001.
Teaching the case:
The following questions can be used to guide the discussion.

1. Microsoft has innovated and developed software products that have provided enormous benefits
to consumers and helped launch industries. It has also created approximately 5,000 millionaires
among its employees. What is the government’s concern in this case?
2. Is the government trying to protect competitors or consumers?
3. How might the alleged conduct harm consumers? What role do network effects play?
4. What specifically are the alleged violations of the antitrust laws and is there evidence to support
those allegations? (The case is necessarily brief and cannot present all the evidence or Microsoft’s
critique of that evidence.)
5. What were the impediments to settling this case?
6. Should Microsoft have been found guilty?
7. What are the pros and cons of the remedies discussed in the case? Did Judge Jackson make the
right decision regarding remedies?
8. Was the settlement between the DOJ and Microsoft appropriate?
9. Were the 9 states right in rejecting the settlement?
10. After the appeal what remedies should the new court impose?
Discussion:
The structural remedy of auctioning the source code for Windows to three or so bidders would
allow the marketplace rather than the government to determine the development of the industry.
Also, Microsoft would not be limited in whatever it wanted to do. It could, for example, integrate
all of its software and its related services businesses without excluding competitors who would
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have the source codes. Some commentators, however, argue that this would not have the desired
effect because the purchasers would not be able to hire enough programmers and software writers
in a short enough time to actually compete with Microsoft. (Recall that competing with Microsoft
would require extremely rapid development engineering, since Microsoft has in the works a stream
of new software applications and upgrades to its operating system.) Whether the government had
the authority to order the auctioning of Microsoft’s intellectual property is not clear.
Since the time at which the antitrust suit was rumored and then filed, Microsoft has relented on a
number of its contract requirements with PC manufacturers giving them more flexibility in their use
of software. Microsoft was also believed to have moderated its extensions into handheld machines
and Internet access software. This gave rivals a window in which to innovate and compete.
In 2002 both Netscape (AOL) and Sun Microsystems filed private antitrust lawsuits against
Microsoft.
In May 2002 Microsoft announced that it would offer a “service pack” that would allow computer
makers and consumers to install non-Microsoft software such as browsers, e-mail services, and
streaming software. This would also allow them to conceal Microsoft’s desktop icons. Microsoft
was complying with the parts of the district court ruling upheld by the Court of Appeals.
Microsoft has now resolved most if not all the antitrust lawsuits against it. It settled with Novell
($536 million), AOL ($750 million), and Sun Microsystems ($1.6 billion). It also settled with the
12 states and the District of Columbia reportedly for $1 billion, including Massachusetts $34
million, North Dakota $9 million, Arizona $104.6 million, and Tennessee $64 million.
The status of the European Union’s antitrust cases against Microsoft is discussed in Chapter 15.
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Chapter 10
Regulation: Law, Economics, and Politics
This chapter introduces the general framework of government regulation including its legal
foundations, its economic rationales, and its politics. Chapter 11 addresses the regulation of
financial markets, and Chapter 12 is devoted to environmental protection and regulation.
A lecture on regulation could expand the discussion of periods of regulation to provide more detail
on the origins of regulation through public franchise and its introduction in the United States. This
might be combined with a discussion of the early court decisions on the constitutionality of
regulatory statutes. The New Deal period has a rich regulatory history much of which involved
extensions of industry regulation and the beginning of social regulation as in the case of the Food,
Drug, and Cosmetics Act.
The period beginning in the late 1960s has been characterized by two seemingly contradictory
movements. One was deregulation in a number of industries, and the other was the explosion of
social regulation focusing on safety, health, and the environment. These two movements are not
really contradictory and stem from new thinking and changing political forces. Deregulation
resulted from concerns about industry efficiency and reflected an inability of industries to mount
sufficient political power to block the deregulation. (It should be emphasized that the firms and
labor unions in the regulated industries opposed deregulation primarily because of the threat
increased competition posed to their rents.) The courts also played an important role in certain
industries such as telecommunications as the regulators had blocked entry and the courts ruled that
entry could not be blocked under the statutes. The social regulation movement resulted from new
concerns about the environment and the role of government in protecting the health and safety of
individuals, from the evolving preferences of the public, and from activists’ strategies.
Administrative law is perhaps less interesting but is also quite important. This could be combined
with a discussion of due process requirements and their influence on the way regulations are
promulgated, particularly the effect of due process requirements on the speed with which regulatory
agencies make decisions. Perhaps the principal explanation for the difference in regulation in the
United States and Europe is that European countries do not have due process requirements, and
hence many regulatory decisions are made in the administrative agencies (ministries) and largely
out of the sight of the public.
Two important regulatory issues are likely to be addressed at the beginning of the century. The
first is whether Congress will restrict regulation by passing legislation to limit regulatory taking
without compensation. Similarly, the Supreme Court could conclude that the Constitution requires
compensation for the loss of value due to regulation. It has taken some moderate steps in this
direction. Voters in Oregon approved a ballot initiative that requires compensation for regulatory
takings. The second is whether the courts will limit the delegation to agencies without specific
policy guides by Congress. The Court of Appeals decision mentioned in the chapter has raised this
issue. By 2008 little had happened on this issue other than at the state level, where some states
adopted measures similar in spirit to but weaker than that adopted in Oregon.
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Regulatory commissions and agencies have one of the two different structures as described in the
text, but both are subject to a set of political and legal influences illustrated in Figure 10-2. It is
useful to point out that independent commissions are considerably more independent of the
presidency than are the single administrator agencies. The Congress has a substantial influence on
all regulatory agencies.
The explanations for regulation and the forms it takes are of two types. The political economy
perspective focuses on the demand for and the opposition to regulation. The politics of regulation
are largely distributive and can be analyzed and understood through the framework developed in
Part II of the book. The second explanation is found in market imperfections that, in the absence of
regulation, can result in economic inefficiency. It should be stressed that although regulation, in
principle, can improve economic efficiency, government is itself characterized by imperfections.
Coupled with political pressures that can distort policy away from efficiency, regulation can make
performance worse than it would have been in the absence of regulation. This is one explanation
for the deregulation movement.
The literature on market imperfections and the appropriate response to them is extensive and
provides material for a lecture that goes into more detail than could be provided in the text.
Externalities provide the economic efficiency rationale for market-like regulatory mechanisms for
environmental protection as considered in Chapter 12.
Deregulation is continuing in a number of industries such as telecommunications, electric power,

and natural gas, and current developments can serve as the basis for a lecture. The success of the
FCC auctions of the radio spectrum indicates that regulators are turning to decentralized,
efficiency-generating mechanisms. The problems in the California energy market could be used to
discuss the design of markets. Additional incentive measures of generating efficiency are
considered in Chapter 12 in the context of environmental regulation.
An issue such as product safety can be addressed either by regulation or through the courts based
on the tort system, which is considered in Chapter 14. Product safety regulation is intended to
reduce injuries and respond to market imperfections. The Consumer Product Safety Commission
has broad authority but limited resources, limited expertise, and a complex regulatory environment.
Update to the “Accomplishing Through Regulation What Cannot Be Accomplished Through

Legislation” section: The NLRB majority decided to accelerate its decision to shorten the time
between certifying an election to be held and the actual vote. The Democrats decided on this
strategy because the term of one of their members would expire at the end of 2011, and the
incensed Republicans in the Senate were certain to block the appointment of any Democrat. The
NLRB had 2 Democrat members and 1 Republican, and two seats were open. Consequently, when
the current member’s term expired the NLRB would be unable to take any action for lack of a
quorum. (The NLRB had not had a quorum beginning in 2008 during the Bush administration and
continuing for 26 months into the Obama administration.) To stop the accelerated action, the sole
Republican member threatened to resign, which would prevent the NLRB from acting on the
shortened voting period. This would also prevent a final vote on the Boeing case.
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Republicans in Indiana had majorities in both houses of the state legislature, and the governor was
a Republican. Republican members of the legislature announced that they would introduce a right-
to-work bill in 2012. The law would allow all private-sector workers not to join a union and hence
not to have to pay union dues. Twenty-two states had right-to-work laws, with Oklahoma the most
recent to adopt it in 2001. In the other states all workers at a unionized facility had to belong to the
union and pay dues. Republicans said that the law would help reduce unemployment which stood
at 8.9%.
Cases
Merck and Vioxx

This case focuses on an evolving crisis that threatens one of Merck’s most profitable drugs. The
principal decision to be made is whether the drug should be withdrawn from the market. Much is
still unknown about who knew what and when, so the discussion must proceed cautiously.
The case is written in segments giving a history of some of the decision points. A discussion could
proceed segment by segment, as new information became available to Merck, the FDA, and the
public. The case identifies a tension between self-interest and societal well-being, although any
conclusions have to be made with qualifications. Moreover, any examination of the episode
involves hindsight, and hindsight was not available at the time the decisions were made.
The following discussion tracks the progression of the episodes.
Initial Marketing
The pain reliever market is huge, and patients with chronic pain would use an effective pain
reliever on a regular basis. If the potential market were restricted to patients with gastrointestinal
problems, sales would be low, and the corresponding profits would be moderate. Using DTC
advertising would result in much larger sales and high profits. The margin on a patented
pharmaceutical typically is 80-90 percent, so profits on Vioxx sales of $2.5 billion would be $2
billion or more. Self-interest would be served by marketing the drug broadly with heavy DTC
advertising. This strong an incentive was probably difficult to pass by, particularly because Merck
had a strong incentive to catch up quickly to Pfizer which had shortly before received approval to
market its Cox-2 inhibitor Celebrex.[1] Moreover, there are always risks associated with any new
drug.
Having said that, some commentators believed that DTC advertising was a culprit in increasing
demand beyond the point warranted by cost-benefit analysis. That is, when patients demand a drug
by brand name, doctors are under pressure to prescribe it. Some will succumb to that pressure,
when the drug is not needed. This means that the drug is used more broadly than warranted by its
therapeutic value.
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Not blocking the Cox-1 enzyme loses a cardiovascular benefit as with aspirin. This meant that
there could be greater risk of cardiovascular events with Vioxx than with aspirin. The test against a
placebo, however, had shown no statistically significant effect on cardiovascular risk.
The incentives to limit initial use of the drug and to conduct a clinical test on cardiovascular risk
comes from the liability system, which as considered in Chapter 14 is a institution of society
intended to align private and societal interests. If Merck evaluated the liability risks and concluded
that the profits from sales outweighed the liability cost, a study would not be justified. The
utilitarian calculus, however, is improved by enabling people to make informed decisions about
their health care, so conducting a test and providing information would seemingly be justified.
Utilitarianism seems to call for conducting a test. Note that this may establish a right of patients to
have the information on risks. That right would be instrumental.
Prudence may also suggest that clinical tests be run to determine if there is a risk of cardiovascular
events. Merck decided to conduct a clinical study, although not one to assess cardiovascular
effects.
Success
Vioxx was a huge success, and much of that success was due to DTC advertising. The VIGOR
study was intended to establish the effectiveness of Vioxx for patients with gastrointestinal
problems. The data indicated twice as high a rate of cardiovascular events with Vioxx compared to
the control of naproxen. Since naproxen was believed to have beneficial cardiovascular effects and
the initial Vioxx tests against a placebo found no difference, a plausible conclusion was that the
difference was do to the benefits of naproxen. Still, the other hypothesis could not be rejected that
Vioxx use caused a higher incidence of adverse cardiovascular events. The Merck press release
entitled, “Merck Confirms Favorable Cardiovascular Safety profile for Vioxx” clearly seems
unjustified. That Merck would issue such a press release suggests that it is basing its decisions on
self-interest.
A reasonable approach for Merck would be to work with the FDA to determine not only what
information should be incorporated on the label but also whether doctors and patients should be
notified of the results. Reducing its DTC advertising would sacrifice self-interest for a possible
reduction in as yet an unknown risk. If DTC advertising were to continue, the risk of
cardiovascular events should receive greater mention.
Conducting a clinical trial to study cardiovascular risks certainly is more warranted given the
results of the VIGOR trials.
APPROVe Study
Criticism of Vioxx began in August 2001 and continued in conferences and in The Lancet. The
FDA sharply criticized the Merck press release. Merck did not take this criticism as a reason to
alert patients and doctors of the results of the APPROVe study.
Merck decided not to conduct clinical trials on cardiovascular risk, and this may be a reasonable
decision if those risks could be identified using data from the APPROVe study that was already
underway. It is interesting, however, to note that Merck had decided to conduct trials for a new
indication for Vioxx and not to conduct a trial for the possible risk identified in the VIGOR study.
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This again suggests that decisions were being made based on self-interest rather than
utilitarianism. If the liability system provides sufficient incentives for care, acting on self-interest
is justified in the utilitarian framework.
When during the APPROVe study Merck should have gone to the FDA and warned patients and
doctors is not clear. The role of its outside safety review board is also not clear. It is interesting to
note, however, that it was the board that continued to point to the higher rate of cardiovascular
results.
Certainly by September 2004 Merck had to act. Whether withdrawing the product form the market
was required is not clear. At a minimum DTC advertising and push by Merck’s detail (sales) force
had to be stopped. Moreover, doctors and patients had to be notified.
The Lancet Article

