Chapter 14: Business regulation

CHAPTER 14 Business Regulation If anyone can find such a thing as an “unregulated industry,” he can sell it at a profit to the Smithsonian. George Champion ame an industry that has not, in some way, been under the authority of a government regulatory agency at some time. At the start of the century such a task would have been relatively simple. Today, with government extending its activities in all directions, it is not. Almost every economic activity either is or has been, at some time in the past, subject to some type of regulation at one stage in the manufacturing, wholesaling, or retailing functions. The list of federal regulatory agencies virtually spans the alphabet -- FAA, FDA, FEA, FPC, FRS, FTC, ICC, NTHSA, OSHA, SEC – to say nothing of the various state utilities commissions, licensing boards, health departments, and consumer protection agencies. As a result, it is much easier to list regulated industries than to name an unregulated one. Air transport, telephone service, trucking, natural gas, electricity, water and sewage systems, stock brokering, health care, taxi services, massage parlors, pharmacies, postal services, television and radio broadcasting, toy manufacturing, beauty shops, ocean transport, legal advice, slaughtering, medicine, embalming and funeral services, optometry, oyster fishing, banking, and insurance—all are regulated. Regulation was in the 1960s and 1970s, especially, one of the nation’s largest growth industries (although there was something of a “recession” in regulations in the 1980s). Why have people been willing to substitute the visible foot of government for the invisible hand of competition? Explaining regulation -- why and how it happens -- is a major challenge to economists. 1 Although several insightful theories have been proposed, statistical tests of those theories are incomplete and are at times based on crude data. Some instances of regulation or changes in regulatory policy cannot be explained by current theories. At best, we can only review what is known about regulation and project the economic results. Today regulatory agencies are increasingly criticized by economists, businesspeople, consumers, and consumer advocates. The major concern is the extent to which regulation is designed to benefit the regulated industry. Some critics want more regulation, others less, depending largely on how they view the process of regulation. 1 The major alternatives are reviewed in James C. Bonbright, Albert L. Danielsen, and David R. Kamerschen, Principles of Public Utility Rates, 2 nd ed. (Arlington, VA: Public Utilities Reports, Inc., 1988), Ch. 2. N Chapter 14 Business Regulation 2 To understand the controversy surrounding regulatory policy, we must first understand the theory. This chapter begins with a brief description of several major federal regulatory agencies and then proceeds to the various theories. Major Federal Regulatory Agencies Federal regulatory agencies have existed for about a century. From their origins and functions we can learn much about the regulatory process. The four broad sectors of interstate commerce that have been regulated, in some cases for almost one hundred years, are communications, energy, transport, and urban services. Most regulating commissions—consisting of 3 to 7 members, typically appointed but sometimes elected—try to achieve basic economic goals of efficiency, and promoting certain social- political goals, including safety. Beyond setting minimum and maximum prices, government regulations often control the entire rate structure of an industry. They may limit entry into the industry or stipulate what services and goods will be provided at what levels, and to whom. Regulatory approval is required to offer new services, or to expand, modify, curtail, or abandon a particular service. In short, regulation can -- and often does -- pervade all dimensions of production and distribution. The Interstate Commerce Commission (ICC) The Interstate Commerce Commission (ICC) was established n 1887 to deal with unfair business practices in the railroad industry. By the latter half of the nineteenth century, railroad companies had overbuilt and were engaging in cutthroat competition through customer rebates and price discrimination. In self-defense, several companies had formed a cartel to divide the market and set prices. The ICC was established to protect both consumers and small competitors and was supported by both the railroad and their customers. Since then, the ICC’s regulatory authority has been expanded to cover all motor carriers except airplanes engaged in interstate commerce—mainly trucks, boats, and buses. In the past, the commission has been authorized to set minimum and maximum rates. It is also responsible for ensuring adequate service. The seven members of the commission are nominated by the president and approved by the Senate for a term of seven years. No more than a simple majority of the commissioners may belong to the same political party, and a commissioner may be removed for “just cause,” including conflict of interest. Some muse that while regulation has tended to favor those who are regulated at the expense of consumers, even the regulated industries have been harmed by regulation. One economist put it this way: Chapter 14 Business Regulation 3 A good way to understand what has happened [to railroads] is to imagine a business that is prevented from adjusting its prices to changing market conditions and from negotiating with its customers. Furthermore, imagine that the business is not permitted to decide how much of its principal inputs to purchase, how much it will pay for them or even how to use them, and it may not decide where it will operate. Worse yet, imagine that it faces strong competitors who are not encumbered by similar constraints. It would be surprising if such a business survived at all. This is only a slight exaggeration of the railroads’ position before 1980. 