The Regulation of Business
Antitrust vs. Regulation
  • Under ideal conditions, the market mechanism may also provide optimal outcomes.
    1. Laissez Faire – the doctrine of “leave it alone,” of nonintervention by government in the market mechanism.
    2. To achieve this ideal
      • all producers must be perfect competitors
      • people must have full information about tastes, costs, and prices
      • all costs and benefits must be reflected in market prices
      • pervasive economies of scale must be absent.
    3. These ideal conditions are rarely, if ever, attained leading to market failure.
  • Behavioral Focus.
    1. Government intervention may be appropriate in industries where market power prevails.
    2. There are two options for the focus of intervention:
      • the structure of an industry.
      • the behavior of an industry.
    3. Antitrust laws address both issues.
    4. Government regulation focuses almost exclusively on behavior.
  • Social vs. Economic Regulation
    1. Social regulation is concerned with such issues as workplace safety, health, environmental protection, and highway safety.
    2. Economic regulation is more directly focused on prices, production, and the conditions for industry entry or exit.
  • Government Failure
    1. The choice is not between imperfect markets and flawless government intervention but rather between imperfect markets and imperfect intervention.
    2. Government failure may be worse than market failure.
Natural Monopoly
  • One of the best arguments for monopolies is that they can achieve economies of scale.  
    1. there are doubts as to whether consumers will benefit from the resulting cost savings.
  • Declining ATC  Curve
    1. Natural Monopoly - an industry in which one firm can achieve economies of scale over the entire range of market supply.
    2. The distinctive characteristic of a natural monopoly is its downward-sloping average total cost (ATC) curve.
    3. The marginal cost (MC) curve lies below the ATC curve at all rates of output.
    4. The economies of scale offered by a natural monopoly imply that no other market structure can supply the good as cheaply.  Hence, natural monopoly is a desirable market structure.
  • Unregulated Behavior.
    1. Although the structure of a natural monopoly may be beneficial, its behavior may leave something to be desired.
    2. The unregulated pricing of a natural monopolist violates the competitive principle of marginal cost pricing.
    3. Because P > MC, consumers are not getting accurate information about the opportunity cost of products sold in monopoly markets.
    4. The economic profits potentially earned by monopolist may violate our visions of equity.
Regulatory Options
  • Price Regulation
    1. Price Efficiency - The government could force the monopolist to set its price equal to marginal cost. 
    2. Subsidy - in a natural monopoly, MC is always less than ATC.  Hence, marginal cost pricing by a natural monopolist implies a loss on every unit of output produced.  In order to provide efficient pricing, a subsidy must be provided to the natural monopoly.
    3. Production Efficiency – In a natural monopoly, production efficiency is achieved at capacity production, where ATC is at a minimum.
  • Profit Regulation.
    1. The government can regulate the natural monopoly so that it makes a “normal” profit
    2. If a firm is permitted a specific profit rate, it has no incentive to limit costs.
  • Output Regulation
    1. The government can regulate the natural monopoly’s output.
    2. Regulation in the quantity produced may induce a decline in quality.
    3. Goal conflicts are inescapable, and any regulatory rule may induce undesired producer responses.
    4. Second-best Solutions - A realistic goal for regulation is that regulators will have to choose a strategy that balances competing objectives (e.g., Price efficiency, equity) to improve market outcomes, not to perfect them.
The Costs of Regulation
  • Administrative Costs
    1. Someone must sit down and assess these regulation tradeoffs.  The costs of these lawyers, accountants, engineers, etc. represent a real cost to society.
  • Compliance costs
    1. There is a cost for regulated firms to educate themselves, change their production behavior and to file reports with the regulatory authorities.
  • Efficiency Costs
    1. Inefficient regulation (bad decisions, incomplete information, and faulty implementation) has a cost associated with it.
  • Balancing Benefits and Costs
    1. Regulatory intervention must balance the anticipated improvements in market outcomes against the economic cost of regulation.
Deregulation in Practice
  • The push to deregulate is prompted by two concerns:
    1. The dynamic inefficiencies that regulation imposes.  These inefficiencies accumulate over time making the regulated industry less productive than desired.
    2. Advancing technology destroys the basis for natural monopoly.
  • Railroads
    1. The railroad industry is an example of natural monopoly with high fixed costs and negligible marginal costs.
    2. The Interstate Commerce Commission (ICC) was created in 1887 to limit monopolistic exploitation of the railroad situation while assuring a “fair” profit to railroad owners.
    3. With the advent of buses, trucks, subways, airplanes and pipelines as alternative modes of transportation, railroad regulation became increasingly obsolete.
    4. The Railroad Revitalization and Regulatory Reform Act of 1976, followed by the Staggers Rail Act of 1980, granted railroads much greater freedom to adapt their prices and service to market demands.
    5. Railroad companies used that flexibility to increase their share of total freight traffic.
    6. The railroads prospered under deregulation by reconfiguring routes and services, cutting operating costs, and offering lower rates.  Between 1986 and 1993, the average cost of moving freight by rail dropped by 69 percent.
    7. Not all rates fell, however.  After a series of mergers and acquisitions the top four railroads moved nearly 90 percent of all rail freight in 1998-99.  Some firms held monopoly positions on specific routs.  Shippers in these ‘captive’ markets were paying rates 20-30 percent higher than in non-monopoly routes.
  • Trucking
    1. In the 1930s, Congress broadened the powers of the ICC to regulate interstate trucking to protect the industry from the effects of the Great Depression.
    2. As a result, the industry flourished with its regulation-protected profits.  It became so profitable that people were willing to pay $500,000 for a trucking license.
    3. Entry regulations were relaxed in 1978 and major reforms were instituted by 1979.  Between 1980 and 1992, the number of firms increased from 18,000 to over 48,000.  By 1981, the value of existing truck licenses had fallen to $13,000.