Meta analysis is quite controversial because it collects studies of apples and oranges and treats
them the same. In this case, Merck’s criticism of the article seems warranted. The meta-analysis
showed nothing not contained in the earlier studies. Merck should provide a critique of the article,
and let it go at that.
The article, however, is symptomatic of the feeding frenzy that occurred around the recall. Merck
needs to be prepared to deal with the additional scrutiny and to recognize that it will now be
conducting its affairs in the eye of the media.
Congressional Hearings
Congressional hearings are to be taken seriously if for no other reason that they provide an
opportunity for critics to air their criticisms before the committee and the news media. The study
by Dr. Graham was based on epidemiological data and used statistical analysis to estimate the
effects. The FDA traditionally does not give much weight to such studies. Instead, it puts its
confidence in controlled trials. It is not surprising that Graham’s study was referred to as junk
science and said to be irresponsible. For example, suppose that Kaiser represented 1 percent of
patients and that 2.7 million took Vioxx. Graham’s estimates then indicate a death rate of 1 percent
of Vioxx users. Such a rate seems far too high, given the result of the controlled trials. Moreover,
27,785 deaths had been caused by Vioxx, someone would surely have noticed and notified the FDA
or the news media.
Nevertheless, Merck has to take the hearings and Graham’s study seriously, since at a minimum
they attract media attention. It should conduct informational lobbying with Congress members and
provide a careful critique of Dr. Graham’s study.
Conclusions
The bottom line is that utilitarianism does not require that Vioxx be withdrawn from the market,
since it provides important pain relief for many patients and the additional risk of cardiovascular
events is low. What utilitarianism commands is that the risk be fully disclosed, so that patients and
doctors can make their own decisions about benefits and costs based on the available information.
Since DTC advertising results in use beyond that warranted by the therapeutic benefits of Vioxx,
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that advertising should be withdrawn or restricted. Indeed, DTC advertising about the possible
risks associated with Vioxx might be warranted because of the overuse of the drug.
Developments
The hundreds of lawsuits filed against Merck for deaths and injuries were consolidated into a class
action to be tried in federal court in New Orleans. The many shareholder lawsuits filed against the
company were consolidated in a federal court in Trenton, New Jersey. Merck set aside $765
million for legal costs.
Vioxx provided a easy target for fraudulent lawsuits against Merck. The company sought dismissal
of a lawsuit filed by a woman who claimed that her husband died of a heart attack caused by
Vioxx. Merck upon investigation found that the prescription for Vioxx had never been filled and
that the free samples she claimed her husband had taken had not been manufactured until six
months after his death. The judge refused to grant a dismissal.
In February 2005 documents were revealed indicating that Merck had organized and was prepared
to launch a major cardiovascular study in 2002 but had abruptly cancelled it because it would have
involved “high-risk patients.” The study was scheduled to be completed by March 2004. If that
study had been conducted, the increased risk might have been identified earlier.
In October 2004 a study was halted that was testing whether Celebrex and naproxen reduced the
risk of Alzheimer’s disease revealed that patients taking naproxen had a 50 percent higher
incidence of cardiovascular events compared to a placebo. This seems to contradict the belief of
Merck in the VIGOR study.
Also in February 2005 Wellpoint, a large health care insurer reported that a study of its patient data
showed a 20 percent higher risk of heart attacks and strokes with Celebrex and Vioxx and 50
percent with Bextra. The study had compared people over 40 who had taken one of the drugs for
over 18 months with people over 40 who did not take any of the three drugs.
In May 2005 Merck CEO Raymond V. Gilmartin resigned on the day congressional investigators
disclosed documents indicating that the company had told its sales force not to mention the results
of the VIGOR study but to emphasize the previous message that Vioxx protected the heart. Merck
had argued that the study results were due to the beneficial effects of naproxen.
In additional to congressional investigations Merck was under investigation by the Department of
Justice and the Securities and Exchange Commission.
The congressional investigations also focused on the FDA and its procedures for reviewing post-
marketing data. An FDA official acknowledged that there were “lapses” in its reviews. The Bush
administration had added $5 million to the FDA’s budget to increase its scrutiny of post-marketing
data. The FDA established a advisory committee to review the safety of already approved drugs.
In February 2005 an FDA panel voted 17 to 15 that Vioxx could be sold to some patients but with
strong warnings.
Merck decided to withdraw Vioxx from the market.
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Merck fought the lawsuits and won 11 of the 18 Vioxx lawsuits that went to trial, and in the most
celebrated decision in Texas for the plaintiff the judge reduced the award from $253.4 million to
$27.2 million. The court decisions strengthened the bargaining power of Merck. A total of 47,000
lawsuits alleging heart attacks or stokes from Vioxx had been filed, and under the auspices of a
federal district judge Merck and 6 attorneys from around the country negotiated a settlement for
$4.85 billion. The terms of the agreement required that 85 percent of the plaintiffs sign up for the
settlement. A total of 44,000 signed up, allowing the settlement to take effect. The average
settlement was expected to be $100,000.
Merck has not reintroduced Vioxx. Pfizer has never withdrawn Celebrex from the market.
Developments: In 2011 Merck paid $950 million and pleaded guilty to criminal misdemeanor
charges “that the company illegally promoted its former painkiller Vioxx and deceived the
government about the drug’s safety.”5 Earlier Merck had settled thousands of products liability
lawsuits alleging deaths and injuries for $4.85 billion. The $950 million was to be paid to the
federal and state governments.
Pfizer and Celebrex

Much of the analysis for the Merck and Vioxx case in Chapter 5 is relevant to this case and will not
be repeated.
When Vioxx was withdrawn, for two reasons Pfizer should immediately review all the studies of
Celebrex. The first reason is moral; i.e., the company has a moral obligation to assess whether
there are unrecognized risks associated with the drug. The second reason is that private and public
politics was directed at all Cox-2 inhibitors. This review should include both internal and external
studies and uncompleted as well as completed studies. (Pfizer reviewed only completed internal
studies.)
If its review identified no increased risk, Pfizer need not withdraw Celebrex nor stop advertising,
although suspending advertising would be a prudent measure. The preponderance of evidence
apparently indicated no increased risk. The fact that Onsenal had a more potent dose of celecoxib
suggests that Merck should delay introduction of the drug. This should be decided jointly with the
EU approval agency.
National Cancer Institute Study
The results indicated a serious enough concern that the NCI study was called off. Pfizer thus faced
a serious decision. At a minimum it should stop its DTC advertising, and prudence suggests
withdrawing Celebrex. Advertising to doctors is less of a concern because most doctors have the
5
Wall Street Journal, November 23, 2011.
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expertise to evaluate the study results. At a minimum Pfizer needs to review the data with the
FDA. Certainly, the label has to be changed to reflect the additional risk.
If Pfizer does not withdraw Celebrex and Bextra, it must explain clearly to doctors and the public
why the drugs should remain on the market. The drugs have benefits for patients, and the
utilitarian calculus is improved when individuals make informed decisions. This suggests leaving
the drugs on the market if doctors and consumers can be informed of the better-understood risks.
The extensive media coverage given to Celebrex will warn patients and doctors.
The Alzheimer’s Study and Public Citizen
Public Citizen’s citizen petition was filed before the Alzheimer’s study data was discovered, and
that study added fuel to the fire. Pfizer then faced allegations that it concealed the study because of
the evidence of elevated risks. This is the stuff of lawsuits.
Should Pfizer have published the study when it was completed? At the time it certainly was not
customary in the industry to do so. It would have been surprising to see a company do more than
Pfizer did. Today, those results would have been published. Pfizer made the data available when
Dr. Schneider urged the company to do so.
Developments
Pfizer decided not to withdraw Celebrex from the market when Vioxx was withdrawn. After the
NCI study was reported, Pfizer decided not to withdraw Celebrex. It concluded that the adverse
cardiovascular effects of Celebrex were rare, particularly at the dosage most patients take, which
was less than used in the NCI study. Pfizer, however, decided to suspend its advertising of
Celebrex to consumers.6 It, however, continued its advertising to doctors.
In the European Union Pfizer and the European Medical Agency agreed to delay the marketing of
Onsenal. The Agency said its preliminary review of the submitted showed an increased risk of
“serious cardiovascular events.” The Agency requested additional data.
Pfizer’s review of studies on Celebrex included only internal studies conducted by the company
and restricted attention to completed studies. The 1999 study was not included in its review
because it had not been completed. Documents subsequently released showed a sharp
disagreement between the company and the FDA on labels for Celebrex. Documents released also
showed that when Bextra and paracoxib were submitted for approval by the FDA, reviewers were
critical of the drugs. The FDA rejected paracoxib, and Bextra was not approved as a treatment for
acute pain.
Two weeks after Merck withdrew Vioxx, Pfizer warned doctors that patients who had had coronary
bypass surgery and took Bextra were at greater risk of heart attacks. Celebrex and Bextra were
chemically different from Vioxx, and Pfizer maintained that its studies had shown no increase in
cardiovascular risk, other than for coronary bypass patients.
6
The previous month the FDA had forced Pfizer to withdraw two ads for Viagra.
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Shortly after Merck withdrew Vioxx from the market, Pfizer announced a new study to see if
Celebrex protected patients with heart disease. A University of Pennsylvania researcher who had
conducted a study of mice suggested a mechanism by which combining Celebrex and a drug that
operates like aspirin could cause heart attacks and strokes.
In October 2004 a study that was testing whether Celebrex and naproxen reduced the risk of
Alzheimer’s disease was halted when it was found that patients taking naproxen had a 50 percent
higher incidence of cardiovascular events compared to a placebo.
The congressional investigations focused on the FDA and its procedures for reviewing post-
marketing data. An FDA official acknowledged that there were “lapses” in its reviews. The Bush
administration had added $5 million to the FDA’s budget to increase its scrutiny of post-marketing
data.
Pfizer faced a myriad of lawsuits on Celebrex as the trial lawyers circled the company.
Enron Power Marketing and the California Market

The establishment of a market for electricity has been a major accomplishment, but the design of
the market is a challenge because electricity is a nonstorable good. This means that electricity must
have a time of supply (i.e., when electricity will be delivered into the grid) and a time of demand
(i.e., when a user of electricity will take delivery). The ISO played the role of coordinating demand
and supply and sending electricity through the power grid. The ISO was charged with meeting all
demand, so it needed to maintain readily available reserve generating capacity or other supply to
meet unexpected demand; e.g., because of hot weather. Market efficiency was enhanced by being
able to move electricity from areas of excess supply to areas of excess demand.
The market for electricity and the California experience are discussed in the chapter. The design
flaws are identified there. One major problem was that consumer demand was unaffected when
shortages developed, since prices were fixed.
Several structural problems also complicated the market in California. First, no new generating
capacity had been built in the state for a decade. This was due to opposition by environmentalists
and NIMBY groups and because low-cost electricity could be imported from other states. Second,
economic growth had increased the demand for electricity. Third, a bottleneck in the distribution
grid made it difficult to move electricity between the north and south of the state. These factors as
well as flaws in the design of the market provided opportunity for traders to manipulate the market.
Enron had a large share of the California electricity trading, but its share was probably less than
half. Its share was large enough, however, to manipulate the market. Its “inc-ing” strategy was
clear manipulation. Its Get Shorty strategy required providing false information to the ISO. Death
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Star and load shift also manipulated the market. Playing on the price cap took advantage of the
California market rules about electricity produced in the state and electricity imported from other
states. These strategy may or may not have been illegal, but it is clear that Enron was gaming the
market. That the law firms told EPM to stop using these strategies also indicates that they were at
least violating the rules established for the California market.
The market rules required that the telephone calls of all traders be recorded, so there is a record of
the use of these strategies. Some of these recordings were used in the documentary movie Enron:
The Smartest Guys in the Room released in 2005.
From the perspective of utilitarianism a market is intended to serve the goal of economic efficiency,
which in turn increases aggregate well-being. The manipulation of the market made it operate less
efficiently, so the manipulation was a moral wrong even if it were legal.
The manipulation also had distributive consequences. It resulted in a transfer of wealth from
California customers to the traders. The customers that paid the high prices were generally
businesses, since the price to residential consumers was fixed. This could be a wash in the
utilitarian calculus as discussed in the text. The other losers were the shareholders of the electric
utilities in California, which went bankrupt. This bankruptcies, however, were due to the regulated
prices and the shortage which drove up wholesale prices. Those bankruptcies were likely little
affected by the market manipulation. The other major distributive effect was on California
taxpayers and customers who were required to pay for the electricity contracted for by the
California governor. The trading manipulation probably had little effect on this contracting.
Teaching the case
The following questions can be used to lead the discussion.

