(De)Regulation Of Business

Chapter 12

Antitrust vs. Regulation Under ideal conditions, the market

mechanism provides optimal outcomes: All producers must be perfect competitors. People must have full information about

tastes, costs, and prices. All costs and benefits must be reflected in

market prices. Pervasive economies of scale must be

absent.

Antitrust vs. Regulation These ideal conditions are rarely, if

ever, attained, leading to market failure.

– Market failure - An imperfection in the market mechanism that prevents optimal outcomes.

Behavioral Focus Antitrust laws give two options for

government intervention: The structure of an industry. The behavior of an industry.

Behavioral Focus Antitrust is government intervention

to alter market structure or prevent abuse of market power.

• Regulation is government intervention to alter the behavior of firms, for example, in pricing, output, or advertising.

Natural Monopoly A natural monopoly is desirable because it

can achieve economies of scale. However, it is likely that consumers will not

benefit from the resulting cost savings.

Natural monopoly – An industry in which one firm can achieve economies of scale over the entire range of market supply.

Declining ATC The distinctive characteristic of a

natural monopoly is its downward-sloping average total cost (ATC) curve.

The marginal cost (MC) curve lies below the ATC curve at all rates of output.

Declining ATC The economies of scale offered by a

natural monopoly imply that no other market structure can supply the good as cheaply.

– Economies of scale - Reductions in minimum average costs that come about through increases in the size (scale) of plant and equipment.

Unregulated Behavior The unregulated pricing of a natural

monopolist violates the competitive principle of marginal cost pricing. Marginal cost pricing – The offer

(supply) of goods at prices equal to their marginal cost.

Unregulated Behavior Because P > MC, consumers are not

getting accurate information about the opportunity cost of products sold in monopoly markets.

– Opportunity cost – The most desired goods or services that are forgone in order to obtain something else.

Unregulated Behavior The natural monopolist’s profit-

maximizing output also fails to minimize average total cost.

Unregulated Behavior The economic profits potentially

earned by monopolist may violate our visions of equity.

– Economic profit – The difference between total revenues and total economic costs.

Pric

e (d

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nit)

Quantity (units per period)

Natural Monopoly

Average total cost

Demand

Marginal cost

MCA

qA qC qD0 MR

C

BA

pB

pC

pAUnregulated p

ATC = p

MC = p

Regulatory Options There are a number of regulatory

options to deal with natural monopoly: Price regulation. Profit regulation. Output regulation.

Price Regulation The government could regulate the

monopolist’s price.

Price Efficiency The government could force the

monopolist to set its price equal to marginal cost.

But, in a natural monopoly, MC is always less than ATC.

Subsidy Marginal cost pricing by a natural

monopolist implies a loss on every unit of output produced.

A subsidy must be provided to the natural monopoly in order to provide efficient pricing,.

Production Efficiency In a natural monopoly, production

efficiency is achieved at capacity production, where ATC is at a minimum.

No regulated price can induce the monopolist to achieve minimum ATC.

A subsidy would be required to offset market losses.

Pric

e (d

olla

rs p

er u

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Quantity (units per period)

Price Regulation

Average total cost

Demand

B*Marginal cost

MCA

qA qC qBqD0 MR

C

BA

pB

pC

pD

pAUnregulated p

ATC = p

MC = p

Profit Regulation The government can regulate the

natural monopoly so that it makes a normal profit.

The government would set the price where P = ATC.

Bloated Costs If a firm is permitted a specific profit

rate (or rate of return), it has no incentive to limit costs.

Profit regulation creates incentives for a regulated firm to inflate (“pad”) its costs.

Output Regulation The government can regulate the

natural monopoly’s output. Regulation of the quantity produced

may induce a decline in quality.

