Economics of Regulation and Antitrust, 4th Edit..


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Economics of Regulation and Antitrust
Viscusi, W. Kip.; Vernon, John Mitcham; Harrington,
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Economics of Regulation and Antitrust
Second Edition
W. Kip Viscusi
John M. Vernon
Joseph E. Harrington, Jr.
The MIT Press
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Page iv
Fourth printing, 1998
First MIT Press edition 1995
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Preface to the Second Edition
The Rationale for Regulation and Antitrust Policies
Antitrust Regulation
The Changing Character of Antitrust Issues
Reasoning behind Antitrust Regulations
Economic Regulation
Development of Economic Regulation
Role of the Courts
Criteria for Assessment
Questions and Problems
Recommended Reading
The Making of a Regulation
State versus Federal Regulation: The Federalism Debate
Advantages of Federalism
Advantages of National Regulations
The Overlap of State and Federal Regulations
The Character of the Rulemaking Process
The Chronology of New Regulations
Nature of the Regulatory Oversight Process
The Nixon and Ford Administrations
The Carter Administration
The Reagan Administration
The Bush Administration
The Clinton Administration
The Criteria Applied in the Oversight Process
Regulatory Success Stories
Promotion of Cost-Effective Regulation
Distortion of Benefit and Cost Estimates
The Regulatory Role of Price and Quality
The Impact of the Oversight Process
The Cost of Regulation
Other Measures of the Size of Regulation
The Character of Regulatory Oversight Actions
What Do Regulators Maximize?
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The Capture Theory
Other Theories of Influence Patterns
Comprehensive Models of Regulatory Objectives
Questions and Problems
Industrial Organization Analysis
59
Entry Barriers
Product Differentiation
62
Enforcement and Remedies
Exemptions from Antitrust
Summary and Overview of Part I
Appendix. Antitrust Statutes
Sherman Act
Clayton Act
Federal Trade Commission Act
Efficiency and Technical Progress
Economic Efficiency
Partial Equilibrium Welfare Tools
Oil Industry Application
Some Complications
X-Inefficiency
Monopoly-Induced Waste
Estimates of the Welfare Loss from Monopoly
Technical Progress
Importance of Technological Change
An R & D Rivalry Model
Questions and Problems
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Oligopoly, Collusion, and Antitrust
Game Theory
Example 2: Compatibility of Standards
The Strategic Form of a Game
Nash Equilibrium
Oligopoly Theory
The Cournot Solution
Other Models of Oligopoly
Product Differentiation
112
A Theory of Collusion
Cartel Problems
Collusion: Railroads in the 1880s
Antitrust Law toward Price Fixing
Economic Analysis of Legal Categories
Per Se Rule Cases
Conscious Parallelism
132
Questions and Problems
135
Appendix A
Game Theory: Formal Definitions
Appendix B
The Addyston Pipe Case
The Opinion of the Court
145
Scale Economies
Entry Conditions
Dominant Firm Theory
Static Analysis
Dynamic Analysis: Limit Pricing
Limit Pricing
Investment in Cost-Reducing Capital
Raising Rivals' Costs
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Preemption and Brand Proliferation
187
Questions and Problems
190
7
Mergers
195
Antitrust Laws and Merger Trends
Reasons for Mergers
199
200
Reducing Management Inefficiencies
Other Motives
Horizontal Mergers
Benefits and Costs
207
1992 Merger Guidelines
Conglomerate Mergers
Potential Benefits
220
Questions and Problems
Vertical Mergers and Restrictions
Vertical Mergers
225
Extension of Monopoly: Fixed Proportions
Extension of Monopoly: Variable Proportions
239
Vertical Restrictions
Resale Price Maintenance
Territorial Restraints
Exclusive Dealing
260
Questions and Problems
Monopolization and Price Discrimination
The Possession of Monopoly Power
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Intent to Monopolize
271
1890-1940: Standard Oil and United States Steel
1940-1970: Alcoa and United Shoe Machinery
1970 to Present: Kodak, Cereals, IBM, and Others
Predatory Pricing: Proposed Legal Definitions
The ATC Rule
The Output Restriction Rule
Joskow-Klevorick Two-Stage Rule
Price Discrimination and the Robinson-Patman Act
Systematic Discrimination
Unsystematic Discrimination
296
298
Questions and Problems
Economic Regulations
Introduction to Economic Regulation
What Is Economic Regulation?
Instruments of Regulation
Control of Price
Control of Quantity
Control of Entry and Exit
Control of Other Variables
Brief History of Economic Regulation
Formative Stages
Trends in Regulation
The Regulatory Process
Overview of the Regulatory Process
Regulatory Legislation
Independent Regulatory Commissions
Regulatory Procedures
The Theory of Regulation
Normative Analysis as a Positive Theory
Capture Theory
Economic Theory of Regulation
Taxicab Regulation
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Summary and Overview of Part II
Questions and Problems
Theory of Natural Monopoly
The Natural Monopoly Problem
Permanent and Temporary Natural Monopoly
Subadditivity and Multiproduct Monopoly
Alternative Policy Solutions
Ideal Pricing
Franchise Bidding
Actual Solutions
370
Public Enterprise
372
Questions and Problems
Natural Monopoly Regulation
The Rate Case
Accounting Equation
Regulatory Lag
The Rate Level
Rate Base Valuation
Cost of Equity Capital
The Sliding Scale Plan
Price Caps and Performance Standards
Averch-Johnson Effect
Rate Structure
FDC Pricing
Undue Discrimination
Peak-Load Pricing
Costs of Power Production
Peak-Load Pricing Model
Regulation/Deregulation of Electric Power
Effectiveness of Price Regulation
407
Questions and Problems
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Franchise Bidding and Cable Television
Theory of Franchise Bidding
Contractual Arrangements for the Postbidding Stage
Assessment of Franchise Bidding
Cable Television
Historical/Regulatory Background
Cable Television as a Natural Monopoly
Franchising Process
Assessment of Franchise Bidding
Is Government Intervention Welfare-Improving?
448
Questions and Problems
Public Enterprise
General Background
Positive Theory of Public Enterprise
Managerial Model of a Firm
Managerial Model of a Private Enterprise
Managerial Model of a Public Enterprise
Comparison of Public and Private Enterprise
Municipal Electric Utilities
Pricing Behavior
Allocative Efficiency Comparison
Productive Efficiency Comparison
Assessment of Private versus Public Utilities
468
471
Questions and Problems
Dynamic Issues in Natural Monopoly Regulation: Telecommunications
Transformation of a Natural Monopoly
Basis for Natural Monopoly Regulation
Sources of Natural Monopoly Transformation
Regulatory Response
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Benefits and Costs of Separation
Breakup of AT&T
Telecommunications and Computers
The Future of the Telecommunications Industry: Digital Convergence
Industry Forces
Technology and Regulation
Policy Issues
513
Questions and Problems
515
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Theory of Price and Entry/Exit Regulation
Direct Effects of Price and Entry/Exit Regulation: The Imperfectly
Some Indirect Effects of Price and Entry Regulation
Some Indirect Effects of Price and Exit Regulation
Regulation and Innovation
Intertemporal Approach
Application: New York Stock Exchange
Application: Advertising of Eyeglasses
Counterfactual Approach
Application: State Usury Laws
547
Questions and Problems
Economic Regulation of Transportation: Surface Freight and Airlines
Transportation Industry
Surface Freight Transportation
Regulatory History
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Description of Regulatory Practices
Effects of Regulation
574
Regulatory History
Description of Regulatory Practices
Effects of Regulation
597
Questions and Problems
Economic Regulation of Energy: Crude Oil and Natural Gas
The Theory of Price Ceilings
Price and Quantity Regulation of the Crude Oil Industry
Regulatory History
Oil Prorationing
Regulatory Practices
Rationale for Prorationing
Solutions to the Common Pool Problem
Effects of Prorationing
Mandatory Oil Import Program
Regulatory Practices
Effects of Regulation
Crude Oil Price Controls
Regulatory Practices
Effects of Price Regulation
Price Regulation of the Natural Gas Industry
Regulatory History
Regulatory Practices
Effects of Price Regulation
648
Questions and Problems
650
Risk in Perspective
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Wealth and Risk
Irrationality and Biases in Risk Perception
Policy Evaluation
Regulatory Standards
Marginal Analysis
Discounting Deferred Effects
Present Value
Uncertainty and Conservatism
The Role of Risk Ambiguity
The Role of Political Factors
Economic Models of Environmental Policies
Voting Patterns
Summary and Overview of Part III
Questions and Problems
Recommended Reading
683
20
Policy Evaluation Principles
Willingness-to-Pay versus Other Approaches
Variations in the Value of Life
Empirical Estimates of the Value of Life
Value of Life for Regulatory Policies
Survey Approaches to Valuing Policy Effects
Valuation of Air Quality
Exploratory Nature of the Survey Approach
Sensitivity Analysis and Cost Effectiveness
Risk-Risk Analysis
Questions and Problems
708
Environmental Regulation
The Coase Theorem for Externalities
The Coase Theorem as a Bargaining Game
A Pollution Example
Long-Run Efficiency Concerns
Transactions Costs and Other Problems
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Smoking Externalities
Special Features of Environmental Contexts
Selecting the Optimal Policy: Standards versus Fines
The Role of Uncertainty
Pollution Taxes
Global Warming and Irreversible Environmental Effects
Assessing the Merits of Global-Warming Policies
How Should We React to Uncertainty?
Multiperson Decisions and Group Externalities
The Prisoner's Dilemma
The N-Person Prisoner's Dilemma
Applications of the Prisoner's Dilemma
The Enforcement and Performance of Environmental Regulation
Enforcement Options
Enforcement Trends
Environmental Outcomes and Enterprise Decisions
746
Questions and Problems
748
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Changing Emphasis of Product Regulation
Premanufacturing Screening: The Case of Pharmaceuticals
Weighing the Significance of Side Effects
Drug Approval Strategies
Trends in Motor Vehicle and Home Accident Deaths
The Decline of Accident Rates
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The Rise of Product Liability
The Negligence Standard
The Strict Liability Standard
Events Study Evidence on Liability Costs
Escalation of Damages
Risk Information and Hazard Warnings
Self-Certification of Safe Products
Alternatives to Direct Command and Control Regulation
Questions and Problems
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23
The Potential for Inefficiencies
Compensating Wage Differential Theory
Risk Information
On-the-Job Experience and Worker Quit Rates
Informational Problems and Irrationalities
802
OSHA's Regulatory Approach
The Nature of OSHA Standards
The Reform of OSHA Standards
Regulatory Reform Initiatives
Changes in OSHA Standards
OSHA's Enforcement Strategy
Inspection Policies
Trivial Violations
OSHA Penalties
OSHA Regulations in Different Situations
OSHA and Other Factors Affecting Injuries
Agenda for Policy Reform Efforts
Questions and Problems
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Patents and Pharmaceuticals
Economics of Invention and Patents
Background on Patents
Welfare Analysis of Patents
Pharmaceuticals and the Role of Patents
Industry Structure
Other Policies That Affect R&D Incentives
863
Questions and Problems
Name Index
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PREFACE TO THE SECOND EDITION
One of the most exciting areas of economic policy is government regulation and antitrust. These efforts affect
virtually all aspects of our lives, ranging from the food we eat to the prices we pay. This policy area has undergone
dramatic changes in the past two decades. The traditional topics in this area would have included issues such as
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Because this has been a fertile area of economic research for several decades, a large body of economic reasoning
can be brought to bear in analyzing these issues.
Economics of Regulation and Antitrust
is the only economics
textbook whose focus derives from the insights that economic reasoning can provide in analyzing regulatory and
antitrust issues. This approach contrasts with previous treatments, which concentrate on the character of these
policies and relegate the economic issues to a minor role.
This approach, which we established in the first edition, has been carried forward in this edition as well. New
topics, such as the regulation of environmental tobacco smoke, have been added. Other topics, such as
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The minimum economics background needed for this book is an introductory price theory course. This background
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introductory chapter, are noted below. Otherwise, chapters within a part can be assigned in whatever order the
instructor wishes. Any chapters that the instructor wishes to omit may be excluded.
Part I, which focuses on antitrust policy, includes a healthy dose of the analytical tools of modern industrial
organization. Chapter 3 is an introductory overview of antitrust policy and of the other chapters in Part I.
Efficiency and technical progress are explained in Chapter 4 as tools for evaluating policies. At least the first half
of this chapter is probably necessary reading for understanding Chapters 5-9.
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Table A
Suggested Course Outlines
Part I
Part II
Part III
Course Focus
Balanced one-quarter course
Economic regulation
Industrial organization
course is the balanced one-quarter course. Such a course would include the introductory material in Chapters 1 and 2 as
general background; Chapters 3-5, 7, and 9 from Part I; Chapters 10 and 12 from Part II; and Chapters 19, 20, and 22 from
Part III.
The second course approach is a conventional antitrust course. It would place the greatest reliance on Part I of the book,
which includes Chapters 3-9. Instructors who wish to provide a broader perspective on some of the other topics in
regulation might augment these chapters with the indicated chapters for the one-quarter course.
A course focusing on economic regulation would include primarily the introductory section and Part II of the book, or
Chapters 1-2, 4, 10-18, 22, and 24. Similarly, a course focusing on social regulation would include the introductory section
and Part III of the book, or Chapters 1-2, 4, and 19-24. In situations in which we have taught such narrowly defined
courses, we have often found it useful to include the material from the balanced one-quarter course as well, to give the
student a broader perspective on the most salient economic issues in other areas of government intervention.
Given the frontier treatment of industrial organization in Part I, this book could also be used in a policy-oriented course on
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courses, the objective is to focus on the empirical aspects of government regulation and antitrust policies, as well as
the character of these policies. Moreover, these courses would require no advanced undergraduate economic
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The government acts in many ways. The most familiar role of the government is the subject of public finance
courses. The government raises money in taxes and then spends this money through various expenditure efforts. In
addition, the government also regulates the behavior of firms and individuals. Our legal system is perhaps the most
comprehensive example of the mechanism by which this regulation takes place.
This book will be concerned with government regulation of the behavior of both firms and individuals within the
context of issues classified as regulation and antitrust. Regulation of firms involves much more than attempting to
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Heading to work, our regulated individual climbs into a Japanese car that was successful in not violating any
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ber of sellers of a product, and consumers would be fully informed of the product's implications. Moreover, there
would be no externalities present in this idealized economy, as all effects would be internalized by the buyers and
sellers of a particular product.
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Antitrust Regulation
The first of the three parts of the book deals with antitrust policy. Beginning with the postCivil War era, there has
been substantial concern with antitrust issues. This attention was stimulated by a belief that consumers were
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Reasoning behind Antitrust Regulations
The major concerns with monopoly and similar kinds of concentration are not that being big is necessarily
undesirable. However, because of the control over the price exerted by a monopoly there are economic efficiency
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they will not charge excessive prices. We do not wish to incur all of the efficiency and equity problems that arise
as a result of a monopoly. Prominent examples include public utilities. It does not make sense to have a large
number of small firms providing households with electricity, providing public transportation systems, or laying
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in technological improvements. We want the electric power company to innovate so that they will be able to
provide cheaper power in the future. However, if we capture all the gains from innovation and give them to the
consumers through lower prices, then the firm has no incentive to undertake the innovation. We cannot rely on
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regulation, one must assess not only how the regulatory agencies function but what doctrines govern the behavior
of the courts. These matters will also be addressed in Part 3.
Criteria for Assessment
Ideally, the purpose of antitrust and regulation policies is to foster improvements judged in efficiency terms. We
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economic foundations and mechanisms by which this private interest becomes manifest.
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National Labor Relations Board
National Regulatory Commission
Office of Information and Regulatory Affairs
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THE MAKING OF A REGULATION
A stylized account of the evolution of regulation and antitrust policies is this: A single national regulatory agency
establishes the government policy in an effort to maximize the national interest, where the legislative mandate of
the agency defines its specific responsibilities in fostering these interests. The reality of regulatory policymaking
differs quite starkly from this stylized view. The process is imperfect in that some observers claim that
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states regulate insurance rates quite stringently, whereas in other states these insurance rates have been deregulated.
The terms under which there are payouts under insurance schemes also vary with locale, as some states have
adopted no-fault rules in accident contexts. States also differ in terms of the factors that they will permit insurance
Federal regulations should not preempt State laws or regulations, except to guarantee rights of national
citizenship or to avoid significant burdens on interstate commerce.
A number of sound economic rationales underlie this principle of federalism. First, local conditions may affect
both the costs and benefits associated with the regulation. Preferences vary locally, as do regional economic
conditions. Areas where mass transit is well established can impose greater restrictions on automobiles than can
states where there are not such transportation alternatives.
The second potential advantage to decentralized regulation is that citizens wishing a different mix of public goods
can choose to relocate. Those who like to gamble can, for example, reside in states where gambling is permitted,
such as Nevada or New Jersey. The entire theory of local public goods is built around similar notions whereby
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through the use of state regulation permits such choices to be made, whereas if all regulatory policies and public
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The efficiency rationale for federal regulation is often more general, as in the case of antitrust policies. If the
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standard for its water pollution discharges. Many states have assumed authority for the enforcement of these
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mulgated by these agencies must be consistent with their legislative mandate, or they run the risk of being
improvements in the regulation, and in a few rare instances OMB rejects the regulation as being undesirable. At
that point, the agency has the choice either to revise the regulation or to withdraw it.
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even further by judicial deadlines or deadlines specified in legislation, which require the agency to issue a
regulation by a particular date. In recent years regulatory agencies have begun to use these deadlines strategically,
submitting the regulatory proposal and the accompanying analysis shortly before the deadline so that OMB will
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and environmental regulatory agencies in the 1970s, it became apparent that some oversight mechanism was
new regulations.
This review process was formalized under the Ford administration through Executive Order No. 11821. Under this
order, regulatory agencies were required to prepare inflationary impact statements for all major rules. These
statements required that agencies assess the cost and price effects that their new regulations would have. Moreover,
President Ford established a new agency within the White House, the Council on Wage and Price Stability, to
administer this effort.
Although no formal economic tests were imposed, the requirement that agencies calculate the overall costs of their
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The review process itself was not binding in any way. The Council on Wage and Price Stability examined the
inflationary-impact analyses prepared by the regulatory agencies to ensure that the requirements of the Executive
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costs of regulatory impacts was a common focus of Carter's regulatory oversight program, but no formal
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officials present a relatively cogent case concerning the lack of merit of a particular regulation, there are political
factors and economic consequences other than simply calculations of benefits and costs that will drive a policy
As a postscript, it is noteworthy that the Reagan administration undertook a review of this cotton dust standard
shortly after taking office. Although Reagan administration economists were willing to pursue the possibility of
overturning the regulation, at this juncture the same industry leaders who had originally opposed the regulation
now embraced it, having already complied with the regulation, and they hoped to force the other, less
technologically advanced firms in the industry to incur these compliance costs as well. The shifting stance by the
Sec. 2. General Requirements. In promulgating new regulations, reviewing existing regulations, and
developing legislative proposals concerning regulation, all agencies, to the extent permitted by law, shall
adhere to the following requirements:
a. Administrative decisions shall be based on adequate information concerning the need for and
consequences of proposed government action;
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If, however, the benefit-cost test conflicts with the agency's legislative mandateas it does for all risk and
environmental regulationsthe test is not binding.
The third major change in the Executive Branch oversight process was the development of a formal regulatory
planning process whereby the regulatory agencies would have to clear a regulatory agenda with the Office of
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instituted in the 1980s. Lead emissions declined dramatically in the 1980s, and the reduction in lead pollution
represents the greatest environmental success story of that decade.
Promotion of Cost-Effective Regulation
One general way in which the government promotes the most cost-effective regulation is through the
encouragement of performance-oriented regulation. Our objective is to promote outcomes that are in the interests
of the individuals affected by regulations rather than simply to mandate technological improvements irrespective of
their impact. This concern with ends rather than means leads to the promotion of the use of performance-oriented
regulations whenever possible.
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versial, but in fact it represents an ongoing problem with respect to risk regulations.
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involve little more than stealth policymaking that is masquerading as a scientific exercise.
The Regulatory Role of Price and Quality
A general principle that has guided the development of regulation and in particular the deregulation effort is that
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Federal regulations impose estimated direct costs on the economy as high as $175 billionmore than $1,700
for every taxpayer in the United States. These costs are in effect indirect "taxes" on the American
publictaxes that should only be levied when the benefits clearly exceed the costs.
Roughly half of these costs are attributable to EPA regulations, as earlier estimates of the costs imposed by EPA
policies indicated that these regulatory costs alone were in the range of $70-$80 billion per year.
In the absence of regulatory reform efforts, these costs would be substantially higher. The Council of Economic
Advisors estimates that airline deregulation led to $15 billion worth of gains to airline travelers and airline
Similarly, estimates suggest that savings resulting from trucking deregulation have been in excess of
$30 billion annually.
The annual benefits from railroad deregulation have also been substantialon the order of
$15 billion annually.
The total savings from these deregulation efforts in the transportation field are on the order
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Table 2.1
Annual Cost of Federal Regulation (Billions of 1991 Dollars)
Environmental regulation
Other social regulation
Economics regulationsefficiency
Process regulation
Subtotal of costs
Economic regulationstransfers
Total costs
Source:
Thomas D. Hopkins, ''Costs of Regulation: Filling the Gaps.'' Report prepared for
Regulatory Information Service Center, August 1992.
workers. From an economic standpoint this is not an efficiency loss, but simply an effort that passes money around
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ities has long been widespread. Moreover, unlike the regulatory efforts themselves, paperwork often lacks the
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1936-1991
number of pages in the
Code of Federal Regulations
was just over 50,000, which has been consistent with the
assessment of the nature of the oversight activity that has led to many of these changes. Table 2.2 summarizes the
oversight actions undertaken in the 1980s. When the oversight process began, OMB approved almost 90 percent of
regulations without change. At the present time, the overall approval rate is just under 75 percent as most
regulations proposed by regulatory agencies are consistent with OMB's guideline without any modification.
The second largest category consists of regulations that are consistent with the guidelines after specific changes in
the regulation have been made. Some of these changes have been quite consequential. For example, at OMB's
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Table 2.2
Types of Actions Taken by the OMB Regulatory Oversight Process on Agency Rules 1981-1991
Percentage in
Action taken
Consistent without change
Consistent with change
Withdrawn by agency
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Such incremental modifications in regulation are where we would expect the regulatory oversight process to have
its greatest influence because major conflicts, such as those over the entire thrust of a regulatory policy, would be
escalated to higher political levels. If all regulatory policy decisions were escalated in this manner, the president
would have little opportunity to devote time to other national problems. In any year, there are hundreds of major
regulations and an even greater number of minor regulations that agencies will issue. In 1989, for example, OMB
reviewed 179 major regulations from the U.S. Department of Labor and 104 major regulations from the U.S.
Environmental Protection Agency.
Given the substantial volume of regulatory activity, the only feasible way to
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ests that it serves.
Stigler has been most successful in testing this model with respect to the economic regulation
agencies, such as the Interstate Commerce Commission. Examples of how government regulation can foster
industry interests abound. Regulation of airline fares can, for example, provide a floor on airline rates that enables
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Congress and the judiciary play a restraining role, and lobbyists for and against the regulation can affect the
political payoffs to the regulatory agency as well. The actual strength of the influences undoubtedly varies
depending on the particular context.
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strength of the analysis does affect the policy outcome. It should be noted, however, that the particular price and
cost effects of the regulation did not appear to be as influential as the overall quality of the economic analysis.
Other players have an impact as well. The economic resources of the trade association for the particular industry
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Table A.1
Costs of Federal Regulatory Agencies
(Fiscal Years, Millions of Dollars in ''Obligations'')
% Change
1994-95
Animal and Plant Health Inspection Service
-3.5%
Federal Grain Inspection Service
Packers and Stockyards Admin.
Department of Health and Human Services:
Food and Drug Administration
Department of Housing and Urban Development:
Consumer Protection Programs
Department of Justice:
Drug Enforcement Admin.
-2.8%
Department of Transportation:
Coast Guard
Federal Aviation Administration
-0.7%
Federal Highway Administration
Federal Railroad Administration
-25.3%
-6.7%
table continued on next page
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Table A.1
continued from previous page
1994-95
Department of the Treasury:
Bureau of Alcohol, Tobacco and Firearms
Employment Standards Admin.
Office of the American Workplace
Pension and Welfare Benefits Administration
Architectural and Transportation Barriers Compliance
Equal Employment Opportunity Comm.
National Labor Relations Board
table continued on next page
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Table A.1
continued from previous page
Council on Environmental Quality
Department of Defense:
Army Corps of Engineers
Department of Interior:
Fish and Wildlife Service
Office of Surface Mining Reclamation and
35.8%
-6.2%
Environmental Protection Agency
Department of Energy:
Economic Regulatory Admin.
15.4%
Federal Inspector for the Alaska Natural Gas
-7.1%
Nuclear Regulatory Commission
-9.9%
-9.8%
Total Social Regulation
table continued on next page
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Table A.1
continued from previous page
1994-95
Economic Regulation
Finance and Banking
Department of the Treasury:
Comptroller of the Currency
Farm Credit Administration
Federal Deposit Insurance Corporation
-16.5%
Federal Reserve System:
Federal Reserve Banks
Federal Reserve System Board of
National Credit Union Administration
TotalFinance and Banking
-4.1%
Industry-Specific Regulation
Civil Aeronautics Board
Commodity Futures Trading Comm.
Federal Communications Commission
Federal Energy Regulatory Comm.
-4.0%
Federal Maritime Commission
Interstate Commerce Commission
Renegotiation Board
Total-Industry-Specific Regulation
-0.4%
table continued on next page
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Table A.1
continued from previous page
% Change
1994-95
Economic Regulation
General Business
Cost Accounting Standards Board
Council on Wage and Price Stability
Department of Commerce:
International Trade Administration
-9.1%
Export Administration
Patent and Trademark Office
Department of Justice:
Antitrust Division
Federal Election Commission
Federal Trade Commission
International Trade Commission
Library of Congress:
Copyright Office
Securities and Exchange
TotalGeneral Business
Total Economic Regulation
GRAND TOTAL
Notes: * = less than $500,000
- = agency not operational
n/a = not available
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Table A.2
Costs of Federal Regulatory Agencies
(Fiscal Years, Millions of Constant Dollars in "Obligations," 1987 = 100)
% Change
1994-95
Animal and Plant Health Inspection Service
-6.0%
Federal Grain Inspection Service
-77
-2.7%
Packers and Stockyards Admin.
-2.7%
Packers and Stockyards Admin.
-2.2%
Department of Health and Human Services:
Food and Drug Administration
Department of Housing and Urban
Consumer Protection Programs
Department of Justice:
Drug Enforcement Admin.
-5.3%
Department of Transportation:
Coast Guard
Federal Aviation Administration
-3.3%
Federal Highway Administration
Federal Railroad Administration
-22.3%
-8.8%
table continued on next page
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Table A.2
continued from previous page
Department of the Treasury:
Bureau of Alcohol, Tobacco and Firearms
-1.2%
-2.7%
-2.7%
-0.4%
Employment Standards Admin.
Office of the American Workplace
Pension and Welfare Benefits Administration
Architectural and Transportation Barriers Compliance
-2.7%
Equal Employment Opportunity Comm.
National Labor Relations Board
-0.4%
table continued on next page
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Table A.2
continued from previous page
1994-95
Council on Environmental Quality
Department of Defense:
Army Corps of Engineers
Department of Interior:
Fish and Wildlife Service
Office of Surface Mining Reclamation and
-28.4%
-8.3%
Environmental Protection Agency
Department of Energy:
Economic Regulatory Admin.
-15.6%
-2.7%
Federal Inspector for the Alaska Natural Gas Pipeline
-9.2%
Nuclear Regulatory Commission
-11.5%
-11.4%
Total Social Regulation
table continued on next page
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Table A.2
continued from previous page
% Change
1994-95
Economic Regulation
Finance and Banking
Department of the Treasury:
Comptroller of the Currency
Farm Credit Administration
-0.3%
Federal Deposit Insurance Corporation
-16.4%
Federal Reserve System:
Federal Reserve Banks
-2.7%
Federal Reserve System Board of Govs.
-2.7%
-2.7%
National Credit Union Administration
TotalFinance and Banking
-6.5%
Industry-Specific Regulation
Civil Aeronautics Board
Commodity Futures Trading Comm.
Federal Communications Commission
-2.1%
Federal Energy Regulatory Comm.
-6.4%
Federal Maritime Commission
-2.7%
Interstate Commerce Commission
-2.7%
Renegotiation Board
TotalIndustry-Specific Regulation
-3.1%
table continued on next page
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Table A.2
continued from previous page
% Change
1994-95
Economic Regulations
General Business
Cost Accounting Standards Board
Council on Wage and Price Stability
Department of Commerce:
International Trade Administration
-10.8%
Export Administration
Patent and Trademark Office
Department of Justice:
Antitrust Division
Federal Election Commission
Federal Trade Commission
-0.6%
International Trade Commission
-2.7%
Library of Congress:
Copyright Office
Securities and Exchange Commission
TotalGeneral Business
Total Economic Regulation
-1.8%
GRAND TOTAL
Notes:
less than $500,000
- = agency not operational
n/a = not available
Numbers may not add to totals due to rounding.
Source:
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Introduction to Antitrust
In this section we will be concerned with the unregulated sector of the economy. That is, we will consider
industries that are not subject to governmental controls on product standards, prices, profits, or entry and exit.
have for their purpose the understanding of the structure and behavior of the industries (goods and services
producers) of an economy. These courses deal with the size structure of firms (one or many, ''concentrated''
or not), the causes (above all the economies of scale) of this size structure, the effects of concentration on
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Economists at Harvard University in the 1930s and 1940s are usually credited with starting the field of industrial
Structure-Conduct-Performance
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61 percent
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ance should facilitate full employment of labor and other resources. It can also be argued that the operations of
industries should produce an equitable distribution of income.
While these additional elements of performance are important, they are heavily influenced by various
macroeconomic policies, such as tax policy, and only marginally by antitrust. Hence in this book we shall focus on
efficiency and technical progress.
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In summary, this schematic structure-conduct-performance model provides an overview of the book. We need to
understand both the economics of how industries behave and the impact of government policies. And it is
important to be able to evaluate economic performance under alternative policy variations. We now examine the
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The second statute passed in 1914 was the Federal Trade Commission (FTC) Act. The objective of this legislation
was to create a special agency that could perform both investigatory and adjudicative functions. Prior to this time,
the Antitrust Division of the Justice Department was the sole enforcement agency in antitrust matters. The FTC Act
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Table 3.1
Antitrust Cases Filed in U.S. District Courts, 1970-1989
U.S. Cases
Private as
% of Total
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
defendants to pay damages in order to avoid a trial. The damages are usually less than those claimed by the
plaintiff, but the uncertainty of the outcome of a trial can make it in both parties' interests to agree on some
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Another remedy is an injunction. An injunction is a court order to prohibit an antitrust violator from some specified
future conduct. For example, a firm may be prohibited from only leasing (and not also selling) its copying
machines, or only selling film and development services as a package.
Fines or prison sentences may be used in criminal cases brought under the Sherman Act. These are usually
reserved for price-fixing cases, such as occurred in the famous electrical equipment industry in the early 1960s. In
that case, the judge sent seven defendants to jail for thirty days and fined the firms several million dollars.
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Exemptions from Antitrust
Congress has granted certain industries and business activities exemptions from antitrust. These include labor
unions, export cartels, agricultural cooperatives, regulated industries, and some joint research and development
Labor unions were exempted from antitrust in the Clayton Act itself. The reasoning for the exemption was to
permit labor to match the bargaining power of employers. There are some limits to the exemption, however.
The Webb-Pomerene Act of 1918 exempted export associations. Hence, firms can combine in an association to fix
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For an economist interested in the evaluation of antitrust policy, the performance block of Figure 3.1 is especially
important. Hence the entire next chapter is devoted to explaining the two performance dimensions: economic
efficiency and technical progress.
Chapter 5 begins the study of antitrust policy with analysis of oligopoly theory and collusive pricing. As is true
with other antitrust chapters, the relevant antitrust decisions will be described. The following chapter focuses on the
structure block of Figure 3.1: concentration and entry barriers. It provides a useful background for examining
antitrust policy toward mergers in Chapter 7.
Chapter 8 on vertical relationships and Chapter 9 on monopolization conclude the antitrust section of the book.
These two final chapters can be differentiated from earlier chapters inasmuch as they focus on possible
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one-tenth of the involved sales. These figures are from Richard A. Posner,
Antitrust Law
(Chicago: University
of Chicago Press, 1976).
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c. It shall be unlawful for any person engaged in commerce, in the course of such commerce, to pay or grant, or to
receive or accept, anything of value as a commission, brokerage, or other compensation, or any allowance or
discount in lieu thereof, except for services rendered in connection with the sale or purchase of goods, wares, or
merchandise, either to the other party to such transaction or to an agent, representative, or other intermediary
therein where such intermediary is acting in fact for or in behalf, or is subject to the direct or indirect control, of
any party to such transaction other than the person by whom such compensation is so granted or paid.
d. It shall be unlawful for any person engaged in commerce to pay or contract for the payment of anything of value
to or for the benefit of a customer of such person in the course of such commerce as compensation or in
consideration for any services or facilities furnished by or through such customer in connection with the
processing, handling, sale, or offering for sale of any products or commodities manufactured, sold, or offered for
sale by such person, unless such payment or consideration is available on proportionally equal terms to all
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Efficiency and Technical Progress
As indicated in the preceding chapter,
economic performance
is the term used to measure how well industries
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distributionleaving those problems to the field of public finance (which studies taxation and transfer payments).
Hence we now
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Demand





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), the area
AP*D
in Figure 4.1 is the consumer surplus. Producer surplus, defined in an analogous manner,
is equal to the profit of the firms in the industry. Because firms receive revenues of price
times output
is, area 0
Q*DP*)
and they incur costs equal to the area under the marginal cost curve, 0
Q*DC,
they earn a
producer surplus of the difference,
Notice that maximizing total surplus is equivalent to maximizing the sum of consumer and producer surplus. We
next show that maximizing total surplus is equivalent to selecting the output level at which price equals marginal
cost. In Figure 4.1, assume that output
Q'
is being produced and sold at price
Q'F.
Clearly, at the output
marginal willingness-to-pay
Q'F
exceeds the marginal cost
Q'H.
Hence a small increase in output of
increase surplus by the area of the slender shaded region (approximately
FH
width). Output increases
would continue to increase surplus up to output
*. Hence, maximizing surplus implies that output should be
increased from
Q'
to
adding an increment to total surplus of area
FHD.
Of course, by an analogous argument,
we can show that output increases beyond
* would reduce surplus since marginal cost exceeds marginal
willingness-to-pay. In short, equating price and marginal cost at output Q* maximizes total surplus.
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Monopoly