1. What was wrong with the design of the California market?
2. Should a company take advantage of flaws in the design of a market?
3. Should a company manipulate a market if it has the ability to do so?
4. Is this type of market manipulation commonplace in trading markets; e.g., on Wall Street as
illustrated in the quotation from the CEO of Kiodex at the end of the case?
5. What was wrong with the inc-ing and Get Shorty strategies?
6. What was wrong with ricochet trades?
7. How should Enron Power Marketing have conducted its trading business?
8. Should the power trading companies be responsible for the contract signed by the California
governor?
Developments
Enron, as everyone knows, went bankrupt as indicated in the Chapter 19 case The Collapse of
Enron: Responsibility and Governance. EPM was sold as indicated in this case.
Criminal charges apparently have not been brought against EPM or its traders.
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On June 17, 2004 FERC Chairman Pat Wood, III said, “As our 2002-2003 staff investigation
showed, the corporate culture at Enron ‘fostered a disregard for the American energy customer.’
These taped conversations indicate that this corrosive attitude seeped down from the corporate
offices to the employees at the front line.”
California politicians sought to cancel the supply contracts signed by Governor Gray Davis. In
June 2003 FERC rejected California’s request to invalidate those $12 billion contracts. FERC
concluded that the prices were high but not invalidate by the trading strategies. FERC stated, “The
contracts were entered into voluntarily in a market-based environment, the Commission pointed
out. The Commission found no evidence of unfairness, bad faith, or duress in the original contract
negotiations. It said there was no credible evidence that the contracts placed the complainants in
financial distress or that ratepayers will bear an excessive burden.”7
In a separate proceeding California sought reimbursement of $9 billion on overcharges on

electricity already purchased and consumed. FERC concluded that California should receive a $1.8
billion refund from power suppliers. Many other FERC actions have been taken against individual
companies. Details are available at www.ferc.gov.
California officials also filed lawsuits in state courts to reclaim funds from suppliers. For example,
the attorney general filed a lawsuit in May, 2005 seeking $1 billion from PowerEx and PNM. The
lawsuit alleged that the companies engaged in ricochet trading by buying electricity in California,
sending it out of state, and selling it back to the ISO at a high price.
The bottleneck between the north and south was finally relieved in December 2004, when a third
transmission line was added to Path 15 in Fresno and Merced counties. The ceremonial switch was
thrown by Governor Arnold Schwarzenegger, who was elected after voters recalled Governor Gray
Davis. Davis had signed to electricity supply contracts with high prices.
The California electricity market has been redesigned and is back in operation.
7
FERC News Release, June 25, 2003.
189
Chapter 11
Financial Markets and Their Regulation

This is a new chapter focusing on the financial crisis and the regulation of the financial markets that
resulted from it. The rulemaking on the regulation was far from complete in mid-2012 with
regulators grappling with the Volcker Rule, capital requirements, and many other issues. The
lobbying on the issues was intense, and the outcomes were uncertain.
The causes of the financial crisis are many and varied. Moreover, considerable disagreement
remains over the causes. A lecture could recap and evaluate the explanations given in the chapter.
The leap from the identification of causes to the appropriate actions to take is a long treacherous
one, since intervention in highly competitive markets can be hazardous. New regulatory rules will
be written over the next months and years, and only experience will identify the wisdom of the
rules. The financial services industry is waging an intense lobbying effort to obtain favorable
interpretations of Dodd-Frank. One instance pertains to what is a “qualified residential mortgage,”
which would be exempt from the 5 percent retention requirement. The industry argues for a broad
definition such as that used for “qualifying mortgages” under Fannie May and Freddie Mac. The
proposed rule was for a 20 percent down payment, which was considerably narrower than a
“qualifying mortgage.” Both industry and consumer groups called for a more inclusive rule.
Consumer groups feared that credit would be less accessible under an 80-20 rule. More than a year
has passed since the proposed rule was announced, and a final rule has yet to be promulgated.
The chapter provides some details on the collateralized debt obligations and credit default swaps
that were at the heart of the financial crisis, and some additional explanation could be provided in a
lecture. The securities were not the cause of the crisis, but they did make it easier to issue bad
mortgages and leverage a financial services firm with off the balance sheet financing. These
securities play a role in the chapter case Goldman Sachs and Its Reputation.
The chapter case Credit Ratings Agencies presents information on the companies that securities and
identifies the principal alternatives available to regulators.
Jamie Dimon, CEO of JPMorgan Chase, was a strong advocate for less regulation of financial firms
than called for by Dodd-Frank. He and the company were humbled by a hedging loss initially
reported to be $2 billion. The company had knowingly adopted a supposed hedging strategy for
exposure to European financial risks. The hedge was not a true hedge but instead was a bet on the
direction of movement of European financial securities. The hedge strategy was ordered by top
management. An internal JPMorgan Chase memorandum reportedly stated that the loss could
reach $9 billion, and on the disclosure of the memorandum, the company’s stock price dropped by
2.2% more than the other financial stocks. For many people, Dimon’s credibility was called into
question.8
8
San Jose Mercury News, June 29, 2012.
190
The Dodd-Frank Act contained a requirement that all findings and conclusions provided in the
underwriting of the securities had to be made publicly available, whereas in the past these had been
privileged communications. This meant that lawyers, accountants, and investment bankers faced
having their opinions and judgments made public. Ed Gainor of the law firm Bingham McCutchen
said, “Lawyers and accountants would be highly reluctant to publish their opinions and conclusions
because their letters are specifically for the parties to whom they are addressed.”9 This aspect of
Dodd-Frank may provide a field day for trial lawyers.
The Volker rule is Section 619 of the Dodd Frank Act. Former Citibank CEO John Reed
commented on the need for the Volker rule. “You asked me why trading exploded. Profit. An
aggressive trading culture is very difficult to control within the context of a bank. That is why
culturally it’s important to keep proprietary trading separate from the commercial banks.”10
Proprietary trading is of two types. One type is not client-facing and involves the investment of the
firm’s own funds; this is sometimes referred to as principal investing. The second takes place in
conjunction with client-based activities including market-making and securities-backed
transactions.
The alternative to proprietary trading is to form a hedge fund, and critics of the Volcker rule
warned that funds would be moved from the banks on Wall Street to unregulated hedge funds. In
2010, nine traders in Goldman’s financial strategies group left Goldman to join KKR to set up a
new hedge fund. Gary Cohn, the number two executive at Goldman Sachs commented on the
effects of the new regulation: “In the next few years, the unregulated sector will grow at an
exponential rate. Risk is risk. My concern is that…risk will move from the regulated, more
transparent banking sector to a less regulated, more opaque sector.” He added, “What I worry most
about is that in the next cycle, as the regulatory pendulum swings, we are going to have to use
taxpayer money to bail out unregulated businesses that, unlike the banks in the last crisis, may not
be able to repay them.”11 The unregulated sector refers to hedge funds and other financial activity
outside the purview of regulators.
In addition to working to loosen the stringency of the regulation called for by Dodd-Frank, banks
worked to reduce or at least delay the Basel III requirements.
Incentives for Mischief in Mortgage and Financial Markets

