Regulation

David Levinson (Based on

notes by Tae Oum)

Instruments of Government Intervention

1. moral suasion;– speeches, conferences, information,– advisory and consulting bodies,– studies/research– reorganizing agencies

2. government expenditures;– grants– subsidies– public provision of facilities

3. regulation - economic regulation, other regulation;– taxes, tariffs– guidelines– rules– fines, penalties

4. government ownership and/or control of enterprise

Objectives for Government Intervention

• to achieve maximum social welfare in the presence of market failure;– natural monopoly– existence of externality;

• - positive• - negative

• macro-economic objectives;– controlling inflation– maintaining employment– balance of payments

• socio-economic objectives;– to achieve desired

income distribution– mobility of handicapped– industrial policies

• indirectly subsidize certain industries

– safety

other objectives;– national unity– national prestige– national defense

Economic Regulation

• an attempt by government to deliberately alter the allocation of resources and distribution of incomes away from that which would have occurred in the absence of such regulation;

• a means by which government can attempt to substitute its judgement of what constitutes a 'proper' allocation of resources and distribution of income for the outcome yielded by the market;

• transportation had been a heavily regulated industry until recently;

Types of Economic Regulation in Transport

• The regulatory agencies are granted a broad power to regulate the following aspects of the industry:– price regulation - maximum rate, minimum

rate, rate structure– entry and exit regulation– rate-of-return regulation– antitrust (anti-combines) regulation

including mergers and acquisition– regulation on financial arrangements and

accounting practices

Theory of Economic Regulation

There are two opposing theories on why economic regulations exist;

• Consumer Protection. The regulation is a device for protecting the public against the adverse effects of monopoly. (traditional and ideal view)

• Protection of Industry Interest. The regulation is procured by politically effective groups (assumed to be composed of the members of the regulated industry itself), for their own protection. (more recent view).

Protection of Industry

• industry attempts acquire regulation mainly because regulation will help them generate economic rents; producers have a more vested interest in the industry than does individual consumer.

• producers are far more effective in pressuring government than are general interest consumer groups.

• Stigler (1971) argues that producers essentially "capture" regulatory agencies. "as a rule, regulation is acquired by the industry and is designed and operated for the industry and not for the "public interest". Therefore, regulatory commissions end up "protecting" industry from consumers.

Railway Regulation

Started regulation in 1887. • railway monopoly in many markets: user

protection• need to provide services to uneconomic

points: cross-subsidy• some destructive competition; anti-trust need• shortrun marginal cost seemed low relative

to "full costs";• political pressures to intervene;

Trucking Regulation

• Started regulation in 1930s.• began to question the efficacy of

competition as a regulator of business;

• a strong push for "codes of fair competition" in society as a whole;

• start to regulate trucking although it was a competitive industry.

Airline Regulation

Started regulation in late 1930s.• to help create national network • subsidization of the infant industry• protection from competitive entry

to effect cross-subsidization (taxation by regulation - regulatory inspired cross-subsidization).

Economic Rationale for Regulation

• The main objective is to maximize social welfare by correcting market failure.

• 1. To force monopolies to produce the level of output that maximize social welfare;

• 2. To encourage the infant industry to get off-ground;

• 3. To prevent "destructive (cut-throat) competition"

• 4. To correct for externalities;

Monopolies

• the industry is inherently "monopolistic" because of economies of scale, limited markets, or requires high initial investment;

• existence of high fixed (indivisibilities), common and/or joint costs;

Infant Industries

• a combination of regulation on entry, quantity supplied, subsidy

• usually the nation sees existence of a large external benefits

• or important non-economic benefits to the nation.

Cut-Throat Competition

• instability in supply prices - regulate to smooth out output prices

• uneconomic rate levels;• predatory pricing

– immature pricing behaviour - oligopolists overreaction to competitive event

– high fixed cost with slow adjustment - short run pricing below total average costs, especially in recession when there are a lot of excess capacity

Externalities

• higher prices to induce less production/consumption of bad externality

• eg., pollution

Entry Regulation

Entry into industry;– certificate of Public

Convenience and Necessity (PCN)

– burden of proof (of need for new services) is on applicant;

– being replaced by Fit, Willing and Able criteria;

– no need to show need for new service

– common carrier obligation - must serve all requests from public;

• Entry onto routes;– route licence

required– more relevant for

air and truckers– licence may

restrict carriers to certain commodities or classes of service

Exit Regulation

• Pre-Deregulation– was almost

impossible to abandon uneconomic routes or branchlines;

– carriers were required to cross-subsidize between profitable and unprofitable routes;

• Post-Deregulation– can apply to the

regulatory agency to abandon branchlines or exit from a route;

– the agency either approve or give direct subsidy to maintain uneconomic services;

– Usually required advance notice for a certain period before abandoning or exiting;

Price Regulation• Pre-deregulation period

– carriers apply to regulators for any rate change

– regulatory agency can approve, deny or vary the changes

– generally no inflation adjustments were built in rates

– burden is on the carrier to prove need for changes

– unjust and unreasonable rates not allowed;• - e.g. youth fares can be

judged as justly high monopoly or predatory prices can be judged as being unreasonably high or low.

