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Econ 201Lecture 9.2

Intro to Regulation:

Overview, Goals, History

6-04-09

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Government Regulation

• Major categories – Anti-competitive behavior

• Price Discrimination• Collusion• Mergers/acquisitions

– Natural Monopolies– Externalities

• Pollution• Fishing, forestry, mining, oil drilling

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Government Regulation

• Tools available– Statutory

• Prohibitive– E.g. Price fixing/restricting output, cartels, collusive behavior

• Fines, breakup (divestiture)

– Deregulation• Removing regulation

– Airlines, Banking

• Incentive mechanisms– Managed competition

– Incentive design

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Promoting Efficiency

• Goals of regulation– Promote Technological Innovation– Efficiency in Production– Efficiency in Allocation

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Efficiency in Production

• Produce Goods at Least Cost– Firms to operate at the minimum of their Long

Run Average Cost Curve

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Efficiency in Allocation

• Marginal value consumers place on last (marginal unit) produced to equal the resource “opportunity” costs– MV = MC at the marginal unit

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Government Regulatory AgenciesAdministrative Agencies

• Federal Trade Commission (1914) Act– “empowered to pursue abuses of trade that could lessen competition”

• Department of Justice (DOJ)– Jointly charged with FTC for overseeing and enforcing antitrust policy– Established by the Judiciary Act of 1789 – 1870 Act: handle the legal business of the United States. – control over all criminal prosecutions and civil suits in which the United

States had an interest • Federal Communications Commission (FCC)

– established by the Communications Act of 1934 – charged with regulating all non-Federal Government use of the radio

spectrum (including radio and television broadcasting), and all interstate telecommunications (wire, satellite and cable) as well as all international communications that originate or terminate in the United States.

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What Happens in Different Markets?

• Monopoly/Oligopoly– Single-price monopolist/cartel– Price Discrimination

• Block pricing – 2nd degree• Third degree: different prices for different WTP

– Income, sex, age, geography

• Monopolistic Competition– “branding” for market power– Geographic pricing,

• e.g., Madison Park shell, CD grocery stores • Price points and product proliferation

• Perfect Competition

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Perfect Competition

• Standard of comparison for all market models (optimal)– Productive efficient

• Firms operate at min of LRAC or exit

– Technological innovate• Innovate or die

– Allocative efficient• Consumers value marginal unit at MV

– Equals firm’s cost of producing marginal unit

• No deadweight loss

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Monopoly

• Not Efficient in Production– Never operate at min of LRAC– Underutilized capacity and resources

• Not Technologically Innovative– No incentive to invest in/develop new

technology when you’re the only firm

• Not Efficient in Allocation– P (=MV) > MR = MC– Deadweight loss

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Monopolistic Competition

• Not Efficient in Production– Never operate at min of LRAC– Underutilized capacity and resources

• Technologically Innovative– Competition with other firms provides incentive

• Not Efficient in Allocation– P (=MV) > MR = MC– Deadweight loss (but not as great as Monopoly)

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How Has the Government Sought to Regulate Markets?

• Punishing Anti-Competitive Behavior– Pricing/market tactics

• Collusion– Price-fixing, restricting output

• Price Discrimination• Predatory Pricing

– Impose fines for AC tactics

• Preventing Anti-competitive Behavior– Mergers and Acquisitions

• Review by appropriate administrative agency

– Divestiture/breakups

• Regulating Natural Monopolies• Deregulation(sic) of Selected Industries

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Punishing AC Behavior

• Punishing firms for behaving like a monopoly– Sherman anti-trust Act (1890)

• “conspiring to fix prices or restrict output”

– Clayton Act (1914)• More sophisticated price discrimination• Tie-in sales – requiring the purchase of 2nd good• Stock purchases/acquisitions

– Robinson-Patman(1936)• 3rd degree price discrimination • Amendment to Clayton Act

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Reviewing Mergers

• Primarily aimed at preventing mergers or acquisitions that reduce competition– FCC regulates communications media

(newspapers, tv, telecomm, radio)– FTC and DOJ regulate the rest

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How do they determine whether a merger reduces competition?

• Herfindahl-Hirschman Index or HHI, – measure of the size of firms in relationship to the

industry – Meant to be an indicator of the amount of competition– sum of the squares of the market shares of each

individual firm. • decreases in the Herfindahl index generally indicate a loss of

pricing power and an increase in competition, whereas increases imply the opposite

• DOJ guidelines– Mergers resulting in HHI > 1800 can be challenged

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Are All Mergers Equal?