2 For decades now, economists have advocated reducing the ICC’s power. Finally, in 1980 the trucking and railroad industries were partially deregulated. Although the ICC no longer sets truck rates and routes, it still controls market entry through its authority to issue licenses. The Federal Trade Commission (FTC) The independent five-member Federal Trade Commission (FTC) was an agency established by Congress in 1914 to enforce the antitrust laws, especially the Clayton Act. The Antitrust Division of the Department of Justice is the other federal antitrust enforcement agency dealing especially with the Sherman Act. FTC commissioners are appointed and serve seven-year terms. To carry out their duties, they are given the power to probe through corporate records and summon corporate executives to hearings on unfair competitive practices. They can also issue formal complaints and order a company to cease its illegal acts. For example, state bar associations once restricted lawyers from advertising their services. The FTC ordered a halt to such restrictions on the grounds that they thwarted competition. The Reagan administration tried to reduce the regulatory power of the FTC by cutting its budget—a ploy resisted by Congress. In the early 1980s, however, FTC decisions began to reflect the free market views of its new chairman, James C. Miller, a Reagan appointee who later served as the head of the Office of Management and Budgeting. The Federal Communications Commission (FCC) The Federal Communications Commission (FCC), established by the Communication Act of 1934, regulates telephone, telegraph, and broadcasting companies. Its seven commissioners, who are appointed for seven-year terms, set rates for interstate telephone and telegraph services and issue licenses to radio and television stations. The FCC determines who can engage in broadcasting, and it prescribes the nature of broadcast services, the location of radio and television stations, and the areas they serve. Licenses are issued for three years, after which the station’s programming is reviewed for license renewal. To ensure renewal, a station must engage in some public-service broadcasting. 2 “The Track Record,” Regulation No. 1 (1987): 23—24. Chapter 14 Business Regulation 4 To the extent that some available frequencies have not been put into use for radio and television transmission, the FCC has restricted entry into the broadcast business. It has also held up the introduction of cable service, which would vastly increase television programming variety. Yet in other ways the agency has sought to increase competition. At one time the American Telephone and Telegraph Company (AT&T) had a virtual monopoly over the sales of telephones. Beginning in the late 1960s, however, the FCC moved to introduce competition into the sale of telephone equipment and the delivery of long-distance service. In 1984, AT&T was separated from its twenty-two operating companies, which were consolidated into seven regional holding companies. AT&T maintained its manufacturing company, Western Electric, and the jointly owned Bell Laboratories. (See the Perspective on the AT&T break-up on page 21 in this chapter.) The Federal Energy Regulatory Commission (FERC) The Federal Power Act of 1930 established The Federal Energy Regulatory Commission (FERC). It is in the Department of Energy. Its authority was limited at first to the regulation of waterpower. In 1935, however, the FERC was authorized to regulate the rates, service, corporate practices, and security issues of interstate electric utilities. Beginning in 1938, it was empowered to fix rates for wholesale interstate natural gas service. At its zenith, FERC regulated electric, gas, gas and oil pipelines, and water power sites. The commission’s five members serve five-year terms. In the late 1960s and early 1970s, the FPC came under attack for its tight controls on the price of natural gas. In 1975, 1976, and 1977, several states experienced serious shortages of natural gas when the FPC-restricted price -- only one-quarter of the going price in producer states like Texas -- severely discouraged out-of-state sales. Natural gas was partially deregulated in early 1983, but was re-controlled in 1984 for two more years. Starting January 1, 1985, all gas discovered after April 20, 1977 was deregulated, while gas discovered before this date was—for the most part—not deregulated. The Nuclear Regulatory Commission (NRC) After the Atomic Energy Commission, which began in 1946, was abolished, The Nuclear Regulatory Commission (NRC) was established in 1974. The NRC licenses and regulates nuclear energy to protect the public health and safety, maintain national security, and comply with the antitrust laws. The NRC also sponsors a research program in reactor safety, fuel cycles, environmental protection, and so forth, and licenses imports and exports of nuclear materials. The Securities and Exchange Commission (SEC) In response to many instances of stock fraud, as well as the plunge in stock prices during the Great Depression, Congress established The Securities and Exchange Commission (SEC) in 1934. The SEC licenses stock exchanges and polices their activities. It has (but no longer exercises) the authority to regulate fees charged by brokers for carrying out their customers’ transactions. In 1975, when the SEC decided to allow competitive Chapter 14 Business Regulation 5 determination of stockbrokers’ fees, those fees fell almost immediately by about 30 percent. The SEC also supervises the issuance of new securities by corporations and disclosure of information relating to those