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). Chapter 14 Business Regulation 11 FIGURE 14.2 Long-Run Marginal and Average Costs in a Natural Monopoly In a natural monopoly, long-run marginal cost and average costs decline continuously, over the relevant range of production, because of economies of scale. Although the long-run marginal and average cost curves may eventually turn upward because of diseconomies of scale, the firm’s market is not large enough to support production in that cost range. FIGURE 14.3 Creation of a Natural Monopoly Even with declining marginal costs, the firm with monopoly power will produce where marginal cost equals marginal revenue, making Q m units and charging a price of P m . Unless barriers to entry exist, however, other firms may enter the market, causing the price to fall toward P 1 and the quantity produced to rise toward Q 1 . At that price-quantity combination, only one firm can survive—but without barriers to entry, that firm cannot afford to charge monopoly prices. At a price of P 1 , its total revenues just cover its total costs. Economic profit is zero. If the price does fall to P 1 and only one firm survives, its total revenue will be its price times the quantity produced, Q 1 (or P 1 x Q 1 ). Notice that at that level, the firm’s average cost is equal to P 1 . Therefore the total cost of production (the average cost times the quantity sold) is equal to the firm’s revenue. The firm is just covering its costs of production, including the owner’s risk cost. Now alone in the market, the firm may think it can restrict output, raise its price, and reap an economic profit. Still it faces the ever- present threat of some other company entering the market and underpricing its product. Arguments for the Regulation of Natural Monopolies From a purely theoretical perspective, then, the existence of a natural monopoly is insufficient justification for regulation. Unless there are significant barriers to entry to an industry and an inelastic market demand, natural monopolies should not be able to charge monopoly prices. Proponents of regulation reply that some industries, like the electric Chapter 14 Business Regulation 12 utilities require such huge amounts of capital that no competitor could be expected to enter the market to challenge the natural monopoly. That argument presumes, however, that the generation of electric power must take place on an extremely large scale. Such is not necessarily the case. Furthermore, the capital needed to produce electricity on a profitable scale can be raised by many large corporations, if economic profits exist. Yet another argument for regulation—one more often voiced by the firms themselves than by consumers—is that production by natural monopolies generally requires large quantities of fixed capital assets, which become a sunk cost once purchased, to be ignored in short-run production and pricing decisions. If industries with long-run decreasing costs are vulnerable to destructive price wars, then firms that ignore massive fixed costs in the short run will eventually destroy themselves. This argument, however, presumes that entrepreneurs will enter an industry in which self-destruction is a likely outcome—a questionable presumption. In actuality, many industries—oil and automobile production, for instance—support a significant amount of competition despite extensive capital needs. Neither oil nor automobile producers seem likely to destroy themselves in the near future. However, modern transaction cost theory suggests that regulation may be needed as a contract arising because consumers need protection from monopolistic exploitation by producers, and producers need protection from opportunistic exploitation arising from the long-lived, transaction specific, idiosyncratic, immobile capital investments that are required to provide service. Proponents of the regulation of natural monopolies point also to insufficient output and revenues. Even if an unregulated industry produces Q 1 units and prices that output at P 1 (see Figure 14.4), it has not reached the efficient output level. That would be the level at which marginal cost equals marginal benefit—the point at which the marginal cost curve intersects the demand curve. That level is Q 2 in Figure 14.4. Why does output fall short? FIGURE 14.4 Underproduction by a Natural Monopoly A natural monopolist that cannot price discriminate will produce only Q 1 megawatts, less than Q 2 , the efficient output level, and will charge a price of P 1 . If the firm tries to produce Q 2 , it will make losses equal to the shaded area, for its price (P 2 ) will not cover its average cost (AC 1 ). Given the market demand curve, the firm could sell an output of Q 2 for only P 2 , earning total revenues of P 2 times Q 2 . Since the average cost of producing at that output level -- AC 1 on the vertical axis -- would be greater than the price, total costs, at AC 1 x Q 2 ,would be greater than total revenues. The loss to a firm that tried to produce at the Chapter 14 Business Regulation 13 efficient output level is shown by the shaded area on the graph. To produce at the efficient output level, a company would require a subsidy to offset that loss, or it would begin to price discriminate, charging progressively lower prices for additional units sold. Once a firm is given a subsidy, its pricing and production decision must be closely monitored, for its incentive to control costs will be weakened. If the firm allows its cost curves to drift upward, the price it can charge will also rise. In Figure 14.5, the firm’s long-run marginal and average cost curves shift up from LRMC 1 and LRAC 1 to LRMC 2 and LRAC 2 . Following the rule that price should be set at the intersection of the long-run marginal cost and demand curves, regulators permit the price to rise from P 1 to P 2 . The firm’s subsidized losses shrink from the shaded area P 1 abATC 1 to P 1 cdATC 2 —but the quantity produced drops also, from Q 1 to Q 2 . Consumers are now getting fewer units at a higher price. __________________________________________ FIGURE 14.5 Regulation and Increasing Costs If a natural monopoly is compensated for the losses it incurs in operating at the efficient output level (shaded area P 1 ATC 1 ba), it may monitor its costs less carefully. Its cost curves may shift up, from LRMC 1 to LRMC 2 and from LRAC 1 to LRAC 2 . Regulators will then have to raise the price from P 1 to P 2 , and production will fall from Q 1 to Q 2 . The firm will still have to be subsidized (by an amount equal to shaded area P 2 ATC 2 dc), and the consumer will be paying more for less. Thus, production may be just as inefficient with regulation as without it. Critics point to the U.S. Postal Service as an example of an industry that is closely regulated and subsidized, yet highly inefficient. Yet if the postal industry were truly a natural monopoly, it would be a low-cost producer and would not need protection from competition. Proponents of regulation see the inefficiencies we have just demonstrated as an argument for even more careful scrutiny of a regulated firm’s cost—or for government control of production costs through nationalization. Not all natural monopolies need subsidies to operate at an efficient output level. For all megawatts up to Q 1 in Figure 14.4, the unregulated firm can charge up to P 1 , a price that just covers its costs on those units. If its product cannot be easily resold, the firm can price discriminate, charging slightly lower prices for the additional units beyond Q 1 . As long as its marginal prices are on or below the demand curve and above the marginal cost curve, the firm will cover its costs while moving toward the efficient output level—and it can do so without giving other firms an incentive to move into its market. If its product can be resold, however, some people will buy at the lower marginal prices and resell to those who are paying P 1 , cutting off the firm’s profits. . 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. 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