  • Telephone Service.
    1. Technology outpaced regulation and greatly reduced the cost for new firms to provide long-distance service.
    2. Long Distance
      • In 1982, the courts put an end to AT&T’s monopoly. 
      • Since then, over 800 firms have entered the industry, and long-distance telephone rates have dropped sharply.
      • Between 1983 and 1990, long-distance telephone rates fell more than 40 percent.
      • The quality of service has also been improved with fiber-optic cable, advanced switching systems, cell phones, and myriad new phone-lines services.
      • Long-distance telephone use in the United States has tripled.
    3. Local Service
      • As long distance services increased, the monopoly nature of local rates became painfully apparent.
      • Local rates kept increasing after 1983 while long-distance rates were tumbling.
      • New technologies permitted “wireless” companies to offer local service if they could gain access to the monopoly networks.
      • Congress passed the Telecommunications Act of 1996 requiring the Baby Bells to grant rivals access to their transmission networks.
      • Potential rivals accuse the Baby Bells of foot dragging by charging excessive access fees, imposing overly complex access codes, requiring unnecessary capital equipment, and raising other entry barriers.
      • Four years after the mandate the “open access” the Baby Bells still held near monopoly positions in local telephone service.
  • Airlines
    1. The Civil Aeronautics Board (CAB) was created in 1938 to regulate airline routes and fares.
      • The primary objective was to ensure a viable system of air transportation for both large and small communities.  The focus of the CAB was on profit regulation.
      • A secondary objective was to ensure air service to smaller, less-traveled communities.  Short hauls entail higher average costs and, therefore, higher fares.  Cross-subsidization was used in the regulation of the industry to keep local rates low.
      • By fixing airfares, the CAB eliminated price competition between established carriers.
    2. No Price Competition
      • The CAB eliminated price competition between established carriers.
      • The absence of new entrants and price competition kept interstate airfares high.
      • Using intrastate airlines, which are not regulated by the ICC, studies showed that regulated interstate fares were as much as 60 percent higher than those on comparable intrastate routes.
    3. Cost Inflation
      • Despite the high regulated fares, established carriers were unable to reap much profit.  Unable to compete on the basis of price, the established carriers had to engage in nonprice competition through product differentiation (advertising, more frequent flights, first-run moves, free drinks etc.).
      • The profit regulation came to be regarded as a failure since the airlines were not making substantial profits and consumers were not being offered very many price-service combinations. 
    4. New Entrants
      • The Airline Deregulation Act of 1978 changed the structure and behavior of the airline industry.
      • This act eliminated the regulatory barrier to entry.
      • Between 1978 and 1985, the number of airline companies increased from 37 to 174.
      • The share of domestic markets with four or more carriers grew from 13 percent in May 1978 to 73 percent in May 1981.
      • Price competition reduce average fares as much as 40 percent below regulated levels.
      • There were some unforeseen positive externalities associated with the airline industry deregulation.  In addition to the 40% average drop in airline fares, the increased use of air travel led to fewer auto accidents and fatalities as well as better air traffic control.
    5. Entry Barriers
      • To exploit their hub dominance, major carriers must keep rivals out.
      • One of the most effective entry barriers is their ownership of landing “slots”.
      • In 1998 United Airlines controlled 82 percent of the slots at Chicago’s O’Hare, up from 66 percent in 1986.
      • Delta controls 83 percent of the slots at New York’s Kennedy airport.
      • Smaller airlines complain that they can’t get access to these slots, even when they are not being used.
      • Critics argue that despite the increasing industry concentration, there is more competition in most airline markets.  They argue the airline industry is a contestable market. 
  • Cable TV
    1. The cable TV industry has gone through both deregulation and re-regulation.
    2. Initially a regulated industry, Congress was convinced by 1984 that broadcast TV and related technologies offered sufficient competition to ensure consumers fair prices and quality service.  The Cable Communications Policy Act of 1984 deregulated the industry.
    3. After a period of rapid price growth, the industry was re-regulated in 1992.
    4. Cable operators claim that with the emergence of new and competing technologies (e.g. satellite subscription services), regulation is not necessary.  They claim that the lost revenue will keep them from desired upgrades.
    5. Congress responded to these industry complaints by deregulating the cable industry again.  The Telecommunications Turns Act of 1996 mandated that rate regulation be phased out and ended completely by March 1999.
    6. Cable prices soared again.  In 1997-98, cable rates rose four times faster than inflation.
    7. As the deadline for rate regulation approached, Congress was contemplating re-regulating the industry.  Critics asserted that alternative technologies were still not viable competitors to the cable monopolies.
  • Electricity
  1. The electric utility industry is the latest target for deregulation.
  2. New high-voltage transmission lines can carry power thousands of miles with negligible power loss.
  3. There is no longer a need to rely on a regional utility monopoly.
  4. At the wholesale level, utility companies have been trading electricity across state lines since 1992.  Now they are under pressure to allow retail competition as well.
  5. As in the telephone industry, the local utilities are being forced to grant rival power companies access to their wires.
  6. Norway deregulated its electric industry in 1991 and prices soon declined by 20 percent.
  7. In 1998, California opened its transmission networks to competition and 200 companies, from as far away as Atlanta, registered to supply power.
Deregulate Everything?
  1. In many industries, deregulation has resulted in more competition, lower prices, and improved service.
  2. Even as technology grows, there will likely always be a need for regulation to some degree to keep existing firms from erecting barriers to entry to these new industries.
  3. The transmission networks for local telephone service and electricity delivery are still natural monopolies.  Although the government can force owners to permit greater access, an unregulated network owner could still extract monopoly profits through excessive prices.

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last updated January 15, 2011