issuances. The commission has five members, who are appointed by the president for terms of five years. It has jurisdiction over securities and financial markets, and electric and gas utility registered holding companies. The Food and Drug Administration (FDA) Food and drugs have been regulated to some degree since the turn of the century. Not until 1931, however, was the Food and Drug Administration (FDA) established, as part of the Department of Health, Education, and Welfare (now called the Department of Health and Human Services). The FDA is responsible for ensuring the purity, safety, effectiveness, and accurate labeling of certain foods and drugs. No prescription or over- the-counter drug can be sold on the market before it has been judged safe and effective by the FDA. The agency is also responsible for enforcing a wide variety of consumer protection laws pertaining to the labeling, packaging, and advertising of foods and drugs. The Occupational Safety and Health Administration (OSHA) Probably no government regulatory agency is currently more controversial than the Occupational Safety and Health Administration (OSHA). Organized in 1969, in response to numerous reports that worker safety and health was not adequately protected, OSHA has formulated thousands of health and safety standards. To meet its requirements businesses have had to spend tens of billions of dollars. Those who believe government has an important role in protecting workers have praised OSHA, suggesting that if anything, the agency should conduct more inspections and impose higher fines to induce businesses to meet established standards. Businesses, on the other hand, have condemned OSHA’s expensive standards as ineffective and wasteful. The Public Interest Theory of Regulation Regulation has often been justified on the grounds that it is in the public interest, meaning that it helps to achieve commonly acknowledged national goals. Some of the goals that may be pursued through regulation include: • a more democratic allocation of the nation’s resources (and a reduction in the importance of profit in such decisions); • an increase in market efficiency; • enhancement of the nation’s ability to pursue certain essentially political objectives—improvement of the national defense, redistribution of costs of economic decisions, conservation of resources, and provision of certain public goods, such as public safety. Economists’ theories of regulation tend to be based on the goal of increasing market efficiency. One of the sources of market inefficiency economists cite most frequently is externalities, or third-party effects of market transactions. Chapter 14 Business Regulation 6 Regulation to Capture Externalities The market failure problems that externalities can cause were discussed much earlier. You will recall that an externality or spillover is a cost or benefit imposed on or enjoyed by other members of society by the activities of a producer or consumer that are not borne or enjoyed exclusively by the direct cause. An information disparity or asymmetry between producers and consumers is a form of market failure. Regulation is often imposed to ensure public safety, an economic good that is sometimes, but not always, an externality. Product features that ensure the safety of the purchaser—for instance, shock- absorbing steering columns—can be handled with reasonable efficiency by the market. Safety devices that benefit other persons, however, may not be provided by a market system. For example, shock-absorbing bumpers benefit not only the person who buys a car but also those who may be involved in a collision with the buyer. If John collides with a car protected by shock-absorbing bumpers he may sustain less damage than he would have otherwise, without having paid for the protection received. He free rides on Mary’s and the other driver’s purchase. Because of the externality, the quantity of shock- absorbing bumpers purchased in an unregulated market will fall short of the economic optimum. Hence the need for regulation of safety equipment like shock-absorbing bumpers—and headlights, brakes, and/or windshield wipers. Regulation sometimes benefits all producers, particularly when it enhances their reputation for safety. If people believe that a given product is safe, unscrupulous competitors may take advantage of the public’s faith by reducing the safety of their products and cutting their production costs. Bad experiences with a product can make consumers skeptical of all firms, thereby reducing the price they are willing to pay for goods that may not prove to be safe. Thus by restoring consumer confidence, consumer protection laws can actually benefit the food and drug industries and toy manufacturers. To the extent that the SEC contributes to the securities industry’s reputation for honesty, regulators can be seen as producers of public goods. However, externalities do not necessarily require government intervention. In certain cases a rearrangement of property rights may be more efficient. Regulation to Curb Monopoly Monopoly is frequently cited as a source of market inefficiency. The first regulatory agencies were organized to deal with abuses of monopoly power. Monopoly can also be a source of inequity if there is undue price discrimination, although there are circumstances where price discrimination is socially optimal. If ownership of an industry is concentrated in a few large corporations, they can form a cartel and behave as if they were a monopoly, dividing the market, restricting output, raising prices, and distorting the price structure. To do this profitably, however, requires that demand initially be inelastic and entry be restricted somehow. During the 1970s and 1980s, the fear of such monopoly power motivated proposals to regulate