The following note describes some of the incentives for bad loans in the mortgage market.
In the loan origination market mortgage brokers, non-bank lenders, and some banks
operated with an explicit strategy of “originate to distribute,” under which there was no intention of
holding the loans made. The loans were used to back collateralized debt obligations (CDOs) issued
by a special-purpose vehicle (SPV), a paper vehicle that held the mortgages and issued CDOs.
Writing in the New York Times Joe Nocera described the incentives provided by the securitization
of mortgage loans: ``Economists call the phenomenon moral hazard. Bankers have a different
term: I.B.G. The phrase implies that by the time a deal goes sour, ‘I’ll be gone’ after having
9
Wall Street Journal, July 22, 2010.
10
Institutional Investor (America’s Edition), December 2010.
11
Financial Times, January 27, 2011.
191
received a sizable bonus."12 Farmer and Geanakoplis (2008) wrote (p. 28), “But [lenders]
apparently underestimated the amount of fraud in the loans. The brokers arranging the loans did
not own them. The loans were sold and repackaged into bonds that were in turn sold to hedge
funds and other investors. Since the brokers knew they would not bear the losses from defaulted
loans, they evidently did not have enough incentives to check the truthfulness of the borrowers.
And the investors apparently did not monitor the brokers carefully enough, perhaps lulled by the
good behavior of the loans during the period of housing appreciation.” Indeed, those who
expressed concerns about the CDOs could be fired. Ken Linton, a former trader for Lehman
Brothers, commented on the culture that led the firm to be the top producers of mortgage-backed
securities: “Anyone at our level who had a different view than senior management would find
themselves going somewhere else quick. You are not paid to rock the boat.” 13
The incentives of intermediaries in the mortgage lending market were asymmetric with
large payoffs on the up-side and small risks on the down-side. Kane described the incentives as
follows: “When commissions and other fees for service are paid upfront, managers and line
employees of firms that originate, securitize, rate, or insure loans fear that they are passing up
short-run income whenever they nix a questionable deal. At the same time, accountants, appraisers,
and even government supervisors know that they can win business from competing enterprises in
the short run by establishing a reputation for not challenging a troubled client's dodgy
representations about asset values or assessing its efforts to transfer risks off balance sheet as
conscientiously as a third party might suppose.”14 Blinder described the incentives that motivated
the deal-makers: “Take a typical trader at a bank, investment bank, hedge fund or whatever.
Darwinian selection ensures us that those folks are generally smart young people with more than
the usual appetite for both money and risk-taking. Unfortunately, their compensation schemes
exacerbate these natural tendencies by offering them the following sort of go-for-broke incentives
when they place financial bets: Heads, you become richer than Croesus; tails you get no bonus,
receive instead about four times the national average salary, and may (or may not) have to look for
a new job. These bright young people are no dummies. Faced with such skewed incentives, they
place lots of big bets. If tails come up, OPM [Other People's Money] will absorb almost all the
losses anyway.” 15
Many mortgage brokers relied on automated loan approvals for which documentation of the
borrower's qualifications was not required or was incomplete. Jeff Schaefer, the former executive
in Lehman Brothers’ Aurora Loan Services unit, reported that he “used to talk with [a Lehman
trader] three or four times a day to get his marching orders on mortgage pricing and credit
standards. It was these conversations, he says, that helped him decide whether to require borrowers
to document their income on whether to give them so-called no-doc loans.”16 Schaefer explained
the lack of documentation, “A lot of it was risk based on FICO (credit) scores,” he says. “While
you may have had no-doc loans, people had very high credit scores, which are based on the ability
to pay their debt. And because they have been paying, the income they stated is reasonable.”17
Some lenders went further and encouraged their brokers to make riskier loans. The head of Taylor,
12
New York Times, September 12, 2009.
13
14
Edward J. Kane, “`Incentive roots of the securitization crisis and its early mismanagement.” www.voxeu.org, March
3, 2009.
15
Alan S. Blinder, “Crazy Compensation and the Crisis.” Wall Street Journal. May 28, 2009.
16
17
St. Petersburg Times, September 27, 2009.
192
Bean & Whitaker Mortgage Corporation, which became the 12th largest home mortgage lender,
“acknowledges it was one of the few lenders making FHA loans for mobile-home purchases and
one of the last to impose minimum credit scores for FHA borrowers. ‘I felt that the spirit of the
program was to try to provide home loans to those borrowers,’ he says.”18 The absence of
documentation was hidden from investors who bought CDOs, although not necessarily from the
credit ratings agencies.
With complete information investors would reduce the price they paid for a CDO by the
cost of the risk thereby imposing the full consequences on the lender. Information, however, was
far from complete. In particular, subprime loans were made to a new class of borrowers who
previously had not qualified under traditional lending standards, so the models and historical data
used by the credit ratings agencies were inadequate for rating the new CDOs. In addition, lenders
and the investment banks that designed the CDOs influenced beliefs through their marketing of the
CDOs to investors. In some cases their messages involved misrepresentation and possibly fraud,
and in others they reflected the exuberance of riding a wave of rapid economic growth, rising
housing prices, and large capital gains.
The new class of mortgage loans was inherently riskier than traditional mortgage loans, but
these new mortgages could be profitably packaged, tranched, and sold to investors. For nonbank
lenders profits were earned on the difference between the price at which loans could be sold and the
cost of the borrowed capital used to fund the loans. The premium was due in part to exuberant
expectations and false diversification, but it was also due to demand fueled by regulatory changes
that allowed financial institutions to pursue higher returns by purchasing high yield CDOs. Sheila
Bair, chairman of the FDIC, commented on the impact of the regulatory changes: “The same dollar
of capital could now support as much as five times the volume of these triple-A securities. It is not
entirely coincidental that in the subsequent years, financial service companies swung into high gear
creating new classes of rated securities. With their promises of triple-A quality and higher yields in
some cases, these products were very attractive to banks that wanted to boost returns on equity, and
to economize on regulatory capital.”19
The marketing of securities backed by subprime mortgages was aggressive and in some
cases involved unethical practices and possibly fraud. Elizabeth MacDonald wrote, “behind the
scenes Goldman Sachs worked hard to clean up its books by burying the worst ‘dogs’ of these
assets in baskets of subprime securities, then traveling the world over to sell these investments by
targeting the ‘buy and hold’ crowd, investors not as smart as their other hedge fund clients.20 Fraud
could result, for example, if the subprime lender misrepresented information to a credit rating
agency or from false statements to investors and shareholders about the quality of the loans.21 For
example, in its complaint against Countrywide CEO Angelo Mozillo and two other former
Countrywide executives, the Securities and Exchange Commission (SEC) stated that the executives
“misled the market by falsely assuring investors that Countrywide was primarily a prime quality
mortgage lender that had avoided the excesses of its competitors. ... But concealed from
shareholders was the true Countrywide, an increasingly reckless lender assuming greater and
18
Wall Street Journal, September 17, 2009.
19
Sheila Bair, “Remarks to the Global Association of Risk Professionals,” February 25, 2008.
20
http://emac.blogs.foxbusiness.com/2010/04/27/new-details-emerge-goldman-case
21
See Roger Lowenstein, New York Times, April 27, 2008, for a description of risky mortgages and Moody's review of
them.
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greater risk.”22 Similarly, the SEC accused three former executives of the New Century Financial
Corporation of fraud, stating in its civil complaint, “The calculations [of bad loans] misled
investors by implying that virtually all of New Century's borrowers had considerable equity in their
homes, whereas, in fact, nearly one-third of New Century's borrowers had no equity in their homes
whatsoever.”23 Fraud allegations were also directed at the investment banks that constructed and
marketed the CDOs. In December 2009 Morgan Stanley was sued by a pension fund alleging that
it collaborated with Moody's and Standard & Poor's in obtaining a AAA rating for a CDO backed
by mortgages from New Century and Option One Mortgage. “The complaint asserted that Morgan
Stanley knew the CDO's assets were far riskier than the ratings suggested, but was ‘highly
motivated to defraud investors’ with pristine ratings because it was simultaneously ‘shorting’
almost all the assets....’Morgan Stanley was betting the entire investment it was promoting would
fail’ ...’The firm achieved its objective.’”24 As former Lehman Brothers securities salesman Tom
Ollquist stated, “I have blood on my hands.” 25
Although lenders operate under a variety of organizational forms, one common
characteristic is that they operate through loan originators. The originators could be either loan
officers employed by the lender in decentralized offices, as in the case of Countrywide's 1300
storefront offices and Washington Mutual's retail branches that between 2000 and 2003 grew by 70
percent to 2,200, 26 or independent mortgage brokers. Mortgage brokers accounted for 60 to 70
percent of the lending during the early part of the decade. Herbert Sanders, head of World Savings,
said “You have to understand how independent brokers work. They are the whores of the world.”
Yet by 2006 independent brokers were accounting for 60 percent of World Savings' loan
business.27
In most jurisdictions in the United States mortgage brokers do not have a fiduciary duty to
borrowers. Consequently, a broker could originate a first mortgage knowing that the borrower
would have to take out a second mortgage and would be unlikely to be able to make the payments
on both unless the economy was strong. Similarly, a broker could require only a small down
payment, increasing the likelihood that the borrower might walk away if housing prices fell. Or, a
broker could originate a first mortgage with an adjustable interest rate knowing that it was unlikely
that the borrower could meet the payments on the adjusted rate and would have to refinance, which
could be problematic if the economy were weak or credit were tight at that time. Brokers thus
could knowingly violate traditional lending standards by exploiting borrowers so as to maximize
their income within the compensation structure provided by the lender.
Whether subprime lenders believed that their loans had a negative expected return at the
time they were made is unclear, and the returns on subprime loans could have changed over time.
For example, in its fraud complaint against the three former Countrywide executives, the SEC
stated, “Countrywide engaged in an unprecedented expansion of its underwriting guidelines and
was writing riskier and riskier loans, ...”28 The SEC also stated, “By the end of 2006,
Countrywide's underwriting guidelines were as wide as they had ever been, and Countrywide made
22
Securities and Exchange Commission, Press Release, June 4, 2009.
23
New York Times, December 8, 2009.
24
25
26
27
28
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an increasing number of loans based on exceptions to those already wide guidelines, even though
exception loans had a higher rate of default.”29 In its fraud complaint against the former executives
of New Century Financial Corporation, the SEC stated, “New Century's business was anything but
‘good’ and it soon became evident that its lending practices, far from being ‘responsible,’ were the
recipe for financial disaster.”30 These complaints suggest that the expected return on some
subprime loans was negative at least is the latter part of the bubble period.
The difficulties in avoiding writing high risk mortgages were in part due to the activities of
brokers. Taylor Bean was fined $75,000 by the state of Kentucky for funding loans originated by
unlicensed brokers. It also paid $9 million in a settlement with 14 states over “alleged improper
lending practices that stemmed from weak internal controls on high-risk mortgages ...”31 Taylor
Bean had a department to screen “out fraudulent loans, but they struggled to keep up with the flow
of new mortgages. ‘It was kind of like trying to write speeding tickets on an eight-lane highway
with a moped,’ says Craig Weitzel, who was the fraud department manager.”32 Lenders thus
frequently had imperfect information about the practices of the brokers that originated the loans.
The expanded and more risky lending and the marketing of mortgage-backed securities
sowed the seeds of their own destruction. The expanded lending was fueled by expectations of
rising house prices, and as housing prices began to fall in 2006, some borrowers became delinquent
on their mortgages and some walked away from their investments. At Lehman Brothers, Ken
Linton “recalls vividly the days in early 2007 when his financial models began to throw up more
warnings showing delinquencies and defaults, and he remembers colleagues on his desk raising
questions about loan quality. But he said the firm's ranking as the top loan originator on Wall
Street, not to mention the pressures put on the desk by Lehman's growth-obsessed leadership, made
it difficult for even the most senior executives to raise questions, even a senior vice president like
Mr. Linton.” 33
As an illustration of the information problem when lenders relied on brokers, Taylor, Bean
“used short-term loans … to buy mortgages from a network of brokers and community banks that
dealt with customers.”34 Moreover, lenders may have had difficulty identifying the quality of the
loans the brokers initiated. Particularly with the prevalence of no-doc loans, assessing the brokers'
lending decisions and inferring their type was likely to have been difficult and costly.
Many subprime lenders operated through independent brokers in the originate-to-distribute
market, and brokers had strong incentives to originate loans. Monitoring of the origination
decisions was difficult, as illustrated by the comment from the manager of Taylor, Bean's fraud
department. Moreover, loan origination was subject to a variety of types of fraud by borrowers and
brokers, as detailed by the Mortgage Asset Research Institute. According to CNNMoney.com, the
fraud cases “include so-called ‘liar’ loans, in which mortgage professionals knowingly listed false
income claims for borrowers; inflated appraisals, in which mortgage loan officers or brokers
pressure appraisers to overvalue a home so it would qualify for a bigger mortgage; and false
29
30
31
32
33
34
Wall Street Journal, September 17, 2009.
195
occupancy claims, which is when buyers claim they will live in a home but are actually buying it
for investment purposes.”35
Cases
Goldman Sachs and Its Reputation

Goldman Sachs became a whipping boy of the media and Congress as a result of its active role in
the financial markets leading up to their collapse and because of disclosures of some of its
transactions. Goldman was a major player in financing mortgage lenders, constructing and
marketing CDOs, and trading in securities on its own account. The company also reorganized as a
bank holding company so that it could receive TARP funds. As conditions worsened prior to the
collapse, Goldman had aggressively decreased its exposure to mortgage backed securities and had
hedged its remaining risks with credit default swaps. It had aggressively pursued payments from
AIG on CDSs, and its pressure was widely believed to have contributed to the failure of AIG,
requiring a bailout by TARP. During the crisis Goldman outperformed other banks, remained
profitable, and continued to have the highest average compensation of any bank.
The AIG, Abacus AC1, and Facebook episodes are well described and can each be discussed. The
major unknown is whether these are isolated incidents or whether they are typical of Goldman’s
conduct, which had not been disclosed.
Whether Goldman did anything wrong depends on whether its clients were sophisticated investors
as Tourre and Blankfein suggest. But, even if they were, there is a question of whether fraud was
involved, as the SEC charged. If the Abacus AC1 transaction was not fraud, it was a close relative,
and Goldman was sufficiently concerned about facing a trial that it agreed to a settlement.
Another central issue is whether Goldman’s culture when its reputation earned from its investment
banking business has been replaced by a trading culture emphasizing short-term profits.
The class discussion could address the extent to which Goldman’s reputation had been damaged
and whether its clients’ views of the bank have been affected.
One consequence of the developments described in the case is that Goldman is now a focus of
media attention with its actions widely reported. Goldman now lives in the eye of the media.
A central issue for the future is what effect Dodd-Frank will have on the bank, and how the bank
will adapt to the final regulations.
1. Are Goldman Sachs’ problems ones of perception, as Blankfein indicated?
35
http://money.cnn.com/2010/4/26/real-estate/mortgage-fraud-rose/index.htm?source=cnn...
196
2. Did Goldman do anything wrong in the AIG episode?
3. Did it do anything wrong in the Abacus AC1 episode?
4. In trading on its own account does Goldman look for counterparties that have “a view
different” from its own?
5. Is it likely that there were other similar episodes that were never disclosed or were these
idiosyncratic?
6. Did it do anything wrong in aggressively reducing its exposure to mortgage backed
securities?
7. Was Goldman living up to its first business principle: “Our clients’ interests always come
first.”?
8. Is part of the problem that the bank is run by traders, as John Whitehead implies?
9. As a client of Goldman Sachs would you be confident that it was putting your interests
first?
10. Why did it attempt to skirt the SEC 500 investors rule in the Facebook funding? Was the
SEC skeptical of the Facebook deal because of the Abacus and other episodes?
11. Has its reputation been damaged or does it remain the elite of the elite?
12. Are the recommendations of its Business Standards Committee sufficient to reassure clients
and ensure that their interests come first?
13. Is there an inherent conflict of interests in try to serve four roles as advisor, fiduciary,
market maker, and underwriter? Should it operated in its four roles at arm length?
14. How will Dodd-Frank affect the bank?
Update: Goldman’s profits have declined, and some commentators attributed the decline to less
aggressive trading on its account. The bank stated that the lower profits were due to taking less
risk.
Goldman was not the lead underwriter for the Facebook IPO. Whether Goldman would have done
a better job than JP Morgan Chase and Morgan Stanley is not clear.
Goldman contributed $350 million to its charitable foundation in 2010, down from $500 million in
2009.
The British excess compensation tax was $600 million for Goldman.
Asset management involves investing other people’s money. BlackRock manages $3.45 trillion
and Pacific Investment Management manages $1.3 trillion, whereas Goldman Sachs Asset
Management manages $677 billion.36 Goldman is a major player in asset management, but is
dwarfed by larger asset managers such as BlackRock.
The practice in the industry is not to tell a client on one side of a transaction who is on the other
side.
With regard to the failure of AIG and Goldman’s role in the failure, a New York Federal Reserve
official deleted a sentence from the RFP for the Maiden Lane III vehicle created for managing the
TARP funds for AIG. The sentence mentioned that the CDS holders were paid in full. On
36
Institutional Investor (America’s Edition), December 2010.
197
November 11, 2008 he explained, “As a matter of course, we do not want to disclose that the
concession is at par unless absolutely necessary. In this case, not sure it is necessary because this
has nothing to do with the ML III structure.” Congressman Darrel Issa (R-CA) commented, “It’s
not conjecture, it’s not speculation, it’s fact, the New York Fed gave a back-door bailout to AIG’s
counterparties and then tried to cover it up. The veil of secrecy that swept through the Fed
embraced a mentality that treated transparency as a dispensable luxury rather than a moral
imperative.” (House Committee on Oversight & Reform, no date).
Two quotations that could be used in the discussion are:
“The world’s most powerful investment bank is a great vampire squid wrapped
around the face of humanity, relentlessly jamming its blood funnel into anything that
smells like money.” Matt Taibbi, Rolling Stone, 1082-1083, July 9-23, 2009.
I’m just a banker “doing God’s work,” quipped Lloyd C. Blankfein, CEO, Goldman
Sachs, in an interview with the London Times, November 8, 2009.
Credit Ratings Agencies