Pric

e (d

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rs p

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nit)

0Quantity (units per period)

Minimum Service Regulation

Average total cost

Demand

D

Marginal cost

pA

pD

pCpB

qA qD qC qBMR

Unregulated p, q

Imperfect Answers A realistic goal is to choose a strategy

that balances competing objectives. The choice isn’t between imperfect

markets and flawless government intervention.

• The choice is between imperfect markets and imperfect intervention.

Imperfect Answers In some cases, government failure

may be worse than market failure.– Government failure – Government

intervention that fails to improve economic outcomes.

The Costs of Regulation There are costs associated with

regulation: Administrative costs. Compliance costs. Efficiency costs.

Administrative Costs Someone must sit down and assess

these regulation tradeoffs. The costs of these lawyers,

accountants, and engineers represent a real cost to society.

Compliance Costs There is a cost for regulated firms to

educate themselves, change their production behavior and to file reports with the regulatory authorities.

Efficiency Costs Inefficient regulation (bad decisions,

incomplete information, and faulty implementation) has a cost associated with it.

Balancing Benefits and Costs Regulatory intervention must balance

the anticipated improvements in market outcomes against the economic cost of regulation.

Deregulation in Practice The push to deregulate is prompted

by two concerns: The inefficiencies that regulation

imposes. Advancing technology destroyed the

basis for natural monopoly.

Railroads The Interstate Commerce Commission

(ICC) was created in 1887 to limit monopolistic exploitation of the railroad situation while assuring a “fair” profit to railroad owners.

Railroads With the advent of buses, trucks,

subways, airplanes and pipelines as alternative modes of transportation, railroad regulation became increasingly obsolete.

Railroads The Railroad Revitalization and

Regulatory Reform Act of 1976 and the Staggers Rail Act of 1980, granted railroads much greater freedom to adapt their prices and service to market demands.

Railroads Railroad companies used that

flexibility to increase their share of total freight traffic.

The railroads prospered by reconfiguring routes and services, cutting operating costs, and offering lower rates.

Railroads Between 1986 and 1993, the average

cost of moving freight by rail dropped by 69 percent.

Railroads After a series of mergers and

acquisitions the top four railroads moved nearly 90 percent of all rail freight in 1998-99.

Some firms held monopoly positions on specific routes and charged 20-30 percent more than in non-monopoly routes..

Railroad Traffic: Before and After Deregulation

0

600

500

400

300

200

100

1970 75 76 7774737271 78 79 80 81 82

Deregulation

Telephone Service With high fixed costs and very low

marginal costs, the telephone had long been an example of natural monopoly.

Technology outpaced regulation and greatly reduced the cost for new firms to provide long-distance service.

Long Distance Telephone Service In 1982, the courts put an end to

AT&T’s monopoly. Since then, over 800 firms have

entered the industry, and long-distance telephone rates have dropped sharply.

Rates have fallen and service has improved.

Local Telephone Service As competition in long distance

services increased, the monopoly nature of local rates became painfully apparent.

Local rates kept increasing after 1983 while long-distance rates were tumbling.

Local Telephone Service New technologies permitted

“wireless” companies to offer local service if they could gain access to the monopoly networks.

Local Telephone Service Congress passed the

Telecommunications Act of 1996 requiring the Baby Bells to grant rivals access to their transmission networks.

Local Telephone Service The Baby Bells have been accused of

charging excessive access fees, imposing overly complex access codes, requiring unnecessary capital equipment, and raising other entry barriers.

Local Telephone Service The FCC and state regulatory

agencies lowered entry barriers in 2001-02 which allowed rivals to increase market share to 12 percent.

Airlines The Civil Aeronautics Board (CAB) was

created in 1938 to regulate airline routes and fares.

Its primary objective was to ensure a viable system of air transportation for both large and small communities.

Airlines The focus of the CAB was on profit

regulation.

• A secondary objective was to ensure air service to smaller, less-traveled communities.

Airlines Short hauls entail higher average

costs and, therefore, higher fares.

• By fixing airfares, the CAB eliminated price competition between established carriers.

