(De)Regulation Of Business

1. (De)Regulation Of Business Chapter 12

2. 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.

3. 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.

4. Behavioral Focus • Antitrust laws give two options for government intervention: • The structure of an industry. • The behavior of an industry.

5. 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.

6. 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.

7. 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.

8. 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.

9. 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.

10. 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.

11. Unregulated Behavior • The natural monopolist’s profit-maximizing output also fails to minimize average total cost.

12. 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.

13. Price (dollars per unit) Quantity (units per period) Natural Monopoly Average total cost Demand Unregulated p pA ATC = p C pC Marginal cost B pB MC = p A MCA 0 qA qC qD MR

14. Regulatory Options • There are a number of regulatory options to deal with natural monopoly: • Price regulation. • Profit regulation. • Output regulation.

15. Price Regulation • The government could regulate the monopolist’s price.

16. 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.

17. 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,.

18. 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.

19. Price (dollars per unit) Quantity (units per period) Price Regulation Average total cost Demand Unregulated p pA ATC = p pD C B* pC Marginal cost B pB MC = p A MCA 0 qA qC qD qB MR

20. 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.

21. 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.

22. Output Regulation • The government can regulate the natural monopoly’s output. • Regulation of the quantity produced may induce a decline in quality.

23. Price (dollars per unit) 0 Quantity (units per period) Minimum Service Regulation Demand Unregulated p, q pA D pD Average total cost pC Marginal cost pB qA qD qC qB MR

24. 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.

25. Imperfect Answers • In some cases, government failure may be worse than market failure. • Government failure – Government intervention that fails to improve economic outcomes.

26. The Costs of Regulation • There are costs associated with regulation: • Administrative costs. • Compliance costs. • Efficiency costs.

27. 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.

28. Compliance Costs • There is a cost for regulated firms to educate themselves, change their production behavior and to file reports with the regulatory authorities.

29. Efficiency Costs • Inefficient regulation (bad decisions, incomplete information, and faulty implementation) has a cost associated with it.

30. Balancing Benefits and Costs • Regulatory intervention must balance the anticipated improvements in market outcomes against the economic cost of regulation.

31. 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.

32. 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.

33. Railroads • With the advent of buses, trucks, subways, airplanes and pipelines as alternative modes of transportation, railroad regulation became increasingly obsolete.

34. 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.

35. 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.

36. Railroads • Between 1986 and 1993, the average cost of moving freight by rail dropped by 69 percent.

37. 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..

38. 600 500 400 300 Deregulation 200 100 0 1970 71 72 73 74 75 76 77 78 79 80 81 82 Railroad Traffic: Before and After Deregulation

39. 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.

40. 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.

41. 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.

42. Local Telephone Service • New technologies permitted “wireless” companies to offer local service if they could gain access to the monopoly networks.

43. Local Telephone Service • Congress passed the Telecommunications Act of 1996 requiring the Baby Bells to grant rivals access to their transmission networks.

44. 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.

45. 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.

46. 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.

47. Airlines • The focus of the CAB was on profit regulation. • A secondary objective was to ensure air service to smaller, less-traveled communities.

48. Airlines • Short hauls entail higher average costs and, therefore, higher fares. • By fixing airfares, the CAB eliminated price competition between established carriers.

49. 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.

50. 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.