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To reinforce the points made above, we can use specific numerical demand and cost functions. In particular,


demand
marginal and average cost
The monopoly price is therefore
= $60,



m
B





m
P
c
CB





c
D





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absence of the controls. This resulted in efficiency losses, according to Arrow and Kalt, of approximately $2.5
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the single firm could be replaced with a large number of firms with no effect on costs.
To take an extreme case, consider Figure 4.3. Economies of scale are such that the long-run average cost curve
LRAC
. As Figure 4.3 shows, the average cost of output
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Figure 4.3, the policy problem becomes one of regulating the natural monopolist. The approach usually followed in
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Equilibrium



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X-Inefficiency
Other types of inefficiency may be important in monopoly. First, we consider X-inefficiency, so named by
Leibenstein in his well-known 1956 article on the subject.
Thus far, we have assumed that both monopolists and
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the demand elasticity by assuming that firms maximize profit. The first step in their analysis is to note that a firm's
profit-maximizing price
P*
satisfies the following relationship:
where
Substituting (P* -
P*
for
in Equation (4.3), it follows that
where
* is firm profits. Because
* = (
, where
AC
is average cost, the last equality in (4.4) uses the
assumption that marginal cost is constant so that
MC = AC.
Cowling and Mueller showed that the deadweight
welfare loss created by a firm is approximately equal to half of its profits.
*. Their estimate of
DWL
was around 4 percent of GNP, considerably higher than that found by Harberger. If one includes advertising
expenditures as wasted resources associated with rent-seeking behavior, their measure jumps to 13 percent of GNP.
Of course, inclusion of all advertising expenditures assumes that all advertising lacks any social value. This is
clearly false, because some advertising reduces search costs for consumers. Thus one would expect Cowling and
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It is clearly important to understand the quantitative size of the welfare loss from price exceeding marginal cost,
for any given
Thus the shift represents
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conceived as consisting of two parts: the movement from
to
(the effect of technological change) and the
movement along the production function from
to C (the effect of increased capital per worker-hour). As stated
earlier, Solow found that the amount of the total increase in Q due to technological change (the movement from
to
was greater than that due to increased capital per worker-hour (the movement from
to C).
of private resources allocated will depend upon profitability considerations, which, in turn,
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will depend on such things as the expected demand for the product and the technical feasibility of the project. And,
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Another plan is to spend $1 million per year for 5 yearswith a present value of $3.8 million. This is a second point
CC'.
Clearly the implication is that it costs more to shorten the time to innovation. There are several reasons for
this: Costly errors can be made when development steps are taken concurrently instead of waiting for the
information early experiments supply. Second, parallel experimental approaches may be necessary to hedge against
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revenues by the firm can lead to a situation in which the innovation is simply unprofitable-with a zero rate of
innovation. Such a case is shown by the function
, which corresponds to five rivals. Presumably five rivals is
"too many" and would result in too much imitation for R & D to be undertaken at all.
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A more fundamental issue is that it may be naive to conceive of the public policy issue as one of choosing the
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Questions and Problems
c. The social cost of monopoly can be disaggregated into two distinct types of cost. What are these two types of
costs, and what are their respective magnitudes?
3. Discuss the concept of "equity cost" used in the oil industry study by Arrow and Kalt. Do you think it is
generally true that "consumers" have lower incomes than "producers"? Does it matter to your answer that labor
unions and senior citizens have large ownership interests in corporations through pension funds?
4. A (mini-) refrigerator monopolist, because of strong scale economies, would charge a price of $120 and sell
forty-five refrigerators in Iceland. Its average cost would be $60. On the other hand, the Iceland Planning
a. Consumer surplus under the five-firm industry organization would be larger than under monopoly. If the
demand curve is linear, by how much is consumer surplus larger?
b. Producer surplus under monopoly is larger-by how much?
c. If the Planning Commission thinks that total economic surplus is the correct criterion, which organization of
the refrigerator industry will they choose?
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1. See R. G. Lipsey and K. Lancaster, "The General Theory of Second Best,"
Review of Economic Studies,
for an analysis.
surpluses. For example, the person with marginal willingness-to-pay of
Q'F
has to pay P* and has a surplus of
FG.
P.
4. K. J. Arrow and J.
P. Kalt, "Decontrolling Oil Prices,"
Regulation,
September/October 1979.
5. Actually, Arrow and Kalt noted that the $2.5 billion efficiency gain from decontrol should be reduced to $1.9
billion to reflect the fact that the efficiency gains would accrue primarily to producers. Thus the final comparison
was a $1.9 billion gain and a $1.4 billion loss in favor of decontrol.
6. E. H. Chamberlin,
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15. R. M. Solow, "Technical Change and the Aggregate Production Function,"
Review of Economics and Statistics,
August 1957.
16. E. F. Denison,
Trends in American Economic Growth,
1929-1982 (Washington, D.C.: Brookings Institution,
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Oligopoly, Collusion, and Antitrust
Section 1 of the Sherman Act prohibits contracts, combinations, and conspiracies that restrain trade. Although this
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The


advertising at a low rate, which is $100, we derive profit of $400. If instead firm 1 advertises at a low rate and firm
2 advertises at a high rate, then firm l's profit is 150 [= (10)(100)(0.25) 100] and firm 2's profit is 550 [=
(10)(100)(0.75) - 200]. Finally, if both firms advertise at a high rate, then each receives profits of 300 [= (10)
(100)(0.5) - 200].
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firm 2 will advertise at a high rate, then it earns $150 from low advertising but $300 from high advertising.
Therefore, profit-maximizing behavior by firm 1 is to advertise intensively regardless of how much it believes firm
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The


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That is, given the strategies chosen by all players, a player's payoff function tells him his state of well-being (or
welfare or utility) from players having played those strategies.
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tical products. The distinguishing features of the Cournot model are that firms choose quantity (rather than price)
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These profits clearly demonstrate the interdependence that characterizes oligopoly. The profit of firm 1 depends not
only on its own output but also on the output of firm 2 (and, similarly,
depends on
and
). In particular, the
higher
is, the lower is
l
(holding
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when
is raised from 10 to 30, firm 1's demand and marginal revenue curves shift in. This reflects the fact that
for any value of
, a higher value of
results in firm 1 receiving a lower price for its product. Because its
demand is weaker, firm 1 produces less in response to firm 2's producing more. Hence, firm 1's best reply function
is downward sloping; that is, firm 1 produces less, the more firm 2 is anticipated to supply.
A Nash equilibrium is defined by a pair of quantities such that each firm's quantity maximizes its profit given the
other firm's quantity. The appeal of such a solution is that no firm has an incentive to change its output given what
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example, at
= 30 and
= 15, firm 2 is maximizing its profits (it is on its best reply function) but firm 1 is not.
Given
= 15, firm l's profit-maximizing output is 22.5 (see Figure 5.3).
To summarize, the Nash equilibrium of the Cournot game (which we also refer to as the Cournot solution) is
= 400
= 400
= 60
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The Cournot price is less than the monopoly price because each firm cares only about its own profits and not
industry profits. When firm 1 considers increasing its output, it takes into account how this output increase affects
but ignores how it affects
. As a result, in maximizing one's own profit, each firm produces too much from
the perspective of maximizing industry profit. Hence the monopoly price (which is also the joint-profit-maximizing
price under constant marginal cost) exceeds the Cournot price.
Though each firm is maximizing its own profit at the Cournot solution, both firms could simultaneously raise their
profits by jointly reducing their output from 20 toward the joint-profit-maximizing output of 15. The problem is
that neither firm has an incentive to do so. Suppose that firms were to communicate prior to choosing their output
and agreed to each produce 15. If firm 1 actually believed that firm 2 would go along with the agreement and
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never produce 15 anyway. Note the similarity with the problem faced by firms in the advertising game of Example
Recall that the elasticity of demand measures how responsive demand is to a change in price. According to this
formula, as the number of firms increases, the right-hand side expression in (5.9) becomes smaller which implies
that the price-cost margin shrinks. The reader is referred to Table 16.1 for a numerical example that establishes that
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Using the example from the preceding section, the Stackelberg leader chooses its quantity to maximize:
    -    q1    -    (30    -    0.5q1)]q1    -    40q1(5.10)This expression is firm 1's profit where we have substituted firm 2's best reply function, 30- 0.5
, for its quantity,
. This substitution reflects the fact that firm 1 influences firm 2's quantity choice. Solving for the value of
maximizes (5.10), one finds that the leader produces 30 units and the follower responds with a quantity of 15 (= 30
- 0.5 30). Compared to the Cournot solution, firm 1 produces more and firm 2 produces less and thus the leader
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in response to firm 2 charging a higher price as some of firm 2's consumers decide to buy from firm 1. Generally,
the stronger is a firm's demand, the higher is its profit-maximizing price. It follows that the higher firm 2's price
becomes, the higher is the price that maximizes firm 1's profit so that its best reply function is upward sloping.
As with the Cournot game, Nash equilibrium occurs where the best reply functions intersect so that each firm is
choosing a price that maximizes its profit, given the other firm's price. Equilibrium then has firm 1 pricing at
firm 2 pricing at
For our example, the Nash equilibrium entails each firm pricing at 80. To convince yourself
that this is true, if you plug 80 for
in (5.15), one finds that the resulting price for firm 1 is 80 and if you plug 80
for
in (5.16), one finds that the resulting price for firm 2 is 80. Given one's rival prices at 80, it maximizes a
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A Theory of Collusion
The inadequacy of the Cournot solution lies in the limitations of the Cournot model. A critical specification is that
firms make output decisions only once. In reality, firms live for many periods and are continually making output
decisions. To correct for this weakness in the Cournot model, consider an infinitely repeated version of that model.
In each period, firms make simultaneous quantity decisions and expect to make quantity decisions for the
indefinite future. For simplicity, assume that the demand curve and cost functions do not change over time.
and
denote the period
quantity of firm 1 and firm 2, respectively, where
1,2,3, . . . . We first want to
show that one Nash equilibrium for this game has each firm produce the Cournot output in every period:
and
t
= 1,2,3, . . . . Recall that this has each firm's per period profit as 400. A firm's payoff, which is just
the sum of its discounted profits, is then
, profits will be lower in those periods (as 20 units maximizes current profit) while profits
in periods in which the firm continues to produce 20 remain the same. Hence the sum of discounted profits must be
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This strategy says that firm 1 should produce 15 in period 1. Recall that 30 is the monopoly quantity so that each
firm producing 15 maximizes joint profit. In any future period, it should produce 15 if and only if both firms
produced 15 in all periods prior to the current one. Alternatively, if one or more firms deviated from producing 15
in some past period, then firm 1 should produce 20 (the Cournot output) in all remaining periods. This strategy is
called a "trigger strategy" because a slight deviation from the collusive output of 15 triggers a breakdown in
collusion. The strategy for firm 2 is similarly defined:
If both firms use these strategies, then each will produce 15 in period 1. Because each produced 15 in period 1 then,
as prescribed by these strategies, each firm will produce 15 in period 2. By the same argument, the two firms will
produce 15 in every period if they use these strategies. Hence the monopoly price is observed in all periods. If we
can show that these strategies from a Nash equilibrium (that is, no firm has an incentive to act differently from its
strategy), we will have derived a theory which can explain how profit-maximizing firms can sustain collusion.
Given that firm 2 uses the strategy in (5.19), firm 1 receives profit of 450 in each period from using (5.18) so that
its payoff is 450/
. Now consider firm 1 choosing a different strategy. Any meaningfully different
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strategy must entail producing a quantity different from 15 in some period. There is no loss of generality from
supposing that this occurs in the first period. If
, then firm 2 learns after period 1 that firm 1 deviated from
the collusive output. According to firm 2's strategy, it will respond by producing 20 in all future periods. Because
firm 1 is aware of how firm 2 will respond, firm 1 will plan to produce 20 in all future periods after deviating from
15 in the current period, as doing anything else would lower firm 1's payoff from period 2 onward. It follows that if
15, then firm 1's payoff is
The first term is period 1 discounted profits, while the second term is the sum of discounted future profits. Given
that firm 1 deviates output from the collusive level of 15 in the first period, (5.20) shows that the amount by which
differs from 15 affects current profits but not future profits. This is because the punishment for cheating is
, as that output
maximizes current profits (reading off of firm 1's best reply function in Figure 5.3 when
15). Substituting 22.5
for
in (5.20), one then derives the highest payoff that firm 1 can earn from choosing a strategy different from
Figure 5.6 shows the time path of profit from going along with the collusive agreementearn 450 every periodand
cheating on the cartel earn 506.25 in period 1 and 400 every period afterward. Thus, cheating gives higher profits
Working through the algebra, (5.22) holds if and only if
0.89. In other words, if firm 1 sufficiently values future
profits (in other words,
is sufficiently small), it prefers to produce 15 each period rather than cheat and produce
above 15. By the same argument one can show that firm 2's strategy in (5.19) maximizes the sum of its discounted
profits if
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and only if
0.89. We conclude that (5.18) and (5.19) are a Nash equilibrium when the discount rate is
sufficiently low.
In contrast to the one-period game, we have shown that firms are able to produce at the joint-profit maximum
without either firm having an incentive to cheat. What is critical for this result is that a firm's output decision
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firms increases, each firm must have a lower discount rate in order for cheating to be unprofitable at the joint-
profit maximum. Intuitively, as the number of firms increases, two things happen. First, each firm has a smaller
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announcements of fare changes (for example, in the
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Preferred






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cartels involving a large number of firms. When collusion took place in the folding-box industry, no company had
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discount in the transformer order."
The problem arose when Smith decided to split the circuit-breaker order
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1880-1886
to find periods in which firms are colluding, so that price is high, and periods in which collusion breaks down and
firms revert to the Cournot solution.
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Two lawyers, for example, who decide to form a partnership would be illegally in restraint of trade since they
Per se rules always contain a degree of arbitrariness. They are justified on the assumption that the gains
from imposition of the rule will far outweigh the losses and that significant administrative advantages will
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Benefits

A
2



A
l
)


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The aim and result of every price-fixing agreement, if effective, is the elimination of one form of
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This apparent inconsistency was remedied by the Court in a 1940 decision when it once again issued a strong per
se rule toward price fixing. We should note that the composition of the Court had changed significantly from the
1933 version. Also, by 1940 there was little remaining public support for cartelization as a remedy for depressions.
(The National Industry Recovery Act, which promoted this idea, was ruled unconstitutional in 1935.)
The 1940 decision, Socony-Vacuum, involved the gasoline industry. Independent refiners were dumping gasoline
at very low prices. During 1935 and 1936 more than a dozen major oil refiners, including Socony-Vacuum (now
known as Mobil), agreed to a coordinated purchasing program to keep prices up. Each major refiner selected
"dancing partners" (that is, independent refiners) and was responsible for buying the surplus gasoline placed on the
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local Bar Association, raises a presumption that such lawyer is guilty of misconduct." (Generally, professional
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It taxes credulity to believe that the several distributors would, in the circumstances, have accepted and put
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These facts were sufficient for the courts to infer the existence of a conspiracy. However, more recent cases do not
seem to support the view that parallel oligopoly pricing alone will be found to be illegal.
In the 1954 Theatre Enterprises decision the Supreme Court concluded:
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More generally, the argument comes down to this: it is naive to regard oligopolists as shared monopolists in
any comprehensive senseespecially if they have differentiated products, have different cost experiences, are
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output decisions. We chose the Cournot model for several reasons. First, it is widely used by industrial organization
economists. Second, many of the qualitative results of the Cournot solution are intuitively plausible and are
consistent with some empirical evidence. Finally, a number of the most important results generated by the Cournot
model are representative of results from many other oligopoly models. Though the Cournot model is idiosyncratic
in specifying that firms choose output and not price, its results are quite general.
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Questions and Problems
a. Find the Cournot solution.
b. Find an identical output for each firm that maximizes joint profits.
3. Continuing with problem 2, assume that each firm can choose only two outputs-the ones from parts (a) and (b)
in Question 2. Denote these outputs
and
a. Compute the payoff/profit matrix showing the four possible outcomes.
b. Show that this game has the same basic properties as the Advertising Game. In particular, each firm's optimal
output is independent of what the other firm produces.
Now consider firms playing an infinitely repeated version of this game and consider the following strategy for
each firm: (i) produce
in period 1, (ii) produce
in period t if both firms produced
in all preceding
periods, and (iii) produce
in period
if one or more firms did not produce
in some past period. Assume
each firm acts to maximize its sum of discounted profits where the discount rate is
c. Find the values for
such that this strategy pair is a Nash equilibrium.
4. Consider a duopoly with firms that offer homogeneous products where each has constant marginal cost of
a. Show that both firms pricing at marginal cost is a Nash equilibrium.
b. Show that any other pair of prices is not a Nash equilibrium.
Suppose that we limit firms to choosing price equal to c, 2
c,
or 3
c. Compute the payoff/profit matrix.
d. Derive all of the Nash equilibrium price pairs.
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5. In its rivalry with Westinghouse, General Electric instituted a "price protection" plan. This plan stated that if
G.E. lowered its price, it would rebate the price difference to its past customers. Show that this plan makes
a. Derive each firm's demand curve.
b. Find each firm's preferred price when it faces the demand curve in (a). Now assume that firm 1's cost
function is instead
25q + q
while firm 2's is as before.
c. Find each firm's preferred price when it faces the demand curve in (a).
d. Compute each firm's profit when firm 1's preferred price is chosen. Do the same for firm 2's preferred price.
Which price do you think firms would be more likely to agree upon? Why?
e. Show that neither price maximizes joint profits.
f. Find the price that maximizes joint profits. Hint: It is where marginal revenue equals both firms' marginal
g. Would firm 1 find the solution in (f) attractive? If not, would a side payment from firm 2 to firm 1 of $500
make it attractive?
7. In the NCAA case, the Supreme Court held that the rule of reason was applicable even though horizontal price
fixing was involved. Explain the rationale.
8. The Addyston Pipe case involved an internal bidding process by the cartel prior to one member's submission of
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represented by Table 5.1. For an introduction to game theory, see Gibbons, 1992.
4. Augustin Cournot,
Research into the Mathematical Principles of the Theory of Wealth,
English edition of
Cournot, 1838, translated by Nathaniel T. Bacon (New York: Kelley, 1960).
5. Because revenue is
R =
(100-
, marginal revenue equals the first derivative of (100
with respect to
dQ =
100- 2
. Equating
MR
and
100 - 2
= 40, and solving for
yields the profit-maximizing output of
6. To derive firm 1's best reply function, find the value of
that maximizes
This is achieved where marginal
profit is zero: ¶
100- 2
- 40 = 0. Solving this expression for
yields
30 - 0.5
The first-order condition is
Adding the first-order condition over n firms gives
qP' - nMC =
0. Dividing through by
and using
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Multiply S by [1/(1 +
Subtract
/(1 +
) from
Solving this equation for
, one finds that
13. This theory of collusion is due to James W. Friedman, "A Non-cooperative Equilibrium for Supergames,"
Review of Economics Studies
38 (1971): 1-12. Also see James W. Friedman,
Oligopoly and the Theory of Games
(Amsterdam: North-Holland, 1977). The earliest argument that firms would be able to collude successfully is due
to Edward H. Chamberlin,
27. Bork, The Antitrust Paradox, p. 26.
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denote the number of players. The strategy of a player is a decision rule that prescribes how he should play over
the course of the game. All of the strategizing by a player takes place with regards to his selection of a strategy.
is a Nash equilibrium if and only if each player's strategy maximizes his payoff given the
other players' strategies. Formally,
for all
in
and for all
i =
Appendix B
The Addyston Pipe Case*
This case resulted from a price-fixing suit brought in 1896 against six cast iron pipe manufacturers located in
Alabama, Kentucky, Tennessee, and Ohio. The industry was characterized by high fixed costs, fluctuating demand,
high transportation costs, and product homogeneity. The main source of demand for cast iron pipe was from
municipalities and utility companies for the distribution of water and gas.
The Addyston group, as the six firms were known, was in a geographical location that gave it a substantial
transportation advantage over manufacturers in New Jersey, Pennsylvania, and New York (the production center of
the United States at that time).
The six firms and their capacities in tons per year were:
Addyston Pipe and Steel, Cincinnati, Ohio
Dennis Long and Co., Louisville, Ky.
Howard-Harrison Iron Co., Bessemer, Ala.
Anniston Pipe and Foundary, Anniston, Ala.
South Pittsburg Pipe Works, South Pittsburg, Tenn.
Chattanooga Foundary, Chattanooga, Tenn.
During the early 1890s a recession severely lowered the demand for pipe and stimulated firms to seek ways to
* This appendix draws heavily on Almarin Phillips,
(Cambridge, Mass.: Harvard University Press, 1962), Chapter 5.
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member firms. Each firm generally reserved the cities to which it was closer than the others. Each firm was
required to pay a "bonus" of $2 per ton to the cartel for all shipments to the reserved cities.
Pay territory was defined as all other cities west of New York and Pennsylvania and south of Virginia. The
members of the Southern Associated Pipe Works (the official name of the cartel) could bid for jobs in pay territory
First. The bonuses on the first 90,000 tons of pipe secured in any territory, 16 and smaller, shall be divided
equally among six shops. Second. The bonuses on the next 75,000 tons, 30 and smaller sizes, to be divided
among five shops, South Pittsburg not participating. Third. The bonuses on the next 40,000 tons, 36 and
smaller sizes, to be divided among four shops, Anniston and South Pittsburg not participating. Fourth. The
bonuses on the next 15,000 tons, consisting of all sizes of pipe, shall be divided among three shops,
Chattanooga, South Pittsburg, and Anniston not participating. The above division is based on the following
tonnage of capacity: South Pittsburg, 15,000 tons; Anniston, 30,000 tons; Chattanooga, 40,000 tons;
Bessemer, 45,000 tons; Louisville, 45,000 tons; Cincinnati, 45,000 tons. When the 220,000 tons have been
Whereas, the system now in operation in this association of having a fixed bonus on the several states has
not, in its operation, resulted in the advancement in the prices of pipe, as was anticipated, except in
reserved cities, and some further action is imperatively necessary in order to accomplish the ends for which
this association was formed: Therefore, be it resolved, that from and after the first day of June, that all
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In short, the cartel would decide as a group what price would probably win a particular job. For example, Omaha
requested bids for 519 pieces of 20-inch pipe and the cartel estimated that $23.40 per ton was just below what an
outsider could bid. Then Bessemer bid the highest bonus of $8 per ton in the internal auction and won the right to
bid $23.40 to Omaha. Other members then submitted bids to Omaha at prices greater than $23.40 to give the
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over the trade which the defendants were able to exercise, within the limit already described. Much evidence is
adduced upon affidavit to prove that defendants had no power arbitrarily to fix prices, and that they were always
combination, therefore able to deprive the public in a large territory of the advantages otherwise accruing to them
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shares. As a result, a simple count of the number of firms can be a very misleading measure of the degree of
One of the traditional tasks in industrial organization has been to develop a statistic that allows a single number to
measure reasonably the concentration of an industry. In constructing a useful index of concentration, one first
needs to understand the purpose that a concentration index is to serve. From a welfare and antitrust perspective, a
Economists usually state this in an alternative form: All products or enterprises with large long-run cross-
elasticities of either supply or demand should be combined into a single industry.
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Table 6.1
Percentage of Sales Accounted for by the Five Leading Firms in Industries
X and Y
Industry X
Industry Y
To pursue this point, consider the size distributions of the two industries shown as concentration curves in Figure
6.1. The height of a concentration curve above any integer
on the horizontal axis measures the percentage of the
industry's total sales accounted for by the largest firms. In general, the curves will rise from left to right, and at a
continuously diminishing rate. In the limiting case of identical shares, such as in Industry X, the curve becomes a
straight line. The curves reach their maximum height of 100 percent where
equals the total number of firms in the
industry. If the curve of Industry Y is everywhere above the curve of X, then Y is more concentrated than X.
However, when the curves intersect, as they do in Figure 6.1, it is impossible to state which is the ''more
concentrated" industry, unless we devise a new definition.
The most widely available concentration ratios are those compiled by the U.S. Bureau of the Census. Ideally, these
ratios should refer to industries that are defined meaningfully from the viewpoint of economic theory. However, the
census classifications of industries were developed over a period of years "to serve the general purposes of the
census and other government statistics" and were "not designed to establish categories necessarily denoting
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there are only 20 "two-digit" industries. An example is industry 20, the "food and kindred products" industry.
Within this two-digit industry there are nine three-digit industries, such as industry 201, the ''meat products"
industry. Within this three-digit industry there are three four-digit industries, such as industry 2015, "poultry
dressing plants." The Census Bureau has computed concentration ratios for the top four, eight, and twenty firms for
some 450 four-digit industries; these are the ratios most often used in statistical studies of industrial organization.
In Table 6.2 we show four-firm concentration ratios for selected four-digit industries in 1987. The industries were
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Table 6.2
Concentration of Selected Industries, 1987
Chewing Gum
where
equals the number of firms. The HHI is the weighted average slope of the concentration curve (recall from
Figure 6.1 that industries with steeper sloped curves are more concentrated). The weight for the slope of each
segment of the curve is the corresponding s
for that segment.
If an industry consists of a single seller, then HHI attains its maximum value of 10,000. The index declines with
increases in the number of firms and increases with rising inequality among a given number of
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firms. Hence, referring to our example in Table 6.1, while assuming firms 6, 7, and 8 in Industry Y each have 5
where
is the Cournot price,
is firm
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higher is the price-cost margin. In addition, collusion was found to be easier as the number of firms decreases. A
reasonable policy implication from this theory is that one should break up highly concentrated industries.
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with technically qualified personnel working in the industries studied.
To obtain the estimates for their twelve
industries, they interviewed personnel in 125 companies in six countries.
If we take the figures in Table 6.3 at face value, the second column (which gives "efficient firm" size as a
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Table 6.3
Such estimates cannot be forward-looking and are stale when done. They must implicitly embody some
unspecified but homogeneous quality of production management, organization, and control, and must
assume that some unspecified but given quality of overall management is imagined both to choose and to
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An extensive discussion of the various techniques used to estimate economies of scalesuch as engineering cost
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For the case in Figure 6.2,
equals five.
Suppose condition (6.1) does not hold; in particular, consider the first inequality not holding. In Figure 6.2 this
means that six or more firms decide to enter. Because [
K
0 when
5, this could not be a free-entry
equilibrium. Each of the prospective firms expects to have a negative present value from entering the industry. One
or more of these entrants would prefer not to enter. Thus, six or more active firms is too many. Alternatively,
suppose that the second inequality in (6.1) does not hold; that is,
firms plan to enter and [
+ 1)/
0 (for
Figure 6.2, this means
5). In that case, entry of an additional firm is profitable, so that we would expect
additional entry. Hence this is not a free-entry equilibrium either. Only when both inequalities in (6.1) are
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Free-Entry
satisfied is an equilibrium achieved. In that case, entrants have a positive present value and nonentrants would have
a negative present value if they entered.
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that potential entrants might face compared to existing firms and, in particular, the ability of existing firms to create
such disadvantages.
Prior to moving on in our analysis, we can at least touch upon this issue with the use of Figure 6.2. Suppose that, as
shown in Figure 6.2, the cost of entry is
so that five firms enter. Further suppose that, after some number of
(5) rather than
(5). If the cost of entry is still
this rise in demand will induce two
additional firms to enter. However, for reasons that will be considered shortly, the entry cost of a new firm may be
higher than that for earlier entrants. If instead it costs
for a firm to enter the industry today, additional entry will
not occur in response to the rise in demand. As a result, the price-cost margin is higher but entry does not occur to
stay its rise.
Barriers to Entry
The traditional wisdom in industrial organization is that serious and persistent monopolistic deviations of price
from cost are likely only when two conditions coexist: sufficiently high seller concentration to permit (collusive)
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existing firms earn above-normal profit without inducing entry. In other words, Bain defines a barrier to entry in
terms of its outcome.
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In the remainder of this section, we want to focus upon the controversy related to the definition of entry barriers.
The discussion has largely revolved around what Bain has labeled barriers to entry. For example, large amounts of
capital necessary for entry are often cited as a source of cost disadvantage faced by new entrants. Richard Posner
strongly disagrees with this position:
uncertainty of a new entrant's prospects may force the entrant to pay a higher risk premium to borrow funds than
existing firms must pay. Others have observed that when truly huge amounts of capital are required, the number of
possible entrants who can qualify is greatly reduced. And, although this may not bar entry, it could delay it.
reached, after which average cost is constant. Here
is the minimum efficient (or optimal) scale. Suppose that there
is a single firm in the industry and it is producing
and pricing at
Note that its price exceeds average cost.
Joe:
As is apparent from Figure 6.3, scale economies are a barrier to entry. The existing firm is pricing above cost,
. Because price falls below average cost, entry is unprofitable. Of course, a new
firm could instead produce at a low rate and thereby reduce the extent by which price is depressed. However,
because average cost is declining, the new firm would be at a considerable cost disadvantage and once again incurs
losses. In either case, entry is unprofitable.
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Entry?
George:
Why do you assume that the new firm expects the existing firm to maintain its output? Why can't the new
firm enter and slightly undercut the existing firm's price of
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Willig.
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A




the fringe
supplies all of demand when the dominant firm prices above
Therefore,
) = 0 when
; the dominant
. The dominant firm solution entails a price of
the fringe supplying
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*) and the dominant firm supplying the residual of [
*) -
*)] or
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tial capacity is relatively low and that
, so that the dominant firm is at least as efficient as the fringe firms.
Given the dominant firm prices at
) at time
fringe profit at
t
from producing
units is [
When
c
fringe profit is higher the more it produces. In that case, each fringe firm maximizes its profits by producing
at capacity. Thus, fringe supply is
when
C
When
c
then a fringe firm prefers to produce
zero. It follows that the fringe supply function is
In order to be able to expand future production above existing capacity, fringe firms must invest in new capacity.
Capacity is assumed to live forever and cost Z per unit. The key assumption in this analysis is how fringe firms
In words, the fringe has profit of [
) at
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Clearly, pricing at
will achieve
the goal of zero fringe expansion, as fringe firms have no earn-
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(a)





(b)













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ings to finance investment. However, the limit price is actually higher than
Though a price exceeding
allow positive fringe profit, fringe firms find it optimal not to invest in capacity if they expect a price close to
into the future. The reason is as follows. To produce one more unit forever requires an initial investment of
cost of the additional unit of capacity) and a per period cost of
The present value of an initial cost of
forever is
Z +
), where
Thus the limit price is
rZ + C
, which exceeds
In comparing myopic pricing and limit pricing in Figure 6.6, note that myopic pricing gives higher profits upfront
(that is, before
*) while limit pricing gives higher profits in the future (that is, after
*). A dominant firm then
prefers myopic pricing to limit pricing when its discount rate is high, as it values future profit much less than
current profit. In contrast, if the dominant firm is very patient (that is, its discount rate is low), it would prefer limit
pricing to myopic pricing, as the former yields a higher level of profit in the long run.
In fact, the price path that maximizes the dominant firm's sum of discounted profits entails neither myopic pricing
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fringe expansion is relatively small because of its small size. Hence a high price early on is less costly because the
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decision to enter? Second, if they can influence that decision, how does this affect the behavior of incumbent
firms? We can also ask: Even if entry does not occur, does the threat of entry induce incumbent firms to act more
Bain-Sylos
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producing
and selling it at
prior to entry. Given the Bain-Sylos Postulate, this means that the output of the
entrant will simply add to
, causing price to fall. In short, the line segment
AB
is the residual demand facing the
potential entrant (where the entrant's origin is at
). For convenience, we can shift the residual demand curve
leftward to
', thereby making the origin for the entrant along the vertical axis.
Notice that the incumbent firm can manipulate the residual demand curve by its choice of its preentry output. For
example, in Figure 6.7 higher output than
would imply a lower residual demand curve (that is, the dashed curve
). This means that the incumbent firm could choose its output so that the residual demand curve facing the
potential entrant would make entry just unprofitable.
This is shown in Figure 6.8. The long-run average cost curve for a typical firm in this industry is
). This
average cost function holds for both incumbent firms and new firms, so that there is no barrier to entry in terms of
an absolute cost advantage. As shown, average cost declines until
minimum efficient scale, is reached and then
becomes constant.
The key question is: Can the incumbent firm create residual demand curve for the entrant such that entry is
unprofitable? The answer is yes. The residual demand curve
that is just tangent to
) is one for