The credit ratings agencies play a role in the securities industry, although their role is not the
typical one prescribed to them. The ratings are used less by sophisticate investors and more by
unsophisticated investors as in the case of a municipal government agency. The ratings are also
used in loan covenants under which the interest rate on a bank loan may be conditioned on
maintaining an investment grade rating. Many institutional investors are required by law or
regulations to invest only in investment grade securities. The ratings are seldom used by traders
except, for example, when a trader is attempting to guess whether a bond, for example, will be
downgraded. The credit ratings agencies did not anticipate the financial crisis and missed several
crucial events such as the Worldcom collapse and the Lehman Brothers bankruptcy, as did
investors. Whether and what to do about the credit ratings agencies was unclear, and Dodd-Frank
largely delegated responsibility for new regulations on the agencies.
The current issuer pays model has the advantage of making ratings available to all investors, which
can be valuable to unsophisticated investors. The system, however, has a number of weaknesses,
such as ratings shopping and reliance on the issuer for data. Moreover, the agencies give their
ratings models to the issuers, allowing them to engineer securities such as CDOs, to meet the
minimum standard for an investment grade rating, for example. The principal criticisms of credit
ratings agencies, however, are that in many instances they fail to predict well and that they are slow
to revise ratings, as in downgrades. How ratings accuracy and timeliness can be improved is not
obvious, and if there were improvements that could be made, competitive pressures would lead the
agencies to make them. The chapter discusses in more detail the criticism of the credit ratings
agencies and the boxed example “Unintended Consequences—Experts” illustrates the
consequences that mistakes can have.
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The user pays model is attractive in principle, and two agencies (one of which is Kroll) used a
subscription model. This model avoids many of the incentive problems inherent in an issuer pays
system, but its weakness is that the agencies in all likelihood would be unable to generate sufficient
revenue to cover the cost of producing the ratings. The reason is that the ratings are not useful to
large and sophisticated investors, which have their own means of assessing risks. As Buffett said,
they will not pay. (McGurn’s analogy to college guides is thus not a good one.) Whether there is
enough demand among unsophisticated investor s to cover the cost is unclear, and if there were, the
free-rider problem would plague the agencies.
The alternative of easing entry is something that the SEC has been doing in recent years, and
smaller firms such as DBRS have been gaining market share through faster decisions on ratings.
This has been in the context of an issuer pays system, and many of the weaknesses of that system,
such as ratings shopping would persist and perhaps intensify. Easing entry may well improve
credit ratings performance, but it will not solve the problems inherent in an issuer pays model.
An alternative that addresses the ratings shopping problem is to have the SEC select the agencies to
rate each security. The obvious problem with this alternative is determining the basis on which the
SEC selects. Whatever would be chosen would be subject to lobbying pressure and lawsuits, and if
Congress became involved, politics would prevail. Certainly the financial services industry would
vigorously oppose further SEC involvement in ratings.
Removing the liability shield by, for example, designating the “opinion” of the agency as a
judgment by an expert could shut down the credit ratings business, as the boxed example suggests.
Allowing fraud-like lawsuits under a “knowingly or recklessly” standard is a more cautious
measure that would allow for lawsuits in instances of fraud. The agencies would likely respond to
a change in the standard by bureaucratizing their ratings methods to satisfy the courts, providing
little in the way of improved performance.
The SEC could act on its own as a result of the 2006 legislation, and it has taken the first steps to
do so. It could even eliminate the requirement for a rating, i.e., remove the reference to credit
ratings, for a new security. The alternative of eliminating required ratings is attractive because it
would allow the marketplace to determine when and where ratings would be used. The alternative
of having the government provide ratings is fraught with all the problems of government.
Moreover, the government cannot bring the same talent and expertise to producing ratings as the
market can. There is little reason to believe that the government can do a better job than can the
market.
The most attractive alternative seems to be to eliminate required ratings and let the market
determine when and how ratings would be used and produced. One possibility is that if ratings are
valuable to unsophisticated investors, they could form a body to assess risks or could rely on an
agency which would be paid on a subscription basis. Whether there is sufficient demand would be
determined by the marketplace.
1. Is the criticism of the credit rating agencies warranted?
2. Is the First Amendment protection sufficient for the credit ratings agencies?
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3. Evaluate the alternatives from a feasibility and public policy perspective
4. Which alternative should Moody’s support?
5. Which alternative is best from a public policy perspective?
Update: The credit ratings issue is sufficiently complex that little has happened to change the
system. The most likely outcome is additional measures by the SEC, which could include reducing
the types of securities for which ratings are required.
Update on lawsuits: The credit ratings agencies were sued by a large number of investors.
Pension funds in Wyoming and Detroit sued alleging that the ratings agencies had both provided
ratings and assisted in the design of mortgage based securities. The case was dismissed in a federal
court, and the plaintiffs appealed the dismissal. In a unanimous vote of a three-judge panel the
Second Circuit of Appeals upheld the dismissal. In addition to upholding the free speech protection
enjoyed by the ratings agencies, the Court ruled that the ratings agencies had not acted as
underwriters. Moody’s said that since the financial crisis 20 lawsuits against the company had been
dismissed or withdrawn.37
Citigroup and Subprime Lending

This case has been used in Part V Ethics and Corporate Social Responsibility to examine the duties
of a financial services firm operating in a market in which abuse was possible and frequent. This
case has three purposes: (1) to assess the ethics of subprime lending, (2) to identify the moral
motivations for nonmarket action, and (3) to consider what actions Citigroup should take once it
and the rest of the industry come under fire.
The ethics of subprime lending involve well-being, rights, and justice considerations. From the
perspective of utilitarianism, subprime lending fills a gap in the credit markets, allowing many
people to obtain loans for which they would not otherwise qualify. Some of these loans are for
home improvements, and others are used to restructure debts associated with credit cards and other
borrowings. Such lending is important and increases well-being. Well-being is decreased,
however, when people are misled and induced into borrowings that are disadvantageous to them.
Since utilitarianism evaluates actions based on the preferences of individuals, there is nothing
wrong with people freely choosing to take actions that are contrary to their apparent interests.
Indeed, making judgments about what would be good for people can constitute paternalism.
The appropriate test from a consequentialist perspective seems thus to be whether the individuals
would have borrowed the funds if the consequences were fully disclosed to them and they
understood those consequences. If disclosure were complete and borrowers understood, there is
nothing objectionable to the choice to borrow on the subprime market, according to utilitarianism.
It seems clear, however, that disclosure was not complete and that some borrowers did not
understand the consequences.
37
Wall Street Journal, May 12, 2012.
200
The appropriate action from a utilitarianism perspective is to correct the problems while preserving
the market for subprime lending. The moral duty then is for lenders to fully disclose the
consequences of borrowing and avoid enticing people, e.g., some of the elderly, who may not
understand the consequences. This can be accomplished by establishing an instrumental right to
information and a corresponding duty of lenders to disclose that information.
From a Kantian rights perspective a violation of rights would be in failing to treat people as
autonomous ends but rather treating them solely as a means to a profit. Persuading people to
borrow when it is disadvantageous to them treats them as means. People, however, can exercise
their autonomy by digging into the structure and terms of the loans offered. Thus, it is not clear
that there is a violation of Kantian rights, provided the borrower has the capacity to understand the
loans. There may, however, be a violation of instrumental rights as considered in the previous
paragraph.
From a justice perspective the concerns focus on those who are already disadvantaged. This may
be due to income, health, age, or a variety of other circumstances. Since subprime lending provides
access to credit for people who would otherwise not have access to credit, Rawls’ principles would
support preserving the market. His principles, however, would call for measures designed to
protect those who are disadvantaged and unable to protect themselves. This might involve only the
establishment of instrumental rights as identified above, but it might go beyond that to allowing, for
example, people to get out of disadvantageous loans.
Nozick, however, would inquire into how the individuals got into their position of disadvantage. If,
for example, a person had made bad decisions including not protecting herself against risks, Nozick
would not conclude that a moral violation had resulted from subprime lending. Such
disadvantageous loans are a matter of choice.
This case also illustrates the moral motivations for private politics, as considered in Chapters 4 and
6. As is frequently the case activist and advocacy groups were already in place and had on their
agenda the protection of those who were unable to protect themselves. ACORN had decades of
experience dealing with matters involving financial institutions. It had made a practice of
pressuring financial institutions and filing lawsuits against them to block mergers with the objective
of obtaining lending commitments for local communities. It had extracted many millions of dollars
from financial institutions. It thus had experience and expertise to challenge subprime lending
practices. This should have been evident to Citigroup prior to the acquisition.
Citigroup can take a variety of actions. One is to correct any abusive practices of the Associates.
A second it to discipline those who have been involved in abusive practices. A third is to develop
programs to relieve some borrowers who have been treated unfairly. A fourth is to decide which
products it should offer; e.g., should it offer single-premium credit insurance. The actions taken by
Citigroup are discussed below.
Whether Citigroup’s acquisition of the Associates was a bad investment is difficult to say with
certainty, but it appears to have had an unanticipated cost. Citibank should have known ex ante
that the Associates was engaging in questionable practices. It also should have known that activist
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groups were concerned with subprime lending practices. The subprime lending bubble apparently
burst in 2001 shortly after the acquisition. One company that had exploited subprime lending
opportunities was Providian Financial that specialized in providing credit cards to high-risk people
who would have been unable to obtain a credit card from the major issuers. Providian’s share price
increased from under $15 in 1997 to a peak of $66.72 in October 2000. To maintain growth
Providian began to issue cards to increasingly risky individuals. In the summer of 2001 it changed
its accounting procedures revealing large credit losses. In was forced to disclose those losses in
August, and its share price plummeted to below $5. Management was forced out, and a new CEO
was brought in to attempt to rescue the company.38
Discussion questions
1. Is the subprime market beneficial from the point of view of aggregate well-being?
2. Are the alleged abuses serious?
3. What are the objections to the practices from the perspective of utilitarianism?
4. What are the objections to the practices from the perspective of Kantian rights?
5. What are the objections to the practices from the perspective of justice as fairness?
6. What actions if any should Citigroup take to address the objections?
7. What should it do about the activists’ criticisms and actions?
8. Should Citigroup have paid $31 billion for the Associates? What type of due diligence should
Citigroup have conducted?
9. Should Citigroup have anticipated actions from ACORN and other activist groups?
Developments
On November 7, 2000 Citigroup filed a statement with the regulators condemning abusive practices
and announcing a set of measures to avoid abuses. The filing stated:
We condemn predatory practices such as “packing,” “equity-stripping,” and “flipping,” and
our track record with our customers and regulators demonstrates that we excel at satisfying
customers. We condemn targeting low- and moderate-income and minority customers for high
cost credit, and our record demonstrates that we make our credit products available to
customers, including low- and moderate-income and minority individuals, through any sales
channel for which they qualify.
The filing listed a set of measures the merged CitiFinancial would take.
In March 2001 the FTC took action against Citigroup for the Associates’ predatory lending.
Hughes resigned from Citigroup and announced that he would not stand for reelection to the board.
In June 2001 CitiFinancial announced it would stop selling single-premium credit insurance. In
September 2001 Citigroup agreed to pay $20 million to the state of North Carolina to settle its
lawsuit. By September 2001 Citigroup had settled over 200 lawsuits against the Associates and
over 400 remained.
38
Fortune, March 4, 2002. Providian was purchased by Washington Mutual for $6.45 billion in 2005.
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The Associates had over 6,000 brokers, and Citigroup began to review them in 2001. Initially,
Citigroup suspended 1,575 brokers (put them on its “Do Not Buy List”) for a variety of reasons
ranging from inactivity (663) to integrity and failure to provide update documentation (487) and
compliance issues (102). In a second wave it suspended 2,525 brokers for failure to return
Citigroup’s required Code of Conduct.39 Citigroup also suspended a number of the correspondents
that had worked with the Associates.
In October 2001 CitiFinancial released its first annual report on its subprime lending performance.
Its “Real Estate Lending Initiatives Progress Report” reported on CitiFinancial’s progress in
implementing the reforms identified in its November 7, 2000 filing. In addition to suspending
brokers and correspondents, Citigroup initiated a variety of programs to assist buyers. First, it
reviewed all proposed foreclosures and suspended 1,484. Second, it began a graduation program
that allowed borrowers whose credit rating had improved to move to lower cost conventional loans.
Third, it initiated a similar program for credit applicants. Fourth, it broadened an Associates
program to reduce the interest rate on the real estate loans for borrowers who had made payments
on time.
In December 2001 the California Reinvestment Committee, an NGO supported by nonprofit

