Regulation Focus on goal and practice of regulation: Goals of regulation, timeline Causes of regulation Correct market inefficiencies Interest-group

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1 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

2 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?

3 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 = MC 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

4 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?

5 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

6 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).

7 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

8 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.

9 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 p c, 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.

10 Price regulation of nat. monopoly 2. Price regulation for a natural monopoly Natural monopoly: downward sloping AC curve. Graph Note: p = MC results in losses for the firm. Second-best option: regulate price at p a. 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.

11 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.

12 Cross-subsidization 2 Example: 2 markets, each with demand curve p = 5 q. c 1 = 1, c 2 = 4. Unregulated monopoly treats two markets separately: p 1 = 3, p 2 = 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)

13 Rate of return regulation R(K, L) wl Rate of return is defined as K. Regulating ROR is indirect way of 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=R m > r, so you want to lower this amount. In most cases, firm is allowed a fair rate of return s, where (ideally) r m > 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.

14 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 K,L R(K, L) wl rk subj. to R(K, L) wl K s Unconstrained outcome (standard marginal conditions): Constrained outcome: R L = w R K = r R L = w R K = r α < r if s > r (see Appendix of C/P for more details) Graph: if production technology characterized by diminishing returns, then firm will overinvest in capital.

15 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)

16 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.

17 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?

18 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.

19 Conclusions Causes of regulation: market failures interest-group theory Different ways of regulating a monopoly Price regulation Rate of return regulation Deregulation