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which there is no output for a new firm that gives it positive profit. Working backward from the residual demand
curve, an incumbent firm output of
is necessary to generate the residual demand curve. The price associated with
, denoted
is the
limit price.
Critique of the Bain-Sylos Postulate
The key assumption in this analysis is that a potential entrant expects the incumbent firm to respond to entry by
maintaining its output at its preentry rate. Industrial organization economists generally consider the Bain-Sylos
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demand and cost functions are independent of past output decisions, then the postentry equilibrium will be
independent of the incumbent firms' preentry output. Hence the entry decision is independent of preentry output.
Strategic Theories of Limit Pricing
For an incumbent firm to affect entry decisions, its preentry behavior must affect the profitability of entry. What
might cause this to occur? The presumption is that if entry occurs, all active firms will achieve some oligopoly
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An example of a cost function with adjustment costs is
where
is the period
output and
is output from the previous period. The cost to adjusting output is measured
. Notice that it is minimized when
t-1
, so that there is no change in output. It is greater the
bigger the change in output.
When the incumbent firm incurs a cost to adjusting its production rate, we want to argue that its preentry output
will affect the profitability of entry. The more a firm produces today, the higher is its profit-maximizing output in
the future. Because of the cost to adjusting its output, a firm will tend to produce an output close to its past output.
Thus, if the postentry equilibrium is the Cournot solution, then the incumbent firm will produce at a higher rate
after entry, the more it produced in the preentry period. As shown in Figure 6.9, increasing its preentry output shifts
out the incumbent firm's postentry best reply function. A rise in its preentry output then shifts the postentry
equilibrium from point
to
Because the incumbent firm produces more at
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where
is the sum of past outputs:
+ ..
Note that the more a firm produced in the past, the lower
is its marginal cost today. Hence the higher an incumbent firm's preentry output becomes, the lower is its marginal
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with learning about the new brand. Such costs are avoided by sticking with the brand one is currently using, as
personal experience has already relieved this uncertainty. Such costs are referred to as
switching costs.
The demand for a new firm's product comes from consumers who currently buy from existing firms and consumers
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in keeping an incumbent firm's price below the monopoly level even if entry never takes place.
In summary, there are two important conclusions from the limit-pricing literature. First, there are a number of
different ways in which preentry output or price can affect the postentry equilibrium and thereby influence the
Given preexisting capacity stock of
, a firm has fixed (and sunk) cost of
rx.
To produce
when it does not
exceed capacity requires only variable inputs that cost
wq.
However, if output is in excess of capacity, one must
) additional units of capacity. This costs
), which means total cost is
) =
There are three stages to the game and two firmsone incumbent firm and one potential entrant. Firms have
homogeneous products. Initially, neither firm has any capacity.
Stage 1:
The incumbent firm invests in capacity, denoted
Stage 2:
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would this depend on the incumbent firm's initial investment in capacity. The presumption is that each firm chooses
a quantity so as to maximize its profit which means a Nash equilibrium. The point we want to argue is that,
generally, the higher is the initial capacity of the incumbent firm, the higher is the incumbent firm's postentry Nash
equilibrium quantity and the lower is the new firm's postentry Nash equilibrium quantity. In Figure 6.10 is the
marginal cost curve that the incumbent firm faces in stage 3 given an initial capacity of
. Marginal cost is
if the
incumbent firm produces below its initial capacity and jumps to w +
if it produces above
as it must add
capacity which costs
per unit. If the incumbent firm's initial capacity is instead
then its marginal cost is lower
. Generally, when a firm's marginal cost is lower, it desires to produce more. As
a result, in the postentry game, the incumbent firm finds it optimal to produce at a higher rate when its initial
capacity is
than when it is
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of the incumbent firm because any firm's profit is lower when its rival produces more.
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If entry does take place, then firms make simultaneous quantity decisions where each firm can decide to produce at
a low rate (
) or at a high rate (
). A matrix lists the profits for the two firms from the four possible quantity
pairs. The first number in a cell of a matrix is the profit for the incumbent firm, whereas the second number is the
profit for the new firm (recall that
is the cost of entry). For example, if the incumbent firm chooses
= Low,
entry occurs, and both firms produce
, then the profits of the incumbent firm and the new firm are 3 and
4- K,
respectively. Implicit in these profit numbers is that the incumbent firm prefers to produce at a high rate when it
invests heavily in capacity (as its marginal cost is low) and prefers to produce at a low rate when it does not invest
heavily in capacity (as its marginal cost is high for a high rate of production).
If
= Low and entry occurs, the postentry (Nash) equilibrium has both firms producing
. Given that the new
firm produces
, the incumbent firm earns 10 by producing
and 7 by producing
, so it prefers
. Given that
the incumbent firm produces
, the new firm earns 10 -
K
by producing
and 7 -
K
by producing
, so it
prefers
. You should prove to yourself that the other three possible outcomes, (
), (
), and (
are not Nash equilibria. If instead
= High, then the postentry equilibrium has the incumbent firm producing
and earning 9, and the new firm producing
and earning 5 -
How will the potential entrant behave? Well, it depends on the cost of entry and on the incumbent firm's capacity.
If
= Low, then the postentry equilibrium profit for a new firm is 10 -
K.
Hence, if
= Low, entry is profitable
(and will occur) if and only if
10 (note that the potential entrant always earns 0 from not entering). If
High, then postentry profit is 5 -
K
so that it enters if and only if
5.
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incumbent firm chooses the same capacity as a monopolist would who had no threat of entry. In a more general
model, the incumbent firm would strategically raise its capacity in anticipation of entry in order to reduce the new
firm's output.
There are several important lessons to be learned from the preceding analysis. Since capacity is durable and lasts
into the postentry period, an incumbent firm's capacity investment affects its future cost function and thereby
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The rise in firm 2's marginal cost will cause it to reduce its output, which will raise firm 1's revenue. As long as
this revenue increase is bigger than the increase in firm 1's cost, firm 1 will have raised its profits by agreeing to a
higher wage.
Preemption and Brand Proliferation
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Note that (6.3) and (6.4) are quite consistent. Because products
and
are substitutes, if product
is offered, the
demand for product
will fall. Although introduction of
generates positive profit, it reduces profit from the sale
of
. Of course, a new firm that offers only
does not care about the reduced profits on
. In contrast, when the
incumbent firm considers offering
, it cares about total profits. Thus it values the introduction of
by the profits
earned from
less the reduction in profits earned from
In considering how the incumbent firm will behave in response to the rise in demand for
Rearranging the expression in (6.7) gives us
Thus, if (6.8) holds, then the incumbent firm will introduce product
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raising their costs or preempting future entry through one's product decisions. Although for many years industrial
organization economists treated entry conditions as being exogenous to firms, in fact entry conditions are partially
a. Derive the four-firm concentration ratio.
b. Derive the HHI.
d. Suppose the government decides that it wants this industry to have a four-firm concentration ratio of 40
percent or less. How might this be achieved?
3. In 1972 a U.S. senator proposed the Industrial Reorganization Act. Among other things, this act required that
a. If AT&T had been an unregulated monopolist, derive the price that it would have charged.
d. How much is AT&T willing to pay to be an unregulated monopolist? Suppose that we extend this model to
e. Will AT&T's current price be higher or lower than that derived in (c)?
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7. Ace Washtub Company is currently the sole producer of washtubs. Its cost function is
) = 49 + 2
and the
a. Derive the residual demand function for a new firm.
b. Given that the incumbent firm is currently producing
if a potential entrant was to enter, how much would
it produce?
c. Find the limit price. Hint: Find the output for Ace such that the slope of a new firm's average cost curve
equals the slope of a new firm's residual demand curve.
Suppose, instead of assuming the Bain-Sylos Postulate, that we assume active firms expect to achieve a
Cournot solution.
d. Does entry depend on
? Explain.
e. Will there be entry?
a. Derive a new firm's postentry best reply function.
b. Given initial capacity of
, derive the incumbent firm's postentry best reply function.
c. Given
, derive the postentry equilibrium profit of a new firm.
d. Derive the minimum capacity that makes entry unprofitable.
e. Derive the optimal capacity choice of the incumbent firm.
9. From 1979 to 1987, Kellogg introduced the following brands of cereal: Graham Crackos; Most; Honey & Nut
Corn Flakes; Raisins, Rice & Rye; Banana Frosted Flakes; Apple Frosted Mini Wheats; Nutri-Grain; Fruity
Marshmallow Krispies; Strawberry Krispies; Crispix; Cracklin' Oat Bran; C-3PO; Apple Raisin Crisp; Fruitful
a. Should the Antitrust Division of the Justice Department be concerned?
b. Five other companies introduced a total of fifty-one new brands over that same period. Does this fact change
your answer in (a)?
10. The demand for product
is
= 10 - 2
, where
is the quantity of a substitute product that is currently
not being produced. The marginal cost of
a. Find Incumbent's price, quantity, and profit.
b. Incumbent wishes to investigate the possibility of introducing
which is also protected from entry by other
firms. The demand for
is
= 10 - 2
and it also has a constant marginal cost of $1. However, there is a
fixed cost of introducing
of $4. Find the values of X,
Y, P
, and profit for Incumbent. Will Incumbent
introduce
d. Now assume that entry is no longer barred. For simplicity, assume that if a new firm, "Entrant," decides to
introduce
then Entrant and Incumbent
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e. Still assuming that entry is not barred, will Incumbent have an incentive to preempt the entry by Entrant and
offer
first? (It is assumed that if Incumbent offers
then a second seller of
will have negative profits.)
f. If the fixed cost of introducing
a. Referring to your answers in parts (d) and (e) in problem 10, what would be the maximum amounts each
would be willing to pay for the patent?
b. Assume now that a Cournot solution holds if Incumbent sells
and Entrant sells
Find the equilibrium
prices, quantities, and profits.
c. Under the Cournot solution scenario find the maximum amounts that Incumbent and Entrant would pay for
the patent so as to become the sole producer of
d. Explain the intuition underlying your answer to (c) and why it differs in a qualitative way from the answer to
1. United States v. E. I. duPont de Nemours and Co., 351 U.S. 377 (1956).
2. George J. Stigler, "Introduction," in National Bureau of Economic Research,
Business Concentration and Price
Policy
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24. William J. Baumol, John C. Panzar, and Robert D. Willig,
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In Chapter 5 we examined price-fixing agreements among firms and the evolution of antitrust law toward such
conspiracies. In this chapter we continue our study of how cooperation among rivals (in this chapter, by merging)
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in 1904. Of course, the Sherman Act did not contain specific antimerger provisions; Section 1 concerns
combinations in restraint of trade and Section 2 deals with monopolization. In Northern Securities, the
government's attack was based on both sections, and the attempt to combine the two railroads (Northern Pacific
and Great Northern) was found to be illegal. Also, in 1911, two famous monopolies, or trusts as they were called,
were found guilty and were broken up (Standard Oil and American Tobacco).
Because the Sherman Act applied to mergers only when the merging firms were on the verge of attaining
substantial monopoly power, the Clayton Act was passed (in part) in 1914 to remedy this. Section 7 read: That no
corporation engaged in commerce shall acquire, directly or indirectly, the whole or any part of the stock or other
share capital of another corporation engaged also in commerce where the effect of such acquisition may be to
That no corporation engaged in commerce shall acquire, directly or indirectly, the whole or any part of the
stock or other share capital and no corporation subject to the jurisdiction of the Federal Trade Commission
shall acquire the
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Table 7.1
Vertical
Conglomerate
Product Extension
Source:
Federal Trade Commission,
Statistical Report on Mergers and Acquisitions,
various years.
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investor group then buys all the outstanding stock of the company, taking the company private.
Normally, the new owners begin selling off parts of the company to reduce its debt. The new owners also try to cut
costs and lay off employees to increase profitability and to ensure that the huge new debt can be serviced.
Eventually, the investor group hopes to reap large profits by taking the streamlined company public again.
The huge magnitudes of the LBOs and the increasing corporate debt that they create have led to substantial
concern. Some economists worry that such high debt is unsafe, not just for a company but for the entire economy.
Others see it as beneficial for new owners to cut costs and make the new, smaller companies more efficient.
Although these LBOs have attracted a lot of attention and do pose possible policy concerns, they do not appear to
represent antitrust issues. Antitrust concerns might be raised when the various units of the acquired company are
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There may be economies from combining two firms that can lead to greater profitability. These cost savings can
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Principal-Agent
tween profit and output
. For simplicity, think of
as a proxy variable that represents some of the variables that
managers care about in addition to profitfor example, the size of the firm in and of itself (managers' salaries tend to
be higher, the larger the firm). In contrast to management, the owners do not have good information on this
frontier. They must try to induce the management to pick the point on it that the owners prefer. If owners could
"see" the frontier, they would simply order the management to choose output
or be replaced. (Of course,
corresponds to maximum profit.)
Management has a utility function that represents its preferences for profit and
. The indifference curve
this tradeoff and indicates that management's choice is to give up some potential profit (
AC
for agency cost) for a
higher output
Management picks point
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the agent to pick point
The principal, of course, tries to use various profit-sharing plans, stock options, and the
like, to induce the agent to operate closer to
but the basic conflict in objectives means that
AC
will never be
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Horizontal Mergers
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Benefits

2





3
2
1
½
5
10
20
Source:
Computed by authors using formula in note 8.
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the degree to which the merger would lower costs, raise prices, reduce output, and so on.
Cost savings would be especially difficult for antitrust authorities to authenticate because the firms involved would
have to be relied upon for such informationand their incentives would be to overstate cost savings. Uncertainty
about the effects of combining operations on costs is also great, even for the managements involved. Judge Richard
Posner has argued as follows:
Not only is the measurement of efficiency ... an intractable subject for litigation; but an estimate of a
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Benefits





with
(in Figure 7.2) and
with
(also in Figure 7.2), it is apparent that the benefits are
declining and the costs are increasing over time. A sophisticated analysis would then calculate the present
discounted values of the streams of benefits and costs. Clearly, even with benefits greater than costs initially, it is
possible for their present values to reverse this result.
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Industry-Wide Effects
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Applying these considerations to the present case, we conclude that the record supports the District Court's
findings that the relevant lines of commerce are men's, women's, and children's shoes. These product lines
are recognized by the public; each line is manufactured in separate plants; each has characteristics peculiar
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If a merger achieving 5 percent control were now approved, we might be required to approve future merger
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In Brown Shoe, in fact, the Supreme Court went so far as to attribute to Congress a decision to prefer the
interests of small, locally owned businesses to the interests of consumers. But to put the matter bluntly,
there simply was no such congressional decision either in the legislative history or in the text of the
statute.... The Warren Court was enforcing its own social preferences, not Congress'.
Two merger cases were decided by the Supreme Court in 1964 that we shall briefly describe. One involved a
the Alcoa-Rome and Continental-Hazel-Atlas decisions exhibit a different sort of consistency: the
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The Von's decision in 1966 has been especially significant as a precedent.
Von's was the third largest grocery
chain in the Los Angeles area in 1960 when it acquired the sixth ranked chain, Shopping Bag Food Stores. The
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important interaction effect, inasmuch as enforcement agencies are unlikely to bring lawsuits where their
expectation of winning is low.
1992 Merger Guidelines
The 1992 Guidelines
are quite similar to guidelines issued in 1982 by the Justice Department alone. The 1982
version made substantial changes in earlier guidelines. Here we focus on the substance of the present Guidelines
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Geographical

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and thereby permits more mergers to slip by unattacked than a lower price. (Two particular merging firms will
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The Guidelines indicate that the [Agency] will consider various types of efficiencies including economies of
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in Florida and California). These latter two categories are more likely to be challenged by the antitrust authorities.
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A second benefit of conglomerate mergers, especially if other mergers are restricted by antitrust authorities, is the
takeover threat. The idea is that managements are constantly being pressured to perform efficiently by the threat of
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within one year in response to a small but significant and nontransitory increase in price."
Hence, actual
The Commission also found that the acquisition of Clorox by Procter eliminated Procter as a potential
It is clear that the existence of Procter at the edge of the industry exerted considerable influence on the
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The vertical axis measures costs per unit of output and the horizontal axis measures the number of potential
entrants. For simplicity, it is assumed that each entrant would construct one unit of capacity. Thus,
shows a
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average cost premerger,
= $50; average cost postmerger,
= $44; and premerger price,
Assume that the postmerger price,
a. Calculate the value of the deadweight loss, area
b. Calculate the value of the cost savings created by the merger, area
c. Should the merger be allowed? What qualifications should be considered?
2. Assume all of the facts in problem 1 except that now take the premerger price,
, to be $52. How does this
affect your answers to problem 1?
(a) Firms 1 and 2 have decided to merge. They can lower their cost curve from $50 to $48 because of
(b) Now recognize that the two firms above were intitally a part of a five-firm industry in which each firm acts
(c) If social benefits and costs are now computed on an "industry-wide" basis, should the merger be approved?
(d) Now assume that greater cost savings are expected by firms 1 and 2. Their cost curve will shift down to $45
rather than to $48. It is now a real possibility that the new combined firm will decide to cut price to $50 (or just
(e) How might information about rival firms' attitudes toward a merger (or their stock prices) be useful to
antitrust enforcement agencies?
4. A criticism of the model in problem 1 is that price is not related to cost through the standard monopoly theory.
That is, if the merger creates monopoly power, then the postmerger price is precisely related to the postmerger cost
(and the elasticity of demand). Is this a valid criticism?
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Equating
and
Because
divide the left side by (
and the right side by
. The result is
Finally, assuming a constant elasticity demand curve,
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So for
-1,
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Vertical Mergers and Restrictions
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If Pfizer believed the risk premium to be too high, it might decide on a "cost-plus" contract, thereby bearing the
risk itself. But cost-plus arrangements are well known to provide poor incentives for holding down costs. Hence a
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Pre-
other inputs. We can therefore use the symbol
to refer to both the quantity of motors and the quantity of boats.
Note that the boat monopolist's marginal cost is its conversion cost
C
plus the price of a motor,
Hence, the
derived demand for motors is
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just marginal revenue minus the conversion cost
The curve
D'D'
in Figure 8.1 is obtained by finding the
marginal revenue curve corresponding to
(the line
) and shifting it downward by the constant C (that is, by
Of course, the boat monopolist's input demand
D'D'
is also the motor monopolist's product demand curve. The
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Cement

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Cost




where
and
intersect. Total
revenue equals the area under the
schedule and total cost equals the area below
Hence, profit equals the
triangular area
Before the vertical acquisition, however, the sum of the profits of Ace, Jones, and Smith was larger by the shaded
triangular area
EGB.
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as raising rivals' costs.
The key idea of their model can be explained most simply with Figure 8.4.
The demand and supply curves for an input of the Hi-Tec Company,
and S, are shown in Figure 8.4. Initially, the
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disrupting the operation of the agreement. The merger of such a buyer with an upstream firm may eliminate
that rivalry, making it easier for the upstream firms to collude effectively.
In summary, we have suggested that harmful effects from vertical integration are unlikely to occur unless there is
we obtain the derived demand for motors,
D'D'
The motor
monopolist equates its marginal revenue,
D'M',
with its marginal cost of motors,
It therefore charges a price of
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plus the $100 conversion cost, or $500, and therefore sells 300 motorboats for $500 each. The motor monopolist
earns a profit of $400 less $100, multiplied by 300 units, or $90,000.
Now, assume the motor monopolist monopolizes downstream. The marginal revenue corresponding to the final
demand for boats is
DM.
The marginal cost
MC'
of the combined operation is $200, or the sum of the marginal cost
of motors ($100) and the conversion cost ($100). Equating
DM a
MC'
gives an output of 300 boats and a price
of $500. The integrated firm has a profit of $500 less $200, multiplied by 300 units, or $90,000.
The result is that the monopolist gains nothing by monopolizing downstream. Profit is the same pre- and
postmerger. The motor monopolist is able to extract all of the potential profit by choosing its price of motors. And
increased monopoly profits.
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Extension of Monopoly: Variable Proportions
In this section we relax the assumption of fixed-proportions production. As an example, assume that shoe
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Sam's, the shoe manufacturing industry will substitute away from
K
and use a more labor-intensive input mix. In
the fixed-proportions case, this was not possible. No matter what price for motors was charged, more of the other
inputs could not substitute for a motor. Every motorboat required one motor.
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The Brown Shoe case in 1962, discussed earlier under horizontal merger cases, also had important vertical
dimensions.
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Vertical Restrictions
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An





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necessary to infer such a conspiracy. The first case, Monsanto v. Spray-Rite Service, involved a Monsanto
herbicide dealer selling at discount prices. There was evidence that other dealers had complained to Monsanto, and
Monsanto subsequently terminated the dealer. The Court said that evidence of complaints was not sufficient unless
additional evidence tended to exclude the possibility of independent action by Monsanto.
The second case, a Supreme Court decision in 1988, also supports the view that the conditions for RPM to be
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business decisionthe reason being that the dealers would then be able to provide presale informational services to
distribution can be reduced.
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In 1965 a Sylvania dealer in San Francisco, Continental T.V., wanted to open a store in Sacramento but was
prohibited from doing so by Sylvania; Sylvania was doing exceptionally well in Sacramento and did not believe
another dealer would be beneficial. As a result, Continental filed suit against Sylvania under the Sherman Act,
The Supreme Court decided in favor of Sylvania and in so doing made it clear that the case should be decided on a
rule of reason basis:
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The restriction of each merchant to one pattern manufacturer must in hundreds, perhaps in thousands, of
small communities amount to giving such single pattern manufacturer a monopoly of the business in such
The Circuit Court went on to observe that this could lead to ever higher concentration in the pattern business
nationally "so that the plaintiff... will shortly have almost, if not quite, all the pattern business." This is not sound
analysis, however, since it ignores the issue of what a pattern manufacturer must give up to obtain an exclusive
dealing arrangement in the first place. That is, the dry-goods stores can benefit by tough bargaining with potential
pattern suppliers before signing up with a particular one. In short, this theory of monopolizing through foreclosure
is no more persuasive than the foreclosure arguments that we have discussed earlier in this chapter.
In a more recent case decided in 1961 the Supreme Court refused to strike down an exclusive dealing arrangement
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fixed proportions. For example, a movie distributor may require a theater owner to take movie B if he wants movie
A. This is generally referred to as block booking.
One's first reaction to this practice may be that it is irrational. For example, why would a film distributor try to
force movie B on an owner who may have taken A alone but will refuse to take the package deal? He could have
made money on A and now will make zero. Economists and the courts have puzzled over these practices and have
presented numerous explanations. Perhaps the most widely accepted one among economists is that tying is a
Take a patentee selling a patented engine. He will now have the right by contract to bring under the patent
laws all contracts for coal or electrical energy used to afford power to work the machine or even the
lubricants employed in its operation. Take a patented carpenter's plane. The power now exists in the
patentee by contract to validly confine a carpenter purchasing one of the planes to the use of lumber sawed
from trees grown on the land of a particular person.... My mind cannot shake off the dread of the vast
extension of such practices which must come from the decision of the court now rendered. Who, I submit,
can put a limit upon the extent of monopoly and wrongful restriction which will arise
Clearly, the judge was overstating the possibilities in fearing that a patent monopoly could be extended to most
other products in the economy through tying. After all, the demand for the patented product is not infinite, and only
so much consumer surplus can be extracted. Furthermore, Burstein has argued that "the simple and natural view,
so favored by the courts, that ... tie-in sales are primarily for the purpose of extension of monopoly into new
Can it sensibly be accepted that G.S. Suppiger Co. tied salt to its salt-dispensing machinery as part of a
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more of the consumers' surplusor to appropriate some of the triangular shaded areas in Figure 8.8.
A simple block-booking example illustrates the point.
Assume that the maximum values to theater owners for
two movies are as given below:
Maximum Value to Theater Owners
Movie A
Movie B
Fox Theater
York Theater
To obtain the maximum revenue, the movie distributor has several possibilities, although some may be ruled out
because of illegality or nonfeasibility. First, perfect price discrimination would entail charging separately the
maximum value for each movie to each individual:
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Thus the maximum potential revenue is $310. The ability to charge separate prices may not be possible, though.
Assume then that the distributor can charge only one price for each movie. An examination of the values in the
table indicates that the best he could do would be to charge $60 for movie A and $70 for movie B. This "normal"
pricing outcome would yield:
There is one further possibilityblock booking. Suppose that the distributor offers a bundle of movies A and B for a
single price. The bundled price for movies A and B to the Fox Theater could be $170, but this would cause the
York Theater to decline the bundle and generate a total revenue of only $170. Hence the best bundled price would
be $140, inasmuch as this would keep both theaters as customers.
Of course, the point is that block booking yields higher revenue than normal pricing. This does not always work,
however. In this case, Fox will pay more for A than York will, and York will pay more for B than Fox. If, for
example, Fox will pay more for both movies, block booking gives results identical to normal pricing.
The courts take a harsh view of block booking. In the Loew's, Inc., case that was decided by the Supreme Court in
1962, six major film distributors of pre-1948 copyrighted films for television exhibition were found guilty of block
booking.
As one example, Associated Artists Productions negotiated a contract with one television station for
This Court has recognized that "tying agreements serve hardly any purpose beyond the suppression of
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view that the fundamental explanation is price discrimination. Price discrimination is known to have ambiguous
welfare effectsin some cases prices discrimination raises total economic surplus and in others it has a negative
effect. In cases involving patents there is an additional considerationit may increase the appropriability of the
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Demand










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The first term above is the profit from the machine sales and the second term is the profit on paper. The point, of
course, is that tying permits the monopolist to extract a higher overall profit. Tying has permitted the monopolist
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to tie its cards to its tabulating machines because inferior cards would cause the machines to malfunctioncausing a
loss of good will from its customers. Of course, if this is correct, such tying is socially beneficial. The courts have
generally not agreed with this argument, however, and have observed that the manufacturer of the tying good could
simply state the specifications necessary for the tied goods. It would, of course, be in the interests of the customers
to use only the "proper" tied goods.
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Evasion of Price Controls
Tying can be used as a way of avoiding price controls. For example, when gasoline was under maximum price
controls in the 1970s, the excess demand was great. Cars lined up for miles in certain cities to buy gasoline.
Our discussion of the various reasons for tying does not include every possible reason that has appeared in the large
literature on tying. However, our discussion should be sufficient to indicate that it is a complicated practice and that
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International Salt Company had a patent over salt-dispensing machines used in food processing. The company
required all users of the machines to buy their salt from the company as well. They argued that only their salt was
of sufficient quality to function properly in their machines, and the tie-in was necessary to preserve goodwill. The
Supreme Court, however, disagreed:
If others cannot produce salt equal to reasonable specifications for machine use, it is one thing; but it is
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with each machine, that tie-in would be immune from the law. The reason is that the tying product would then be
a. Find the derived demand for lawnmowers facing
Hint: Find the marginal revenue equal marginal cost
condition for
where
R's
marginal cost is the sum of the $5 services cost and the price
that it must pay
per lawnmower. Solving for
gives the derived demand.
b. If M's total cost function is 10 + 5
, find the equilibrium prices and quantity,
and
, and the
profits of the two firms.
c. Assume now that
form a single vertically integrated firm
M-R.
Find the equilibrium values of
and the profit of
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d. Compare the unintegrated case (b) with the integrated case (c). Is it true that both the firms and the public
would prefer (c)? Explain.
3. Assume the same facts as in problem 2 except that monopolist
a. Find the derived demand for lawnmowers facing the manufacturing monopolist
M.
Hint: Make use of the fact
b. Find the equilibrium prices and quantity,
PL, P,
and X, and the profit of
c. Assume that
d. Compare the unintegrated case (b) with the integrated case (c). Is it profitable to monopolize forward? What is
the intuitive explanation for your result?
4. Assume a situation where a monopolist of input
The price of
and its marginal cost are both $1. The demand for the product of industry
is
= 20 -
It can
be shown that the monopolist will charge $26.9
for
to maximize its profit, given that its marginal cost of
is $1. (This can be found by first obtaining the derived demand facing the monopolist using the price equal
marginal cost condition in industry
, and also using the condition for least cost production by industry
c. What is the cost saving that the vertically integrated monopolist will obtain if it produces 9.63 units? That is,
what is the saving compared to the cost found in (a)?
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e. In fact, after the vertical monopolization of Z the firm
M-Z
would have a constant marginal cost of $2. Given
this fact, what is the profit maximizing price
and output Z? Draw a figure to illustrate the overall social
benefits and costs of this vertical integration.
Assume that the maximum values to theater owners for movies A and B are as follows. The Fox Theater values
A at $100 and B at $70. The York Theater values A at $60 and B at $50. Is block booking more profitable than
charging a single price for each movie? Explain.
6. Consider a problem faced by Kamera Company. They have developed a patented new camera that can be
8-4
a. Consumers will purchase only one camera at mosthence, consumer surplus can be viewed as measuring what
they would be willing to pay for a camera. If Kamera must charge both customers the same price for a camera,
what is the price it will charge and what is its profit?
b. Assume now that Kamera decides to tie film to its camera. It requires customers to purchase film from
c. Compare total economic surplus in case (a) with that in case (b).
d. If customer 2 has a different demand curve, say,
= 10 - 5
/4, it reverses the result of (c). What is the
intuitive reason for this reversal?
1. A major expected benefit was that regulation of the monopolistic operating companies would be improved. That
is, the nonregulated Western Electric arm of AT&T had an incentive to charge artificially high prices to the
regulated arm of AT&Tthe operating companies. The reason was that the higher the prices, the higher the operating
companies' "rate bases" and, therefore, the higher their allowed profits. The 1982 Department of Justice Guidelines
cite this "evasion of rate regulation" problem as one basis for challenging vertical mergers.
2. The analogy to a stream is simply that the sales "flow" downstream from raw materials to final product.
3. Brown Shoe Company v. United States, 370 U.S. 294 (1962).
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6. M. J. Peck,
In particular, they argue that in many cases dealers do not provide tangible presale services; rather their idea is
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24. United States v. Loew's, Inc., 371 U.S. 38 (1962).










The first and second terms are revenues from machines and paper respectively, while the last term is the
machine costs. The value of
that maximizes profit is $25. Note that the best profit with only one customer is
$9000, and tying would not be employed.
27. Richard Schmalensee, "Monopolistic Two-Part Pricing Arrangements,"
Bell Journal of Economics,
28. In this case, the tying solution is to charge $3612.50 for the machine and $15 for paper. The profit is $8225 as
compared with only $8000 under no-tying.
29. Siegel v. Chicken Delight, Inc., 448 F. 2d43 (9th Cir. 1971). For an interesting analysis of this case, see B.
Klein and L. F. Saft, "The Law and Economics of Franchise Tying Contracts,"
Journal of Law and Economics,
May 1985.
30. United States v. Jerrold Electronics Corporation, 187 F. Supp. 545 (1960).
31. In terms of Figure 8.6, the efficient input combination is point F. The slope of NN equals the ratio of prices that
the tying monopolist should choose. See R. Blair and D. Kaserman, "Vertical Integration, Tying and Antitrust
Policy,"
American Economic Review,
June 1978, for a more formal analysis.
32. International Salt Co., Inc., v. United States, 332 U.S. 392 (1947).
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Monopolization and Price Discrimination
A major policy concern in the United States has long been the so-called dominant firm. Although few true
Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other
person or persons, to monopolize any part of the trade or commerce among the several states, or with
foreign nations, shall be deemed guilty of a felony.
Three types of acts are condemnedmonopolization, the attempt to monopolize, and conspiring to monopolize. Here
we shall focus on the first actmonopolizationbecause the most important cases are of this type.
It is important to note that the law forbids the act of monopolizing and not monopoly itself. Judge Irving Kaufman
explained the reason for this in a 1979 case in which Eastman Kodak was charged with monopolization: "[O]ne
must comprehend the fundamental tensionone might almost say the paradoxthat is near the heart of Section 2."
Judge Kaufman then quoted a famous passage from an earlier decision involving Alcoa: "The successful
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As we will see in discussing the important monopolization cases, bases for dominant firm status vary considerably.
The earlier cases, for example, were concerned with monopolies achieved through mergers. Standard Oil was
alleged to have become dominant by both mergers and predatory pricing tactics. Alcoa began its domination of
aluminum through patents and economies of scale. These differences mean that monopolization cases are truly
difficult "rule of reason" cases.
As we explained in Chapter 5, there are two parts to rule of reason cases: inherent effect and intent. The currently
accepted Supreme Court statement on monopolization was given in the 1966 Grinnell case:
The offense of monopoly under Section 2 of the Sherman Act has two elements: (1) the possession of
where