organizations and public agencies, issued a report “Stolen Wealth: Inequities in California’s
Subprime Mortgage Market.” The report was critical of subprime lending practices and also of the
access to the prime lending market for failing to lend more to low-income, minority, and elderly
people.
To resolve a Federal Trade Commission complaint, Citigroup paid $215 million to persons the
Commission alleged were deceived into high-priced mortgages by the Associates from1995 to
2000.
The Federal Reserve Board investigated Citigroup for abusive loans made by CitiFinancial from
2000 to 2002. CitiFinancial provided restitution for the borrowers and paid a $70 million fine in
2004.
In January 2003 CitiFinancial and in 2004 Citigroup banned all loans that fell under the
Homeownership and Equity Protection Act (Hopea). A study by Inner City Press-Fair Finance
Watch, however, reported that Citigroup continued to make the loans in violation of its policy.
Citigroup apparently had acquired some lenders and had not required them immediately to comply
with the company’s policy. “A Citigroup spokesman confirmed yesterday that the loans were
made, but in a statement said the affiliates in question had ‘migrated to this policy’ over time. ‘We
have integrated a number of different businesses,’ the spokesman said. ‘We’ve worked to conform
their practices; today, none of these channels originate Hoepa loans.’”40
By 2005 31 states had enacted subprime lending regulations. Those regulations, however, cover
only state chartered banks and not federally chartered banks. The state chartered banks claimed
that they were disadvantaged because federally chartered banks were not covered, and they backed
federal legislation to establish federal standards that would cover all banks. The draft bill was not
39
CitiFinancial, “Real Estate Lending Initiatives Progress Report,” October 2001.
40
New York Times, May 4, 2005.
203
as stringent as the regulations in some states. The bill under consideration in the House had
bipartisan support.
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Chapter 12
Environmental Management and Sustainability

Environmental issues are very important, and environmental protection has broad public support
reflecting the substantial widely distributed benefits resulting from that protection. Environmental
protection, however, has very high costs, and those costs provide restraints on government
regulation. Those costs are largely borne by private parties rather than by government budgets, so
the usual restraints arising from limited budgets are not present. The politics of environmental
protection thus involve powerful interests on both sides of the issues with environmental NGOs
opposing businesses concerned about the cost of additional measures.
Recognition of the high costs of environmental protection has brought increasing attention to
achieving regulatory objectives in a socially-efficient manner. The Coase theorem applies to
environmental issues, which means that there are a variety of incentive mechanisms for achieving
efficiency. Environmental taxes have now been used for CFCs and some other pollutants. Tradable
permits systems are being used more extensively as discussed in the chapter. The chapter case
Environmental Justice and Pollution Credits Trading Systems addresses a challenge to these
systems. This case also includes a simple discussion of how such a system works.
As another example of the point in the text that an externality is reciprocal, Fina, Inc. built a
refinery in Port Arthur, Texas in 1937. When it was built there were no homes near the refinery,
but subsequently a subdivision grew up next to the refinery. When the subdivision was built, an
externality resulted. Fina dealt with emissions, such as those that ate the paint on cars, by making
small cash payments, as with a liability rule, to the residents of the Fairlea subdivision. The
residents, however, decided to undertake a political campaign to force Fina to buy their entire
subdivision. The political strategy involved lobbying, use of children to dramatize the claimed
hazards, and even a media strategy orchestrated for the local TV stations. Fina eventually agreed to
buy the 211 homes for a cost up to as much as $10 million, an amount that was more than its
quarterly earnings.41 Fina responded to the externality caused jointly by the subdivision and its
refinery by removing one side of the externality.
The Coase theorem applies to efficiency and not to distribution, and one feature of environmental
regulation is that there remain uncompensated damages. This provides incentives for additional
regulation and spurs the politics of environmental protection.
The Environmental Protection Agency has the principal regulatory authority for the administration
of a wide set of environmental laws. Its broad authority, however, is limited by the procedural
requirements discussed in Chapter 10. In addition, many of the significant regulatory actions by
the EPA have been challenged in court by one or more of the sides of an issue. Regulation is
subject to government failure as discussed in Chapter 10, and the Superfund is a good example of a
widely-criticized program due to litigation costs and the high cost of cleanup for what some people
41
The Wall Street Journal, December 10, 1991.
205
argue yields only small benefits. The performance of the Superfund would be a good subject for a
lecture on the difficulty of administering a cleanup program.
The politics of environmental protection are complex and take place at all levels of government as
well as through private politics, as in the case of NIMBY activities. The politics are complicated
by scientific uncertainty about environmental damage. This provides an opportunity for advocacy
science. The media clearly finds environmental protection issues to have both audience appeal and
social significance. (The Alar example in Chapter 3 illustrates this point.) The private politics
strategies taken by environmental groups are often quite sophisticated. A good example is their use
of the Toxics Release Inventory to stimulate both national and local political action against
polluters.
Firms are increasingly giving higher status to internal environmental management units and are
experimenting with approaches to environmental control. Environmental cooperation with NGOs
appears to be a more productive approach to resolving certain environmental issues, and the
McDonald’s and the other examples illustrate the approach. General Motors and the Environmental
Defense Fund signed a working accord in mid-1992. Dow Chemical Company has formed a
Corporate Environmental Advisory Committee which reviews its plans for production and product
planning four times a year. Chaired by David T. Buzzelli, a vice-president for environment, health,
and safety, the Committee includes a former administrator of the EPA, a dean of environmental
programs at a major university, and the head of an environmental research organization. Dow has
also had its plant managers form local environmental advisory committees. Dow’s actions were
not entirely applauded by the environmental interest groups. “Daniel J. Weiss, a legislative affairs
director of the Sierra Club, said Dow is a leading member of the Chemical Manufacturers
Association, which he said routinely lobbies against laws aimed at reducing emissions. ‘The
company’s engineers have realized they can save money by reducing pollution, but unfortunately
that does not extend to their policymakers,’ Mr. Weiss said. ‘They still use political money and
their contacts to block legislation.’”42 Through its Responsible Care program the chemical industry
has attempted to improve its environmental performance.
In 2002 BP announced that it had already met its voluntary 2010 goal of reducing greenhouse gas
emissions to 10 percent below 1990 levels. Peter Miller of NRDC said, “It’s refreshing.
[Browne’s] shown it can be done. Predictions that it can’t be done, and that it would be too
expensive, are clearly not true.”43
Sustainability is the underlying concern in Chapter 13 which focuses on renewable power.
Environmental and sustainability cases in the book in addition to those in this chapter include
Personal Watercraft aka Jet Skis (Chapter 2), Shell, Greenpeace, and Brent Spar (Chapter 4),
Anatomy of a Corporate Campaign: Rainforest Action Network and Citigroup (Chapter 4),
BrightSource Energy: The Challenges (Chapter 13), Silver Springs Networks and the Smart Grid
(Chapter 13), T-Solar and the Solar Power Market (Chapter 13), The European Union Carbon Tax
(Chapter 15), Apple and Private Politics in China (Chapter 16), and Environmental Injustice?
(Chapter 22).
42
The New York Times, September 20, 1992.
43
San Jose Mercury News, March 12, 2002.
206
The following provides additional information on the plan McDonald’s and EDF developed.
McDonald’s Environmental Actions
The plan developed by McDonald’s and EDF would affect customers, suppliers, and employees.
“By December, for example, all McDonald’s suppliers must use corrugated boxes that contain at
least 35% recyclable content. Suppliers will be asked to make regular reports to McDonald’s that
measure their progress in reaching their new waste-reduction goals. This Spring, for example, the
company will begin testing a starch-based material in consumer cutlery to replace plastic forks,
knives and spoons. Ten restaurants have begun composting trials for egg shells, coffee grounds
and food scraps. By December, McDonald’s will implement a nationwide program for recycling
corrugated boxes. And later this year, the company will test reusable salad lids and shipping
pallets, pump-style bulk dispensers for condiments and refillable coffee mugs.”44
“The initiatives include the use of brown bags made of recycled paper, smaller paper napkins,
recycling of behind-the-counter cardboard boxes and the elimination of plastic cutlery wrappers
where allowed by local health codes. And the company is trying out reusable coffee mugs,
reusable coffee filters, and pump-style bulk condiment dispensers. The world’s largest food-service
organization said it is looking into replacing the plastic forks, spoons and knives with starch-based
cutlery that could be composted.”45
The task force that developed the plan was composed of four members from McDonald’s and three
from the EDF. The EDF members were given access to McDonald’s data and allowed access to
suppliers. McDonald’s estimated that the waste-reduction plan would cost $100 million a year.
Robert C. Williams, CEO of James River Corporation which had developed the quilted sandwich
wrap that will replace McDonald’s clam-shell package, saw opportunities for certain suppliers.
“This project shows that partnerships can really work. Others can benefit from this, and I’m sure
they will.”46
Cases
Pacific Gas & Electric and the Smart Meter Challenge

This is a case about implementation of the installation of a technology intended to contribute to
sustainability goals and provide major cost efficiencies. Smart meters are at the heart of the
consumer side of a smart grid and enable demand response pricing. The meters, however, have
44
The Wall Street Journal, April 17, 1991.
45
Boston Globe, April 17, 1991.
46
The Wall Street Journal, April 17, 1991.
207
encountered considerable opposition, particularly in California, which as one commentator
observed is home to lots of strange views. The challenge for PG&E is to address the complaints
and opposition in a tightly regulated and media sensitive environment.
The complaints took a variety of forms. Concerns were raised about privacy, violation of rights,
government control (conspiracy), EMF and EHS, and billing errors. Perhaps the most important
for smart grid efficiency was that the meters will not shift demand and hence represent a costly and
unneeded technology that will only reduce metering and billing costs. Demand shifting may not
result because of timid regulators fearful of public reactions and placing burdens on people who,
for whatever reason, do not shift their demand.
Regulators in a number of states have expressed an unwillingness to price peak load electricity at
its (high) cost, preferring to offer discounts to customers who shift demand. Discounts work in the
right direction, but cannot be large enough to have much impact. Regulators fear that if consumers
do not shift their demand and peak load prices are used, consumers will have higher bills and
complain to not only the regulator but the state legislature and governor. Regulators also worry
about burdening the poor and elderly who might be unable to shift their demand, although many
states have programs to help the poor and elderly with their utility bills.
The complaints and timid regulators mean that the gains from smart meters and a smart grid could
be substantially lower than projected.
Some complaints, such as those about billing errors, were investigated and shown to be unfounded,
but anger among some customers remained. PG&E’s Devereaux has already compromised the
credibility of the company’s efforts to address the complaints. Dealing with EMF and EHS is more
difficult, since the evidence is clear, but some people will never believe the evidence. The natural
reaction may be to ignore them, but they can take, as they have done, their beliefs to the media,
town councils, state legislators, and the regulatory commission. As the PUC did, one means of
quelling their anger is to allow them to opt out of the smart meter program. Two issues then
remain. First, how many will opt out and how badly will efficiency be impacted. Second, how
much should they pay to opt out? The answer to the former depends on the latter. The required
payment has to at least cover the cost of bypassing the smart meter and sending someone to read
the meter or replacing a smart meter with an electromechanical meter. Economics principles
indicate that they should also pay for the inefficiency their failure to participate in the smart grid
causes. This could be high. If the cost of opting out is high, the complainers will have their
willingness tested. The interests of the regulators and PG&E should be aligned on this issue, since
the regulators would like participation to be as broad as possible.
1. Are the complaints about the smart meters valid?
2. Can the complaints be ignored?
3. Would you have fired Devereaux?
4. What should PG&E do about the complaints about EMF?
5. Why are the regulators so unwilling to use peak-load pricing for consumers?
6. What kind of opt out opportunity would you propose to the California PUC?
208
7. How should PG&E determine the opt out charge; i.e., what costs should it take into
account?
8. As PG&E do you support Joshua Hart’s call for a moratorium and public hearings?
Update: PG&E proposed an opt-out option of an analog meter at a one-time cost of $270 and $14
a month thereafter. The PUC reject the proposal and proposed a one-time fee of $90 and $15 a
month, but its final order was a one-time fee of $75 and a monthly charge of $10 a month, and for
low income customers the cost was $10 and $5 a month. With only a couple of days left before the
May 1, 2012 deadline for opting out, only 20,000 out of some 9 million customers had opted out.
In May 2011 PG&E announced that it had found 1,600 defective Landis+Gyr meters that ran faster
than they should have. PG&E said it was a “rare defect” representing less than 0.1% of the 2.1
million Landis+Gyr meters installed. A PG&E spokesperson said, “In a nutshell, Landis+Gyr sent
us a small number of meters with a defect that cause them to run fast when they operate at high
temperatures, and they may miscalculate energy bills.”47 Customers affected were given a new
meter, a rebate that averaged $40, and a $25 “customer inconvenience” credit on their next bill.
Mark Turney, executive director of TURN, said, “The meters themselves alerted PG&E to the fact
they weren’t running properly, which makes them look smarter than PG&E, which has ignored
customer complaints for too long.”48
Toshiba announced in May 2011 that it would acquire Landis+Gyr for $2.3 billion.
Environmental Justice and Pollution Credits Trading Systems