• Conglomerate – Merger of firms in unrelated industries

• Vertical Merger– Merger of firms upstream/downstream from each other in

production stream• FCC: ownership of more than 1 media type• Microsoft

• Horizontal Mergers– Firms in the same industry

• Telecomm industry– AT&T divestiture– Verizon/GTE merger; RBOC mergers

• Would the HHI be a valid measure of competitiveness?

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Natural Monopolies

• What is the problem?– Unregulated: price like a monopolist– Set P = ATC => will not supply enough

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Natural Monopolies

• How have they been regulated?– Rate-of-return regulation

• Usually by state utility regulatory commission• Utility is authorized to earn a “rate-of-return” above its

incurred costs– Issues with

» What is a fair rate of return?

» Averch-Johnson effect (incentive to goldplate costs)

– Price caps (used to set LD rates)• Price = base rate + inflation – productivity increases• But what if demand shifts?

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Deregulation

• Why deregulate an industry?– Difficulty in developing an effective regulatory

strategy– Advances in technology reduce barriers to

entry

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Deregulation: Recent Examples

• Airline Industry (1978)

• Trucking and Railways (1980)

• Long distance telecommunications (1984)– AT&T divestiture

• Local telecommunications (1996)– Telecomm Act

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Airlines Deregulation

• Civilian Aeronautics Board – Through 1978

• Responsible for setting fares• Assigning/approving routes• Most competition was non-price

– After 1978• Airlines responsible for setting fares, choosing routes

– Airport terminals and airlines responsible for leasing gates

• Long term lease strategy

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Airlines Deregulation

• Winners and losers– A. Kahn estimates that net savings were

between $17B and $20B per year– Large cities

• Decreases in fares, more frequent service• More traveled routes had direct service

– Smaller cities• Increases in fares, less frequent service• Traveled through “hubs”

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Telecommunications Act of 1996

• The Act both deregulated and created new regulations. Congress forced local telephone companies to share their lines with competitors at regulated rates if "the failure to provide access to such network elements would impair the ability of the telecommunications carrier seeking access to provide the services that it seeks to offer."

• This led to the creation of a new group of telephone companies, "Competitive Local Exchange Carriers" (CLECs) that compete with ("ILECs" or Incumbent Local Exchange Carriers).

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Telecommunications Act of 1996

• The Act both deregulated and created new regulations. Congress forced local telephone companies to share their lines with competitors at regulated rates if "the failure to provide access to such network elements would impair the ability of the telecommunications carrier seeking access to provide the services that it seeks to offer."

• This led to the creation of a new group of telephone companies, "Competitive Local Exchange Carriers" (CLECs) that compete with ("ILECs" or Incumbent Local Exchange Carriers).

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Telecomm Act

• TCA permits new telephone companies to lease the incumbent telephone companies’ network facilities at wholesale prices far below costs.

• Rules encourage entry of firms that avoid building alternative networks and depend on subsidized networks’ facilities. – Few entrants that built alternative networks are now abandoning

these networks (chart) for subsidized leased facilities. • Because regulated wholesale prices are set far below

costs in many states, incumbent telephone companies have also cut their investments. – Neither incumbent nor new entrant investing, equipment

manufacturers have closed plants and industry employment has fallen by half a million jobs.

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www.newmillenniumresearch.org

• CLECs are abandoning their own networks to lease UNEs at bargain prices The recent increase in leased lines is coming at the expense of lines built and owned by CLECs themselves.

• UNE prices are set so low that they discourage CLECs from investing in alternative telecommunications infrastructure.

• Low UNE prices make the ILECs’ wholesale services unprofitable, which discourages continued ILEC investment.

• As a direct result of low wholesale prices, industry-wide telecommunications investment has fallen 40% over the last two years.

• This study finds that the fall in telecommunications investment results in an annual

decline in economic output equivalent to $101 per average household annually. In contrast, the benefits of price reductions resulting from local competition are estimated to be $11.41 per household annually.

• This study finds finds that the economic costs associated with setting artificially low wholesale prices far outstrip the consumer financial benefit

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Brookings Institute

• Robert Crandall of the Brookings Institutehas argued that the forced-access provisions of the 1996 Act have had little economic value, and the primary, sustainable competitive forces in phone and related, non-'radio', telecommunications are the wireline telephone companies, the cable companies, and the wireless companies.

• The Act was claimed to foster competition. Instead, it continued the historic industry consolidation begun by Reagan, whose actions reduced the number of major media companies from around 50 in 1983 to 10 in 1996 , reducing the 10 in 1996 to 6 in 2005.

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So What was the Goal?

• Goals of regulation– Efficiency in Production– Promote Technological Innovation– Efficiency in Allocation