MC


Note: All values are measured at the firm's profit-maximizing output.
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Notice that the Lerner index equals the reciprocal of the elasticity of demand.
For example, if the firm's price is
double the marginal cost and
= 0.5, we also know that the elasticity of demand is 2. Furthermore, it follows that
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Hence the Bain index measures economic profits, in that it subtracts all costs from revenues, including the
opportunity cost of the owners' investment, iV. As Bain observed, "Although excess profits are not a sure
indication of monopoly, they are, if persistent, a probable indication."
Estimating the Bain index using accounting data has many wellknown difficulties.
Accountants do not capitalize
certain investments (advertising and research and development) that should be capitalized for economic analysis.
Both short-run and long-run monopoly power are logically continuous variables, in the sense that they can
take on a whole range of values. The questions about monopoly power that usually interest economists
involve its sources and importance, rather than its existence. Courts, on the other hand, often seem to treat
the existence and importance of monopoly power as though they were equivalent.
In the real world, we do not see monopolies (as in Figure 9.1) with homogeneous products and with blockaded
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Short-Run
Because we have referred to predatory pricing several times, it is appropriate to consider this concept in more
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. A price at this lower level would mean that the firm could not even cover its average variable costs (
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If we look at predation as an investment to achieve or increase future monopoly profits, we should keep the
A one-dollar loss incurred today costs one dollar. At a 10 percent discount rate, an additional dollar profit
three years hence is worth about 75 cents. A dollar profit deferred for five years is worth only 62 cents. If it
cannot be realized in 10 years, it is worth only 38.5 cents. A dollar profit 25 years hence is worth less than a
dime today. It may not pay to count the hereafter.
A final point that may make predatory pricing appear to be unwise is the role of entry barriers. A monopoly price
after
cannot be sustained without high barriers to entry. In short, there are many reasons to view predatory
pricing as an activity that is probably rare.
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for the Rockefellers. If they bought up their rivals, there would be no period of lossesmonopoly profits could have
begun immediately. And with ownership of the production facilities of the rivals, there would be no danger of
reentry by others using those facilities. Finally, an occasional predatory pricing episode could be used to persuade
rivals to sell out cheaply.
Of course, today it is no longer possible to create a monopoly through acquisition of rivals. The 1950 Celler-
Kefauver Amendment to Section 7 of the Clayton Act has been enforced vigorously, as we discussed in Chapter 7.
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America (Alcoa) was the sole American producer of primary aluminum until 1940. In 1945 Circuit Judge Learned
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Vertically


of


In the first definition, Alcoa's consumption of its own primary aluminum production for fabrication purposes is
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not." He argued that 90 percent is the correct share for the following reasons.
First, "All ingotwith trifling exceptionsis used to fabricate intermediate, or end, products; and therefore all
intermediate, or end, products which Alcoa fabricates and sells, pro tanto reduce the demand for ingot itself."
Hence, "Internal Use" should appear in the numerator.
Second, Alcoa in the past had control of the primary aluminum that reappears as secondary aluminum in the
present. Hence, Alcoa "always knew that the future supply of ingot would be made up in part of what it produced
at the time, and if it was as far-sighted as it proclaims itself, that consideration must have had its share in
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1970 to Present: Kodak, Cereals, IBM, and Others
During the current period, a number of ''big cases" have been brought by antitrust agencies. IBM, Xerox, AT&T,
and three breakfast cereal manufacturers were charged with monopolization. The latter case was unusual in that
Kellogg, General Mills, and General Foods were charged by the Federal Trade Commission (FTC) with "shared
monopoly." There were also a number of private suits that have received much attention, including a number of
cases by smaller computer firms against IBM, and Berkey Photo against Eastman Kodak.
None of these cases reached the Supreme Court. Hence the final word on new judicial attitudes toward
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arated the regulated telephone utilities from their main unregulated equipment supplier, Western Electric. (This
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IBM's dominant position in the computer industry is usually attributed to its strong position before computers
existed in the punched-card office equipment business. This gave IBM strong ties to the potential computer users.
IBM delivered its first computer, the IBM 650, in 1954. Thus, while not being the technical leader in computers,
IBM supplied both hardware and software that performed well.
According to the government, IBM engaged in numerous practices that enabled it to maintain its monopoly power.
These practices were argued to be neither "inevitable nor honestly industrial." They were leasing, bundling,
differentiation of software, fighting machines, tying of products, manipulation of purchase-to-lease price ratios,
and education allowances. Unfortunately, we do not have the space to examine all of these practices in depth.
IBM struck first at peripherals manufacturers by announcing the 2319A disk drive as a "new" disk drive. In
fact it was essentially a physical rearrangement of its standard 2314-drive announced for attachment to the
370/145 computer. The 2319A represented a significant price reduction per spindle over IBM's standard
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Finally, we note a private case that was decided by the Supreme Court in 1985.
The facts in the case,
Skiing Company v. Aspen Highlands Skiing,
are unusual and even though the Court found illegal monopolization, it
does not appear to represent a significant change in the Court's treatment of monopolization. The Court found that
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pricing. As we discussed earlier in this chapter, most economists consider predatory pricing to be a rare
phenomenon. One antitrust expert, Robert Bork, has even argued that there should be no legal rules against it:
It seems unwise, therefore, to construct rules about a phenomenon that probably does not exist or which,
Areeda-Turner
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atory pricing strategy. Also, pricing below short-run marginal cost is well known to be economically inefficient.
For these reasons, they would classify such prices as predatory and therefore illegal. However, for outputs to the
right of min
AC,
average cost (
) is less than marginal cost. Because prices above average cost (but below
marginal cost) would not exclude equally efficient rivals, they would permit such prices (even though they would
be economically inefficient).
Finally, because "marginal cost data are typically unavailable," Areeda and Turner propose to substitute average
variable cost (
) for marginal cost. Their conclusion is:
a. A price at or above reasonably anticipated average variable cost should be conclusively presumed lawful.
b. A price below reasonably anticipated average variable cost should be conclusively presumed unlawful.
The Areeda-Turner proposal has stimulated a large number of criticisms and alternative proposalstoo many for a
comprehensive treatment here. For our purposes, it is appropriate to review three of the various alternatives that
have been proposed. The three can be identified briefly as the
ATC
(average total cost) rule, the output restriction
rule, and the Joskow-Klevorick two-stage rule.
The ATC Rule
A number of economists have independently proposed some version of what we term the ATC rule. A key reason
given for preferring the ATC rule to the Areeda-Turner rule is that the latter rule is too permissive, allowing
predators to escape too easily.
Because the final version of the Areeda-Turner rule is that only prices below average variable cost (AVC) are
predatory, the shaded region in Figure 9.5 illustrates how it differs from the ATC rule.
Greer has argued that the AVC rule "produces a defendant's paradise, a monopolist's heaven." He goes on to
observe that "a monopolist with abundant financial reserves could, under the [Areeda-Turner] rule, drive less
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is the dominant firm's preentry level of output and
is the postentry
level of output. Hence this rule states that in the period after entry occurs the dominant firm cannot increase output
above the preentry level.
The Marginal Cost Rule, P
SRMC. This rule permits the dominant firm to increase output in the postentry
period subject to the condition that price will not fall below short-run marginal cost.
Williamson's analysis uses the Bain-Sylos model of limit pricing that we described in Chapter 6. However, for
analytical convenience, his long-run average cost curve (available to all firms) falls in steps rather than
continuously. A key assumption is that
Dominant firms are assumed to be influenced by predatory pricing rules in the following way: whatever
rule is in effect, dominant firms will invest in plant and equipment in an amount and kind such that the
profits of any entrant, were one to appear, would be reduced to zero if the dominant firm responded to entry
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the most aggressive manner allowed by the prevailing rule. An aggressive (as opposed to a conciliatory) response
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response to entry.
Hence the marginal cost rule induces the dominant firm to build a smaller plant (minimum
SRAC at
as compared to
) and charge a higher preentry price (
compared to
) than for the output
restriction rule case. The dominant firm also produces its preentry output at a higher average cost (
Based on these comparisons, Williamson concludes that the output restriction rule is superior on welfare grounds.
He also concludes that it is superior to the average total cost (ATC) rule, although we will not describe that
comparison here.
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Joskow-Klevorick Two-Stage Rule
In a 1979 article
Joskow and Klevorick proposed a two-stage approach to predatory pricing. The first stage
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Price Discrimination and the Robinson-Patman Act
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first-degree or perfect discrimination (in which the monopolist obtains all of the consumer surplus), second-degree
(such as tying), and third-degree (in which demanders are partitioned into groups and each group is charged a
different pricesuch as discounts for children at the movie theater).
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at point
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Single Price
= P
=
=
+ q
= 60
+ q
total profit = $2000
total profit = $1800
The Kevlar example makes it clear that third-degree discrimination, the subject of the Robinson-Patman Act, is
profitable. The next question is to examine the efficiency of price discrimination. For our Kevlar example, we can
compare total economic surplus under the two scenariosdiscrimination and single price. It turns out that in
situations where there are linear demand curves, and where both demand groups buy positive amounts in the single
price case, total surplus always falls when discrimination is allowed. This is the case in our example.
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Price




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Single Price
= $60
= $60
= 40
= 40
= $30
= 10
= 40
= 50
total profit = $1700
total profit = $1600
Discrimination, as before, yields higher profits ($1700 versus $1600). Now, however, total output increases under
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At times Utah Pie was a leader in moving the general level of prices down, and at other times each of the
respondents also bore responsibility for the downward pressure on the price structure. We believe that the
Carload purchases
5,000-case purchases in any consecutive 12 months
50,000-case purchases in any consecutive 12 months
Only five customers ever bought sufficient quantities of salt to obtain the $1.35 per case price. These were large
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In conclusion, although economic analysis reveals that there are cases in which prohibiting price discrimination is
socially beneficial, there are many cases in which it should not be prohibited. The Robinson-Patman Act appears to
be a poor instrument for distinguishing the cases, and reforming the Act may be too difficult. This is similar to the
criticism of predatory pricing law in that the attempt to prohibit certain harmful practices may be, on balance, more
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scind it because of unprofitability. In light of the duPont Cellophane case, how might this rule be modified to
a. The management of firm 1 is considering a strategy of predatory pricing since they believe monopoly profits
would far exceed their current profits. What are the potential monopoly profits in this industry?
b. Ignoring any antitrust concerns, the management wants at least to do an investment analysis of predatory
c. Assume that whatever the numbers above show, the management could choose numbers that make the
b. Assume now that it is illegal for Johnson to charge different prices to A and B. What price will Johnson now
charge and what will its profit be? What is Johnson's quantity sold?
c. Is total economic surplus higher in (a) or in (b)? What is the difference in total surplus in the two cases?
d. Assume now that the demand for Cloreen by industry B is less than above, and is
= 40 -
. Aside from
this change, the facts are as given above. Answer (a), (b), and (c) given the changed demand by industry B.
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allowed" case one group of users (group B) of a new product finds its price too high to buy any of the product. But
under discrimination they would buy a positive amount at the lower price offered them. Further, assume that the
price charged to the original group of buyers (group A) remains unchanged after discrimination is permitted.
a. The legal permission to price-discriminate would benefit the monopolist, but the original group of buyers (group
A) would be harmed. Do you agree or disagree? Why?
b. The legal permission to discriminate would benefit group B buyers and the monopolist, and group A buyers
6. It is useful to observe that
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14. F. M. Fisher, "Diagnosing Monopoly,"
Quarterly Review of Economics and Business,
Summer 1979, p. 16.
15. United States v. Aluminum Co. of America, 148 F. 2d 416 (2d Cir. 1945).
16. United States v. United Shoe Machinery Corporation, 110 F. Supp. 295 (D. Mass. 1953).
17. D. F. Greer,
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38. Robert H. Bork,
The Antitrust Paradox
(New York: Basic Books, 1978), p. 154.










q

q
51. The elasticity of demand is -(
), so substituting
= 60,
= 40, and
dp =
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55. Similar to the point made in note 53, the SMR coincides with
up to output 60; it then jumps vertically
from a negative value to point
and includes segment
56. See R. Schmalensee, ''Output and Welfare Implications of Monopolistic Third-Degree Discrimination,"
American Economic Review,
March 1981.
57. Utah Pie v. Continental Baking, 386 U.S. 685 (1967). An interesting analysis of this case is K. G. Elzinga and
T. F. Hogarty, "Utah Pie and the Consequences of Robinson-Patman,"
Journal of Law and Economics,
58. Federal Trade Commission v. Morton Salt Co., 334 U.S. 37 (1948).
The Antitrust Paradox,
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ECONOMIC REGULATION
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Introduction to Economic Regulation
What is Economic Regulation?
The essence of free enterprise is that individual agents are allowed to make their own decisions. As consumers and
laborers, each person decides how much to spend, how much to save, and how many hours to work. Firms decide
which products to produce, how much to produce of each product, what price to charge, which inputs to use and
from which suppliers to buy them, and how much to invest. In all modern economies, there is also an entity called
government, which decides on such things as the income tax rate, the level of national defense expenditure, and the
growth rate of the money supply. Government decisions like these affect both the welfare of agents and how they
behave. For example, raising the income-tax rate induces some individuals to work fewer hours and some not to
work at all. Although an income tax influences how a laborer behaves, the laborer is left to decide how many hours
to work. In contrast, in its role as regulator, a government literally restricts the choices of agents. More formally,
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approval before undertaking certain investment projects. The presumed objective is to avoid duplicate facilities.
Brief History of Economic Regulation
Formative Stages
What is typically meant by economic regulation in the United States began in the 1870s.
Two important events
took place around that time. First, a key Supreme Court decision provided the basis for the regulation of
monopolies. Second, forces were building in the railroad industry that would result in its being the first major
industry subject to economic regulation at the federal level.
Munn v. Illinois (1877)
In 1877 the landmark case of
Munn v. Illinois
was decided. This case established that the state of Illinois could
property does become clothed with public interest when used in a manner to make it of public consequence,
and affect the community at large. When, therefore, one devotes his property to a use in which the public
has an interest, he, in effect, grants to the public an interest in that use, and must submit to be controlled by
the public for the common good.
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Munn v. Illinois
provided the foundation for regulation to be used to prevent monopolistic exploitation of
Interstate Commerce Act of 1887
Around the time of the
Munn v. Illinois
decision, the railroad industry was going through a turbulent period.
Throughout the 1870s and 1880s the railroad industry was subject to spurts of aggressive price wars intermixed
with periods of relatively stable prices (see Figure 5.7 in Chapter 5). At the same time, the railroads were practicing
price discrimination across different consumers. Those consumers who were charged relatively high prices (due to
relatively inelastic demand) were calling for government intervention. At the same time, the railroads were seeking
government assistance to stabilize prices (perhaps near the monopoly level). The result of these forces was the
Interstate Commerce Act of 1887,
which created the Interstate Commerce Commission (ICC) for the purpose of
regulating rail rates. Although only with later acts of Congress was the ICC given the necessary powers to regulate
price, the Interstate Commerce Act represents an important landmark in Congressional regulatory legislation.
Nebbia v. New York (1934)
So far as the requirement of due process is concerned, and in the absence of other constitutional restriction,
a state is free to adopt whatever economic policy may reasonably be deemed to promote public welfare, and
to enforce that policy by legislation adapted to its purpose.
The Supreme Court tore down any constitutional barrier to economic regulation as long as, in the state's judgment,
such regulation was in the public interest.
Trends in Regulation
Early regulation focused on the railroads and public utilities like electricity, telephone (which encompassed both
local telephone and long
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Business. This
is from
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Table 10.2
Major Economic Deregulatory Initiatives: 1971-1989
Specialized Common Carrier Decision (FCC)
Domestic satellite open skies policy (FCC)
Abolition of fixed brokerage fees (SEC)
Railroad Revitalization and Reform Act
Air Cargo Deregulation Act
Airline Deregulation Act
Natural Gas Policy Act
Deregulation of satellite earth stations (FCC)
Urgent-mail exemption (Postal Service)
Motor Carrier Reform Act
Household Goods Transportation Act
Staggers Rail Act
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Current Regulatory Policy
With most of the clear-cut cases of inappropriate regulation having been dismantled, the current trend is a mixture
of re-regulation and further deregulation. For example, recent legislation not only now permits the regulation of
cable rates but also requires it. Although deregulation of long-distance telephone service has stalled (it is still in a
mode of partial deregulation in which AT&T's fares require FCC approval), current forces may result in the partial
The evolution of regulatory policy will never come to an end. The path it takesand we should make every
effort to see that it takeshowever, is the path not of a full circle or pendulum, which would take us back to
where we started, but of a spiral, which has a direction. This is in a sense only an expression of a
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Stage 2: Implementation
Having passed a piece of legislation, the second stage in the regulatory process is the implementation of this
legislation. Although the legislature can influence its implementation, the immediate responsibility falls to the
regulatory agency. Thus, regulators replace legislators as central actors at the implementation stage while producers
and consumers continue to be relevant. Other important actors may include potential entrants who desire to enter
this regulated industry.
Stage 3: Deregulation
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and exit from the industry. Although the Interstate Commerce Act of 1887 gave the ICC regulatory jurisdiction
over the railroad industry, it took the Hepburn Act of 1906 and the Transportation Act of 1920 for the ICC to have
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Table 10.3
Major Federal Economic Regulatory Commissions
Number of
Size of Staff (FTE)
Interstate Commerce Commission
Railroads (1887)
Trucks (1935)
Water Carriers (1940)
Telephone (1910-1934)
Oil Pipelines (1906-
Federal Communi-cations Commission
Telephone (1934)
Broadcasting (1934)
Cable Television (1968)
Securities and Exchange Commission
Securities (1934)
Federal Power Commission (1935)
Federal Energy Regulatory Commission
Wholesale electricity
Natural gas (1938)
Oil pipelines (1977)
Civil Aeronautics Board (1938)
Airlines (1938)
Source:
This is an adapted version of tables from Leonard W. Weiss, "The Regulatory Reform
Movement" in Leonard W. Weiss and Michael W. Klass (eds.),
Regulatory Reform: What Actually
Happened
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administrative processes, regulation imposes due-process requirements on any changes. In some sense, producers
and consumers have legal rights to the status quo and it can only be overthrown through due process. This is very
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source: several firms may extract oil from a common reservoir, and several fishermen may fish from the same lake.
In their pursuit of utility or profit maximization, these agents do not take into account how their activity reduces the
resource and thus raises the cost of production to other agents.
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fare gains that generates the public's demand for regulation. In this way, the public interest theory uses normative
analysis (when should regulation occur?) to produce a positive theory (when does regulation occur?).
Critique of Normative Analysis as a Positive Theory
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firm pricing behavior. In a well-known study, George Stigler and Claire Friedland examined the effect of
regulation on the pricing of electric utilities over 1912-1937.
They found that regulation had an insignificant,
though downward, effect on prices. In contrast, NPT would predict that regulation would have a strong downward
effect on prices because it forces a monopolist to price at average cost rather than at the profit-maximizing level.
Reformulation of NPT
In light of the contradictory evidence, NPT was reformulated. This reformulation says that regulation is originally
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Critique of the Capture Theory
In that it is in greater agreement with regulatory history, the CT is more compelling than NPT. Nevertheless, the
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phenomenon. In addition, a theory must also explain why we have observed both the regulation and (partial or full)
deregulation of such industries as railroads (regulated in 1887, deregulated in 1980), intercity telecommunications
(regulated in 1910, partially deregulated starting in 1971), trucking (regulated in 1935, deregulated in 1980),
airlines (regulated in 1938, deregulated in 1978), natural gas (price regulated in 1954, deregulated in 1989), and oil
(regulated in 1971, deregulated in 1981). It must also tackle the simultaneous decline of economic regulation and
rise of social regulation in the past two decades.
The Stiglerian Approach
The major breakthrough in the theory of regulation occurred in a 1971 article by Nobel laureate George Stigler,
''The Theory of Economic Regulation."
The value of this contribution was not so much in the predictions that it
generated (it basically produced predictions along the lines of the CT), but in the way it approached the question,
We assume that political systems are rationally devised and rationally employed, which is to say that they
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control regulation. A later paper by Sam Peltzman formalized the analysis of Stigler, and both of these papers have
built on the work of Mancur Olson.
There are three crucial elements to the Stigler/Peltzman formulation. First, regulatory legislation redistributes
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small. The smaller the size of the interest group, the weaker is this free-rider effect because each member's
contribution has a proportionately bigger impact on the eventual impact of the group. Thus, in terms of both
recognition of a need for regulation and implementation of that regulation, the advantage rests in small interest
groups for which the per-capita benefits from regulation are high.
This argument provides some insight into why much of observed regulation favors producers. Producer groups are
typically small in number, with each firm benefiting a large amount from regulation, whereas the primary
opposition is consumers, of which there are typically millions, and the harm that regulation creates, while large in
the aggregate, is small for each consumer.
U.S. Peanut Program
An example of a small group's benefiting from regulation at the cost of a large group is the peanut-quota system.
Since 1949 the federal government has run a program that limits the number of farmers who can sell peanuts in the
United States. Imports are also severely restricted. On top of these restrictions, price supports are used to guarantee
that farmers with peanut quotas can cover their production costs for each year. This generally results in the
minimum selling price being about 50 percent higher than the world price.
For 1982-1987, it was estimated that the average annual consumer-to-producer transfer was $255 million (in 1987
dollars) with an associated deadweight welfare loss of $34 million.
In 1982 there were 23,046 peanut farmers,
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how much wealth is to be transferred to them. For example, a legislator decides on the price structure and, in so
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When x 0, more wealth is taken from group 2 than is transferred to group 1. This "disappearing" wealth is
measured by
and is the welfare loss from regulation.
A property of the Becker model is that aggregate influence is fixed. The implication is that what is important for
then group 1's optimal level of pressure is
), which is denoted
in Figure
10.3. Because the more pressure that group 2 exerts the lower is the influence of group 1, group 1 finds it
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Political



is a
political equilibrium
if, given group 2 applies
pressures
is the pressure that maximizes group 1's welfare
given group 1 applies pressure
is the
pressure that maximizes group 2's welfare.
A political equilibrium is then defined by the intersection of the two
best response functions
) and
) as at that intersection both interest groups are simultaneously exerting
optimal levels of pressure. The political equilibrium in Figure 10.3 is then the pair
The political equilibrium has both interest groups investing in pressure so as to influence the political process. The
optimal pressure for each group is very much dependent on the level of pressure exerted by the other group
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riding. When the free-riding problem is less severe in group 1 than in group 2 (perhaps because group 1 has fewer
All the [franchise] applicants have hired influential lawyers and public-relations consultants, a roster of
whom reads like a Who's Who of former city and state officials.... [A vice president for one of the
applicants] contends that these friends at city hall (who typically command fees of about $5,000 per month)
have tended to cancel one another out.
(see Figure 10.3). For example, if group 1 is expected to apply pressure
then group 2 now
chooses to apply pressure
rather than
because now the welfare loss imposed on group 2 is higher for any given
value of
(due to a higher value of
). This higher value of
in response to an increase in the marginal deadweight loss from regulation. As a result, the new political
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equilibrium is
, which entails more pressure by group 2, as
and less pressure by group 1, as
Because the amount of the transfer,
, equals
) and
) is increasing in
and decreasing in
. As measured by the amount of wealth transfer, regulatory activity is reduced due to
an increase in the marginal deadweight loss associated with it.
An important implication of this result is that regulatory policies that are welfare-improving are more likely to be
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Such pricing behavior is perplexing because it appears to be inconsistent with both profit maximization and welfare
An explanation for cross-subsidization is provided by Richard Posner.
He puts forth the thesis that one of the
functions of regulation is to assist the government in its role of redistributing resources. In this light, cross-
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industry has largely escaped the program of deregulation that took place in the 1970s and 1980s.
Entry Restrictions
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The Value of a Medallion
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Table 10.4
Prices of Taxicab Medallions
Price Range
$32,000-$33,000
Cambridge, MA
$20,000-$25,000
$15,000 or more
Houston
$10,000-$12,000
$400-$500
Minneapolis
$8,000-$12,000
New Orleans
New York City
Oakland, CA
$2,000-$3,000
Portland, OR
$3,000-$9,000
$8,000-$15,000
$1,000-$2,000
$15,000-$20,000
1967-1979
$1,000-$12,000
Somerville, MA
Source:
Updated table from Mark W. Frankena and Paul A. Pautler,
Economic Analysis of Taxicab Regulation,
Bureau of Economics Staff
Report, Federal Trade Commission, May 1984.
current holder of a New York City medallion would stand to lose over $200,000 if free entry were allowed. In
comparison, the value of deregulation to each consumer of taxicab services would be much much lower.
Furthermore, the holding of medallions is typically concentrated in a few large taxicab companies, which makes
this interest group more effective in providing political support in exchange for continued entry restrictions.
Summary and Overview of Part II
As with any sort of economic phenomenon, there are certain empirical regularities associated with economic
regulation. It typically entails regulation over price, quantity, and/or the number of active firms. Regulatory activity
also has certain time-series properties. We have witnessed periodic bursts of legislation. A large amount of
economic regulation took place after the Great Depression, whereas deregulation was hot in the 1980s.
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This chapter provided a brief review of the regulatory process, but it could hardly do justice to the complexity of
this process. Many economic agents are involved at the time of regulation's inception, implementation, and,
perhaps, its dismantling. To understand why the regulatory environment looks the way it does, one must
understand the motives of consumers, firms, unions, legislators, regulatory commissioners, and government
bureaucrats. Several theories of why regulation takes the form that it does were discussed. Different variants of the
economic theory of regulation appear to be most consistent with the evidence. Nevertheless, there is still much
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Theory of Natural Monopoly
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Cost




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pacity, unit costs were falling and constituted a natural monopoly situation. In the late 1960s the number of circuits
had risen to 79,000 (largely because of the requirements of television), and this volume was such that unit costs
were essentially flat (beyond
in Figure 11.2). Hence, by the late 1960s the temporary natural monopoly had
This phenomenon is not rare. Railroads possessed significant cost advantages in the late 1800s, and these
advantages were eroded considerably with the introduction of trucking in the 1920s. This example introduces a
new element, namely, technological change.
That is, over long periods of time it is likely that the cost function
will shift as new knowledge is incorporated into the production process. Hence, permanent natural monopoly is
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Economies





in the following manner. We know that for least-cost
production, each firm must produce at the same output rate and thereby have the same marginal cost. Hence, for a
given point on the
curve, simply double the output rate
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to obtain a point on the
curve. For example, at the minimum average cost point
AC,
double
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a 10-percent greater quantity of each commodity increased by some amount less than 10 percent. The reason that
economies of scale are neither necessary nor sufficient for subadditivity is that in the production of multiple
outputs, the interdependence among outputs also becomes important.
Although various ways have been proposed for measuring these interdependencies, the concept of economies and
diseconomies of scope is appealing intuitively.
Economies of scope mean that it is cheaper to produce, say, 85
cars and 63 trucks within a single firm than it is for specialty firms to produce the required outputs. If you think of
peak-period electric power and off-peak power as different commodities, then economies of scope are clearly
presentthe two commodities can share the same power plant and distribution system.
Sharkey has given an example of a cost function that possesses economies of scale for all outputs, but which is
nowhere subadditive.
His example is
Notice that the total cost after increasing each output by 10 percent is
whereas the total cost increased by 10 percent is
Because the former is less than the latter, economies of scale exist. Nevertheless, the function has diseconomies of
scope that sufficiently outweigh the economies of scale to make cost nowhere subadditive.
To see this, note that the third term in the cost function, equation (11.1), adds a positive amount to cost whenever
Because
, production in the specialty firms, A and B, is cheaper than in a single firm, C. Thus,
economies of scale are not sufficient for cost to be subadditive because of the diseconomies of scope.
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In summary, the definition of natural monopoly in the multiple-output case is that the cost function must be
subadditive. Subadditivity of the cost function simply means that the production of all combinations of outputs is
accomplished at least cost by a single firm. It is a complex matter to specify the necessary and sufficient conditions
for costs to be subadditive. We have shown through some simple examples, however, that it generally depends on
both economies of scale and economies of scope. If both exist, then subadditivity will likely obtain.
of scale alone, however, can be outweighed by diseconomies of scope. Thus, although economies of scale in the
single-product case imply natural monopoly, this does not hold true for the multiple-product case.
Before turning to the various policy solutions to the natural monopoly problem, we shall briefly explain a related
concept known as sustainability. It can be explained best by reference to Figure 11.5.
Figure 11.5 reproduces the cost function for the single-product case from Figure 11.4. Recall that the cost function
is subadditive for outputs less than
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is said to practice linear (or uniform) marginal cost pricing. In other words, a customer's expenditure for a product
is a linear function of price and quantity sold,
. On the other hand, if the firm charges a fixed fee
of the amount bought, and also a per-unit charge
, nonlinear (or nonuniform) pricing would be in effect. Then the
customer's expenditure would be a nonlinear function,
In our ideal pricing discussion, we begin with the linear marginal cost pricing solution. After considering nonlinear
pricing we examine the so-called Ramsey pricing alternative, which applies to multiproduct cases. The section
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Page 360
is less than average cost. The next question is to ask where the subsidy is to come from and what effect this will
have on economic efficiency.
The only ''correct" solution is for the government to raise the subsidy through a lump sum tax, that is, a tax that
would not distort other decisions throughout the economy. Such taxes are rarely, if ever, used in practice. Income
taxes and sales taxes are unacceptable because they create inefficiencies themselves by introducing wedges
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Service employees, for example, have an advantage in bargaining with management, inasmuch as both sides know
that the enterprise will not fail if revenues are less than costs. The Treasury can always be counted on to subsidize
the Postal Service in a pinch. Steel industry labor unions do not have this advantage.
3. On distributional grounds, it can be argued that nonbuyers of the natural monopoly good should not be required
to subsidize the marginal cost buyers. That is, why should the taxes paid by individuals without telephone service
be used to subsidize individuals who purchase such service at a loss-creating price?
A major point of the analysis above is that enterprises should price so that their revenues cover costs. Furthermore,
in the United States, because most public utilities are privately owned firms, it is politically unrealistic to imagine
government subsidizing the losses of private firms. Hence we conclude that there are compelling reasons to accept
the constraint that natural monopolies should operate such that total revenues and total costs are equated.
In the single-product case, linear pricing implies that price must equal average cost if total revenues must equal
total costs. This is shown in Figure 11.8 as price
and output
. This departure from marginal
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cost pricing leads, of course, to the welfare loss given by the shaded triangular area.
The argument above refers to linear pricing; that is, the buyer pays a single price per unit and therefore the buyer's
total expenditure is proportional to total consumption. An important alternative is nonlinear pricing.
Nonlinear Pricing
A two-part tariff is nonlinear and consists of a fixed amount or fee, regardless of consumption, plus a price per
unit. If the price per unit equals marginal cost, then it is possible to have efficient pricing and have total revenues
of the firm equal to its total costs.
For example, if the loss under linear marginal cost pricing is estimated to be
(the shaded rectangle in Figure
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The three "self-selecting" two-part tariffs are
Fixed Fee
One can represent a two-part tariff by a vertical intercept (for the fixed fee) and a straight line with slope equal to
the price per unit. The three such lines in Figure 11.9 represent the three two-part tariffs referred to above. (Notice
that no consumer would wish to consume on portions of the tariffs other than the lower boundary
ABCD.
Hence it
does not matter that these "dominated" portions of the two-part tariffs are not actually part of the declining-block
tariff.) The point is that the declining-block tariff has the same effect as confronting consumers with two-part
tariffs that are tailored to their demands. And, of course, all consumers are free to choose the particular tariff that
they prefer, so that there is no discrimination involved that is likely to be disallowed.
Up to this point our discussion of ideal pricing has been limited to a single-product natural monopolist. We now
turn to the case of a multi-
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ple-product natural monopolist and describe what has become known as Ramsey pricing.
Ramsey Pricing
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Proportionate





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Using this rule, one can derive the actual Ramsey prices.
They are shown in Figure 11.10(b). Hence the firm
would minimize the welfare losses by charging $40 for good
and $30 for good
. At these prices, the demand
elasticities are 0.67 and 1.0, respectively. The deadweight loss triangles are $200 for good
(triangle
) and
$100 for good
(triangle
) for a total of $300. This is, of course, a lower "cost" in terms of welfare by $97
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Loeb-Magat Proposal
Of course, if regulators had perfect information as to the monopolist's costs and demands, the ideal pricing schemes
discussed above could be put into effect by command. However, such is not the case. Although the monopolist
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K
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Franchise Bidding
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agencies are becoming more interested in, for example, marginal cost pricing. In short, regulatory agencies try very
hard to ensure that the monopolist's revenues equal its costs, and historically have been less concerned with the
pricing structure used.
As a result, there is no simple way to describe the pricing structures used under regulation. Price discrimination is
often employed both across customer groups (industrial, commercial, residential, and so on) and within groups
(declining block rates, for instance, 5 cents per unit for the first 300 units, 4 cents per unit for the next 500 units,
and so on).
Richard Schmalensee has observed,
To the extent that utility regulators in the United States have been concerned with rate structures, they have
tended to focus on prices paid by different classes of users. But this focus has typically been motivated and
informed by considerations of equity or fairness rather than efficiency.
Hence, regulatory agencies often try to prohibit undue discrimination across customer groups. They require the firm
to allocate its total costs to customer groups and then adjust their prices if the revenues by groups do not
correspond to the groups' "fully distributed costs."
There is a serious problem implicit in this procedure, however, because a large proportion of a firm's costs are
usually common costs. For example, high-voltage power lines are used in common by all customer groups. And
although arbitrary accounting rules can be made up to apportion these costs among groups (for instance, in
proportion to their respective annual purchases of the product), none are meaningful in an economic sense as a
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common in the United States as it is in other countries. The Postal Service is an example in the United States.
Other examples include various government-owned electric utilities (for instance, the Tennessee Valley Authority)
and Amtrak, the government-owned passenger service railroad.
In other countries, public enterprise is a frequent solution in the public utility sector. For example, electricity,
telecommunications, gas, and railroads are primarily public enterprises in Europe. However, in recent years a
number of countries such as Great Britain have been "privatizing" their public enterprises. That is, they are selling
public enterprises to private investors and then instituting regulation.
In principle, public enterprise would appear to be a sensible alternative. Managers would be directed to maximize
economic surplus there would be no need for regulators to try to channel the decisions of profit-maximizing firms
closer to the public interest. The efficacy of public enterprise as compared to regulation, however, is a complex
issue and will be examined further in Chapter 14.
b. The answer to (a) implies that linear (or uniform) marginal cost pricing
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has a serious problem in natural monopoly situations. Suppose that average cost pricing is employed. Find price,
output, and the deadweight loss compared to (a).
c. Now consider two-part pricinga type of nonlinear (or nonuniform) pricing. Each consumer must pay a fixed
a. What is the largest fixed fee that a poor consumer would pay for the right to buy at marginal cost?
b. Because the poor consumers would not be willing to pay the uniform fixed fee of $50 necessary for the
monopolist to break even, the rich consumers would have to pay a fixed fee of $83.33. What is the deadweight
loss in this case?
c. Third-degree price discrimination could be a solution. That is, if it is legal, resales are not feasible, and
consumers could be identified by the monopolist as being rich or poor, the monopolist could charge different
fixed fees to the two consumer types. If the price per unit is still equal to marginal cost, what are two fixed fees
that are feasible? In this case, what is the deadweight loss?
4. If third-degree price discrimination is not a feasible alternative in 3(c), consider the optimal two-part tariff. That
is, what is desired is the two-part tariff that minimizes deadweight lossor that maximizes total surplus. One way to
think about it is to imagine the case of a zero fixed fee and price equal to marginal cost. This causes a loss of $500
that must be covered. Imagine raising both the fixed fee and the price simultaneously both can cause losses: the fee
by excluding poor consumers and the price by causing deadweight consumption losses. One possibility is to
a. Find the sum of consumer and producer surplus minus the $500 fixed cost (that is, find total surplus) for case
3(b) where the poor are excluded.
c. Compare the efficiency of the tariffs in (a) and (b).
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5. A multipart tariff can be superior to the optimal two-part tariff found in question 4. A multipart tariff involves a
fixed fee plus multiple prices per unit, which depend upon predefined blocks of consumption.
a. Show that by making an additional two-part tariff available to the consumers that they can use at their option,
d. Find the consumer surplus of a rich consumer under the multipart tariff.
e. Find the change in profit of the monopolist. Hence a movement from two-part tariffs to multipart tariffs
a. Find the price that enables the monopolist to break even. (This is the same problem as 2(b).) Call this price
b. Loeb and Magat show that if the monopolist is allowed to choose its own price and to have the regulatory
agency subsidize the firm by an amount equal to consumer surplus at the selected price, the monopoly will select
price equal to marginal cost. What is the price and amount of government subsidy?
c. Loeb and Magat also note that a bidding process for the monopoly franchise would enable the government to
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d. An alternate proposal would make use of two-part tariffs. For example, assume that the current regulated
price is
Now assume that the regulatory agency offers the firm the right to select any two-part tariff that it
wishes as long as the consumer continues to have the option of buying at
(For simplicity, assume a single
consumer.) What is the two-part tariff that the monopolist will choose and what is its profit? What is the
deadweight loss?
e. Assume that the government uses a bidding process to eliminate the monopoly profit in (d). The bid is in the
form of a single price, like
*, that the consumer will always have as an option to the two-part tariff. That is,
the same rules are in effect as in (d) except that now the bidding is for the right to offer a two-part tariff
optional to some
f. Compare the Loeb and Magat proposal in (c) with the proposal in (e). Do both proposals give efficient
prices? Are there any substantive differences?
1. Entry, induced by the monopoly price, is usually assumed to be unlikely in natural monopoly situations.
2. The term permanent is perhaps misleading inasmuch as one can never rule out dramatic technological changes
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11. Throughout this chapter we make the common assumption that the area under the demand curve measures total
willingness-to-pay by consumers. This requires one to assume that the income elasticity of demand is zero (or
small enough to make the error unimportant). See R. D. Willig, "Consumer's Surplus without Apology,"
Economic Review,
September 1976.
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Natural Monopoly Regulation
The theory of natural monopoly and alternative policy solutions were the main topics of the last chapter. The most
common policy solution in the United Statesregulationis the subject of this chapter. Electric power will be used as
our primary example, although some references to other regulated natural monopolies will be made, such as
telephone service, natural gas distribution, and water supply.
In examining regulation, it is useful to keep in mind the benefits and costs. The benefit is to reduce deadweight
losses in efficiency that would exist under unregulated monopoly. The costs are less obvious, but include the direct
costs of regulatory agencies as well as unintended side effects of regulation. An important side effect is higher
costs because of changed incentive structures of regulated firms.
The technology for centralized production and distribution of electric power was first put into operation in
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appointed by the legislature. A typical commission consists of three to twelve commissioners who are assisted by a
staff of up to 2500 members. Many state commissions are smaller. The staff members are trained in accounting,
engineering, economics, and the law.
Some data on the North Carolina Utilities Commission in a recent year are instructive. The North Carolina Utilities
Commission, with seven commissioners and 147 staff members, regulated over 1000 utility companies. Many of
these companies were small trucking companies and water and sewer companies. Three large electric utilities
supplied power in the state, three large companies distributed natural gas, and two large telephone companies were
The commissions typically focus on prices charged by the monopolist. Their mandate is usually somewhat vague,
such as requiring that prices be "just and reasonable" and that there be no "undue discrimination." The procedure is
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Table 12.1
|North Carolina Natural Gas Corporation Statement
Year Ended Dec.
Adjustments for Rate
After Adjustments for Rate
(1) Purchased gas
(2) Labor
(3) Depreciation
(4) Taxes
Total expenses
(5)
Rate Base
Plant less
Working capital
(6) Total
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The third column shows the way the company would like their financial results to look. That is, the company has
In May 1987, the PUC Public Staff Division's Diablo Canyon Team recommended that of the $5.518 billion
that PG&E spent before commercial operation of Diablo Canyon Nuclear Power Plant, the utility should
only be allowed to collect $1.150 billion in rates.... The Public Staff Division alleges that unreasonable
management was to blame for a large part of this cost overrun.
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Actually, utilities are financed by investors in bonds, preferred stock, and common stock. For this reason, the
Percent Cost
Preferred stocks
Common stocks
10.4 (weighted average)
The first two types of securities, bonds and preferred stocks, are not controversial because they have easily
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Page 384
Hence,
best opportunity at the same degree of riskiness. Now if we assume that investors expect dividends to grow at some
constant rate
, where
is less than
k,
equation (12.2) can be solved for the unknown
Assume that the current dividend yield
is 8 percent and investors expect that dividends will grow over time at
7 percent. Then equation (12.3) would yield 15 percent as the cost of equity capital.
depends upon the riskiness of
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Recently, however, there have been some steps taken by commissions to reward efficient utilities and penalize the
in measuring a firm's performance, but one often-heard problem is not true namely, that the firm must have a value
of
that is not less than its cost of capital or it cannot attract capital.
Suppose for simplicity that a firm is known to have a cost of capital of 10 percent and the commission allows it a
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timal'' value of
is unknown; however, one would think that neither extreme is likely to be best.
Price Caps and Performance Standards
In recent years, ''price cap" regulation for telephone companies has been used by the FCC and some states in lieu
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The limited U.S. evidence available supports the view that PC regulation is an effective means of
controlling the
prices
of dominant firms when the control of their
profits
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analysis, but it should be instructive to formulate the problem and provide the solution.
Hence the problem is to choose the quantities of labor and capital to maximize profitthat is, revenue minus the
costs of the inputs, labor and capital. Maximize
subject to
where
P


