Regulation
Focus on goal and practice of regulation:
• Goals of regulation, timeline
• Causes of regulation
– Correct market inefficiencies
– Interest-group theory
• Effects of regulation
– Franchise bidding
– Price/quantity regulation
– Rate of return regulation
– Restrictions on entry
• Deregulation
Goals of regulation
Focus on economic regulation (regulation of competitive element of an industry).
There are exists much social regulation, often not based on economic rationale.
• Same as antitrust: promote economic efficiency
• Increase consumer welfare
Timeline:
• 1930s: heyday of regulation (banking, trucking, airlines)
• 1970s-1980s: wave of deregulation (telecom, trucking, airlines)
What are causes for these trends in regulation?
Causes of regulation 1
Regulation in response to market failures:
1. Natural monopoly: monopoly is the least costly structure for an industry.
Example: downward-sloping AC curve.
Tradeoff between
• productive efficiency: having one firm produce minimize total production
costs
• allocative efficiency: large number of firms required for P = M C leads to
excessive costs to be incurred
Regulate price so that it just covers its production costs.
2. Externalities: Market average cost curve lies below societal average cost curve.
Example: pollution (graph)
Regulate by restricting output
Causes of regulation 2
3. To benefit interest groups (Stigler). “Capture theory”.
Governments have “the power to coerce”. Policymakers interested in maximizing
not only public welfare, but also private gains (eg. political contributions), they
are beholden to interest groups (both firms and consumers) who lobby for
favorable policies.
Important contribution: regulation is not only pro-consumer, but oftentimes
pro-producer.
What do industries lobby for?
1. Favorable treatment via taxes, trade restrictions, subsidies
2. Industries prefer policies which restrict entry.
3. Explains the abundance of entry-restricting regulations (quotas, entry
licenses, geographical restrictions on movements of goods) versus alternative
methods (taxation) which don’t explicitly restrict entry?
4. Example: Canada-US Auto Pact
• Imposed import taxes on producers who did not produce enough cars
domestically (hurt Asian/European producers).
• Struck down by WTO, but big 3 automakers asking Ottawa to maintain
import taxes across the board.
• Raising rival’s costs? Bad for consumers
Causes of regulation 4
Which industries lobby? Those with lower organizational costs: more
concentrated industries?
Which industries will be regulated? Those where the regulated price deviates the
most from non-regulated price:
• Monopolies will be regulated upon the urging of consumer groups.
• Relatively competitive industries may press for regulation which increases
price above MC.
Conforms generally with empirical evidence (monopolists: utilities; competitive
industries: global agricultural products)
Pro-producer regulation can raise prices; in international realm, can encourage
inefficient domestic production (the Indonesian auto industry).
Effects of regulation
Focus on effects of regulation to make monopolies more competitive
Basic problem: monopoly sets price above, and produces below, competitive
levels. Different ways to regulate a monopolist:
• Franchise bidding
• Price regulation
• Rate of return regulation
• Restrictions on entry
Franchise bidding.
Principle is that you allow firms to reap monopoly profits, but extract these
profits from the firm at the beginning through bidding process.
Furthermore, bidding process “selects” out most efficient firm.
Two types:
A. Prospective firms must pay a lump-sum amount for an ensuing monopoly. If
bidding process is competitive, government should capture the monopoly rents.
Example: oral ascending auction. Price rises continuously. Firms willing to
remain in the auction as long as p < π m . When p = π m , firms will drop out, and
(assume) monopoly awarded to one of the firms.
B. Firms bid prices that they promise to charge. If bidding is competitive, then
winning firm will bid a price that just allows them to break even.
Example: monopoly with constant marginal costs c. Competitive bidding yields
willing price p = c.
Price regulation
Consider three types:
1. Standard case
2. Price regulation with strictly downward-sloping AC
3. Uniform price regulation (cross-subsidization)
1. Standard case:
Graph: mandate price at pc , perfectly competitive level. At this level, consumer
surplus is maximized.
However, no guarantee that monopoly is making positive profits here, due to
possible fixed costs.
This tradeoff acute for case of natural monopoly: downward-sloping AC curve
Set price=AC: possible tradeoff between consumer surplus, and productive
efficiency.
Price regulation of nat. monopoly
2. Price regulation for a natural monopoly
Natural monopoly: downward sloping AC curve. Graph
Note: p = M C results in losses for the firm.
• “Second-best” option: regulate price at pa . Here firm is just breaking even,
but consumer surplus is not maximized.
• “First-best” option: Consumer surplus maximized when price set at
marginal cost c, and firms losses are subsidized. But typically govt taxes
distort consumer demand, with the result that consumer surplus may be
higher under “second-best” solution.
Regulatory lag: delay in enforcing regulated prices gives firms incentives to cut
costs, avoid becoming a “fat cat”. Regulated price is a “high-powered” incentive,
since firm reaps all the rewards from its cost-cutting efforts.