This case is based on public information and “Westco” is a composite of a group of oil companies
that were the targets of the environmental justice lawsuits and activist strategies in the Los Angeles
area.
The environmental justice campaign involves private politics as led by activists outside of and
within government. Activist groups have sought new ways of advancing their objectives of
increasing protection of the environment and redistributing wealth and opportunity, and in this case
pollution, in favor of the disadvantaged. (The strategies of activists and their private nonmarket
action are considered in Chapter 4.) Within government the Clinton-Gore administration has
sought to advance its corresponding goals without seeking new legislation from Congress, which
beginning in 1995 had Republican majorities in both Houses. In the environmental area EPA
administrator Browner has started a number of innovative and controversial programs, as discussed
in Chapter 12 of the book. The EPA’s environmental justice campaign and Clinton executive order
are two examples of these initiatives.
47
48
209
The environmental justice issue arose in association with the location of hazardous waste facilities
and dumps. These facilities were naturally located where land was cheapest. People with low
incomes also locate where land prices and housing are cheap. This means that these facilities
would tend to be located disproportionately in low-income areas. To the extent that minorities and
women are disproportionately represented among low-income people, there is a disparate effect on
them. To the extent that there are health hazards or other risks associated with these facilities, low-
income people could be disproportionately exposed to harm. Clinton’s executive order and
Browner’s campaign addressed these concerns. This is thus an issue of distributive justice.
The lawsuits and activist actions in the Los Angeles area address quite a different issue—the
distribution of pollution reduction. The pollution credits trading system in Los Angeles is used in
conjunction with a pollution reduction program and is intended to achieve environmental objectives
in a socially efficient manner. This type of trading system implements a utilitarian objective of
aggregate welfare maximization by allowing low cost abaters to abate more and high cost abaters to
abate less than the average required by the environmental objective. The way this is accomplished
is by issuing permits for the emission of pollutants equal to the emissions allowed by the
environmental objective and then allowing those who have low abatement costs to sell their excess
permits to those with high abatement costs. This results in lower total costs of achieving the
environmental objective. Because the aggregate cost of abatement is lower, the environmental
objective can be more aggressive that it would have been had the aggregate cost of abatement been
higher. These trading systems are discussed in Chapter 11 and an example is presented in the case.
Numerical examples such as that presented in the case can be tricky because a holder of permits
can enter on either side of the market for permits; i.e., it can buy or sell credits. The example is set
up so that the incremental cost of abatement is 15 for both buying and selling and hence there is a
unique price of 15 for a credit. That is, if the price of a credit were less that 15, b would buy credits
rather than abate 100 pounds. If the price were above 15, b would increase its abatement from 100
pound to 200 pounds and sell its allocation of 100 permits. For example, suppose that the price p
of a credit were p = 16. Then, b has an incentive to increase its abatement from 100 to 200 pounds
because doing so costs 15 a pound and it can sell the permits it no longer has to use for 16. Thus,
even though in equilibrium a sells credits to c, it is b’s costs that establish the equilibrium price for
a credit.
The facts pertaining to the lawsuits and the allegations of the activists are unclear, but if the AQMD
is to be believed, the trading system is not associated with an increase in pollution but instead with
a decrease in pollution. The AQMD states that the standards of the CAA are met and that the
program is in full compliance with the law. Moreover, the AQMD has a separate rule to deal with
hot spots. In addition, there is no indication that pollution emissions at the refineries and the
marine terminals are higher than they were before. Under the trading system, however, they may
not have had to reduce their emissions, since they could have purchased credits as did source c in
the example. This is the likely situation.
The activists’ claims are probably strategic and intended to attract news media coverage of their
campaign and obtain sympathetic treatment of it. The activist’s objectives are probably for lower
aggregate emissions in favor of the disadvantage and obtain compensation from the oil companies.
They may be willing to trade higher aggregate pollution levels for redistribution; i.e., to move from
210
a utilitarian outcome such as point C in Figure 22-7 to the Rawlsian point B. The redistribution in
favor of the residents near the oil refineries and the marine terminals thus comes at the expense of
the other residents of the Los Angeles basin.
The activists’ strategy is not only to argue that the trading system results in violations of federal
environmental standards but that it discriminates against minorities and women. The claimed legal
basis for this argument is Title VI of the Civil Rights Act of 1964. Whether the courts will agree
with this argument is problematic. Also, whether there is a greater incidence of certain diseases
caused by hydrocarbon emissions around the facilities is unclear and requires a careful statistical
study. The activists’ parading of ill people before the TV cameras is a standard strategy.
Without judging the merits of the lawsuits, the claims about the distribution of pollution reduction
are a legitimate moral issue. As indicated above, a utilitarian system could yield a different
conclusion than the Rawlsian system. Furthermore, if people have a moral right not to have their
health harmed and if the facts are that there is harm, then a rights perspective could rule out some
alternatives, including a trading system, as illustrated in Figure 22-3. Presumably, the AQMD’s
separate rule for hot spots is intended to deal with such a health risk.
This issue could also be addressed from the perspective of the Coase theorem as discussed in
Chapters 12 and 14. The rights in this case have been allocated to the refineries and marine
terminals to emit pollutants in accord with established standards. The activists and the residents
thus could pay the oil companies to reduce their emissions. Part of the activists’ strategy is to use
the Civil Rights Act to change the assignment of rights. With the rights assigned to residents, the
oil companies would be forced to pay the residents.
The business community reacted strongly against the environmental justice campaign, and
Congress acted to slow its progress. Harry Alford has taken the point on this issue and argues that
not only are the activists exploiting the civil rights laws but the campaign is likely to have adverse
distributive consequences for people in the inner city and for poor people in other areas. He cites
the adverse effect on the brownfields developments to provide jobs in cities, and the U.S.
Conference of Mayors apparently agrees with him. Alford also points to the loss of jobs in low-
income areas, as in the case of the Louisiana petrochemicals plant. The environmental justice
campaign seems to require that a company whose facilities emit pollutants allowed under the law
should locate in an area where there were no low income people and where minorities and women
are not disproportionately located.
Teaching the case:
The following questions can be used to lead the discussion.

1. What is the moral justification for a pollution credits trading system?
2. How does such a system work to achieve social efficiency?
3. How does a trading system affect the distribution of pollution compared to a command-and-
control system in which each pollution source is required to meet the same emissions standard?
4. What are the moral claims of the activists? Are they morally justified? Under which ethical
system? Are the rights implicitly claimed instrumental or intrinsic?
5. What strategy are the activists using to pursue their objectives? What are their objectives?
211
6. Evaluate Alford’s arguments. Are they compelling?
7. If their claims were morally valid, what measures could be used to address the moral concerns?
Should a trading system be abandoned? Modified?
8. What should Bentley do?
Discussion
The moral issues in this case seem to be matters of justice rather than rights. That is, the hot spots
policy is intended to deal with immediate health risks, and it is not the case that people have a well-
established right to have their health protected from possible hazards of the type present in the case.
If there is an imminent health risk, the AQMD should so determine and take action.
The principal issue is then social efficiency versus responding to the interests of low income
people. More specifically, should a trading system than can yield major cost savings to society be
sacrificed in favor of the disadvantaged. The answer seems to be “no.” There are likely to be
better means of responding to the interests of the disadvantaged, if that is morally justified. One
means is to provide them with cash. A second would be to move them from the areas around the
refineries. A third would be to provide services including medical care for those who are ill.
The Bush administration reined in the EPA’s environmental justice program, and the courts did not
overturn trading systems. Activists continue to complain about environmental justice, but they have
had little effect.
Environmentalist versus Environmentalist