R



K




L




w



r




s





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Page 389
Averch-Johnson
Least-Cost
The
variable is positive because
s- r
and
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because it is these prices that cause concern to consumers. Hence, if, as appears to be the case, nominal prices
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by these customers and services. For example, power plants and transmission lines, telephone switching centers,
and pipelines all represent common costs that apply to most customer classes or services.
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At this point, the demands for the two products must be specified. Assume that the demand functions are
With the demand information, the actual FDC prices can be found by equating equations (12.11) and (12.12). This
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Although we have implicitly assumed that two-part pricing is not feasible in the example, notice that if it were
feasible, the "first best" solution would be to charge marginal cost prices to each group; that is, each price would be
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is, therefore, 20 + 450/
, or $26.4 for
70. Similarly, the AIC for
at
= 70 is $25. Here, the test for
subsidy-free prices is that the prices equal or exceed their respective AICs. The logic is that if each product
contributes to total revenue an amount that at least covers the extra costs it causes (when added to the production of
the other products), then it should be viewed as a beneficial addition. To the extent that its incremental revenues
exceed its incremental costs, the revenues required from the other products are reduced. The Ramsey prices of $30
and $25 also pass this test. In fact, these two tests always give the same answers. (Note that the FDC price of
72.8 units is $23.6 while the AIC of
is $24.8. Hence the FDC prices fail the subsidy-free test by this test too.)
It should be pointed out that FDC prices do not necessarily fail subsidy-free tests. They may pass the subsidy-free
tests and still be economically inefficient.
Under certain conditions of subadditivity of cost (that is, when the natural monopoly is sustainable), it is true that
Ramsey prices are subsidy-free in the sense that no outsider would find it profitable to enter. Hence the regulator
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In anticipation of the next section on peak-load pricing, we provide a final example of ''unfair'' subsidization.
Consider two groups of electricity customers: day customers and night customers. A plant costing
K
dollars is
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Demand for electric power typically varies in a reasonably predictable cyclical patterndaily, weekly, monthly, and
seasonally. The demand might follow the pattern in Figure 12.3 for a typical weekday. Hence, peak demand occurs
at midmorning and is only 70 percent of that amount at midnight. Demand over the weekend might equal only 50
percent of the high during the week.
In a recent year, Duke Power Company produced some 55 billion kilowatt hours of electricity. If it had
experienced a constant rate of demand over the year, Duke Power could have produced that amount of electricity
with a capacity of 6300 megawatts (assuming, for simplicity, no downtime for maintenance or for other reasons). In
fact, during one hour on January 11, Duke had its peak demand for the year, requiring a capacity of 11,145
megawatts! The company actually had some 13,234 megawatts of installed capacity. (Installed capacity is higher
than expected peak demand to provide a reliability margin in view of the uncertainty in demand and to allow for
unplanned outages of power plants.)
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Duke Power's capacity consisted of
coal-fired
A typical electric-power system has a mixture of plant types because it leads to a lower overall cost of supplying
the variable pattern of demand. Nuclear plants have relatively low variable or "running" costs, but have relatively
high fixed (capital) costs. They are, therefore, suited for running as the "base load" plantsas many hours per year as
possible. Combustion turbines, on the other hand, have relatively high running costs but low fixed costs. They are
Short-Run
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time, charging a price equal to short-run marginal cost (SRMC) would require a continuously changing price.
In order to explain the principles of peak-load pricing most clearly, it will help to abstract greatly from the real-
world complexity just described. Hence we turn now to a vastly simplified model.
Peak-Load Pricing Model
In Figure 12.5 we make the assumption that demand is given by the peak demand curve for exactly half of the day,
and by the off-peak demand curve for the other half of the day. For simplicity, it is assumed that the two demands
are independentthe price in the peak period, for instance, does not affect the quantity demanded in the off-peak
Also, it is assumed that "running" costsfor example, fuel for electricity productionare constant at the level
until capacity is reached at
K.
At the output
, no further output is possible, as indicated by the vertical line that is
labeled
SRMC.
Hence we have a so-called "rigid" plant with the
SRMC
curve being equal to
for outputs less than
, and then becoming vertical at the plant capacity. One can think of this as an approximation to the smoothly
increasing
SRMC
curve in Figure 12.4.
The dashed horizontal line at the level
is labeled long-run marginal cost (
). The assumption here is that
represents the cost of an additional unit of capacity, and that it is possible to add capacity in
Peak-Load
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increments of single units if desired.
The economically efficient solution is to charge a price equal to
SRMC
order to use the existing plant optimally. The
LRMC
the shaded triangle that represents the increase in consumer surplus attributable to the capacity increase. Hence, at
the new capacity
price is again equal to
SRMC
and LRMCindicating that
K*
is the optimal capacity.
Now, assume that the electric utility follows the practice of charging a single price that does not vary over the day,
say, a price of
*. This situation is shown in Figure 12.6. As we mentioned earlier, this would represent the pricing
policy generally followed in the United States before peak-load pricing began to be implemented. In order to
satisfy demand at the peak at this price, capacity of
is required. Because optimal capacity is
where price
equals
LRMC,
the single-price policy leads to too much capacity. The deadweight loss associated with this is
shown as the shaded triangle
EFG.
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Dead






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Demand






goodit can be used by both peak and off-peak demanders (though at different times). This implies that the total
willingness-to-pay for the plant is obtained by adding vertically the demand curves for the two groups of
demanders. This total willingness-to-pay curve, the kinked curve
ABC,
is the demand for capacity. For example, at
the output
the marginal willingness-to-pay is
by peakers and
by off-peakers, for a total of
Because the
capacity cost is
is the optimal capacity. The efficient prices for using this capacity are
and
, which, of
course, add to
Hence, in this case, the two groups share the capacity costs, unlike the firm peak case. (If we had
a nonzero
the prices in each period would also include
In practice, each day is not divided into two distinct periods of peak and off-peak demands. Rather, demand
changes continually over the day, and there are also changes from week to week and season to season. This implies
that the implementation of peak-load pricing requires
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5 P.M.-6 P.M.
Weekdays 2 P.M.-5 P.M.
In addition to the time varying rates, there would normally be a fixed charge per billing period. The rates above
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idea was to compare the price of electricity in states with regulation to the price in states without regulation.
Unfortunately, because state regulation now exists almost everywhere, S-F had to go back to the 1920s and 1930s
to find states without regulation.
This data problem consequently makes their results of limited relevance to the
present time.
To illustrate the nature of their study, S-F found that in 1922 the average price of electricity was 2.44 cents per
kilowatt-hour in states with regulation and 3.87 cents in states without regulation. Of course, this simple
comparison is invalid because prices vary for reasons other than the existence of regulation. However, once they
controlled through multiple regression analysis for other variables (such as the percent of power generated in
hydroelectric plantswhich is less costly than power in coal plants), S-F claimed that no statistically significant
difference in price remained.
Some critics have argued that S-F did find some beneficial effects of regulation at slightly lower standards of
statistical significance. They have also observed that the study period covered a time when regulation was just
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provisions unrelated to electricity, the relevant provision for our purposes gave the Federal Energy Regulatory
Commission (FERC) the right to order utilities to "wheel" power over their transmission lines. If Utility A wants to
sell power to non-adjacent Utility B, and can only do so by using Utility C's transmission lines, then Utility C can
assist in the transaction by wheeling the power from A to B.
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high-voltage transmission have improved the feasibility of increasing numbers of these transactions. It should also
be noted that wholesale power is also being sold by so-called independent power producers who are not subject to
Hundreds of utilities and wholesale power producers buy and sell electricity over the superhighway every
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cents per kilowatt-hour, whereas others pay up to 12.
Utilities with high costs would find themselves losing
customers and, given their large fixed costs, would either have to raise rates to their remaining customers or take
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Edison faces a demand curve with the constant elasticity of demand 2.857, or
-2.857
If Edison were
unregulated, it would produce efficiently at a constant average and marginal cost of $1. However, because of
Averch-Johnson effects, it uses too much capital under regulation and produces at an average cost of $1.01.
Edison charges a price of $1.35 and sells
= 0.42.
a. Find the price and quantity if Edison were an unregulated monopoly. Hint: Marginal revenue is
(1 -
b. Find the sum of consumer and producer surplus for the case where Edison is regulated and where it is not.
Hint: Using calculus, it can be shown that consumer surplus is (0.54)
. Does regulation, even though
imperfect because of Averch-Johnson effects, nevertheless result in an improvement over an unregulated
monopoly case?
c. Of course, the first-best case of price-equal marginal cost and efficient production is superior to regulation.
Find the efficient solution. Draw a figure that shows the two types of losses that regulation causes as compared
to the efficient solution.
d. Assume now that the utility commission decides to lower the allowed rental rate from $0.80 closer to the
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its industrial customers than from its residential customers. Is this a good reason? Hint: How can Edison
a. If
= $16,
= 0.08, and existing spaces are 120, what would be the socially optimal prices during the three
periods?
b. What is the optimal number of spaces and what are the corresponding prices?
c. The above case is a so-called firm peak case, with peak demanders paying all capital costs. Now suppose that
= $5 and
= 0.08. If peak demanders pay all capital costs, what quantity is demanded by peak demanders? If
off-peak demanders pay zero, what is their quantity demanded? (Fractions of spaces are legitimate.) This is the
shifting-peak case.
d. For the demand curves in (c), find the optimal number of spaces and the corresponding prices.
1. State of California,
Public Utilities Commission Annual Report 1986-1987,
2. The book by A. Lawrence Kolbe and James A. Read, Jr., with George R. Hall,
The Cost of Capital: Estimating
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7. H. Averch and L. Johnson, "Behavior of the Firm Under Regulatory Constraint,"
American Economic Review,
December 1962.
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23. P. L. Joskow, "Regulatory Failure, Regulatory Reform, and Structural Change in the Electrical Power
Industry,"
Brookings Papers: Microeconomics,
24. Hoffman, "Power Moves," p. 53.
25. OTA,
Energy Efficiency,
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Franchise Bidding and Cable Television
In spite of considerable deregulation in the 1980s, the government has continued to play a significant role in
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monopoly, we would expect to observe a price that is too high and/or excessive entry into the industry.
This scenario provides the rationale for the regulation of a natural monopoly. To ensure the efficient number of
firms in an industry, entry regulation is typically proposed to prevent more than one supplier from operating.
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the English auction. Assume that the auctioneer starts at a high bid and lowers the bid as long as there are two or
more active bidders. As soon as the bid is lowered to the point at which there is only one remaining bidder, the
franchise is awarded to that bidder. In exchange for the franchise, the winning bidder is to charge a price for
service equal to the final bid.
. This entails the most efficient firm pricing at
average cost.
If the franchise is awarded via a modified English auction, the first question to ask is, What will be the optimal
bidding strategy for a firm? Imagine that prior to the start of the auction, a firm decides on the bids
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for which it will remain active. It should be clear that firm
will choose to remain an active bidder when the bid
is greater than
. If
exceeds
and firm
wins, it then earns above-normal profits as it ends up being able to
charge a price which exceeds average cost. If
is less than
, then firm
leaves the bidding because if it should
win with a bid less than
it will have to charge a price less than average cost and thereby incur losses. Thus the
optimal bidding strategy for firm
is to remain active as long as
is at least as great as
. At a bid of
, firm
would earn normal profits, as winning the franchise would result in average cost pricing.
four bidders will signal they are active. Because there is more than one bidder active, the auctioneer lowers the bid.
Once
falls below
firm 4 will drop out of the bidding. However, the bid will continue to fall because there are
still three active bidders. Firm 3 will drop out once
is less than
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As soon as
falls just below
, firm 2 will leave the bidding. Because this leaves firm 1 as the only active bidder,
the outcome of the auction is that firm 1 wins the franchise and charges a price slightly less than
(the final
winning bid).
There is good and bad news resulting from the auctioning-off of the franchise. The good news is that the firm with
the lowest average cost curve is the franchise owner. This will always be true because the firm that is most efficient
can always outbid the other firms. The bad news is that price is approximately equal to
which exceeds the
franchise owner's average cost. Consumer's surplus is lower by the shaded area
than when average cost
pricing is used.
, there will still be two active bidders (the ones with average cost
function
)). Thus the bid will fall until it reaches
At that bid, the two firms are indifferent to winning
the franchise. Once the bid falls below
, both drop out. To decide on the winner, the auctioneer will have to
Thus the ability of franchise
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Thus far we have painted an excessively rosy picture of franchise bidding. It is best to think of our analysis up to
this point as representing the potential of franchise bidding. In the next section we will be concerned with how
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Two-Part
normal profit; that is,
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average-cost pricing, the latter franchise bidding scheme results in a price of
versus
This lower price yields
higher welfare. The conclusion one draws is that for franchise bidding to lead to a socially desirable solution, the
franchise must be auctioned off to the firm offering the lowest price for service and not the highest franchise fee.
Quality of Service
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Introducing the quality dimension into the franchise bidding process greatly complicates matters. It is important to
note that to handle these complications a bigger role for government is required. This includes monitoring quality
(as well as, of course, price) and specifying the attributes of the service to be provided by the franchise owner.
Because the main attraction of franchise bidding is the minimal role for government, the advantage of franchise
bidding over regulation is reduced as more realistic elements, like product quality, are introduced into the analysis.
Rent-Seeking Activity
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tasks, or even bribing elected local government officials with direct cash payments or contributions to their
campaign funds.
(see Figure 13.5). In order for them to earn normal profit, a higher price
will have to be charged in order to cover cost and the franchise fee. For example, suppose that the franchise owner
has to pay 100
percent of gross revenue to the local government. Firm revenue is then
) where
, which exceeds
It is important to note that the welfare loss from the imposition of a
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franchise fee is due to the resulting higher price. The fee itself does not represent a reduction in welfare, as it is just
a transfer from the franchise winner to politicians and/or taxpayers (via the local government). The other source of
welfare loss from rent-seeking activity is the use of real resources, for example, attorney fees and the provision of
public services. Although such expenditures have some value, the value of the resources used usually falls short of
their resulting value. Rather, such expenditures are made in order to acquire rent.
We can conclude that if the franchising process allows room for rent-seeking behavior, social welfare is not as high
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vantage the current franchise owner does have is that it has already invested in plant and equipment. In contrast, a
new firm would have to make this major investment. Thus, while the incumbent firm would be willing to bid down
to average variable cost, a new firm would not bid below its average total cost. The result is that a new firm could
be more efficient than the current franchise owner but the latter would outbid it. In Figure 13.6 the new firm has
average cost curve
), while the incumbent has average cost curve
) and average variable cost curve
). Even though
)
), the franchise is renewed by the current owner because
). The resulting price would be
This problem can be rectified by the transfer of capital from the previous franchise owner to the new one. The
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provide for penalties if quality is not kept up to the specified level. With recurrent short-term contracts, penalties
are less essential because the incumbent firm can be penalized at renewal time.
Ex-Post-Opportunistic Behavior
As we mentioned earlier, the current franchise owner will typically have certain advantages over prospective
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agency can always threaten a franchise owner with public ownership of the franchise.
Finally, it should be mentioned that opportunistic holdup may also work in the other direction. Once a firm has
sunk considerable resources, the government agency has power emanating from its monopsonistic position. By
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franchise bidding begins to look more and more like regulation. The apparent advantages to franchise bidding
become less outstanding. Still, franchise bidding is an interesting alternative to regulation and it has considerable
potential. The next section will analyze how franchise bidding has performed with regard to cable television. This
application will provide us with some insight as to how franchise bidding has fared in practice in solving the
natural monopoly problem.
Cable Television
The first cable systems were constructed in the late 1940s for the purpose of improving the reception of broadcast
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ulatory authority over television broadcasting. During the early period of cable television in the 1950s, cable
television was allowed to grow with a minimum of regulatory interference. The FCC even went so far as to refuse
to accept regulatory jurisdiction over cable television on the basis that it was neither a broadcasting facility nor a
wire common carrier. Its general policy was to allow auxiliary services to television, like cable systems, to develop
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Table 13.1
Cable Television Industry Growth, 1976-1993
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
Saturation = number of U.S. households passed by cable systems/number of U.S. house-
These developments were followed with tremendous growth in the cable television industry (see Table 13.1). In the
1970s less than a third of all households had access to cable. Now, cable service is nearly universal with it being
available to more than 96 percent of households. Commensurate with this rise in availability has been a rise in sub-
scribership. From 1976 to 1993, the number of subscribing households increased fivefold and stood at over 57
million. Growth in revenue has been equally spectacular as nominal revenue has increased more than twenty-fold.
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During this phase in which cable service became ubiquitous, the regulatory issues were very different from those
in the early part of cable's history. Since the early 1980s, the central regulatory issues have concerned cable rates
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the physical design of a cable system. The purpose of the headend is to receive signals and process them for
distribution. A major part of the headend is the antenna, which receives the signals. (It is for this reason that cable
systems were originally referred to as community-antenna television, or CATV.) Once received, the signals are
then distributed via the distribution plant, which has historically used coaxial cable though now fiber optics is the
preferred technology. As of 1993, TCI, the largest cable operator, planned to spend $2 billion to install fiber optics.
Its intention is to have the new system reach 90 percent of its customers. An important benefit from upgrading
its system is that it will have the technology to offer phone service to its cable subscribers. (For more on this issue,
see Chapter 15.) The final element of the cable system is the subscriber interface. It connects a subscriber to the
distribution plant.
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Average








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duced unit cost by almost 1 percent.
Although the evidence is supportive of the hypothesis that cable television
is a natural monopoly, it is not overwhelming.
Franchising Process
Given that the available evidence is supportive of cable systems exhibiting economies of density, there exists a
rationale for a government providing exclusive rights to a cable company over a geographic area. The evidence we
have considered also suggests that there may be little cost inefficiency from allowing several firms to serve a
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Description of Proposal and Contract
The proposal submitted by an applicant to the local government typically provides a technical account of the
proposed system, the programming services, and prices. A description of the proposed system includes the number
of channels, the pay channels that will be available, and any auxiliary services like two-way interactive channels.
Price information includes the basic monthly price per subscriber and the price of pay channels.
(1) duration of the license (not to exceed 15 years); (2) area(s) to be served; (3) line extension policy; (4)
construction schedule; (5) initial rates and charges; (6) amount and type of bond and insurance; (7) plan for
local supervision; (8) criteria to be used in assessing applicant qualifications; (9) location of any free
installations (e.g., public schools, police and fire stations, and other public buildings); and (10) equal
employment opportunity practices. Suggested items are: (1) capability of the system; (2) plan for access
channels and facilities; (3) plan for municipal coordination with the licensee; (4) types and patterns of
ownership; (5) coordination with contiguous communities; and (6) subscriber rights of privacy.
More generally, one would expect bidders to include any items in a proposal which are likely to give them an edge
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on how well the franchise owner performs over time. Related to this issue is the degree of opportunistic holdup.
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Table 13.2
Major Franchise Awards, 1980-1982
Cost of Basic
Households in Franchise
Area (thousands)
System Length
Capital Cost (millions
of dollars)
$6.50
42
Cablevision
$2.00-8.00
COX
$6.92-13.95
$7.95-11.95
$0.00-10.95
(80 in use)
Ft. Worth
$3.95-10.95
United
$5.95-11.95
Warner Amex
$3.95-10.95
(86 in use)
$2.95-9.95
$5.35-9.45
(60 in use)
Source:
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Table 13.3
Politically Imposed Costs of Franchise Monopoly (per month per subscriber)
Uneconomic Investment
Franchise Fees
Total Costs
Low Estimate
Mid-Point Estimate
10.04
High Estimate
Source:
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revenues. Even taking into account the roughness of these estimates, the politically imposed costs of franchising
appear to be considerable.
Performance After the Initial Award
Clearly, there is anecdotal evidence of franchise owners reneging on their proposal once the franchise is issued.
The winning proposal for the Milwaukee franchise called for a 108-channel system at a monthly basic service price
of $4.95. Not long after the award was issued, the franchise winner renegotiated its contract and instead installed a
54-channel system at a monthly basic service price of $11.95.
The systematic evidence is rather mixed. On the one hand, cable franchises were renegotiated in twenty-one of the
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Table 13.4
9 fewer channels
Franchise Fee
0.2 percent higher
Community Channels
0.8 fewer channels
Basic System Price (Monthly)
Basic Price per Channel Offered
Lead Pay Channel Price
* Indicates the difference is statistically significant at the 0.05 level in a one-tailed test.
Source:
Mark A. Zupan, "Cable Franchise Renewals: Do Incumbent Firms Behave Opportunistically?"
RAND Journal of Economics
20 (1989): 473-82.
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ities like local telephone. By 1979 at least ten states had some form of rate regulation.
This regulatory movement was cut short by federal legislation. Price controls over pay channels were discontinued
in 1979 and, beginning in December 1986, the Cable Communications Policy Act of 1984 prohibited federal and
state or local regulation of basic cable prices.
Continued regulation would be allowed only where effective
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1984-1993
While the profitability of the cable industry has never been higher, its political vulnerability has never been
more evidentand the two events are connected. By fortuitously steering themselves through the regulatory
maze to arrive at the bliss point of a legally protected but unregulated monopolist [as created by the
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1984 Act], cable companies have traded friends for wealth in the political game.
Is Government Intervention Welfare-Improving?
Natural monopoly is one of the few economic rationales for government intervention. Though the statistical
evidence supports the hypothesis that cable television is a natural monopoly, some economists have argued that
recent events put into question the social value of government intervention and, in particular, the use of franchise
Price Regulation
Recent experience with rate regulation is not promising in that the government does not appear to have control over
the instruments to achieve a socially preferred outcome. Cable program services are divided into basic, premium,
and pay-per-view. Rate regulation only applies to basic service. Thus, in response to a government authority like
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Table 13.5
Price/Quality
-21.9%
-8.3%
+ 14.3%
-19.8%
* On most popular tier of basic programming.
Source:
Data are from Paul Kagan Associates, General Accounting Office, and National Cable
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One firm's cost function is
) = 100
while the other firm's cost function is
) =
The franchise is
auctioned off using a modified English auction where the firm offering the lowest price for service wins the
a) Who will win the franchise?
b) What will the winning bid be?
2. Continuing with question # 1, suppose the local government decides to issue the franchise to the firm that offers
the biggest fee. An English auction is used where the firm offering the biggest payment to the local government
wins the franchise. The franchise owner is free to charge any price that it likes. (Note: The marginal revenue curve
is 100 -
a) Who will win the franchise?
b) What will the winning franchise fee be?
c) What will price be?
(Hint: Calculate monopoly profit for each of the two bidders.)
a) Maximize consumer welfare
b) Maximize government revenue
c) Maximize the number of consumers who buy this service.
a) Recurrent short-term contracts
b) Long-term contracts
c) Recurrent short-term contracts in which the local government owns the capital.
5. In practice, almost all cable television franchises are renewed.
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10. Should local telephone companies be allowed to operate a cable system? If so, how should they be regulated?
. For example, one firm
could agree to drop out of the bidding at
where
in exchange for a cash payment. This would allow
both firms to earn higher profits in comparison to when the bid is driven down to
The inability to collude is
then an essential condition if franchise bidding is to achieve a socially desirable outcome.
4. This criticism was originally made by Lester Telser in "On the Regulation of Industry: A Note,"
Journal of
Political Economy
77 (November/December 1969): 937-52.
5. Recall that a two-part tariff has a customer pay a fixed fee for the right to purchase a good and a per unit price
for each unit purchased.
6. The significance of this assumption is that the demand curve will not shift as we change the fixed fee. Increasing
the fixed fee is equivalent to reducing consumer income. If the demand curve was not perfectly income-inelastic, it
would shift in as we increase the fixed fee under the assumption that the good is normal. In order to simplify the
analysis, we assume the demand curve is not responsive to changes in income.
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36. Prager, 1989.
38. Ibid.
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40. Mark A. Zupan, "Cable Franchise Renewals: Do Incumbent Firms Behave Opportunistically?"
RAND Journal
of Economics
20 (Winter 1989): 473-82.
41. For estimates of the effect of deregulation on the value of cable franchises, see Adam B. Jaffee and David M.
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Public Enterprise
The ultimate objectives of any government policy that is designed to handle the natural monopoly problem are to
have a single firm producing efficiently and pricing at the socially optimal level. The first objective can be
achieved relatively easily by issuing a monopoly for the provision of the service to a privately owned firm. In
acting to maximize its profit, the firm will produce efficiently. Unfortunately, the objective of profit maximization
also leads to a price above the social optimum and thereby creates deadweight welfare losses.
To induce the firm to price in a socially efficient manner, we have thus far analyzed two alternative policies. One
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shareholders, the manager of a public enterprise is ultimately accountable to voters.
This chapter is concerned with assessing public enterprise as an approach to handling the problem of natural
monopoly. Of specific interest is comparing its performance to the regulation of a privately owned firm, which is
the most common policy in the United States. In contrast, public enterprises are used quite extensively in Europe.
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Less by design and more by accident, the Italian government controls vast parts of the industrial sector including
almost all of shipbuilding. This came about during the depression in the 1930s. At that time, the government
citizens. In the case of BT, a most interesting strategy was pursued:
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Positive Theory of Public Enterprise
Everywhere else in this book, we assume that firm behavior is motivated by the desire to maximize profit. Profit
maximization seems to be the single most plausible objective of a privately owned firm, as it results in the
maximization of shareholders' wealth. By specifying the objective of a firm (or, more generally, an economic
agent), we can make predictions as to how it will respond to government policies. Such predictions are essential in
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[M]anagers are therefore influenced to divert resources from the production of attributes which will not be
monitored to those which will. In so doing they will increase the perceived value of the [public enterprise's]
For example, suppose that the quality of a service is easily observable but cost is not. The manager will then tend
to choose too high a level of quality in order to increase political support. The important point is
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that the imperfections inherent in using attributes to measure managerial performance are likely to lead to strategic
behavior by the manager. The manager will tend to produce those attributes to a degree that is excessive from
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a private enterprise. All these actions tend to increase nonpecuniary benefits from the job.
Comparison of Public and Private Enterprise
Relative to an unregulated private enterprise, our analysis suggests that a public enterprise will price lower,
practice less price discrimination, and earn lower profits. There also seems to be a plausible case for public
enterprise to be less efficient. A manager of a public enterprise has a tendency to use more capital and labor in
order to reap nonpecuniary benefits like fewer consumer complaints and an absence of labor strife.
These differences in behavior are generated by two factors. First, income and job tenure are raised by increasing
firm profit for the manager of a private enterprise but are raised by increasing political support for a public
enterprise's manager. This results in lower prices for a public enterprise and greater inefficiency, for example,
overinvesting in product reliability to gain consumer-voter support. The second factor is that the manager of a
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According to this analysis, both a regulated private enterprise and a public enterprise will experience productive
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insignificant. In light of the poor information that regulatory agencies typically have about demand and, especially,
cost functions, such a finding is not surprising. Because the firm has a significant information advantage, a
regulatory agency may often have little choice but to accept the proposed tariff. On the other hand, other studies
have found electricity prices to be severely constrained by regulation. In some cases it was estimated that the
monopoly price was 20 to 50 percent higher than actual regulated prices.
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Table 14.1
Mean Electricity Prices (cents per kwh) for Residential, Commerical, and Industrial Customers
Service Class and
Consumption Level (kwh per
Private Utilities
Government Price as
Percentage of Private
3.92¢
3.42¢
3.42¢
3.01¢
.50¢
.41¢
87.2%
88.0%
2.95
2.31
2.54
1.95
.41
.36
84.1
84.4
-.04
1.90
1.58
1.68
1.30
.22
.28
88.4
82.3
1.86
1.75
1.60
1.36
.26
.39
86.0
77.7
Commercial
3.94
3.94
3.26
3.26
.68
.68
82.7
82.7
3.69
3.43
2.99
2.71
.70
.72
81.0
79.0
3.50
3.31
2.76
2.53
.74
.78
78.9
76.4
2.71
2.45
2.21
2.03
.50
.42
81.5
82.9
2.40
1.92
2.01
1.71
.39
.21
83.7
89.1
Industrial
2.31
2.31
1.89
1.89
.42
.42
81.8
81.8
2.10
1.85
1.74
1.56
.36
.29
82.9
84.3
1.92
1.74
1.61
1.47
.31
.27
83.9
84.5
1.84
1.70
1.55
1.45
.29
.25
84.2
85.3
Source:
Non-residential
Total
Source: Federal Power Commission, National Electric Book; 1968 from Sam Peltzman,
"Pricing in
Public and Private Enterprises: Electric Utilities in the United States," Journal
of Law and Economics,
April 1971.
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Page 466
on an allocative efficiency basis. By charging a price closer to that which maximizes profit, privately owned
utilities cause greater deadweight welfare losses. However, even though average price may be higher, there can still
be greater welfare associated with privately owned utilities because of more extensive price discrimination.
such that the
following relationship holds:
so that average price is lower. Comparing prices
and
as measured by the
sum of triangle
abc
and
. In addition, a price of
triangle
def
less triangle
The discriminatory pricing schedule yields higher welfare even though it results in a
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Page 467
electricity per customer. In estimating the effects of the type of ownership on average sales per customer, he first
controlled for other factors that could affect the difference in average sales. These factors included income,
population size, regional differences, and average price. Once holding these factors constant, Peltzman found that
average sales per customer were higher for privately owned utilities than for public utilities.
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Assessment of Private versus Public Utilities
It is clear that the evidence concerning the relative efficiency of regulated privately owned utilities and publicly
owned utilities is mixed. Nevertheless, a survey of comparative studies provides general support for the hypothesis
that there is greater productive efficiency with private enterprise. Table 14.3 lists a number of such studies for
industries ranging from electric utilities to refuse collection to weather forecasting. Most of these studies conclude
that publicly owned firms are less efficient than privately owned firms.
Perhaps the major advantage of a privately owned firm is that it is subject to the disciplining force of the capital
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Page 469
Table 14.3
Comparisons of Private and Public Performance
Area, Author, and Year of
Wallace and Junk
Public firms have 40-75% higher operating costs and 40% higher investment
cost per kwh.
Meyer (1975)
Public firms have lower operating costs but higher transport and distribution
Private firms are as efficient, and probably more efficient, with respect to
operating costs.
Junker (1975)
Neuberg (1977)
Public cost 23% less than private.
Pescatrice and Trapani
Public costs less than private.
Primeaux (1977, 1978)
DeAlessi (1974)
Private sector supply lower cost than public.
DiLorenzo and
Public firms are slightly less productive.
Atkinson and Halvorsen
Public and private firms are equally cost inefficient.
Mann and Mikesell
Public firms have 20% higher costs.
Morgan (1977)
Public firms have 15% higher costs.
Crain and Zardkoohi
Public firms are 40% less productive.
Health and Insurance
Clarkson (1972)
In nonprofit-making hospitals "red tape" is more prevalent.
Wilson and Jadlow
Frech (1979)
Pier, Vernon, and Wicks
Municipal suppliers are more efficient.
Kitchen (1976)
Municipal suppliers are more costly than private ones.
Pommerehne and Frey
Operating costs are significantly lower for private than the for municipal
Stevens and Savas
Municipal firms are 10-30% more costly than private firms.
Collins and Downes
Non significant cost differences.
Public firms are 45% more costly.
Savas (1974, 1977)
Private less costly than public.
Edwards and Stevens
Public service less costly than private.
Oelert (1976)
Public firms have on average 160% higher costs compared with the contract
price of private firms.
table continued on next page
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Page 470
Table 14.3 (cont.)
Comparisons of Private and Public Performances
Area, Author, and
Year of Study
Caves, Christensen,
and Swanson (1980)
No significant differences in productivity; CN (Canadian National) was less
efficient during the highly regulated period before 1965; its productivity has
since increased more rapidly than that of CP (Canadian Pacific).
Davies (1977)
Private airline is clearly more efficient than the public one.
Nichols (1967)
Mutual firms have 13-30% higher operating costs.
Davies (1982)
In private banks productivity and profitability are higher than in public banks.
The cleaning of offices is 42-66% more expensive if undertaken by the public
corporation itself than if it is contracted out.
Fischer-
Cleaning costs could be reduced by 30% if 80% of the space were contracted
Weather Forecasting
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Page 471
Davies estimated three measures of productivity. They are presented in Table 14.5. For all three measures, the
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Table 14.5
Productivity Measures for the Australian Airline Industry
Tons of Freight and Mail Carried
per Employee
Passengers Carried per
Revenue Earned per
1959-60
1960-61
1961-62
1962-63
1963-64
1964-65
1965-66
1966-67
1967-68
1968-69
1969-70
1970-71
1971-72
1972-73
1973-74
Average
Trans Australian Airlines (Public Firm)
1958-59
1959-60
1960-61
1961-62
1962-63
1963-64
1964-65
1965-66
1966-67
1967-68
1968-69
1969-70
1970-71
1971-72
1972-73
1973-74
Average
Source:
Australian Airlines Annual Report, 1958-1974, from David Davies, "Property Rights and
Economic Efficiency: The Australian Airline Revisited,"
Journal of Law and Economics,
April 1977.
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Thus, more definitive conclusions than the ones we have offered may present themselves in the near future.
Questions and Problems
1. Do you think that social welfare is higher with a regulated private enterprise or a public enterprise? Does your
answer depend on the industry? What about for the distribution of electricity?
2. Why do public enterprises practice less price discrimination than regulated private enterprises? Does it have
anything to do with the Robinson-Patman Act?
3. Privatization is a central economic issue for Eastern Europe. Should all public enterprises be privatized? Of
those privatized, which should be regulated?
4. Why do public enterprises tend to have higher costs than private enterprises? Do you think this reason is
sufficient to always prefer regulated private enterprises over public enterprises?
5. Compare regulation, franchise bidding, and public enterprise. Discuss the advantages and disadvantages of each.
a. The legislature becoming more pro-consumer.
b. An increase in fixed costs.
c. A fall in marginal cost.
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Page 474
6. Recall that when a regulated firm overcapitalizes, it does so in order to maximize profits by increasing its rate
base. Although the capital-labor ratio is inefficient from a production perspective, the resulting ratio is the one that
maximizes profits.
7. Important sources for this section include Louis DeAlessi, "An Economic Analysis of Government Ownership
and Regulation: Theory and Evidence from the Electric Power Industry,"
Public Choice
19 (Fall 1974): 1-42; and
Louis DeAlessi, "The Economics of Property Rights: A Review of the Evidence,"
Research in Law and Economics
2 (1980): 1-47.
8. George J. Stigler and Claire Friedland, "What Can Regulators Regulate? The Case of Electricity,"
Journal of
Law and Economics
5 (October 1962): 1-16.
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Dynamic Issues in Natural Monopoly Regulation: Telecommunications
Handling rate cases is perhaps the most commonly performed duty of a regulatory agency, but it is by no means its
only duty. Because regulators are ultimately responsible for maintaining a healthy industry and maximizing social
welfare, their tasks can be very far-ranging. This chapter is concerned with examining some of the more important
tasks related to the evolution of a regulated industry.
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Page 476
place that alter the production technology or introduce unregulated substitute products. In response to these
changes, regulators must adapt policy. With regard to monopoly regulation, we can identify two potential dilemmas
resulting from changes in the environment. First, the shifting of cost and/or demand functions changes the socially
optimal price. Regulators must adjust the regulated price in response to these events. A second and perhaps more
troublesome problem arises when shifts in these functions are so severe as to call into question the need for
monopoly regulation. In other words, cost and demand conditions may change to the point that the industry is no
longer a natural monopoly.
This section will explore the sources of such a transformation and assess the effects of different regulatory policies
when such a transformation has been thought to occur. We will then apply these concepts to events that have taken
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Page 477
priateness of regulation. Consider the U-shaped average cost curve in Figure 15.1. Scale economies are exhausted
at an output of
The socially optimal price is
then
(equal to minimum average cost of
, which is sufficient to
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Page 478
support three firms at the efficient size of
. There would appear to be little basis for regulating such an industry.
The general rule of thumb is that monopoly regulation is appropriate when the minimum efficient size of the firm
is three
times the efficient firm size. In that situation, an unregulated environment is likely to be the appropriate policy.
A peculiar feature of the preceding example is that the socially optimal supply is an integer multiple of minimum
efficient scale. Specifically, when demand is
and
that
. If, for example,
then industry cost is
minimized by having two firms, each producing
/2. We then find that our earlier result holds more generally if
the average cost curve has a range of outputs that minimize average cost. Rather than use such an average cost
function in future examples in this chapter, we will use the standard U-shaped average cost curve, though
remembering that results are robust if we consider a more realistic average cost function of the type in Figure 15.2.
Sources of Natural Monopoly Transformation
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Page 479