the oil and automobile industries, among others. Chapter 14 Business Regulation 7 Figure 14.1 shows a cartelized industry producing at an output level of Q m and selling at a price of P m . That output level is inefficient in two respects. First, it is less than the maximum, Q c. Second, the marginal benefit of the last unit produced (equal to its price) is greater than its marginal cost. Although consumers are willing to pay more than the cost of producing additional units, they are not given the chance to buy those units. The cartel’s price-quantity combination not only creates economic profit for the owners, which may be considered inequitable or unjust, but results in the loss of net benefits, or “deadweight welfare loss,” equal to the shaded triangular area abc. FIGURE 14.1 The Effect of Regulation on a Cartelized Industry The profit-maximizing cartel will equilibrate at point a and produce only Q m units and sell at a price of P m . In the sense that consumers want Q c units and are willing to pay more than the marginal cost of production for them, Q m is an inefficient production level. Under pure competition the industry will produce at point b. Regulation can raise output and lower the price, ideally to Q c P c ., thereby eliminating the deadweight welfare loss, equal to the triangle abc, resulting form monopolistic behavior. Regulation can force firms to sell at lower prices and to produce and sell larger quantities. Ideally, firms can be made to product Q c units and to sell them at price P c , which is the same price-quantity combination that could be achieved under highly competitive conditions. At that output level, the marginal benefit of the last unit produced is equal to its marginal cost. Government regulators need not demand that a company produce Q c units. All they have to do is require it to charge no more than P c . Once that order has been given, the portion of the demand curve above P c , along with the accompanying segment of the marginal revenue curve, becomes irrelevant. The firm simply is not allowed to choose a price-quantity combination above point b on the demand curve. Then the profit- maximizing producer will choose to sell at P c , the maximum legal price. With marginal revenue guaranteed at P c , the firm will equate marginal revenue with marginal cost and produce at Q c , the efficient output level. Ideal results cannot be expected from the regulatory process, however. The cost of determining the ideal price-quantity combination can be extraordinarily high, if not prohibitive. Since regulators do not work for regulated industries, they will not know the details of a company’s marginal cost or demand elasticity. The problem is particularly acute for regulators of monopolies, since there are no competitors from which alternative cost estimates can be obtained. Furthermore, if prices are adjusted upward to allow for a company’s computed costs, a regulated firm may lose its incentive to control costs. To Chapter 14 Business Regulation 8 the extent that regulators force prices below the level a regulated monopoly would otherwise charge, however, regulation serves the public interest by increasing market efficiency. A call for regulation also has gone out to conserve scarce resources such as in radio and television broadcasting, natural gas, oil and water. Free market processes may result in overproduction relative to the perceived future societal needs. The cost of the regulatory process must be emphasized. If regulation is truly to serve the public interest, it must increase the efficiency of the entire social system. That is, its benefits must exceed its costs. Too often the net benefits of regulation are overestimated because of a failure to consider its costs, which were estimated to exceed $100 billion in the early 1980s. The Special Case of the Natural Monopoly So far our discussion of monopoly power has assumed rising marginal costs (see Figure 14.1). One significant argument for regulation, however, is based on the opposite assumption. Some believe that in industries such as electric utilities, referred to as public utilities, the marginal cost of producing additional units actually decreases over the long run. That is, within the relevant range of the market demand, the long-run marginal cost curve slopes downward. Subadditive costs occur when a single firm can supply all the industry output demanded more efficiently than two or more firms can, making competition infeasible and creating a natural monopoly. In a natural monopoly, long- run marginal and average costs normally decline with increases in production, so that a single firm dominates production. Natural monopolies tend to be dominated by one firm, which will see monopoly profits once it is established as the sole producer. Natural monopolies are seen as prime candidates for regulation because their dominance in the market allows them to exert considerable monopoly power, provided demand is initially inelastic and entry is restricted. Table 14.1 shows the current status of the public utility sector, where the regulated firms were traditionally thought to be natural monopolies. As the table shows, though, this is not necessarily the situation today. Assume, for example, that economies of scale lead to a long-run decline in the marginal cost of producing additional units of electricity. By producing on a larger scale, a firm can exploit the efficiencies of very large turbines to produce additional megawatts at a lower cost. Whether the size of generators can be increased indefinitely without producing diseconomies of scale is a matter of debate, as we will see later. Proponents of large electric plants believe that economies of scale are considerable—so extensive that in order to produce power at the lowest possible cost, only