Airlines Regulators used cross-subsidization to

keep local rates low.– Cross-subsidization – Use of high prices and

profits on one product to subsidize low prices on another product.

No Entry The CAB was extremely effective in

restricting entry into the industry. From 1938 until 1977 the CAB never

awarded a major route to a new entrant.

No Price Competition The CAB eliminated price competition

between established carriers. The CAB fixed airfares on all routes.

Bloated Costs Despite the high regulated fares,

established carriers were unable to reap much profit.

Costs rose as carriers used frequent flights and product differentiation to attract passengers.

Bloated Costs Profit regulation came to be regarded

as a failure.– Airlines weren’t making substantial profits.– Consumers weren’t being offered very many

price-service combinations.

New Entrants The Airline Deregulation Act of 1978

eliminated the regulatory barrier to entry. Barriers to entry – Obstacles that make

it difficult or impossible for would-be producers to enter a particular market.

New Entrants Between 1978 and 1985, the number

of airline companies increased substantially.

Price competition reduced average fares as much as 40 percent below regulated levels.

Increasing Concentration Unable to match lower fares and

increased service, scores of airline companies exited the industry in the period 1985-95.

The combined market share of the three largest carriers nearly doubled between 1985 and 1993.

Increasing Concentration Some companies have gained near

monopoly power in specific “hub” airports.

Ticket prices are 45 to 85 percent higher on monopolized routes than on routes where at least two airlines compete.

Entry Barriers Major carriers exploit their hub

dominance, and keep rivals out through their ownership of landing slots.

Entry Barriers Defenders of deregulation argue that

most airline markets are competitive. They argue the airline industry is a

contestable market. Contestable market – An imperfectly

competitive industry subject to potential entry if prices or profits increase.

Cable TV The cable TV industry has gone

through both deregulation and re-regulation.

Deregulation The Cable Communications Policy Act

of 1984 deregulated the industry.

Congress believed that broadcast TV and related technologies offered sufficient competition to ensure consumers fair prices and quality service.

Reregulation After a period of rapid price growth,

the industry was re-regulated in 1992. Cable operators were required to

reduce prices by nearly 17 percent in 1993-94..

They claimed that the lost revenue will keep them from desired upgrades.

Deregulation The Telecommunications Turns Act of

1996 mandated that rate regulation be phased out and ended completely by March 1999.

Cable prices soared again.

Annual Increase in Price of Basic Cable Service

+5.1%

RegulatedPrices

1976 – 86

DeregulatedPrices

1986 – 92

+9.5%

ReregulatedPrices

1992 – 95

+0.9%

DeregulatedPrices

1996–2002

+7.1%

Electricity The electric utility industry is the

latest target for deregulation.

The industry had long been regarded as a natural monopoly.

Bloated Costs, High Prices Critics complained that local utility

monopolies allowed costs to rise and had little incentive to apply new technologies.

Demise of Power Plant Monopolies There is no longer a need to rely on a

regional utility monopoly.

New high-voltage transmission lines can carry power thousands of miles with negligible power loss.

Local Distribution Monopolies Although technology destroyed the basis

for monopoly in power production, local natural monopoly in power distribution remain.

California’s Mistakes California legislation stripped local

utilities of their production capacity.

California utilities became totally dependent on third-party power producers.

California’s Mistakes A ceiling was placed on retail

electricity prices, but not on wholesale prices.

• When wholesale prices rose sharply in 2000, many California utilities declared bankruptcy because retail prices were fixed too low.

Better Strategies Other states and countries have

demonstrated how deregulation can generate much better results.

Deregulate Everything? In many industries, deregulation has

resulted in more competition, lower prices, and improved service.

Changing consumer demand, new technologies, and substitute goods had made existing regulations obsolete.

Deregulate Everything? One shouldn’t conclude that

regulatory intervention never made sense just because the regulations later became obsolete.

(De)Regulation Of Business

End of Chapter 12