Efficient

over time, the optimal output would
increase from
to
. Given an efficient firm size of
the basis for monopoly regulation would no longer exist.
There are, of course, many sources of exogenous increase in demand. These include, for example, an exogenous
change in consumer preferences toward the good, an increase in consumer income (if the product is a normal
good), a reduction in the price of a complement, or even the
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Page 480
development of a complementary product that raises the value attached to the good by consumers.
Cost Side
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Page 481

The










to
Prior to the fall in fixed costs, the socially optimal price was defined
where price equals average cost:
With average cost at
, the socially optimal price equals minimum
average cost,
Because demand is
. Obviously, average cost is higher. Because fixed costs now make up a smaller
proportion of total cost, minimum efficient scale has fallen from
to
. A smaller minimum efficient scale makes
the industry less
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Page 482

The










to
. Because two efficient-sized firms can profitably exist at the socially optimal price, monopoly regulation is no
longer appropriate. However, if the demand curve is instead
), which is relatively elastic, the optimal output
falls a lot, from
to
. Hence a natural monopoly still exists even though minimum efficient scale has fallen.
To summarize these results, we find that technological innovations and changes in input prices affect the cost and
demand conditions underlying the rationale for monopoly regulation. Reductions in the fixed-cost component of the
cost function clearly make the industry less suited for single-firm production by reducing efficient firm size and
increasing the socially optimal industry output rate. Changes in the variable-cost function have less clear effects, as
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Page 483
Regulatory Response
Suppose that a regulated monopoly has experienced the type of change just described. Perhaps an innovation
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The left-hand side is the cost of a two-product firm supplying both products
and
. The right-hand side is the
total cost of having
produced by one firm and
produced by another firm.
In addition to assuming that there are economies of scope, we will assume that there are
product-specific
economies of scale.
For the single-product case, economies of scale mean that average cost is declining. Product-
specific economies of scale are a similar concept but defined instead for the multiproduct case. The incremental
cost of producing
is defined to be the added cost from producing
given that
of product
is already
being produced:
Average incremental cost of
is then
If product
has product-specific economies of scale, then the average incremental cost of producing
is declining.
We assume that the regulated monopolist has product-specific economies of scale with respect to both products
and
We now want to argue that if a multiproduct cost function has both economies of scope and product-specific
economies of scale, then it is a multiproduct natural monopoly. That means the cost of producing
and
minimized by having a single firm in the industry. Suppose that there are
firms producing product
and
producing product
. Because there are economies of scope, total industry cost is reduced by having these 2
combine into
two-product firms. That is, the average cost of a single firm producing
), exceeds the
average incremental cost of a two-product firm producing
) [see Figure 15.5(a)]. Given product-
specific economies of scale, average cost is lower, the more a firm produces. Thus, total cost is reduced by having
the
two-product firms combine into a single firm. This means, of course, that the industry is a natural monopoly.
and product
at
where the
regulated firm earns normal profits:
so that the regulated firm earns normal profit. We have assumed that the price of product
is less than its average
incremental cost [Figure
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Cross-Subsidization
15.5(b)]. In order for losses from the sale of Y to be covered, the price of product X must then be relatively high
(Figure 15.5).
What we want to show now is that there is room for wasteful entry under partial deregulation even though the
monopolist is earning normal profit and it is a natural monopoly. Recall that partial deregulation allows entry but
continues price regulation for the regulated firm. Depicted in Figure 15.5(a) is the average cost curve of a single-
product firm. A new firm can profitably enter by pricing slightly less than
. Note that entry will not take place
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Page 487
ing section.
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Thus, cost efficiency demanded single-firm production, and that firm was AT&T.
Transformation of a Natural Monopoly
Though microwave transmission existed prior to World War II, it was not commercially viable until certain
technological breakthroughs were achieved by the research and development program funded by the U.S.
government as part of the war effort. The economic significance of microwave transmission rests in its ability to
inexpensively transmit large amounts of information via radio beams. In contrast to open-wire line or coaxial cable,
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Page 489
Thus the central station in a microwave system can start, stop, slow or speed unattended equipment; open
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Page 490
average-cost curve shifts from
) to
. In this case, a
natural monopoly still exists, as the cost function is subadditive at
. On the other hand, suppose that the
quantitative effects are greater so that the average cost curve shifts from
) to
) and demand from
to
. At the socially optimal price of
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Page 491
average cost curve seems to be flattening out around 240 circuits. If economies of scale are exhausted around that
size, then a natural monopoly would have existed for many telecommunication routes in the late 1940s. However,
with the increase in demand since the 1950s, only the very low-density routes would still be a natural monopoly at
240 circuits. The larger intercity routes have demand of several thousand circuits, which suggests that many
efficient-sized firms could have profitably existed. It should be noted that these conclusions are restricted by the
fact that they are true only for 1962 and that our conjecture as to what the average cost curve looks like after 240
circuits is correct.
In his 1975 study, Leonard Waverman found for the mid-1960s that scale economies were exhausted at around
1000-1200 circuits.
In the late 1960s the New York-Philadelphia route had demand of around 79,000 circuits.
In light of his estimate of minimum efficient scale of 1000-1200 circuits, he concluded that several suppliers could
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Page 492
Mc decision, AT&T entered the Telpak tariff, which called for volume discounts on PLS. Presumably, AT&T's
objective was to make it profitable for businesses to buy AT&T's services rather than build their own system.
Ultimately, the FCC disallowed the Telpak tariff because it was not justified by the cost estimates.
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Table 15.1
AT&T
MCI
Sprint
Other
Source:
Data for 1984 and 1988 are from Arsen J. Darnay and Marlita A.
Reddy,
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Page 496
-3.4%
11-22
- 24.4
23-55
- 36.7
56-124
-46.4
125-292
-48.9
293-430
-47.4
431-925
-48.8
926-1910
- 47.0
1911-3000
- 52.4
3001-4250
-45.6
4251-5750
-42.4
Source:
Rates are for AT&T for a ten-minute direct-dialed daytime call within the U.S.
Data are from the FCC and the table is from ''Special Report: Telecommunications,''
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some economists have argued that they are entirely responsible for the fall in rates. Since the breakup, there has
been a shifting of the recovery of the fixed costs of local telephone systems from long-distance companies to final
consumers. This has manifested itself as falling access charges for long-distance companies to connect to the local
exchange system and higher monthly subscriber line charges for final consumers. A series of accounting changes
has also reduced interstate costs and raised intrastate costs. Compared to 1984, one finds that AT&T's carrier access
charges were $9.266 billion less in 1991, while its rate reductions translated into $8.22 billion less of revenue.
Although it is not clear that reduced access charges can explain all of the fall in rates, their magnitude puts into
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The preceding argument deals with the switching technology. The second argument that the LTM is no longer a
natural monopoly is based on advances in transmission. Specifically, it is that cellular telephony has greatly
Taken as a whole, therefore, new transmission technologies have increased the number of potential
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there is likely to be some capital that is shared by products
and
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AT&T was accused of attempting to monopolize the telecommunications industry by using its dominant position in
three segments of that industry: local exchange, long distance, and terminal equipment. The case went to court on
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Page 505
left open to AT&T. This did not improve the situation, because AT&T placed considerable restrictions on the
specialized common carriers.
Only in 1974 did the FCC order interconnection in its Bell System Tariff Offering
decision. When MCI expanded entry into message toll service, the same problem arose. Their entry was approved
by the U.S. Court of Appeals in 1975, but not until 1978 was AT&T was forced to interconnect with MCI's
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Page 506
the computer industry.
The war effort in the 1940s not only led to the development of microwave technology
a monstrously large and unwieldy machine. It was two stories tall, weighed thirty tons, and covered 1,500
make life easier for its parent and harder for its parent's rivals.
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For these reasons, the FCC pursued a policy of separation. However, rather than simply prohibit AT&T from
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Page 508
Table 15.3
The Status of the Telecommunications Industry
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Page 509
auctions that may increase severalfold the number of wireless providers. Second, cable companies have expressed
interest in providing local telephone service and are on the verge of beginning to do so. Cable systems already
have access to more than 90 percent of U.S. homes, but the provision of telephone service would require an
upgrading of their systems from coaxial cable to fiber optic. Cable industry leader TCI has already announced
plans to spend $2 billion on installing a fiber optic system for 90 percent of its 9.5 million customers by 1996.
In Great Britain, cable companies are currently providing local telephone, and it appears that customers in
Rochester, New York, will be the first within the United States to have local telephone service provided by their
cable company. In May 1994 the New York Public Service Commission chose to allow Time Warner's local cable
unit to offer phone service starting in 1995.
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Page 510
cable service by local telcos is currently in motion. In July 1994 Bell Atlantic was given approval by the FCC to
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Page 511
has auctioned off spectrum to expand the number of wireless communication carriers. In 1992 it adopted rules
allowing local telcos to offer "video dial tone" services for other companies that want to distribute TV
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Page 512
There are a number of legal obstacles to entry. The 1982 consent decree that broke up the Bell System expressly
forbids RBOCs from providing interLATA service.
The 1984 Cable Act codified a longtime FCC rule that
prevented local telcos from offering cable services in their territory. A recent Court of Appeals decision overturned
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Page 513
ing only some consumers at the cost of others and, if so, is deregulation politically feasible?
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(
P
)



(
P
)




(
P
)



10 and
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Page 515
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communications," in Courville, DeFontenay, and Dobell, and Leonard Waverman, "U.S. Interexchange
the ordinary telephone.
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Theory of Price and Entry/Exit Regulation
The major task before us is to understand how price regulation, along with entry/exit regulation, can directly and
indirectly affect the decisions of firms and thereby influence social welfare. Because price regulation is common to
most forms of economic regulation, this analysis should be applicable to most regulated industries. The particular
form of price regulation which we consider is the specification of the price at which firms must sell their product
or service. Modeling regulation in this manner is clearly an abstraction inasmuch as price regulation can take the
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Page 521
occurred in an unregulated environment. Performing this task requires making conjectures as to the properties of
the industry equilibrium in the absence of regulation. It is natural to suppose first that an unregulated industry
Recall from Chapter 6 that minimum efficient scale is the
which exceeds
The reduction in
consumer surplus from the rise in price is measured by trapezoid
Of course, part of this loss in
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Page 522

The








, so that average cost is
firm profits will equal
; that is, rectangle
Substracting total industry profits from the loss in
consumer surplus, the welfare loss from regulation is then the shaded area in Figure 16.1.
There are two distinct sources of welfare loss. First, there is the reduction in welfare resulting from the reduction of
output from
to
. This loss is measured by triangle
. The second source of welfare loss is due to the
. Because this falls below
minimum efficient scale, each firm's average cost is higher under regulation. The rectangle
measures the
value of additional resources used to produce
relative to the preregulation equilibrium.
It is interesting to note that given price regulation, the imposition of entry regulation raises social welfare. Because
the regulated price
ex-
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Page 523
ceeds average cost, there is an incentive for firms to enter the industry. For example, suppose one firm entered. The
new equilibrium would still have a price of
as that is mandated by the regulatory agency, but each firm would
now be producing slightly less; specifically, the amount
. Because profits for the new firm equal
which are positive, entry would occur. However, note that firm average cost has increased from
to
AC'
in response to entry. Thus, the total cost of providing industry supply of
has been increased by the
To avoid this additional welfare loss, it is best that the regulatory agency prohibit entry
it is regulating price. Actually, it may even be best for the regulatory agency to go a step further and actually
to
If
is still less than minimum efficient scale,
then firm average cost is lower at a firm output rate of
than at an output rate of
. In that case, the total
cost of supplying
is reduced by eliminating one of the firms. Of course, these conclusions concerning the
optimality of restricting entry are conditional on price regulation already being in place. Regulation of entry may
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Page 524
Second-Best
where
exceeds not just the unit cost of type 1 firms but also that of type 2 firms. In that case, the
equilibrium has (unregulated) type 2 firms supplying
units of product A at a price of
Now suppose that further regulation is imposed in that
all
Furthermore, assume consumers slightly prefer the product provided by type 1 firms so that if both
type 1 and type 2 firms sell at the same price, all demand will go to type 1 firms. Under this assumption, the
equilibrium under the new regulatory regime has all firms pricing at
which reduces consumers
surplus by
Second, more efficient firms are producing so that industry profits rise by
If rectangle
exceeds triangle
abe,
then the expansion of regulation has actually raised social welfare. The reason for this
is that the initial regulatory regime had less efficient
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Page 525

The






The


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with each producing
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Table 16.1
Profits and Social Welfare for the Cournot Solution
Number of
2
3
4
5
6
7
-23
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Page 528
active firms.
The key point is that the private interests of a firm generally do not coincide with the interests of
and prohibits both entry and exit. Each firm now supplies
instead of
Because
quite close to minimum efficient scale, it appears that the industry has the optimal number of firms for supplying
Although there were too many firms when price was
P',
there are now the correct number of firms when price is
lowered to
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Page 529
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The






and
for products
and l, respectively.
is the demand for product
when its price is
and the demand
curve is
;
). Implicit in the demand curve for product
is that the price of the lower quality substitute
is
Given that product
is priced at
, note that the
demand for product
is zero when product
is also priced at
. This reflects the fact that if the prices are the same,
then every consumer prefers the high quality product so that the demand for the low-quality product is zero.
Now consider a regulatory policy which specifies that firms must price their products at
regardless of quality.
units of product
being produced and consumed while product
is no longer produced.
The welfare loss from regulation is measured by the shaded triangle under the demand curve
inasmuch as this is the consumer surplus foregone from no longer having the option to buy the low-quality, low-
priced product. It is important to note that the increased area under the demand curve for good
due to its shifting
out to
), does
not
represent a welfare gain. Rather, this area
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measures the increased willingness to pay for product
given that product
is no longer available. The increased
area under the demand curve for product
tells us that there is a greater welfare loss from eliminating product
when product
is not available relative to when product
is available. A second point to make is that the increase in
, is not a measure of the loss realized by
consumers from regulation. It is true that consumers who previously purchased the low-quality product are now
paying a higher price of
as opposed to
, but it is also true that they are receiving a higher quality product than
the welfare loss is then the sum of the two shaded triangles. In
addition to the loss from product
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Page 532
A second source of productive inefficiency from price and entry regulation is the continued operation of inefficient
firms that would have perished under free entry. In an unregulated environment, new firms replace those firms that
are relatively inefficient. Entry regulation neutralizes the mechanism by which efficient firms are rewarded and
inefficient firms perish. This analysis suggests that if a regulated industry is deregulated, one would expect entry
and exit to occur simultaneously: exit taking place by the less efficient firms and entry occurring to replace those
Some Indirect Effects of Price and Exit Regulation
where
and
is the unit cost of producing good 2 (see Figure 16.5). The immediate welfare loss from such
a policy is, of course, triangle
abc.
However, note that the industry is incurring losses equal to
rectangle
If the firm is to earn at least normal profits, which is necessary in order to raise new capital and
avoid bankruptcy, the regulatory agency must increase the price of product 1 from the socially efficient level of
to
Here
. The welfare loss of
a policy designed to subsidize the supply of product 2 is then the sum of triangles
abc
and
def.
In pursuing
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Page 533
Cross-Subsidization
a policy of increasing the supply of one product, cross-subsidization is often used even though it entails the spread
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Page 534
to dynamic efficiency; specifically, its effect on the incentive to invest in research and development (R&D) as well
as the incentive to adopt new innovations. The importance of technological innovation in the modern economy
cannot be underestimated. In his famous 1957 study, Nobel lauerate Robert Solow concluded that 90 percent of the
doubling of per-capita nonfarm output in the United States over the period of 1909-1949 was due to technical
advance.
Given the importance of technological innovation in the economy, it is essential to consider the
ramifications of regulation on the pace of technological progress.
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Page 535
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Page 536
an innovation becomes available to the regulated firm that would lower average cost to
c".
The regulated firm can
do one of three things. First, it can choose not to adopt the innovation. Second, it can adopt the innovation, reduce
cost to
c",
and receive profits measured by the rectangle
cabc".
Of course, these above-normal profits are received
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Page 537
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Page 538
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Page 539
Application: New York Stock Exchange
Based on commission schedule in effect as of December 5, 1968.
Cost estimate based on survey for 1969 by National Economic Research Associates.
Source:
Gregg A. Jarrell, "Change at the Exchange: The Causes and Effects of
Deregulation,"
Journal of Law and Economics
27 (October 1984): 273-312.
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Page 540
273-312.
tional investors like managers of pension funds. The SEC continued to deregulate throughout the early 1970s by
reducing the minimum order size at which negotiation was allowed. The legislative branch of the government
entered the deregulatory process by passing the Securities Act Amendments of 1975. This legislation mandated that
the SEC prohibit the NYSE from fixing commission rates.
Figure 16.7 provides a time-series of average commission rates for individual and institutional investors during the
first five years of deregulation. Rates fell drastically. Almost immediately rates dropped about 25 percent in
response to deregulation. Because of cross-subsidization, deregulation resulted in commission rates rising for small
orders (at least for non-institutional transactions) and falling for large orders. Rates fell in excess of 50 percent for
orders in excess of 10,000 shares.
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Page 541
The deregulation of many industries in the 1980s provided economists with the data which allowed the use of an
intertemporal approach. However, before that time, when industries had been regulated for decades, economists
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Page 542
that advertising makes it less costly for consumers to learn which firm has the lowest price, a firm with a high price
will experience lower demand, whereas a firm with a low price will experience higher demand compared to when
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Page 543
approach has been used, for example, to estimate regulatory-induced allocative inefficiencies from crude-oil price
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Page 544
the
real interest rate.
For example, if the nominal rate is 9 percent and the inflation rate is 5 percent, then the real
interest rate is 4 percent. Consider someone borrowing $10,000 on January 1, 1994, under the agreement that it is to
be paid back with interest on December 31, 1994. If the bank lends the money at a 5 percent (nominal) rate, then
the borrower must pay back $10,500 at the end of the year. If the inflation rate was 5 percent in 1994, then the
$10,500 the bank receives at the end of the year buys the same amount of goods that $10,000 purchased at the
beginning of the year (as prices have risen by 5 percent). For having forgone the use of $10,000 for a year, the
bank has nothing to show for it! If instead the inflation rate had been 0 percent, then that $10,500 received on
December 31, 1994, means $500 more in goods that the bank could have bought at the beginning of the year. In
this case the real interest rate is 5 percent, whereas in the former case it was 0 percent. What matters for lending
and borrowing decisions is the real interest rate.
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Page 545
To consider the effects of a usury ceiling, plotted in Figure 16.8 is the demand curve for real loans (that is, after
controlling for the inflation rate), denoted
), and the supply curve,
), where
is the nominal interest rate
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Page 546
then the usury ceiling is binding. In that case, the theory predicts that the greater is the
distortion, as measured by
, the greater is excess demand and the more attractive are loan terms to lenders.
This takes the form of a higher average ratio of loan to property value and a shorter average loan maturity. The
is not observed when the usury ceiling is binding.
As is described below, some researchers solved this problem by jointly using the counterfactual and intertemporal
To estimate the effects of usury ceilings on loan terms, a study by Steven Crafton examined quarterly data during
1971-1975 for residential mortgages.
What is interesting about that time period is that usury ceilings were
binding in some but not all quarters. The research strategy was to use data from those quarters for which the
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Page 547
where the variables on the right-hand side of the equality are the exogenous variables.
is the rate of
rated bonds,
is the interest rate paid by lending institutions to borrow funds from the Federal Home Loan
Bank Board, and (
is the mortgage rate from the previous quarter. What all this says is that when the usury
when the usury ceiling was binding. For a quarter
in which it was binding, one plugs in the values for
, and (
in the above equation. The resulting
number is the simulated value for
which we will denote
The estimated distortion in nominal interest rates
due to the usury ceiling is then estimated to be
and the terms
the greater was the ratio
of loan to property value (as lenders were demanding higher downpayments) and the smaller was the maturity of
the loan.
This chapter had two objectives. First, we sought to provide an introductory analysis of the effects of price and
entry/exit regulation on allocative and productive efficiency. We found that the static welfare effects of price
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Page 548
greater incentive to adopt cost-saving innovations. Entry regulation cuts off a source of innovation in the form of
a) Derive the welfare gain from deregulation.
b) How does your answer to (a) change if the firm with the innovation can license other firms to use its
technology?
3. For the case in Table 16.1, find the per firm subsidy or tax that results in the socially optimal number of firms.
a) Derive the value of this innovation under regulation.
b) Derive the value of this innovation under deregulation.
5. Suppose the government considers regulating the price of automobiles. What difference does it make if it also
regulates the quality of the automobile sold?
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Page 549
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Page 550
Jarrell, "Change at the Exchange: The Causes and Effects of Regulation,"
Journal of Law and Economics
(October 1984): 273-312.
12. Lee Benham, "The Effect of Advertising on the Price of Eyeglasses,"
Journal of Law and Economics
(October 1972): 337-52.
13. Steven M. Crafton, "An Empirical Test of the Effect of Usury Laws,"
Journal of Law and Economics
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Page 551
Economic Regulation of Transportation: Surface Freight and Airlines
From the mid-1970s to the early 1980s, the United States witnessed an unprecedented program of deregulation.
Industries that had been long under government control found themselves "free at last." From the perspective of
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Table 17.1
Modal Shares of Intercity Freight Ton Miles, Selected Years, 1929-1988*
and Canals
0.0
1939
62.4
0.0
1944
68.6
0.0
1950
56.2
0.0
1960
44.1
0.0
1970
39.8
0.2
1975
37.3
0.2
1980
37.5
0.2
1987
36.8
0.3
1988
37.0
* Includes both for-hire and private carriers
Source:
Clifford Winston, Thomas M. Corsi, Curtis M. Grimm, and Carol A. Evans,
Effects of Surface Freight Deregulation
(Washington, D.C.: The Brookings Institution, 1990).
there is no adequate substitute for airline travel. Hence, it is not too severe a restriction to focus solely on airlines in
the provision of long-distance passenger travel.
These two transportation subindustriessurface freight and airlines are common in that they have a long history of
economic regulation. In addition, both have been deregulated to at least some degree in recent years and, as a
result, should provide informative case studies of the impact of economic regulation.
Surface Freight Transportation
In this section we will explore the regulation of the railroad and trucking industries in the United States. In
assessing the effects of the regulation of surface freight transportation, it is important to consider the cross-effects
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Page 554
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Page 555
railroads. When the Motor Carrier Act was passed, poor road conditions and the limited size of trucks prevented
the diversion of much rail traffic. This situation changed drastically in the 1950s with the development of the
interstate highway system and the presence of an unregulated trucking sector comprising owner-operators, who
carried exempt commodities, and manufacturers and wholesalers providing their own freight transportation.
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Page 556
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Page 557
plausible hypothesis for why trucking was regulated is that the presence of an unregulated trucking sector made it
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Page 558
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Page 559
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Page 560
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Ton-Mile
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Ton-Mile
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Page 563
trains, it was found that rail rates were actually
higher
by 2 percent in the deregulated period 1980-1985.
It is presumed in that study that the effects of deregulation occurred immediately on enactment of the Staggers Act
in 1980. Actually, deregulation was much more gradual. A study by economists at the Federal Trade Commission
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Page 564
Finally, a recent study examined rates charged by sixty-one motor carriers of general freight from 1975 to 1985.
It found that deregulation had lowered rates by 15-20 percent by 1983 and by 25-35 percent by 1985. The growing
effect of deregulation on motor carrier rates may be due to increased productivity growth. Such growth will be
reviewed later.
Additional evidence comes from the state level. Around the same time as the Motor Carrier Act of 1980, a number
of states also deregulated intrastate trucking. In fact, the first full deregulation in the U.S. transportation industry
occurred when Florida deregulated trucking on July 1, 1980. State regulation was quite comparable to that on the
federal level, both in terms of pricing and entry policy. One study examined the effect of deregulation in Florida
and in Arizona, which was deregulated in July 1982.
Controlling for several factors that influence rates,
including the commodity class, the shipment size, and the type of motor carrier, changes in motor carrier rates
were examined for Arizona from January 1980 to October 1984 and for Florida from January 1979 to October
1984. It was found that deregulation caused average intrastate motor carrier rates to fall for half of the routes in
Arizona and all of the routes in Florida. A second study focused upon motor-carrier rates for Florida for the more
limited time period of June 1980 to September 1982.
It found that average rates fell by almost 15 percent.
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Page 565
Table 17.2
Shares of Average Commodity for Sampled Manufactured Goods
For-Hire
Source:
Coal
Grain
Source: Freight Commodity Statistics,
1970-1982, American Railway Association. Taken from Thomas
Gale Moore, "Rail and Trucking Reform," in Leonard W. Weiss and Michael W. Klass (eds.),
Regulatory Reform: What Actually Happened
(Boston: Little, Brown, 1986). Copyright © 1986 by
Leonard W. Weiss and Michael W. Klass. Reprinted by permission of HarperCollins Publishers.
Associated with this switch in the commodities being carried, there has been a sharp decline in single-car
shipments by railroads and a sharp increase in multicar shipments. The decline of single-car shipments may
represent a transfer of the short-haul gathering function from railroads to trucking as the railroads have abandoned
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Page 566
Table 17.4
Quality of Service after Motor Carrier Act of 1980
Quality of trucks
Promptness of service
Availability of service
Adjustment of claims
Need for supervision
Willingness to serve off-line points
Source:
Thomas Gale Moore, ''Rail and Trucking Deregulation,'' in Leonard W. Weiss and Michael W.
Klass (eds.),
Regulatory Reform: What Actually Happened
(Boston: Little, Brown, 1986), p. 35.
Copyright © 1986 by Leondard W. Weiss and Michael W. Klass. Re-printed by permission of
HarperCollins Publishers.
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Page 567
portation services, it was estimated (in 1977 dollars) that the deregulation of motor carrier rates increased their
welfare by almost $4 billion per year. Although the deregulation of rail rates was found to reduce grain rates, which
raised shippers' welfare by about $280 million per year, it raised all other rates (on average) and this reduced
welfare by $1.35 billion. Thus, shippers' welfare went up by $2.89 billion annually due to the change in surface
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Page 568