Environmentalists had pushed hard for AB 32, and the ARB chose a cap-and-trade system to
reduce emissions to 1990 levels by 2010. A cap-and-trade system was being used in the U.S. for
SO2 and NOx emissions, in the European Union for reducing CO2 emissions, and under the Kyoto
Protocol for greenhouse gases emissions. As the case indicates the system was opposed by
California special interest groups with the old environmental justice refrain, claiming that the cap-
and-trade system would allow polluters to increase their emissions and endanger vulnerable
communities. (See the chapter case Environmental Justice and Pollution Credits Trading Systems
and the discussion in this Manual.) The groups sought command-and-control regulation with the
“maximum technologically feasible and cost-effective reductions.” The interest groups also
supported a carbon tax that they apparently believed would force all polluters to reduce their
emission. The groups took their cause to the California courts, which rejected the command-and-
control approach but held that the ARB should have justified more fully its rejection of a carbon
tax.
The interest groups also objected to the offsets alternative incorporated in the cap-and-trade system.
Offsets were permitted under the Kyoto system and were widely used in the European Union. The
groups objected to the offsets because the benefits from the reductions in emissions could accrue to
people in other states rather than to Californians. Although the cap-and-trade system primarily
212
pertained to CO2 emissions which would equally benefit everyone, the interest groups argued that
when CO2 emissions were reduced, other harmful pollutants would necessarily be reduced
benefitting Californians.
Emitters had strong incentives to oppose a carbon tax because that would impose a distributive
burden on them. They, however, were confident that the ARB would reject a carbon tax as it had in
the first place.
Although the author of AB 32 referred to the claims of the interest group as “false assertions,” the
groups repeated their allegations and applauded the court’s decision.
1. What underlies the objections of the California Communities Against Toxics and the
Communities for a Better Environment?
2. What kind of regulation do they want?
3. Are their objections warranted?
4. Did Judge Goldsmith decide the case correctly? Should he have required a carbon tax?
5. Is a carbon tax better or worse than a cap-and-trade system?
6. What effect is the cap-and-trade system likely to have on the California economy?
Update: The ARB adequately justified its cap-and-trade decision, and the regulatory system went
into effect in mid-2012. One concern with the regulation was that it would increase the marginal
cost of emissions substantially and thus increase the cost of doing business in California. With an
unemployment rate of 10.8 percent in June 2012, 2.6 percent above the national average, increasing
costs could drive more jobs out of the state.
Many companies that would be subject to the cap-and-trade system did not vigorously oppose it
because they understood that the allowances would be allocated to them without a charge. With the
state of California having huge budget deficits activists began arguing that all the allowances
should be auctioned rather than given for free to the emissions sources. The companies obviously
opposed the proposed change. The ARB did not change its proposal which called for the auction of
only a small proportion of the allowances with companies receiving their allowances for free. The
scope of the cap-and-trade system is to expand in 2015 to include the transportation and natural gas
sectors. The revenues from the auction are expected to increase substantially at that time.
213
Another random document with
no related content on Scribd:
6, 19, 172
mizlāgōth,
184
mizrāḳōth,
184
Moab,
116 f.
Moabites, invasion by,
249 f.
Molech (Malcam, Milcom),
125, 293
Mount Gerizim,
Samaritan Temple on, xxi, xxxviii
Mount Moriah,
176
Mount Seir,
32, 251, 281
Mount Zion,
xxxviii f.
Mulberry trees,
100
Music, the Levitical service of,
lii, 305 f.
Musical guilds,
xxiii, 145, 333
Muski,
5
Muṣri,
19, 172
Nabonidus (Nabu-na’id),
344, 351
Nabopolassar,
344, 350
Nabulus,
49
nāgīd,
33, 92, 295
naḥal,
252
Names,
significant, 24, 145 f.;
lists of, in oriental Histories, 1 f., 79
Nathan the prophet,
113, 168, 207, 305
Navy,
206
nēbhel,
96 f.
Nebuchadnezzar (Nebuchadrezzar),
347 f., 351
Neco I and II,
327, 336, 343 f.
nēr (nīr),
259
Neriglissar (Nergalšar-uṣur),
351
Nethinim,
65, 137
New Testament (passages of) referred to:
Matthew i. 3‒6, 15
Matthew i. 7, 23
Matthew v. 22, 293
Matthew v. 39, 244
Matthew xxiii. 35, lviii, 277
Matthew xxv. 15, 290
Mark ii. 26, 102
Mark ix. 43, 293
Mark xi. 2, 7, 96
Mark xvi. 1, 235
Luke i. 5, 143
Luke i. 7, 266
Luke ii. 36, 335
Luke iii. 31, 22
Luke vii. 44‒46, 297
Luke xi. 51, 277
Luke xii. 55, 192
Luke xv. 18, 21, 296, 321
Luke xix. 4, 172
John i. 45, 16
John iii. 27, 296
John xi. 54, 222
John xii. 3, 7, 235
John xviii. 1, 303
John xix. 39, 40, 235
Acts vii. 60, 278
Acts viii. 40, 287
Acts ix. 32, 27
Acts xii. 1, 228
Acts xii. 21, 159
Acts xii. 23, 222
Acts xiii. 2, 138
Acts xxi. 37, 163
Acts xxii. 24, 163
Romans i. 1, 138
Romans xi. 2, xxxii
Galatians i. 15, 138
2 Thessalonians ii. 11, 243
1 Timothy iii. 15, 114
Hebrew ii. 16, 297
1 John i. 9, 215
Revelation ii. 20, 335
Revelation xxi, 12‒16, 182
Nimrod,
7
Nineveh,
327
Nisan, the first month,
89, 301, 310, 339
Nobles, the,
273
Numbering of the people, see David
Numbers high in Chronicles,
xlix, 92, 133, 135 ff., 164 f., 178, 195, 204, 210, 218 f.,
221 f., 225 f., 239, 281, 294
ōb,
325
Obelisk of Shalmaneser II,
122, 206
Oblations (tᵉrūmāh)
314
Obsolete English words:
At (after verbs of asking), 241
Grave (verb = carve), 174
Magnifical, 134
Play (= dance), 96, 106
Polls (= heads), 137
Skill (verb), 174, 333
Oded,
229, 295 f.
ōhel,
197, 274
Omar, the Mosque of,
181
‘ōnēn,
325
Onyx,
164
Ophel,
291, 328
Ophir,
164, 202, 257
Oracle, the,
180, 185, 187
Ornan,
131, 177
Osorkon,
226
Overseers,
173, 176, 333
P, or “Priestly” narrative,
xx, 2 f.
paḥōth,
205
Palace, the,
163, 166
Palmyra,
199
Paphos, the temple of,
180
Parbar,
151
Parvaim,
178
Passover, the,
of Hezekiah, 308 ff.;
of Josiah, 310, 320, 339 ff.
Pelethites,
120, 167
Pentateuch, the,
xiv, xx, 238, 337 ff.
Perfect heart, a,
93, 160, 165 f., 231, 248
Pestilence,
130 f.
Petrie, W. M. Flinders,
History of Egypt, 226, 344
Philistines,
the original seats of the, 7;
war with the, 74, 99 ff., 126, 286 f., 297;
invasion by, 262 f.
Phinehas,
69
Phœnician language,
173
Physicians,
235
Pillar,
271
Pillars (Jachin and Boaz),
179 f., 184
Plague,
193
Play on words,
15, 57, 254, 282
Poll-tax,
274, 347
Porch of the Temple,
177
Porters, see Doorkeepers
Posts (= runners),
309
Precious stones,
178
Priesthood, the double,
102, 167
Priests,
51 f., 303, 307, 312 ff.;
courses of, 66;
sons of the, 71;
David’s organisation of the, 141 ff.
Princes of the sanctuary,
142
Princes of the tribes of Israel,
155
Prophetess,
335
Psaltery,
96, 103, 146, 188, 204
Psalms xcvi, cv, cvi,
107
Pul,
34, 37
Punt (Put),
6
Rabbah,
121, 125
Ramoth-gilead,
51, 240, 245
Rechabites, the,
21
Recorder (= chronicler),
120, 332
Rehoboam,
211 ff.
Rephaim,
126 f.;
valley of, 81, 99
Rhodians,
5
River, the (= the Euphrates),
13, 206
Robertson Smith, W.,
Old Testament in the Jewish Church, 16;
Religion of the Semites, 83, 180, 213, 219, 224
Robinson’s Arch,
150
Ruler of the house of God, the,
66, 315, 340
Ryle,
Genesis, referred to, 2 f., 6;
(on Ezra and Nehemiah), 143, 163, 273, 296, 334 f.;
Prayer of Manasses, 328
Sabbath,
351
Sackcloth,
131
Sacrifice,
consumed by fire from heaven, 195;
daily morning and evening, 141, 276;
sevenfold, made by Hezekiah, 304;
of thank offerings and burnt offerings, 306 f.;
of peace offerings, 106, 132, 307, 328
St Mary’s Well,
323 f., 327
Salt,
covenant of, 219;
the valley of, 119, 281
Samaria,
266, 309
Samaritan schism, the,
xxi, xxxviii
Samuel,
the descent of, 41;
the seer, 70, 168, 234
Sargon,
309, 317
Satan (= the Adversary),
128
Saul,
genealogy of, 62 f., 72;
defeat, death and burial of, 73 ff.
Saws,
126
Scorpion,
209
Scribe,
120, 142, 157
Sea of the Temple, the,
119, 181 f., 184, 300
Seer,
70, 168, 234
Sennacherib, threatened invasion by,
316 ff.
sēpher hattōrah,
338
Septuagint, the, version of Chronicles,
lviii f.
Shalmaneser,
122, 206, 309
Sharon,
35;
the great maritime plain, 156
Sheba,
6 f.;
Queen of, 202 ff.
shēbhet,
83
Shechem,
48, 56, 207
shelaḥ,
270, 319
shĕlāṭīm,
118, 270
Shemaiah,
210, 215
Sheminith,
set to the, 104
Shephēlāh,
156, 172, 207, 288, 298
Shewbread,
71 f., 139, 141, 162, 174, 221, 304
Shields of gold,
118, 205, 270, 323
Shihor, brook of,
96
Shishak, invasion by,
214 ff.
Siloam, the Lower Pool of,
318
Singers, the families of the,
xvi, xlii, 38, 42, 104, 145 ff., 341
ṣinnah,
205
sippim,
269
Slings,
288
Smith, G. A.,
Historical Geography of the Holy Land, 74 f., 81, 83,
171, 184, 192, 207, 212, 226, 249 f., 255, 294,
297;
Jerusalem, 78 f., 163, 288, 291, 318 f., 324, 327;
(in Encyclopedia Biblia), 118;
Early Poetry of Israel, 294
Sojourners,
165 f.
Solomon,
133 ff., 160 ff.;
twice crowned, 167;
great sacrifice of, 169 f.;
vision of, 170 f.;
horses and chariots of, 171 f.;
makes preparations for building the Temple, 173 ff.;
begins to build the Temple, 176 ff.;
brings the Ark into the sanctuary, 186 f.;
blessing and prayer of, 189 ff.;
the night vision of, 197 f.;
cities of, 198 ff.;
arrangements of, for the Temple worship, 201 f.;
the fleet of, 202;
the greatness of, 204 ff.
Sorcery,
325
Spices,
204, 235
Stir up the spirit,
37, 262, 352
Store cities,
233, 238
Strangers, see Aliens
Suburbs,
47, 95, 212, 316
Sun-images,
224, 331
Sycomore,
156, 172, 207
Syria, Syrians,
9, 17, 116, 124;
invasion by, 278
Syriac Version, the,
lix
Syro-Ephraimite war, the,
294 f.
Tabali,
5
Tabernacle,
70, 94, 133, 274 f.
Tabor,
50
Tadmor,
199
Tamar,
199
ṭaph,
252
Tarshish (= Tartessus),
5, 54, 205 f., 257 f.
Tarsus,
5
Task-work,
126, 134, 200
Tekoa,
18, 26, 254
Tell el-Amarna letters,
5, 58, 78, 121, 212
Teman,
11
Temple, the,
gates of, 68, 268 f., 272 f., 291;
David’s preparations for building, 133 ff.;
measurements of, 134, 177;
the pattern of, 161 ff.;
Solomon prepares to build, 173 ff.;
description of, 176 ff.;
dedication of, 186;
restoration of, 274 ff.;
cleansing of, 301 ff.;
repair of, 332 ff.;
Cyrus decrees the rebuilding of, 351 f.
Tenderhearted,
220
Tent,
69, 94, 101, 106, 186, 274
tĕrū‘ah,
106, 230
tĕrūmāh,
314
Testimony, the,
270 f., 274
Text of Chronicles, the,
xxii, lviii, 7, 13, 15, 16, 18, 21, 27, 28, 35, 41, 42, 46,
49, 54, 55, 56, 58, 59, 60, 68, 82, 85, 115, 182,
214, 217, 227, 248, 255, 259, 323, 336
Thistle (= thorn),
283
Threshing-floor,
97, 131 f., 242
Thucydides referred to,
xlviii
Tigris,
122
Tilgath-pilneser (Tiglath-pileser),
34, 37, 292, 297 ff., 309
Times (= changes, opportunities),
93, 168
Tisri, the seventh month,
186
Tithe,
313 f.
Titus, Arch of,
230
tōrah,
191, 228, 338
Torrey, C. C.,
Ezra Studies, xxxiii f., xlvi, lviii, lx, 38, 218, 237, 264 f.,
343, 345
Treasuries, the,
161
Trees, large,
76, 294
Tree-worship,
224
Trumpets, silver,
105, 112, 188, 196, 221, 230, 305
Tyre,
5, 8, 134
Tyrseni,
5
Uriah,
86, 120
Urim and Thummim,
99
Uzziah,
285 ff.
Valley of salt, the,

119, 281
Veil of the Temple, the,
179
Ventriloquism,
325
Vessels of gold,
185 f.
Vulgate, the,
lix
Wardrobe, keeper of the,

335
Wellhausen, J., references to,
lvi, lix, 20, 237, 271
Wilson’s Arch,
150
Wrath,
247, 249, 277, 323
Zadok,
39 f., 92, 102, 111, 142, 155, 167, 314
Zechariah, martyrdom of,
277
Zedekiah the king,
349 f.
Zedekiah the prophet,
242, 244
Zemaraim, the battle of,
218 ff.
Zerah the Ethiopian,
225 f.
Zidon, Zidonians,
8, 134
Ziz,
252
Zobah,
116 f., 122, 124, 199
CAMBRIDGE: PRINTED BY JOHN CLAY, M.A.

AT THE UNIVERSITY PRESS
WESTERN ASIA
(EARLY TIMES)
Cambridge University Press.

Copyright Cambridge University Press.
THE ENVIRONS OF JERUSALEM
Cambridge University Press

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Business and Its Environment 7th

Edition Baron Solutions Manual

GOVERNMENT AND MARKETS

Antitrust: Economics, Law, and Politics

The AT&T and T-Mobile Merger?

The Microsoft Antitrust Case

Teaching the case:

The following questions can be used to guide the discussion.

Deregulation is continuing in a number of industries such as telecommunications, electric power,

Update to the “Accomplishing Through Regulation What Cannot Be Accomplished Through

Merck and Vioxx

The Lancet Article

Pfizer and Celebrex

National Cancer Institute Study

The Alzheimer’s Study and Public Citizen

Enron Power Marketing and the California Market

Teaching the case

The following questions can be used to lead the discussion.

In a separate proceeding California sought reimbursement of $9 billion on overcharges on

Financial Markets and Their Regulation

Incentives for Mischief in Mortgage and Financial Markets

Goldman Sachs and Its Reputation

Two quotations that could be used in the discussion are:

Credit Ratings Agencies

Citigroup and Subprime Lending

In December 2001 the California Reinvestment Committee, an NGO supported by nonprofit

Environmental Management and Sustainability

Sustainability is the underlying concern in Chapter 13 which focuses on renewable power.

McDonald’s Environmental Actions

Pacific Gas & Electric and the Smart Meter Challenge

Environmental Justice and Pollution Credits Trading Systems

Teaching the case:

The following questions can be used to lead the discussion.

Environmentalist versus Environmentalist

Valley of salt, the,

Wardrobe, keeper of the,

CAMBRIDGE: PRINTED BY JOHN CLAY, M.A.

Cambridge University Press.

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