Cross-subsidization 1
2. Uniform price regulation
Monopoly offers array of products which vary in cost. For equity reasons, govt.
may regulate uniform prices for all the products.
Example: postal services, local telephone service (“universal service”)
Cross-subsidization: Regulate a uniform price such that losses in higher-cost
market made up for by profits in lower-cost market.
Cross-subsidization 2
Example: 2 markets, each with demand curve p = 5 − q. c1 = 1, c2 = 4.
• Unregulated monopoly treats two markets separately: p1 = 3, p2 = 9/2. This
is profit-maximizing outcome.
• Regulate price=3. No single-market firm will operate in market 2.
• Multiproduct monopoly makes losses of −2, but profits of 4 in market 1.
Will agree to operate.
• Main point: cross-subsidization is inconsistent with profit maximization, but
only multiproduct monopoly willing to do it. This is reason why you want a
monopoly for these services: (argument against deregulating trucking, post
office)
Rate of return regulation
R(K, L) − wL
Rate of return is defined as
. Regulating ROR is indirect way of
K
regulating profits (easier to compare ROR across firms than profits).
ROR=r: normal rate of return (occurs in competitive equilibrium; invest until
marginal profit is marginal cost of capital)
Unregulated monopoly would earn ROR=Rm > r, so you want to lower this
amount.
In most cases, firm is allowed a “fair rate of return” s, where (ideally)
rm > s > r.
ROR-regulated firm has incentive to use more capital, since this decreases its
ROR. This bias towards capital is the Averch-Johnson effect.
Rate of return regulation 2
Example:
• w is wage rate, r is cost of capital, s is regulated ceiling on ROR
• Constrained profit maximization:
max R(K, L) − wL − rK subj. to
K,L
R(K, L) − wL
≤s
K
• Unconstrained outcome (standard marginal conditions):
∂R
∂R
=w
=r
∂L
∂K
• Constrained outcome:
∂R
∂R
=w
= r − α < r if s > r
∂L
∂K
(see Appendix of C/P for more details)
• Graph: if production technology characterized by diminishing returns, then
firm will overinvest in capital.
Rate-of-return regulation 3
Evidence for the A-J effect?
• Utilities choose capital-intensive methods of production?
• Joskow: A-J assume that ROR is always monitored. Not true: evidence that
regulators monitor in inflationary periods, when consumer complain about
rising (nominal) prices. In other periods, firms basically unconstrained in the
ROR they can earn, so no reason to distort labor-capital ratios.
• Benefit of the A-J effect: encourage innovation? But probably more direct
ways to do so (subsidies for R&D)
Restrictions on entry
4. Restrictions on entry (taxicab regulation)
Restrictions on competition (government monopolies, restricted store hours, etc.)
usually difficult to justify from a consumer welfare point of view.
Interest-group theories can explain: industries who lobby the most gain favorable
legislation from contribution-maximizing policymakers. Consumers lose from
resulting higher prices.
Examples:
• Trade restrictions: industries prefer quotas. Quotas allow firms to gain all
the surplus, as well as restrict entry.
• Agricultural policies: price floors, subsidies, restrict imports.
However, lobbying or general rent-seeking activity is also competitive process.
Will all the rents from favorable legislation be dissipated in lobbying activity?
(identical logic to franchise bidding)
Economic justification: Restrictions on entry help maintain quality standards.
Opportunistic behavior by favored firms is potentially “disciplined” by consumer
complaints.
Effects of deregulation
Main argument for deregulation: allows most efficient market structure to
emerge. Natural monopolies (should) remain monopolies, artificial monopolies
will become competitive.
• Airlines: lower prices, price wars, less emphasis on service. Development of
“hub and spoke” network: jury still out on cost efficiencies versus perceived
market power by dominant airlines at their “hub” airports.
• Trucking: lower rates. Technical progress: development of “intermodal”
services (ship-rail-truck), applied logistics to minimize empty trucks, provide
“just-in-time” services to clients to minimize usage
• Telecom: widely perceived that long-distance users “cross-subsidized” local
telephone users. How will relative prices change? Allowing long-distance
carriers to enter local markets requires allocating access to local carrier’s
network: how to set “access” charges?
Deregulation 2
Deregulation episodes are a chance to verify the interest-group theory.
When should a market be deregulated? Stiglerian theory says when pressure of
relevant interest groups is reduced: when industry profits fall (i.e., industry has
less to gain), or if consumers get better organized.
• Railroads: deregulation pressures began to mount in 1950s, when railroad
profits fell. But why took until 1970s to deregulate?
• Taxicab industry: not deregulated. Very high regulated industry profits, as
evidenced by prices of taxicab medallions (average $200,000 in NYC).
Supports theory.
• Trucking: inconsistent. Profits were high at time of deregulation, and little
sign of consumer anger.
Conclusions
• Causes of regulation:
– market failures
– interest-group theory
• Different ways of regulating a monopoly
– Price regulation
– Rate of return regulation
• Deregulation