Bankruptcies



Source:
Data




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Page 569
299-316.
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Page 570
data from 1973-1978, it was estimated that a wage premium of 50 percent was paid to union workers in the
trucking industry; that is, union workers earned a wage 50 percent higher than non-union workers performing
comparable work with comparable skills. In contrast, from 1979 to 1985 (in the absence of regulation) the union
premium was only 27 percent, which is very close to the national average of 28 percent.
By opening these
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Page 571
Table 17.5
Overall Productivity Growth for U.S. and Canadian Railroads (average annual
1956-1963
1963-1974
1956-1974
United States
Canadian National
Canadian Pacific
Atchison, Topeka and Santa Fe
Southern Pacific
Source:
Douglas W. Caves, Laurits R. Christensen, and Joseph A. Swanson, "The High
Cost of Regulating U.S. Railroads,"
Regulation,
January/February 1981: 41-46. Reprinted
with the permission of The American Enterprise Institute for Public Policy Research,
Washington, D.C.
ductivity growth would have been in the absence of regulation. Of course, this estimate will encompass all sources
of reduced productivity growth, including reduced innovations and reduced investment.
For this purpose, cross-country analysis was performed that compared the growth in total productivity for U.S.
railroads over 1956-1974 to the growth achieved for Canadian railroads during the same time period. Growth in
total productivity of inputs is equivalent to a decline in cost per unit of output. Although both industries had access
to the same innovations, the Canadian railroads were subject to much less regulation than U.S. railroads. As shown
in Table 17.5, for 1956-1974 total productivity growth in the railroad industry was 3.3 percent in Canada, but only
0.5 percent in the United States. Because there is a large number of small and relatively weak railroads in the
United States, the study sought to control for differences in U.S. and Canadian railroads by selecting a comparable
subsample. Those chosen were Canadian National and Canadian Pacific for Canada and Atchison, Topeka and
Santa Fe and Southern Pacific for the United States. At least for the period 1963-1974, this subsample supports the
hypothesis that regulation reduced productivity growth. If U.S. railroads had experienced the growth in
productivity that Canadian railroads had, it has been estimated that the cost of providing rail services in 1974
would have been $13.83 billion lower (in 1985 dollars). This is striking evidence of the productive inefficiencies
brought about by the regulation of the railroad industry.
It was estimated that deregulation of the motor-carrier industry caused productivity to fall by .05 percent in the first
year of deregulation but to grow every year thereafter (the data went up to 1984). By 1984, productivity was 16
percent higher. The initial fall is thought to be due to the adjustment that deregulation required. It is also important
to note that the 16 percent rise is for those motor carriers that were still
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Page 572
operating in 1984. Because deregulation presumably caused the least efficient firms to exit, the actual productivity
gains were higher.
Effect of Regulation on Profits
One of the more impressive accomplishments of deregulation is the resurrection of the profitability of the railroads.
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Page 573
of the Motor Carrier Act of 1980, inasmuch as it put into law many of the changes made by the ICC.
Summarizing many of the studies that estimated the welfare loss from the regulation of surface freight
transportation, Professors Robert D. Willig and William J. Baumol state:
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Page 574
comprehensive legislation that deregulated intrastate trucking; another two never had regulation. Many of the
regulated states have a regulatory structure comparable to that at the federal level prior to the Motor Carrier Act of
1980. Many of them have gone on to relax entry and rate regulation by way of bureaucratic initiative and limited
legislation.
The regulation of intrastate but not interstate rates has led to some notable distortions. For example, Cargill
supplies flour to Lubbock, Texas, from its plant in Wichita, Kansas, even though it has a plant in Fort Worth,
Texas, that is 162 miles closer. Because intrastate rates are regulated, supplying from the latter plant would cost
about 28 percent more. Steel imported from out-of-state to Spokane through Seattle costs $14 per ton to transport it
from Seattle. However, steel produced in Seattle costs 31 percent more to be transported to Spokane.
Regulation has been a feature of the airline industry from almost its inception. Then, quite suddenly, things began
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Page 575
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Page 576
1977, the pace of deregulation accelerated as he further reduced entry restrictions and controls over fares. Major
fare-cutting followed.
Airline Deregulation Act of 1978
In response to these CAB reforms, fares were lower
industry profits were actually up in 1978. With such
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Page 577
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Table 17.6
Short haul (109 miles)
Short-medium haul (338-373 miles)
Source:
Simat, Helliesen and Eichner, Inc., "The Intrastate Air Regulation Experience in Texas and
California," in Paul W. MacAvoy and John W. Snow (eds.),
Regulation of Passenger Fares and
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Page 580
Table 17.7
First Class
Southwest Intrastate
"Executive Class"
"Pleasure Class"
Source:
Simat, Helliesen and Eichner, Inc., "The Intrastate Air Regulation Experience in Texas
and California," in Paul W. MacAvoy and John W. Snow (eds.),
Regulation of Passenger Fares
Air-
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Page 581
Tables 17.6 and 17.7, the intertemporal evidence confirms the hypothesis that CAB price regulation was
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Page 582
Table 17.8
Ten-minute reduction in transfer time
Ten percentage points increase in flights on time
Carrier not to have a fatal accident in the preceding six months
Source:
Steven A. Morrison and Clifford Winston, "Enhancing the Performance of the
Deregulated Air Transportation System," in Martin Neil Baily and Clifford Winston (eds.),
Brookings Papers on Economic Activity: Microeconomics 1989
(Washington, D.C.: The
Brookings Institution, 1989). Reprinted by permission.
not (holding all other characteristics the same), the airline with the recent accident must offer a fare which is
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Page 583

Load



Source:
David










and

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Page 584
consumers was then in not having the option of choosing a low-priced low-quality product. In assessing the welfare
implications of regulation, it would then seem that one must consider both the welfare loss from higher fares and
that the overall quality of service is lower under deregulation, because the hub-and-spoke system trades off longer
travel time (as there are fewer direct flights so that more flights require a transfer) for a wider array of departure
times. To address this question, a study analyzed 812 city pairs with and without regulation. It used actual data on
fares and flight frequency for 1977 as the regulatory benchmark. To ascertain the effect of regulation, these data are
compared with projected data for 1977 conditional on the route structure and fares being what they were under
deregulation (specifically, 1983). Table 17.9 shows that real fares declined in medium hub-large hub and large hub-
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Page 585
Hub-and-Spoke
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Page 586
Table 17.9
Weighted Average Percentage Change in Fares and Frequency from Deregulation (1977)
Number of
Category of Route
City Pairs
Nonhub-nonhub
Nonhub-small hub
Nonhub-medium hub
-0.4
Nonhub-large hub
Small hub-hub
Small hub-medium hub
Small hub-large hub
Medium hub-medium hub
-4.3
Medium hub-large hub
-6.8
Large hub-large hub
-17.6
-3.5
Source:
Steven Morrison and Clifford Winston,
The Economic Effects of Airline
Deregulation
(Washington, D.C.: The Brookings Institution, 1986). Reprinted by
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Page 587
Table 17.10
Annual Gains to Travelers from Airline Deregulation (billions of 1993 dollars)
Fares
Travel Restrictions
-3.3
Load Factor
-0.6
Number of Connections
-0.8
Mix of Connections (On-line/Interline)
Travel Time
- 3.3
Source:
Steven A. Morrison and Clifford Winston, ''The Evolution of the
Airline Industry,'' Northeastern University, manuscript, August 1994.
fares and travel times and delays from the end of 1976 to the end of 1978.
This period captures the initial effect
of price deregulation, but not the effect of the restructuring of the route system. The average real standard coach
fare fell by almost 5 percent while first-class fares went from being 150 percent of the coach fare to 120 percent.
Because lower fares brought forth greater volume of traffic, load factors rose from 55.6 percent to 61.0 percent.
Once taking into account the effect of deregulation on travel time and delays, the estimated gain to consumers was
about 10 percent of an average prederegulation round trip fare or about $25 to $35 per round trip (recall that all
figures are in 1985 dollars). Any undesirable changes in travel time and delay were more than compensated for by
the reduction in fares. It is important to note that this welfare measure does not take into account lower welfare due
to reduced on-board services and higher load factors.
Table 17.10 provides the most up-to-date estimates of the welfare gains from deregulation. Consumers are gaining
$12.4 billion annually from lower fares under deregulation and $10.3 billion from greater flight frequency. On the
downside, increases in travel restrictions, travel time, load factors, and the number of connections have all reduced
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Page 588
Table 17.11
Average Annual Percentage Decline in Unit Cost
1970-1975
1975-1983
Non-U.S.
Non-U.S.
Operating Characteristics
Technical Efficiency
Total Productive Efficiency
Source:
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Page 589
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Page 590
1955-1990
Flying?
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Page 591

Industry



Source:
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Page 592
Table 17.12
Major Airline Mergers Since Deregulation
Pan American-National
Approved by CAB
Texas International-National
Approved by CAB
Eastern-National
[The] reconcentration of the industry reflects in part the deplorable failure of the Department of
Transportation to disallow even one merger, or, in all but
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Page 593
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Page 594
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Table 17.13
Hubbing and Fares at the 30 Largest U.S. Airports
Atlanta
Memphis
Dallas/Ft. Worth
Pittsburgh
Salt Lake City
St. Louis
-4.0%
Chicago, O'Hare
Denver
Minneapolis
Houston, Intercontinental
New York, Kennedy
-0.7%
Baltimore
Phoenix
-28.4%
Miami
-14.3%
Seattle
San Francisco
-1.5%
Los Angeles
-5.3%
Philadelphia
Honolulu
-20.8%
Newark
Las Vegas
-27.8%
Houston, Hobby
-23.4%
Orlando
-15.6%
Boston
Washington D.C., National
Tampa
-12.4%
San Diego
-18.1%
New YorkLa Guardia
Source:
concentration. One can also use an intertemporal approach by examining how fares along a particular route change
as concentration changes. This approach was used by examining how airline mergers that increased concentration
along some routes affected air fares. An analysis of twenty-seven mergers in 1985-1988 revealed that the merging
airlines, on average, raised air fares by 9.4 percent more on those routes for which they both previously provided
service. Furthermore, rival airlines on those routes responded by increasing their air fares by 12.2 percent.
majority of the evidence
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Page 596
supports the hypothesis that increasing concentration has translated into higher fares.
An important lesson to be learned from the deregulation of the airline industry is that if we are to realize the
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Page 597
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Page 598
2. Why were the railroads in favor of regulation in the 1880s but in favor of deregulation in the 1950s?
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(Cambridge, Mass.: Harvard University Press, 1982); Theodore E. Keeler,
Railroads, Freight, and Public
Policy,
(Washington, D.C.: The Brookings Institution, 1983); and Thomas Gale Moore, "Rail and Trucking
Deregulation," in Leonard W. Weiss and Michael W. Klass (eds.),
Regulatory Reform: What Actually
Happened
(Boston: Little, Brown, 1986).
If you like this book, buy it!
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Page 600
Braeutigam and Roger G. Noll, "The Regulation of Surface Freight Transportation: The Welfare Effects
Revisited,"
Review of Economics and Statistics
56 (February 1984): 80-87.
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Page 601
60. Franklin M. Fisher, "Pan American to United: The Pacific Division Transfer Case,"
Rand Journal of
Economics
18 (Winter 1987): 492-508.
61. "Happiness is a Cheap Seat,"
The Economist,
February 4, 1989, pp. 68, 71.
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62. Steven A. Morrison and Clifford Winston, "The Evolution of the Airline Industry," Northeastern University,
photocopy, August 1994.
63. Data is for 1992; Morrison and Winston, 1994.
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Page 603
Economic Regulation of Energy: Crude Oil and Natural Gas
At least since the industrial revolution, the energy industry has been critical in the world economy. Energy is an
amount of heat required to raise the temperature of one pound of water by one degree Fahrenheit.
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Page 604
1947-1975
228-48.
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Page 605
World natural gas flow, 1986
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Page 606
In the next section, we briefly review the welfare implications of economic regulation that is characterized by price
and
exceeds
, which is the amount that
firms are willing to supply at a price of
The implications of this price ceiling is that output is reduced from
to
from paying
per unit on
units. On the other hand, consumers lose surplus measured by triangle
bcd
as
less units are
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Page 607
tween rectangle
and triangle
bcd.
On the other hand, firms clearly lose by the imposition of a price ceiling. In
its absence, producer surplus is the triangle
P*cg.
With the price ceiling, producers lose surplus of triangle
dcf
the reduced supply of
and lose rectangle
to consumers through the lower price. Summing the change
. Because there is excess demand of
it is
important from a welfare perspective as to how the
units are allocated among consumers.
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Page 608
To analyze this issue in a simple manner, assume that each consumer wants to buy one unit or nothing. Consumers
differ by their reservation price, the highest price that a consumer is willing to pay for the good. That is, at a price
units are randomly allocated to consumers, perhaps by government mandate. At a price
a total of
consumers want to buy the available
units. Therefore, only a fraction
of consumers who
want to buy the good at a price of
are able to do so. With random allocation of the
units, this means that, for
example, only
of the
) consumers with a reservation price at least as high as
P'
will be able to
purchase the good. The allocation rule is then depicted as the curve
should go to those consumers with reservation prices at least as high as
. Their surplus equals trapezoid
Alternatively, with random allocation of the
units, only a fraction
to
. Because now the consumers' surplus is only triangle
allocation results in an additional welfare loss of triangle
abf
and a total welfare loss of triangle
An important implicit assumption in the above analysis is that consumers cannot resell the good (or, alternatively,
cannot resell the right to buy the good). If they are allowed to do so, then the welfare loss
abf
may be avoided.
Consumers fortunate enough to be allocated the good can resell it to the highest bidder through the secondary
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Page 609
Suppose instead that the allocation of the
units and for those consumers with the highest
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Page 610
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is clear from Figure 18.2). As a result, major players include not only firms and consumers but also governments.
Two particularly important players are, on the demand side, the United States and, on the supply side, the
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Page 612
Table 18.1
Principal Causes of Crude Oil Price Increases, 1947-1981
Principal Factors
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Page 613
from $13.34 in January 1979 to $34.00 by October 1981.
Throughout much of the 1980s, OPEC was subject to
considerable overproduction by its members with the result being a falling price for crude oil. However, the price
of oil can always shoot back up in response to new events; witness the 1990 Iraqi occupation of Kuwait.
Regulatory History
Beginning with the Standard Oil case in 1911, there is a long history of government involvement in the U.S. oil
industry. Of course, that case concerned the oil-refining industry and the focus of this chapter is on the oil-
producing industry. The consumers in our study are made up of domestic refining companies whereas the
producers are domestic and foreign firms that extract oil from wells. To provide an overview, state and federal
regulation from the early part of this century to about 1970 was designed to limit the supply of crude oil. This was
achieved through restrictions on the production of domestic firms and on exports to the United States by foreign oil
producers. From 1970 to 1981 federal regulation switched from this pro-producer stance to one less favorable to
the oil industry as regulation constrained the price that domestic oil companies could charge for their product.
The goal of regulating domestic oil production dates to 1909, when Oklahoma authorized its Corporation
Commission to limit the production of wells in the state. Similar powers were given to the Railroad Commission in
Texas in 1919. However, not until 1928 were the first individual field proration orders issued. These orders limited
production by allocating the total production allowed pro rata among wells. Such a mechanism is referred to as
Events in 1926-1931 spurred a wave of state intervention in the production of oil. One critical event was the
discovery of new reserves, in particular, the East Texas oil field in 1930. This was a 5.5 billion barrel reservoir that
by 1933 had 1,000 firms with a total of 10,000 wells pumping oil from it.
Because of this massive increase in
supply, along with the reduction in oil demand resulting from the Great Depression, oil prices fell sharply. Pursuing
the lead of Oklahoma, Texas instituted prorationing in 1930 and Kansas followed in 1931. The federal government
aided the oil-producing states by passing the Connally "Hot Oil" Act of 1935, which prohibited the interstate
shipment of oil that was extracted in violation of state regulations.
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Page 614
required at least twenty acres per well while the federal government, due to the need for conservation during World
War II, required a minimum of forty acres. After World War II, an additional twenty-two states added conservation
laws that gave state government the right to restrict oil production.
Mandatory Oil Import Program
Before 1957 the United States had no controls on the import of crude oil. In that year, motivated by rising imports,
President Dwight Eisenhower called for a voluntary reduction by domestic oil refiners. Previously, the oil-
producing states had responded to an increase in oil imports by reducing prorationing orders so as to maintain the
domestic price. Needless to say, this policy of voluntary restraint did not work. The program then became
involuntary in 1959 with the Mandatory Oil Import Program (MOIP).
Oil Price Controls
With rising inflation, President Richard Nixon instituted an economy-wide price freeze in August 1971. Two years
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Page 615
Table 18.2
Crude Oil Price Controls, 1971-1988
Price Regulations
Economic Stabilization
Phase I
8/71 to
Economy-wide price freeze.
Phase II
to 1/73
Controlled price increases to reflect cost increase with profit limitations.
Phase III
1/73 to
Voluntary increases up to 1.5% annually for cost increases.
Special Rule No. 1
3/73 to
Mandatory controls for 23 largest oil companies.
Phase IV
8/73 to
Two-tier pricing; old oil at level of 5/15/73 plus $0.35, new oil, stripper oil,
and "released" oil uncontrolled.
Reaction to Shortage
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Page 616
price for oil. Adjusting this demand projection for anticipated changes in inventories, the resulting number is the
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Rationale for Prorationing
State Government as a Cartel Manager
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Page 618
pumped tomorrow and each of those barrels represents foregone profit of
). This loss is discounted
and
denote the rates of extraction for today and tomorrow, respectively, that maximize the present value
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Page 619
where
and
denote the new profit-maximizing rates of extraction. Note that if
= 0 (as is true if there is no
common pool problem), (18.2) is the same as (18.1). The key implication of
0 is that a landowner has an
incentive to extract at a faster rate today; that is,
. For every barrel of oil not pumped today, a landowner
of that barrel to his neighbors. Because the pool is shrinking over time because of one's neighbors also
drawing from it, an individual landowner has an incentive to speed up extraction so as to acquire oil before it is
acquired by the other landowners. Each landowner engages in this practice of fast extraction so that the overall rate
of extraction is higher than when it is owned by one individual.
With a common pool problem such as this one, profit maximization by each landowner results in a rate of
extraction that exceeds the socially optimal rate. Each owner is induced to pump more today, relative to the social
optimum, because postponing extraction is costly because the other landowners will drain the field in the
meantime. To see this result graphically, we can rewrite equation (18.1) as follows:
P2    -    MC2(Q2)]and
SUC
stands for "social user cost."
is the marginal revenue from pumping one more barrel today while
) +
SUC
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Page 620

The






This is depicted in Figure 18.5. When instead there is a common pool problem, the cost to an individual landowner
, then satisfies
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Page 621
As shown in Figure 18.5, the common pool problem results in the rate of extraction exceeding the socially optimal
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Page 622
government intervention. As it turns out, there are several private mechanisms that may be able to solve the
common pool problem. In some ways the simplest solution is to have a single individual own all the land over an
oil reservoir (or at least the mineral rights). Of course, this is feasible only if a single landowner can earn greater
profits than the sum of the profits that would be earned by the multiple landowners. Only then would an individual
be able to buy up the land from the various landowners and turn a profit by doing so. When there is a common
pool problem, this is indeed true because a single landowner can coordinate extraction on different lands and
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Page 623
problem exists and private solutions are costly to implement, social welfare may be increased by the government
imposition of production restrictions.
Effects of Prorationing
The evidence on the effects of instituting prorationing is both weak and relatively unsubstantive, but it still
provides some insight into the potential welfare implications of this form of state regulation. First, anecdotal
evidence has shown that prorationing increased the ultimate recovery of oil reservoirs. The productive lives of
twenty fields in Arkansas, Louisiana, Oklahoma, and Texas were examined. Ten fields were developed before and
ten after prorationing. For the pre-prorationing fields, the production rate in the fifteenth year was, on average, 8.6
percent of the peak production rate. In contrast, for the post-prorationing fields, the production rate was 73.9
percent of the peak rate in the fifteenth year.
This evidence is consistent with the predicted effect of
prorationing, which is that it reduces early extraction rates and thereby increases ultimate recovery. However,
conclusions drawn from this analysis are tentative in that it does not control for differences in the fields and does
not compare these rates to the social optimum.
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Page 624
have resulted in a more socially preferred rate of extraction as well as a higher degree of ultimate recovery.
Unfortunately, the available evidence on the impact of prorationing is sufficiently sparse so as to make it difficult
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Page 625
duction. It follows that the supply curve faced by U.S. consumers, which we denote as
If price is less than
, then it is below the world price so that total supply is that which is provided by domestic
producers which is
). If price is at least as high as
, then foreign producers are willing to supply as much as
is demanded. However, the MOIP limits imports to 12.2 percent of domestic supply so that total supply is domestic
supply of
) plus oil imports of (.122)
). This gives us the supply curve
According to Figure 18.6, the equilibrium price under MOIP is
which exceeds the world price. Notice that the
MOIP has achieved its objective of reducing oil imports as they have fallen from D(
) (or distance cf)
to
(or distance
). In assessing the welfare effects of limiting oil imports, first note that consumers are
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Page 626
worse off by the sum of rectangle
and triangle
bcd.
Because demand decreases from
) to
consumers lose surplus measured by triangle
bcd.
In addition, consumers have to pay a higher price of
remaining demand. However, this higher price is paid only for domestic oil so that its expenditure increases by
or rectangle
Although consumers are made worse off, domestic oil producers receive higher
profits because of the increase in demand for domestically produced oil. Oil import quotas increase domestic oil
producers' profits from triangle
to triangle
. Thus, domestic producer surplus rises by
Summing up
the change in consumer surplus and domestic producer surplus, the welfare loss from MOIP is measured by the
sum of triangles aef and bcd. Triangle
bcd
measures the foregone consumer surplus from the fall in demand from
) to
), whereas triangle
aef
measures the value of wasted resources from having domestic oil producers
supply an additional amount of
rather than have it supplied more efficiently by importing oil at a
price of
, one can use the resale price for import quota vouchers because the resale price should reflect the
was estimated to be $1.174 per barrel for 1969.
To give an idea of the
size of the differential, the average world price was around $2.10 per barrel, so that import quotas raised the
domestic price by over 50 percent. With this estimated price differential, one can derive a measure of the welfare
loss from the MOIP if one has information on the domestic supply and demand curves. Based on estimated demand
curves, Douglas Bohi and Milton Russell assume a long-run domestic demand elasticity of -0.5 and a long-run
domestic supply elasticity of 1.0.
Their estimate of the cost to consumers in 1960 was $3.2 billion, from which it
steadily rose to $6.6 billion for 1970.
Crude Oil Price Controls
Regulatory Practices
There are two important aspects to the government regulation of the oil industry beginning in 1971.
First, a
multitier pricing system was used that established different prices for oil according to the vintage of the well and
other characteristics. The main reason for pursuing such a reg-
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Page 627
ulatory structure was to enhance incentives for domestic exploration by allowing higher prices for newly discovered
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Page 628
controlled oil in its total crude oil input was the same as the national average. For example, the national average
was 40 percent in December 1974 so that a refiner who processed 1,000,000 barrels of crude oil in that month
would receive 400,000 (= .40 × 1,000,000) entitlements. If it wanted to refine 500,000 of price-controlled oil, it
would need an additional 100,000 entitlements, which it could acquire by buying them from other firms because
entitlements were transferable.
Windfall Profits Tax
Like EPCA, the Windfall Profits Tax was a three-tier system but, unlike EPCA, it did not control prices. Rather, it
levied an excise tax on domestic oil sales. Tier one included oil produced from fields that were producing prior to
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Page 629
. Oil produced in excess of
BPCL
is considered new oil and its price is uncontrolled. However, recall that for
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Page 630
one barrel of controlled oil to be sold at the world price. One would then expect a firm's supply to be greater under
For the ensuing regulatory program of EPCA, the distortive effect on domestic supply is much more clear-cut. A
firm's marginal revenue curve took the form depicted in Figure 18.8. Once again, production below
is not
subject to price controls so that marginal revenue is
. If the property was producing prior to 1975, then
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Page 631
was in excess demand, a refiner who considered processing one more barrel of crude oil would have to buy on the
is the price of the latter then the refiner saves
on this exchange. It
. Therefore, under the
entitlements program, the marginal cost of one more unit of imported oil to a refiner is less than the world price
. Effectively, oil price regulation subsidized imported oil! We would predict domestic demand to be distorted
upward as a result.
Measuring the Welfare Loss
Depicted in Figure 18.9 are the domestic supply curve for crude oil,
Sd(P),
the domestic demand curve for crude
oil,
), and the world supply curve for crude oil,
). For simplicity, we have assumed that the supply of
imports is perfectly elastic at the world price. The effect of allowing
) to be upward-sloping is considered
In the absence of oil price controls, the equilibrium price would be
, and refiners would demand
* units. At a
price of
, domestic oil producers would optimally supply
units so that imports would be
suppose a price ceiling of
is imposed on domestic oil and an entitlements program is implemented so that the
marginal price faced by domestic refiners is
, which we will denote
. Due to the lower price faced
by refiners, their demand would increase from
* to
**. Because domestic suppliers receive the lower price of
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Page 632

Equilibrium





they are only willing to supply
units. As a result, imports must increase from
to
We can now assess the welfare effects of regulation. Regulation induced domestic refiners to process too much oil
by the amount
Q*.
For those additional units, the social cost, as measured by the world price
, exceeds the
social benefit by the triangle
abc.
In addition, the reduced domestic supply means that more resources are used to
supply
Thus, there is an additional welfare loss of triangle
def.
The total welfare loss from regulation is
then measured by the sum of the two shaded triangles in Figure 18.9.
The size of these triangles have been estimated for 1975-1980 and is shown in Table 18.4. In 1975, triangle
was estimated as $1,037 million (in 1980 dollars), whereas triangle
def
was estimated at $963
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Page 633
Table 18.4
Welfare Losses from Oil Price Controls, 1975-1980 (millions of 1980 dollars)
Demand-Side Deadweight
Supply-Side Deadweight
Additional Expenditure on
1976
1977
1978
1979
1980
Source:
Joseph P. Kalt,
The Economics and Politics of Oil Price Regulation
MIT Press, 1981).
million. The total deadweight loss from distorted supply and demand decisions was $2 billion. From 1975 to 1980,
the average annual welfare loss due to demand and supply distortions was about $2.5 billion so that the total
welfare loss from EPCA was on the order of $15 billion. The welfare loss from regulation fluctuated over time
because of the changing price of world oil. Also note that expenditure on imports increased considerably as a result
of oil price regulation.
There are several caveats that need to be mentioned with respect to these estimates. First, these triangles measure
the welfare loss from regulation under the assumption that the marginal social cost of crude oil is properly
measured by the world price. Thus, when regulation induces domestic consumption to increase from
to
value of that additional consumption is less than the cost of the resources used as measured by
. Because
represents the marginal social cost to the U.S. economy of another barrel of (imported) oil, triangles
abc
and
measure the welfare loss to the U.S. economy from demand and supply distortions. However, it does not measure
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Page 634
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Page 635
entitlements to small refiners, regulation provided an incentive for inefficiently small refiners to operate. The small
refiner bias was found to be increasing over the period of regulation. Refiners with less than 175,000 barrels per
day made up 14.4 percent of total refined product sales in 1972 and this had increased to 17.8 percent by 1975.
Regulation not only resulted in inadequate domestic supply but also changed the composition of the domestic
suppliers toward smaller, less efficient refiners. By doing so, industry average cost was raised and social welfare
was reduced.
Reduced Incentives for Exploration
It has been argued by many economists specializing in the oil industry that regulation reduced the incentive to
explore for new oil reserves. However, since marginal revenue from new oil production was higher than the world
price under EPAA, one would think that regulation would have increased the expected profits from exploration and
thus actually increased the incentive to explore. On the other hand, marginal revenue was constrained below the
world price under EPCA so that the effect on expected profits from exploration would be just the opposite.
A concern of firms is that if they discover new oil reserves, future regulation may reclassify it as old oil and thus
restrict its price below the world price. This effect would tend to reduce the incentive to explore under either
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Page 636
these costs to those associated with supply and demand distortions, the annual welfare loss in 1979 due to
regulation was around $3.2 billion (in 1979 dollars).
On this note, it is interesting to mention that when the Windfall Profits Tax was repealed in 1988, it was creating a
welfare loss in spite of the fact it was no longer collecting revenues. (Prior to that time, however, it did collect
revenues totaling $77 billion over 1980-1988)
. The industry estimated that it incurred on the order of $100
million annually in reporting and complying with the law.
Even when a regulation is not binding, there can be
welfare losses associated with it.
Price Regulation of the Natural Gas Industry
Like crude oil, natural gas is a hydrocarbon and is produced by drilling into an underground reservoir. In fact, gas
amount of energy is stored in only 7.5 gallons of gasoline.
Given its bulkiness, generally the only economical
way in which to transport natural gas is by pipeline.
However, early gas pipelines suffered from serious
problems with leakage. This caused pipelines not to be of great length, which meant that consumers had to be
relatively close to producers. Consequently, the natural gas industry was slower to develop nationally than the
crude oil industry. A sign of the future national scope of the industry took place in 1931 when a pipeline was built
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Page 637
dividual residential and commercial users with the pipeline and thus has many of the properties of a local electric
Economic Structure of Transportation
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Page 638
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Page 639
Decontrol Act of 1989, which fully deregulated gas prices. An overview of the regulatory structure from 1938-
1985 is provided in Figure 18.10.
Regulatory Practices
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Page 640
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Page 641
Effects of Price Regulation

Comparison






Source:
Energy







and


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Page 642
growing interstate demand and the oil price shock. During that time interstate prices for new contracts rose 158
percent from $0.198/Mcf to $0.51/Mcf while intrastate prices for new contracts rose a whopping 650 percent from
$0.18/Mcf to $1.35/Mcf.
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Page 643
is, crude oil), one would anticipate gas prices to increase but the supply response to be minimal once production of
is reached. In light of this model, one can understand FPC policy. By keeping gas prices at
even when
demand has shifted to
), there is no welfare loss because supply is still
while the transfer of wealth from
consumers to producers is prevented.
Unfortunately, history has shown that the interstate supply curve for gas was indeed responsive to the price. A more
accurate representation is that shown in Figure 18.13. In that case, with a price ceiling of
as demand grows from
) to
) to
) an increasing shortage emerges because supply does not respond. With price ceilings in
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Page 644
1970-1977
1970-1972
1972-1977
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Page 645

Comparison









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Page 646
able to receive ample supply of gas while residential consumers in the Northeast had to use expensive alternative
energy sources like oil and electricity for heating. Because utilities and industries could have converted to coal,
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Page 647
Table 18.5
Take-or-Pay Provisions by Contract Vintage
Contract Vintage
Take-or-Pay Requirement
Pre-1973
1973 to April 20, 1977
April 21, 1977, to November 8, 1978
November 9, 1978, to 1979
1980
Weighted-average percentage minimum-purchase requirement (take-or-pay) based on
percentage of deliverability or capacity.
The Natural Gas Policy Act was enacted on November 9, 1978.
Source:
U.S. Energy Information Administration, "An Analysis of the Natural Gas Policy
Act and Several Alternatives," Part I (December 1981), II (June 1982), III (September
1982), IV (May 1983), Washington, D.C. Table from Ronald R. Braeutigam and R.
Glenn Hubbard, "Natural Gas: The Regulatory Transition," in Leonard W. Weiss and
Michael W. Klass (eds.),
Regulatory Reform: What Actually Happened
(Boston: Little,
Brown, 1986). Reprinted by permission of HarperCollins Publishers.
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Page 648
Path to Deregulation
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Page 649
Although we have discussed the regulation of oil and gas separately, one would expect there to be important
a) information is revealed which raises the expected price of crude oil in the future;
b) the interest rate rises.
3. When crude oil price controls were in place, what would have been the welfare implications of a ban on oil
imports? (Use Figure 18.9.)
b) Suppose that the government institutes a price ceiling of 5. Derive the welfare loss from price controls.

Q
)

Q

Q
)



7. Assume that the domestic supply curve for crude oil is
) = 5
and the domestic demand curve for crude oil is
) = 500 - 20
. Further assume that domestic oil refiners face a perfectly elastic supply of oil imports at a price
of 16.
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Page 650
a) Derive the domestic price, the quantity processed by domestic oil refiners, and the amount of imports at the
b) Derive the marginal price of crude oil faced by domestic oil refiners.
c) Derive the effect of regulation on the amount of crude oil processed by domestic oil refiners and the amount
of imports.
d) Derive the welfare effect of regulation on U.S. consumers and producers.
8. Who gained and who lost by prorationing? By crude oil price controls? By natural gas price controls?
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Page 651
8. The source for this description is McDonald, 1971, pp. 158-61. General background references for prorationing
include Zimmermann, 1957; Melvin G. De Chazeau and Alfred E. Kahn,
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Page 652
28. "Windfall Profits Tax Repealed with Trade Bill Signing,"
Oil and Gas Journal,
August 29, 1988, p. 17.
30. General background references include Robert B. Helms,
Natural Gas Regulation
(Washington, D.C.:
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Page 653
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Page 655
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Page 656
Unlike the economic regulation areas, however, there has been no major push toward deregulation. Indeed, the
recent emergence of concerns such as global climate change has increased the extent of this form of regulation.
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Page 657
Table 19.1
Causes of Death in the United States, 1991
Death Rate per 100,000 Population
All causes
Heart disease
Cancer
Stroke
Chronic obstructive pulmonary disease
Accidents
Motor vehicle
Falls
Poison (solid, liquid)
Drowning
Fires, burns
Pneumonia
Suicide
HIV infection
Homicide
Chronic liver disease, cirrhosis
Nephritis and nephrosis
Septicemia
Atherosclerosis
Certain conditions originating in perinatal period
Source:
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Page 658
for job accidents, for example, generally attribute most of these accidents, at least in part, to worker behavior.
In contrast, many of the leading causes of death are more in the domain of individual behavior rather than
regulatory action.
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Page 659
Table 19.2
Risks That Increase the Annual Death Risk by One in 1 Million
Cause of Death
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Page 660
1930-1993
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Page 661
vehicle death rate is lower now than it was sixty years ago, the change has not been great. This comparative
stability is not a reflection of a failure to improve the quality and design of cars. Indeed, dramatic improvements
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Page 662

Perceived




Source:
B.