• Post-deregulation period– carrier simply files

proposed fare changes, and make fares available for customers to look at.

– Regulator can disapprove or vary changes in 'basic fare level' upon complaints

Rate of Return Regulation

• Regulatory authorities explicitly or implicitly used rate-base rate-of-return for the carrier when they examined proposal for fare change. If the carrier made more than fare returns, fare change proposal may not get approved.

Condition of Service Regulation

• e.g., airline regulation in pre-deregulation Canada included;– capacity offered– type of aircraft used – frequency of service– stopover condition;– e.g., PWA had to stop between

Calgary & Toronto

Effects of Economic Regulation 1

• Lack of competitive pressure to due regulatory protection– (entry regulation)– induces x-inefficiency in the industry - gold

plating, fetter-bedding, etc.– encourages transfer of economic rents to

organized input suppliers;• e.g., labour union, aircraft manufacturers.

– dissipating economic rents the industry hopes to gain.

Effects of Economic Regulation 2

• Price Regulations• leads to excessive quality competition

– e.g., Douglas and Miller's work on airline quality competition;

• the industry repeated vicious cycle of regulatory game.

• makes the system much less flexible and far more inefficient.

Effects of Economic Regulation 3

• Cross-subsidization from profitable to unprofitable routes

• society as a whole loses as the total welfare gets reduced as compared with the following alternative solutions;– no cross-subsization– direct subsidy, by raising money from

government general or through air transport tax.

Effects of Economic Regulation 4

• Some regulatory commissions specify a rate-of-return constraint to guide decisions concerning raising or lowering prices. That is the regulatory authority allows a fair rate of return on the value of the assets ("rate base") required to produce the services.

• This gives incentives for the firm to increase its "rate base" by investing more on capital input relative to labour input; In other words, the firm under rate-of-return constraint has relatively more capital vis-a-vis labour than is required to produce any given output.

• This is an important source of allocative inefficiency caused by the regulation.

Industry Performance

• Note that if market failure does not exist, there is no economic need for any economic regulation. Numerous studies have investigated the effect of regulation on the airlines, highway trucking, intercity bus, and taxicabo industries. In all four cases there is an ample body of empirical evidence which suggests that in the absence of regulation the market mechanism would yield an output close to a competitive equilibrium. For these industries, economic regulation has become a prime cause of market failure, far from being a remedy for market failure.

• Therefore, the impact of regulation on price and quantities traded in these industries can be assess by using a competitive solution as the appropriate benchmark.

Benchmarks

• highly inefficient production and operation - x-inefficiency;– d(e.g., 16% cost increase due to this and crown ownership of

carriers - see Gillen, Oum and Tretheway, JTEP, 1990);• permitted artifically high price for labour input;• some transfer of monopoly benefit to equipment

manufacturers (eg. aircraft manufacturers)• services not responsive to customer needs;• allocative inefficiencies;

– over-capitalization (A-J effect)– misallocation of traffic across modes

• high cost of regulatory administration;• carriers lost dynamism - lack of innovations;• static welfare loss (deadweight) loss;• caused distortions elsewhere in the economy;

Deregulation and Effects

• early economic criticisms, 1940s and 1950s;• growing number of academic researchers

criticized during 1960s;• critiques plus empirical measures of the

economic cost of requlation in 1970s;• deregulation gained political support in

1970s;• deregulation became a formal policy in the

U.S. in late 1970s;• deregulation of airlines in 1978, railroads and

trucking in 1980;

Theory of Contestable Markets

• Baumol, Panzar and Willig formalized the conditions under which natural monopolies could be expected to reach efficient equilibria without regulation, an idea put forward by Harold Demsetz earlier.

• broadening the areas in which the outcome of perfect competition applies;

• a broader condition supporting deregulation than perfect competition;

Concept of contestable market:

• potential competition can replace actual competition

• single firm (monopoly) behave like competitive firm

• crucial conditions: free entry and exit

Conditions for Contestability

(Levin, p.404);• equal excess to scale economies and

technology• no sunk costs. a firm can enter and exit

without entry and exit costs, including operating losses resulting from predation.– free entry: no entry barrier– costless exit

• price sustainability, there is a set of prices that can occur after the entry of at

Implications for Regulation

Airline studies:• several studies pointed

out (e.g., Bailey and Panzar).– airline market is only

partially constable– existence of actual

competition is more effective than potential competition

– fares in the markets with potential competition are lower than completely monopoly market but higher than the markets with actual competition.

• little need for regulation if sunk costs low

• design regulation to focus on sunk costs;– regulate sunk facilities

only– modify institutional

arrangements for sunk assets.

• can rely on contestability theory only partially in deregulated airline markets;– mainly due to existence of

entry barriers.