one extremely large electric company can operate in a specified geographical area. The fear is that once that firm emerges from the competitive struggle as the sole producer, it may be tempted to restrict production, charge a higher price, and reap monopoly profits. The theory of natural monopoly is more fully explored below with appropriate graphs. Here we will simply note that it is unconvincing to many economists because it does not account for the presence of potential competitors. New firms, not currently competing in the market, may enter if the sole producer begins to extract economic profits through monopoly pricing. The possibility becomes more obvious if we think of a Chapter 14 Business Regulation 9 natural monopoly as the only hardware store in a small town, or the only amusement park within several counties, rather than as a large electric company. While such producers are technically natural monopolies, they must fear the entry of competition enough to restrain their monopolistic tendencies. TABLE 14.1 Traditional Public Utility Sectors and Their Current Status Primary Monopolies Primary, Party, or Potentially Competitive Local telephone service Long-distance telephone service Local electric power distribution Specialized postal services Local natural gas distribution Railroads Basic postal services Waterways Cable television Pipelines Urban transit Airlines Water and sewage Broadcasting Ports Hospitals Trucking Source: William G. Shepherd, Public Policies Toward Business (Homewood, Ill.: Richard D. Irwin, 1985), Table 12-1, p. 330. Copyright  1985 by Richard D. Irwin. Reprinted with permission. As discussed in the previous chapter, a contestable market is a market—often multiproduct in nature—where ultrafree entry (and exit) constrains potential monopolistic behavior. 3 Contestability emphasizes market performance over market structure. Threatening credible potential entry (and exit) provides a weak “invisible hand” to induce efficient economic performance. The newer concept of contestability is similar to that of the older theory of workable competition in the sense of the analysis of the determinants of market performance. The major contribution of contestability may be in emphasizing the multi-product nature of modern businesses. A Graphic Analysis of Natural Monopoly To expand on our earlier discussion of the behavior of natural monopolies, we can use graphs to examine the arguments for and against regulation of this type of monopoly. A Model of a Natural Monopoly 4 3 In a contestable firm, entry and exit is completely free; the costs and technology are the same for potential entrants as for existing incumbent firms; there are fixed but not sunk costs (unrecoverable from selling fixed inputs elsewhere); and buyers can purchase from the firm(s) that posts first the lowest price. 4 Although today we know that economies of scale are neither a necessary nor a sufficient condition for a natural monopoly, we present this older approach as a tolerably accurate approximation to the more Chapter 14 Business Regulation 10 As described earlier in the book, as the long-run marginal cost of production diminishes, the long-run average cost decreases as well, but at a slower rate. In Table 14.2, the marginal cost of producing each additional megawatt, shown in column 2, decreases from $50 for the first megawatt to $10 for the fifth. Though the average cost of the first unit is equal to its marginal cost, the average cost of subsequent units falls less rapidly than their marginal cost. 5 If we plot the marginal and average cost curves from the table on a graph, they will look like the curves in Figure 14.2. TABLE 14.2 Long-run Marginal and Average Costs of Producing Electricity Long-Run Long-Run Long-Run Average Cost Megawatts Marginal Cost Total Cost [(3) ÷ (1)] (1) (2) (3) (4) 1 $50 $ 50 $50 2 40 90 45 3 30 120 40 4 20 140 35 5 10 150 30 Figure 14.3 shows these same curves along with the electric company’s market demand and marginal revenue curves. According to traditional theory, a firm with decreasing costs will tend to expand production and lower its costs until it becomes large enough to influence price by its production decisions—that is, unit it achieves monopoly power. Then it will choose to produce where all monopolists produce, at the point where marginal cost equals marginal revenue. Thus the monopolistic firm in Figure 14.3 will sell Q m megawatts at an average price of P m , generating monopoly profits in the process. In other words, firms in decreasing-cost industries tend naturally toward monopoly. Although a firm with decreasing costs can expand until it is the major producer in an industry, if not the only one, it will necessarily be able to manipulate price as a result. Suppose a natural monopoly flexes its market muscle and charges P m for Q m units. Another firm, seeing the first firm’s economic profits, may enter the industry, expand production, and charge a lower price, luring away customers. To protect its interests, the firm that has been behaving like a monopoly will have to cut is price and expand production to lower its costs. It is difficult to say how far the price will fall and output will rise, but only one firm is likely to survive such a battle, selling to the entire market at a price that competitors cannot undercut. That price will be approximately P 1 in Figure 14.3. rigorous notion of subadditivity of costs. When costs are subadditive, subsidies may not be necessary to get socially optimal results, but entry may need to be restricted. 5 Remember, average cost is the total cost divided by the number of units produced. If the total cost of two megawatts is $90 ($50 for the first megawatt plus $40 for the second), the average cost of each megawatt is $45 ($90 divided by two units).