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Page 663
The overestimation of low-probability events also has substantial implications for government policy. To the extent
that there is an alarmist reaction to small risks that are called to our attention, and if these pressures in turn are
communicate this information effectively to the public, and to issue regulations that are needed to control the real
risks that are present.
A related result that has emerged in the risk-perception literature is that highly publicized events often are
associated with substantial risk perceptions, even though the risks involved may not be great. This finding is not a
sign of individual irrationality. Typically the events themselves rather than frequency statistics are publicized. We
learn that a number of people have recently been killed by a tornado, but we are not given a sense of the frequency
of these events other than the fact that coverage of tornado victims in the newspaper occurs much more often than
coverage of asthma victims. Because of the sensitivity of risk perceptions to the amount of publicity as well as the
level of the risk, the pressures that will be exerted on risk regulation agencies will not necessarily be in line with
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Page 664
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Benefit-Cost
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Page 666
eventually diminishes. Our task of finding the best level of environmental quality to promote through regulation
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Page 667
Table 19.3
Cost-per-Life Values for Arsenic Regulation
Standard Level
Average Cost per Life ($
Marginal Cost per Life ($
Medium
Tight
Source:
W. Kip Viscusi,
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Page 668
average cost per case of cancer prevented, but the officials responsible for the calculation had not noted that the
last incremental tightening of the standard produced no reduction in cancer cases whatsoever. The marginal cost per
case of cancer prevented in this case was actually infinite for the tightest level of the standard being considered. In
contrast, the average cost per case of cancer remained fairly stable, thus disguising the inefficiency being created.
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Page 669
Table 19.4
Industry Cost Variations for the OSHA Noise Standard
Cost per Worker Protected (thousands of dollars)
Electrical equipment and supplies
Rubber and plastics products
Stone, clay, and glass products
Paper and allied products
Food and kindred products
Chemicals and allied products
Transportation equipment
Tobacco manufactures
Printing and publishing
Electric, gas, and sanitary services
Furniture and fixtures
Textile mill products
Lumber and wood products
Machinery, except electrical
Weighted average
Source:
W. Kip Viscusi,
Risk by Choice.
Copyright © 1983 by the President and Fellows
of Harvard College.
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Page 670
advantage of other productive capabilities with respect to other goods and services that an economy provides.
Discounting Deferred Effects
If all the effects of regulatory policies were immediate, one could simply sum up these influences, treating effects
today the same as one would treat an impact many years from now. Even if one ignores the role of inflation, it is
important to take the temporal distribution of benefits and costs into account. If one could earn a riskless real rate
of interest of
on one's money, then the value of a dollar today is (1 +
) ten years from now. Thus, resources have
an opportunity cost, and one must take this opportunity cost into account when assessing the value of benefit and
cost streams over time. This issue is not unique to the social regulation area, but it plays a particularly important
role with respect to these regulations because of the long time lags that tend to be involved, particularly when
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Page 671
Table 19.5
Discounting Example
Year 0
Year 1
No Discounting
-3.00
-0.00
-3.00
Benefits-Costs
-2.00
Discounting at 5%
-3.00
-0.00
-3.00
Benefits-Costs
-2.00
Discounting at 10%
Benefits-Costs
-2.00
-0.05
be (1 +
). Thus the present value calculation simply puts the future payoff into terms that are comparable to
payoffs today. More specifically, if one has project benefits
and
C
in year
, then the formula is given by
To see the implications of the present value calculation, consider a simplified discounting example in Table 19.5.
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Page 672
will not be yielded for two or three decades. Not surprisingly, a major battleground over discounting was asbestos
regulation, inasmuch as the deferred nature of the risk made discounting a major policy issue in a debate involving
EPA, OMB, and members of Congress. EPA advocated a discount rate of zero so that the benefits of the regulation
would appear to be large.
Although the practice of reducing the value of deferred benefits may seem to be unduly harsh, it will be muted at
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Page 673
may imply differing levels of riskiness that must then be assessed in such a manner that we can draw meaningful
inferences for humans. Even in situations where we can reach a consensus on these issues, there is often a debate as
to how one should model the risk relationships. For example, should one use a linear dose-response relationship or
a nonlinear model? The fact that uncertainty exists does not imply that the risks are unimportant or should be
ignored, but it does create an additional element that must be addressed in the course of risk regulation.
Even in the case of relatively common risks about which much is known, the range of uncertainty may be
substantial. The range of uncertainty is indicated in the final column of Table 19.6. Risks posed by drinking water
regulated by EPA, for example, could be ten times greater or ten times less than the mean estimate of the risk.
Similarly, the risks posed by air pollution could be twenty times less than the mean estimate. In general, the
regulatory approach is to use the upper end of the 95 percent confidence level around a particular risk. In the case
of the statistics in Table 19.6, the risk levels as calculated by government agencies such as the EPA tend to reflect
the annual risk level plus the uncertainty factor implied by the final column.
Table 19.6
Risks and Their Uncertainty
Annual Risk
Motor vehicle accident (total)
2.4 × 10
Motor vehicle accident (pedestrian only)
4.2 × 10
Home accidents
1.1 × 10
Electrocution
5.3 × 10
Air pollution, eastern U.S.
2.0 × 10
Factor of 20 downward only
3.6 × 10
Factor of 3
Sea-level background radiation (except radon)
2.0 × 10
Factor of 3
All cancers
2.8 × 10
Four tablespoons peanut butter per day
8.0 × 10
Factor of 3
Drinking water with EPA limit of chloroform
6.0 × 10
Factor of 10
2.0 × 10
Factor of 10
Alcohol, light drinker
2.0 × 10
Factor of 10
Police killed in line of duty (total)
2.2 × 10
Police killed in line of duty (by felons)
1.3 × 10
Frequent flying professor
5.0 × 10
Mountaineering (mountaineers)
6.0 × 10
Source:
Richard Wilson and E. A. C. Crouch, "Risk Assessment and Comparisons: An Introduction,"
Science,
236 (1987): 268. Reprinted by permission of the American Association for the Advancement of
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Page 674
By erring on the side of conservatism, in effect government agencies distort the true risk levels by differing
amounts. We may be in a situation where a lower risk is the subject of more stringent regulation, not because it
imposes a greater expected health loss, but because less is known about it. Indeed, the biases implied by Table 19.6
may be rather low compared with the actual biases that may be created by the conservatism approach when dealing
with hazards that are far less well understood than the familiar risks covered in that table. These uncertainty factors
ignore other biases that are present, such as the fact that government agencies generally rely on test results for the
most sensitive animal species rather than a weighted average across all species.
Typically government policies are based on a series of conservatism assumptions rather than simply one. Consider
the case of the EPA Superfund program, which is responsible for the cleanup of hazardous waste sites.
The EPA
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Page 675
The Role of Risk Ambiguity
If one were dealing with a single trial situation in which one rarely incurred risk, the precision of the risk judgment
would not enter. Uncertainty should not be a concern in the case of one-period decisions.
This principle can be traced back to the well-known Ellsberg Paradox.
Suppose that you face two different urns,
each of which contains red balls and white balls. Urn 1 contains fifty red balls and fifty white balls. Urn 2 contains
an unknown mixture of red and white balls. Each urn contains a hundred balls, and you cannot see the contents of
either urn. Suppose that you will win a prize if you can correctly guess the color of the ball that will be drawn.
Which urn would you pick from and what color would you name?
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The same type of principle embodied in this example is true more generally. For one-shot decisions, the precision
of the risk is not a matter of consequence. But in sequential decisions in which learning is possible and in which
you can revise your decisions over time, it is preferable to have a situation of uncertainty rather than to have a
precisely understood risk. In situations of uncertainty we can alter a course of action if the risk turns out to be
different than we had anticipated originally.
In regulatory contexts, what this result implies is that the stringency of our regulation may depend in large part on
uncertainty, but we will not necessarily respond in a conservative manner to this uncertainty. If you must take
action now to avoid an environmental catastrophe, then uncertainty is irrelevant. The mean risk should be your
guide. However, if we can learn about how serious the problem is and take effective action in the future, then it
will generally be preferable to make less of a regulatory commitment than one would if this were a one-shot
The conservatism approach to regulatory analysis runs the danger of confusing risk analysis with risk management.
Ideally, the scientific analysis underlying regulatory policies should not be distorted by biases and conservatism
factors. Policymakers should be aware of the true risks posed by different kinds of exposures so that we can make
comparative judgments across different regulatory alternatives. Otherwise, we run the danger of distorting our
policy mix and focusing attention on hazards that offer few expected payoffs but are not well understood.
The Role of Political Factors
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Table 19.7
Explanatory Variable
Air pollution
No significant effect
Water quality
No significant effect
Significant negative
Natural lands
Significant negative
Significant positive (1 out of 9)
Income growth
Significant negative
Significant positive (3 out of 9)
latory policy has been dictated by the economic stakes involved. A chief source of these differences is regional.
Representatives of districts from the declining areas of the Northeast have in particular used regulatory policies to
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Page 678
these states. In contrast, the states in the Frostbelt of the North Central, New England, and Middle Atlantic states
are more likely to vote for strict environmental controls, because these controls will hit hardest on the newly
emerging sources in other regions of the country. In particular, because the main structure of EPA policy imposes
more stringent requirements on new sources of pollution rather than existing sources, more stringent environmental
regulation generally implies that there will be a differential incidence of costs on newly emerging industries and
regions with substantial economic expansion. As a consequence there are important distributional issues at stake
when voting on the stringency of such environmental policies.
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Table 19.8
Factors Affecting Voting Patterns for Stripmining Regulation
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Page 680
state. Because it is the surface-coal industry that will lose from the regulation and the underground coal industry
that will benefit, these influences follow the pattern one would expect.
The final column of estimates adds a capture theory variable, which is the proenvironmental voting record of the
Congressmen. This variable has a positive effect on voting in favor of anti-stripmining legislation, and the
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Page 681
role for economists is in defining what these benefits are, particularly since environmental benefits typically are not
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Page 682
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with the regulatory context? Do you see any rationale, for example, for the difference in regulatory approach?
4. Challenge question. Increasing the rate of discount typically makes one more present-oriented, but this is not
always the case. Construct a sequence of benefit and cost payoffs for two different projects. It is easy to construct a
sequence of payoffs for which project 1 is preferred at low discount rates, and project 2 is preferred at high
discount rates. In this case, one would say that project 1 is more future-oriented. Can you construct a sequence of
benefit and cost payoffs for three different projects so that project 1 is preferred at low discount rates, project 2 is
preferred at intermediate discount rates, and project 3 is preferred at high discount rates? What is the minimum
number of periods that you need to generate such a reversal in preference? What is the minimum number of sign
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Page 684
For a discussion of these factors, see Victor R. Fuchs,
The Health Economy
(Cambridge, Mass.: Harvard
University Press, 1986).
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Page 685
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government regulation in these areas. Victims of pollution do not sell the right to pollute to the firms that impose
Policy Evaluation Principles
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Page 687
to how you think about the calculation. In addition, we are not interested in how much you are willing to pay to
avoid certain death. The level of the probability of risk involved with certain death dwarfs that associated with
small risk events by such an extent that the qualitative aspects of the risk event are quite different. It is noteworthy,
This gives the amount you would be willing to pay per unit of mortality risk. For the specific values given in the
example we considered, the value-of-life number can be calculated as
An alternative way of thinking about the value of life is the following. Consider a group of 10,000 people, one of
whom will die in the next year. As a result, there will be one expected death. If each person would be willing to
contribute the same amount to achieve the risk reduction, then the value of preventing one expected death would be
10,000 multiplied by the willingness-to-pay amount per person. This calculation is identical to that in equation
(20.3) above.
Your value of life implicit in the response you gave is consequently 10,000 times the amount of your response.
Table 20.1 gives different value-of-life estimates depending on the level of your answer. If there is no finite
amount of money that you would be willing to pay to prevent this risk, and if you were willing to devote all of
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Table 20.1
Relation of Survey Responses to Value of Life
Amount Will Pay (Dollars) to Eliminate 1/10,000 Risk
Value of Life (Dollars)
Above 1,000
At least 10,000,000
500-1,000
5,000,000-10,000,000
200-500
2,000,000-5,000,000
50-200
500,000-2,000,000
life-extending decision. When viewed in this manner, making a risk-dollar tradeoff does not appear to be
particularly controversial. Indeed, one might appear to be somewhat irrational if one were willing to expend all of
one's future resources to prevent small risks of death, particularly given the fact that we make such tradeoffs daily,
as some of the risk statistics in Chapter 19 indicated.
For the finite value of life responses, a willingness-to-pay of $1,000 to prevent a risk of death of one chance in
10,000 implies a value of life of $10 million. A response of $500 to prevent the small risk implies a value of life of
$5 million. Similarly, at the extreme end, a zero response implies a value-of-life estimate of zero. Table 20.1
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Page 689
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sonal activities. The idea that it is not feasible to achieve an absolutely risk-free existence and that some tradeoffs
must ultimately be made is becoming more widely understood.
Variations in the Value of Life
One dividend of going through the exercise summarized in Table 20.1 is that individuals will give different
answers to these willingness-to-pay questions. There is no right answer in terms of the value of life. Thus we are
not undertaking an elusive search for a natural constant such as
or
. Rather, the effort is simply one to establish
an individual's risk-dollar tradeoff. Individuals can differ in terms of this tradeoff just as they could with respect to
other kinds of tradeoffs they might make concerning various kinds of consumption commodities that they might
purchase. It makes no more sense to claim that individuals should have the same value of life than it does to insist
that everyone like eating raw oysters.
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Page 692
Table 20.2
Average Annual Traumatic Occupational Fatalities Listed by Industry,
United States, 1980-1985
Fatality Rate
(per 100,000 workers)
Transportation, communications
Construction
Agriculture, forestry, fishing
Manufacturing
Services
Finance, insurance, real estate
Wholesale trade
Source: National Traumatic Occupation Fatalities,
1980-85, National
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Page 693
dollar benefit value
Thus the growth in income will mute to a large extent the influence of discounting when weighing the
consequences of policies in the future.
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Page 694
combinations that give the firm the same level of profits. For example, if a firm lowers the risk level by investing
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Page 695

Derivation


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Equilibrium



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Table 20.3
Summary of Selected Value-of-Life Studies
Risk Variable
Value of
Smith (1976)
Current Population Survey
Bureau of Labor Statistics (BLS)
Thaler and
Survey of Economic
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Page 698
Annual Earnings =
Annual Death Risk
The dependent variable in this analysis is the annual worker earnings, which is not as accurate a measure as the
worker's hourly wage rate, but for expositional purposes it facilitates our task of indicating how one constructs the
value-of-life estimates in the equation. The explanatory variables include the annual death risk facing the worker.
In general, this information is matched to the workers in the sample based on their responses regarding their
industry or occupation.
The coefficient
in equation (20.5) indicates how annual earnings will be affected by an increase in the annual
death risk. If the annual death risk were 1.0, then
would give the change in annual earnings required to face one
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Page 699
that these studies are measuring different things. The value-of-life estimates for samples of different riskiness are
expected to be different because the mix of workers and their preferences across samples may be quite different. In
addition, the degree to which different risk variables measure the true risk associated with the job may differ
substantially across risk measures. Examination of the same sample of workers using two industry-based risk
measures, the Bureau of Labor Statistics data, and the National Traumatic Occupational Fatality data, indicates that
this measurement error alone can lead to a doubling of the estimates.
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Page 700
Table 20.4
The Cost of Various Risk-Reducing Regulations per Life Saved
Year and
Initial annual
Annual Lives
Cost per Life Saved
(millions of 1984 $)
Pass benefit-cost test:
Unvented space heaters
b
2.7 in 10
Oil and gas well service
OSHA-
1.1 in 10
Cabin fire protection
6.5 in 10
9.1 in 10
OSHA-
1.6 in 10
Alcohol and drug control
1.8 in 10
Servicing wheel rims
OSHA-
1.4 in 10
Seat cushion
1.6 in 10
Floor emergency lighting
2.2 in 10
Crane suspended
personnel platform
OSHA-
1.8 in 10
OSHA-
1.4 in 10
Hazard communication
OSHA-
4.0 in 10
2.1 in 10
Fail benefit-cost test:
Grain Dust
OSHA-
2.1 in 10
1.4 in 10
OSHA-
8.8 in 10
Arsenic/glass plant
8.0 in 10
OSHA-
4.4 in 10
Arsenic/copper smelter
9.0 in 10
Uranium mill tailings,
4.3 in 10
Uranium mill tailings,
4.3 in 10
OSHA-
6.7 in 10
2.9 in 10
3.8 in 10
6.0 in 10
4.3 in 10
1.4 in 10
2.0 in 10
Arsenic/low-arsenic
2.6 in 10
1.1 in 10
Land disposal
2.3 in 10
OSHA-
2.5 in 10
OSHA-
6.8 in 10
a
If you like this book, buy it!
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Page 701
OSHA arsenic regulations save lives at a cost of $92.5 million per life, that such efforts are out of line with what
the beneficiaries of such an effort believe the value of such a regulation to be. Moreover, there are likely to be a
wide range of other regulatory alternatives by OSHA or other agencies that are likely to be more cost-effective
ways of saving lives.
Although the range in the value-of-life estimates for the policies summarized in Table 20.4 may seem to be
substantial, in practice many government policies are proposed but not issued because the value of life is even
higher than many of the outliers in this table. For example, in 1984 EPA proposed regulations for benzene/maleic
anhydride that would cost $820 million per life saved. This regulation was rejected by the Office of Management
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Page 702
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Page 703
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Page 704
and which individuals may have already thought about in this context, increasing the accuracy of the survey
Exploratory Nature of the Survey Approach
Overall, survey approaches to establishing the benefits of social regulation represent an important complement to
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Page 705
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Page 706
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Page 707
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Page 708
second policy option, we know that we will be saving three lives at random from the population, but we do not
know whose lives they will be. Should we attach the same benefit value to each of these instances?
for some outcome and then to ask if the respondent would be willing to pay, for example, 10 percent more. This
process continues until the respondent is no longer willing to increase his bid. Some researchers have argued that
this approach will lead to a bias in terms of eliciting the true response. What direction do you believe the bias is,
and why do you believe such a bias would occur?
1. This general approach to valuation of risks to life can be traced back to the work of Thomas Schelling, "The
Life You Save May Be Your Own," in S. Chase (ed.),
Problems in Public Expenditure Analysis
D.C.: Brookings Institution, 1968), pp. 127-62.
2. This principle is the same as in all benefit contexts. See Edith Stokey and Richard J. Zeckhauser,
A Primer for
Policy Analysis
(New York: W. W. Norton, 1978).
3. Variations in the human capital approach are articulated in E. J. Mishan, "Evaluation of Life and Limb: A
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Page 709
Economics (Amsterdam: North Holland, 1986), pp. 641-92. Also see, among others, Richard Thaler and
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Page 711
Environmental Regulation
The range of activities in the area of environmental regulation is perhaps the most diverse of any regulatory
agency.
The U.S. Environmental Protection Agency has programs to regulate emissions of air pollution from
stationary sources such as power plants, as well as from mobile sources such as motor vehicles. In addition, it has
regulations pertaining to the discharge of water pollution and other waste products into the environment. These
pollutants include not only conventional pollutants such as the waste by-product of pulp and paper mills, but also
In situations in which its regulations of discharges and emissions are not sufficient, EPA also undertakes efforts to
restore the environment to its original condition through waste treatment plants and the removal and disposal of
hazardous wastes. Insecticides and chemicals are also within the general jurisdiction of the agency's efforts.
Moreover, the time dimension of concerns is also quite sweeping, as the environmental problems being addressed
range from imminent health hazards to long-term effects on the climate of the earth that may not be apparent until
well into the next century.
In this chapter we will not attempt to provide a comprehensive catalogue of environmental regulations, although
we will draw on a number of examples in this area. The focus instead will be on the general economic frameworks
that are available for analyzing environmental problems. The structure of these problems generally tends to be
characterized by similar economic mechanisms for different classes of pollutants. In each case there is a generation
of externalities affecting parties who have not contracted to bear the environmental damage. A similar economic
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Page 712
cattle rancher. Suppose that Farm A raises cattle, but that these cattle stray onto the fields in Farm B, damaging
Farm B's crops. The straying cattle consequently inflict an externality on Farm B.
What Coase indicated is that assessing these issues is often quite complex. Among the issues that must be
considered from an economic standpoint are the following. Should the cattle be allowed to stray from Farm A to
Farm B? Should Farm A be required to put up a fence, and if so, who should pay for it? What are the implications
from an economic standpoint if Farm A is assigned the property rights and Farm B can compensate Farm A for
putting up a fence? Alternatively, if we were to assign the property rights to the victim in this situation, Farm B,
what would be the economic implications of assigning the property rights to Farm A?
The perhaps surprising result developed by Coase is that from an economic efficiency standpoint the outcome will
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Page 713
Table 21.1
The Coase Theorem Bargaining Game
Feasible Bargaining Requirement:
Maximum Offer Minimum Acceptance
Bargaining Rent:
Bargaining Rent = Maximum Offer - Minimum Acceptance
reciprocal nature of the problem. In this situation, Farm A inflicts harm on Farm B. However, to avoid the harm to
Farm B means that we must harm Farm A. The objective from an efficiency standpoint is to avoid the more serious
The Coase Theorem as a Bargaining Game
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Page 714
which is the first inequality listed at the top of Table 21.1. If this condition is not satisfied, no bargain will take
place, inasmuch as there is no feasible bargaining range. In such a situation in which the minimum acceptance
amount by the pollution victims exceeds the maximum amount firms are willing to offer, there will be no
contractual solution. Firms will select the minimum cost alternative of either installing the control device or paying
the legally required damages amount. The absence of a feasible bargaining range does not imply that the Coase
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Page 715
Table 21.2
Property Right Assignment and the Bargaining Outcome
Basic Aspects of the Pollution Problem
Primary Treatment
Water Purification
of Effluent
Costs
Damage
Bargaining with Victim Assigned Property Rights
Bargaining equation:
Maximum Offer by Company = $100
Minimum Acceptance by Citizens = $300
Company installs controls. No cash transfer.
Bargaining with Polluter Assigned Property Rights
Bargaining equation:
Maximum Offer by Citizens = $300
Minimum Acceptance by Company = $100
Citizens pay company $100 to install controls and also pay
company $100 share of rent if equal bargaining power.
A Pollution Example
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Page 716
company $100 to install the pollution-control device. Moreover, if the bargaining power of the two parties is equal,
the citizens will also pay the firm an additional $100 as the company's share of the bargaining rent.
Utilization of this bargaining-game framework to analyze the Coasian pollution problems provides a more realistic
perspective on what will actually transpire than did the original Coase paper, which assumed that the purchase price
for the transfers will equal the minimum acceptance amount by the party holding the property rights. In each case,
the pollution-control outcome is the same, as the company will install the water treatment device. However, in the
case where citizens do not have the property rights, not only will they have to pay for the water treatment, but they
will also have to make an additional $100 transfer to the company that they would not have had to make if they had
been given the property rights.
The difference in the equity of the two situations is substantial. The citizens must spend $200 if they do not have
the property rights$100 for the treatment cost and $100 to induce the company to install it. If the citizens have the
property rights, the cost is $100 to the company for treatment. In each case, the water treatment is the same.
Long-Run Efficiency Concerns
What should also be emphasized is that this short-run equity issue also is a long-run efficiency issue. Ideally, we
want the incentives for entry of new firms into the industry to be governed by the full resource costs associated
with their activities. If firms are in effect being subsidized for their pollution by citizens paying for their pollution
control equipment, then there will be too much entry and too much economic activity in the polluting industries of
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Page 717
These coordination costs are likely to be particularly large in situations in which there are free riders. Some
individuals may not wish to contribute to the pollution-control effort in hopes of obtaining the benefits of controls
without contributing to them.
It has often been remarked that there is also a potential for strategic behavior. Some parties may behave irrationally
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Page 718
failures and to ensure efficiency, the implications of the Coase Theorem provide us with frames of reference that
can be applied in assessing the character of the different situations that will prevail under alternative regulatory
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Page 719
also under consideration. If the Coase Theorem bargains were truly effective, additional regulations would not be
Medical Care 65
Medical Care 65
Total medical care
Sick leave
Group life insurance
Nursing home care
-0.197
-1.000
Taxes on earnings
-0.274
Source:
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Page 720
such as Alzheimer's, thus diminishing some of their medical expenses later in life. On balance smokers save money
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Page 721
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Page 722
Technology-Based
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Page 723
point such as
, where the cost function begins to rise quite steeply. Such informal considerations of
affordability may lead to an equalization of marginal benefits and marginal costs in some instances, and at the very
minimum will limit the most extreme excesses of regulatory cost impacts.

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Page 724
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Page 725

Differences








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Page 726

Standard

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Page 727
sequently could have a very substantial range depending on how we assess compliance costs.
If we assess these costs incorrectly, then we run the risk of imposing costs that may not be justified. For example,
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Page 728

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Page 729

Distribution










Source:
W.







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Page 730
Table 21.4
Summary of Emissions Trading Activity
Number of
Number of
Estimated Cost Savings
Environmental Quality
40
2
$300
Insignificant
Source:
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Page 731
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Page 732
not, however, replaced the thrust of its policy standards effort with a tradable pollution permit system.
Nevertheless, permits have attractive economic features as firms with the highest compliance costs can purchase
them, thus fostering an efficient degree of control of pollution.
The first advantage of tradable pollution rights is that they enable EPA to equalize the opportunity costs of
pollution control. Second, they encourage innovations to decrease pollution, whereas a rigid standard only
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Page 733
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Page 734
models and the uncertainty regarding factors such as population growth and our pollution-control efforts in the
be an ongoing policy debate.
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Page 735
Whereas in most environmental contexts it is the marginal costs that are more uncertain than the marginal benefits,
in this long-run environmental context, benefits also pose substantial uncertainty. This uncertainty is at a very
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Page 736

Irreversible


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Page 737
rent benefits associated with pollution control, the general policy maxim is that conservatism is the best policy.
Moreover, it is noteworthy that this conservatism arises wholly apart from the presence of any risk aversion.
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Page 738
being considered is that of the purchase of a large or small car.
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Page 739
optimal to catch as many whales as you can. If all of the whaling vessels follow their dominant strategy, as most of
them have, the result is that the whaling population will be overfished and that we will have a dwindling number of
neighbors also use the insecticides. At low and high levels of community-wide insecticide use, the individual
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Page 740
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Page 741
In these various inspection contexts, EPA has several enforcement tools that it can use. Not all of these involve
fines, but they do impose costs of various kinds on the affected firms. EPA can inspect a firm. It can request that
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Table 21.5
EPA Administrative Actions Initiated (by Act), Fiscal Years 1972 through 1988
Clean Air
Clean Water and Safe
Drinking Water Acts
Conservation and
Recovery (1976)
Control Act
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
FIFRA = Federal Insecticide, Fungicide, and Rodenticide Act.
Source:
Based on Clifford Russell, ''Monitoring and Enforcement,'' in Pual Portmey, ed.,
Public Policies
for Environmental Protection
(Washington, D.C.: Resources for the Future, 1990), Table 7.7, using data
from
Mealey's Litigation Reports: Superfund 1,
No. 18 (December 28, 1988): C-5.
these regulations on business by scaling back the enforcement effort. This deregulation approach did little to alter
the structure of EPA regulations or their stringency, which is the main area in which economists would advocate
reform. Instead, the focus was simply on decreasing the cost burdens arising from effective enforcement. Because
of the general consensus and support for effective environmental regulation of the various externalities addressed
by EPA, this deregulation effort does not follow any of the prescriptions that would have been advanced by
economists. In 1983, Anne Gorsuch was replaced as head of EPA by William Ruckelshaus, who quickly restored
the enforcement efforts of the agency and was responsible for shifting the direction of the agency toward the new
classes of hazards.
Environmental Outcomes and Enterprise Decisions
The statistics in Table 21.7 indicate that from the standpoint of firms' investments there has been considerable
emphasis on pollution control
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Page 743
Table 21.6
EPA Civil Referrals to the Department of Justice
Fiscal Year
Hazardous Waste
Toxics, Pesticides
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
Source:
Based on Russell, 1990, Table 7.6, using data from
Mealey's Litigation Reports:
Superfund
1, No. 18 (December 28, 1988): C-l.
efforts. First, the level of investment in pollution control has not been a one-shot expenditure that firms have made.
Rather, there has been a continuing effort to make these investments. Moreover, the level of these investments has
risen over time, even if we adjust for inflation. From 1972 to 1987 the investments in air pollution control almost
doubled in real terms, to a value of $32 billion (1987 dollars). The rise in water pollution control expenditures was
less striking, but nevertheless it was substantial, as firms' investments in water pollution control efforts increased by
almost 50 percent in real terms from 1972 to 1987, reaching a value of $33 billion in 1987. Although evidence of
substantial industry investments does not necessarily imply that these investments will enhance environmental
quality, there are signs that environmental policies are having an impact on enterprise decisions. Moreover, these
figures indicate the substantial stakes that are involved.
The objective of regulatory policy is not simply to promulgate and enforce regulations, but also to improve
environmental outcomes. Assessing the impact of regulations is complicated by the fact that we observe trends in
environmental quality, but we do not know what these trends would have been in the absence of regulation.
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Page 744
Table 21.7
Pollution Reduction Efforts, by Year
Pollution Abatement and Control Expenditures(in millions of dollars)
Air Pollution
Water Pollution
Current Dollars
Current Dollars
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
Sources:
Kit D. Farber and Gary L. Rutledge, "Pollution Abatement and Control Expenditures, 1984-
1987,"
Survey of Current Business,
U.S. Department of Commerce, Bureau of Economic Analysis
(Washington, D.C.: Government Printing Office), June 1989, pp. 24-25. Kit D. Farber and Gary L.
Rutledge, "Pollution Abatement and Control Expenditures,"
Survey of Current Business,
Department of Commerce, Bureau of Economic Analysis (Washington, D.C.: U.S. Government Printing
Office), July 1986, pp. 100-103.
even examination of pollution trends proves to be instructive in many instances.
Table 21.8 summarizes the pollution trends from 1960 to 1988 for five principal categories of air-pollution
emissions. For the first four categories there continued to be steady progress of a fairly modest nature in terms of
improved environmental quality. The categories for which the recent progress has been much less than in EPA's
first decade of the 1970s are particulates (usually arising from fuel combustion, industrial processes, and motor
vehicles), sulfur oxide emissions (chiefly arising from stationary fuel combustion and industrial processes),
nitrogen oxide emissions (arising primarily from highway motor vehicles and cold-fired electric utility boilers),
and carbon monoxide emissions (primarily arising from highway motor vehicles).
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Page 745
Table 21.8
National Pollution Emissions Trends
Pollutant (Teragrams/Year)
Nitrogen Oxides
Carbon Monoxide
1970
1975
1980
1981
1982
1983
1984
1985
1986
1987
1988
Percentage Annual Growth Rate
1960-1970
-1.5
1970-1980
-7.5
-1.9
-2.4
-10.1
1980-1988
-2.6
-1.5
-0.5
-3.2
-20.0
Source:
U.S. Environmental Protection Agency,
National Air Pollutant Emission
Estimate, 1940-1988,
Office of Air Quality, Research Triangle Park, N.C., EPA-450/4-
90-001(March 1990), p. 2.
The category of greatest interest is that of lead pollution given in the final column of Table 21.8. The 1980s marked
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Page 746
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Page 747
global warming as well as more complex externalities, such as the group decisions that lead to overfishing.
Examination of these various contexts as well as the policies that have been developed to address them suggest that
Moderately
Slowly
a. If the driver could undertake voluntary bargains that would be enforceable, what driving speed would result?
a. If the residents are assigned the property rights, and if each party has equal bargaining power, what will be
b. If the firm is assigned the property right to pollute, what will be the predicted outcome and the income
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Page 748
4. The discussion in the chapter regarding the desirability of taxes and regulatory standards focused primarily on
the short-run issues. However, these different policies also have important dynamic implications, particularly
regarding the incentives for innovation. Under which type of governmental approach will there be greater
incentives to innovate in a beneficial way from the standpoint of decreased environmental and health risks?
Suppose that the government must undertake an irreversible policy decision regarding the extent of air pollution
regulation. The government is making this decision in a situation of uncertainty, however. In particular, there is
some probability
that the benefits will remain the same as they are this year for all future years, but there is some
probability 1 -
that benefits will be less in all future years. If we take into consideration the multiperiod aspects,
should we err on the side of overregulation or underregulation, as compared with what we would do within a single
period choice?
6. Figure 21.11 illustrates a multiperson Prisoner's Dilemma for a situation in which the payoff curves for the two
kinds of cars do not intersect. However, there may be externality situations in which the payoffs do intersect,
inasmuch as the desirability of different activities may change in a differential manner for the two different
decisions. If these payoff curves intersected, with the bottom payoff curve intersecting the top from below, what
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Page 749
Mitchell Polinsky,
An Introduction to Law and Economics,
2d ed. (Boston: Little, Brown, 1989).
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Page 751
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Page 752
design change. The result was a series of fatal accidents involving the Ford Pinto, which exploded upon rear
impact, causing severe burn injuries and deaths. The substantial damages that were ultimately awarded by the
courts became part of the increased product-liability price tag being imposed on the nation's businesses.
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Page 753
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Page 754
Factors Affecting Producer and Consumer Actions
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Page 755
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Page 756
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Page 757
Table 22.1
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Page 758
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Page 759

Cost



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Page 760
Table 22.2
New Drug Approvals and Time to Approval
Number of NCE
Avg. Lag Time (Months) from Submission to Approval
All Drugs
1AA/1A Drugs
All Drugs
1AA/1A Drugs
1981
1982
1983
1984
1985
1986
1987
1988
1989
NCE = new chemical entities.
Source:
All figures based on calculations by the authors using chronology of new chemical entities
developed by the University of Rochester Center for Study of Drug Development, July 10, 1990
(computer printout).
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Page 761
of this curve if they adopt an aggressive drug approval policy. The incentives for bureaucratic risk aversion are
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Page 762
the driver faced a marginal benefit curve of
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Page 763
The underlying theory is quite sound and is based on the same kinds of marginal benefit and marginal cost
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Page 764
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Page 765

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Page 766
reduces the perceived risk from the curve
to
then we may end up at a counterproductive outcome such as
point
much more easily. Consumers believe they are at point
, whereas they are actually at point
. The danger
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Page 767
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Page 768
Table 22.3
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
Source:
Robert W. Crandall, Howard K. Gruenspecht, Theodore E. Keeler, and
Lester B. Lave,
Regulating the Automobile
(Washington, D.C.: Brookings
Institution, 1986), p. 37, Table 3-4. Reprinted by permission of The Brookings
Table 22.4
1968-1969
1970-1971
1972
1973-1974
1975-1976
1977-1979
1980
1981
Source:
Lawrence J. White,
The Regulation of Air Pollution Emissions from
(Washington, D.C.: American Enterprise Institute, 1982), p. 61.
Reprinted with the permission of The American Enterprise Institute for Public
Policy Research, Washington, D.C.
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Page 769
designs no longer being useful, U.S. producers sacrificed much of their previous advantage over foreign
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Page 770
Table 22.5
The Reagan Administration's Auto Reform Package
5-Year
Streamlined certification of industry tests on vehicles(Oct. 1981, Nov.
Raised allowable "failure rate" for test of light trucks and heavy-duty
engines from 10 to 40 percent (Jan. 1983).
Reduced spot checks of emissions of vehicles on assembly lines by 42
percent; delayed heavy-duty trucks until 1986 (Jan. 1983).d assembly-
line tests of
High-altitude
Ended assembly-line tests at high altitude, relying instead on industry
data (April 1981).
Consolidated industry applications for temporary exemptions from
tougher emissions standards for nitrogen oxide and carbon monoxide
(Sept. 1981).
Paint shops
Delayed until 1983 tougher hydrocarbon pollution standards for auto
paint shops (Oct. 1981).
Test vehicles
Cut paperwork required to exempt prototype vehicles from
environmental standards (July 1982).
Driver vision
Fuel
Tire rims
Brake tests
Eased from 30 to 20 percent the steepness of grades on which post-1984
truck and bus brakes must hold (Dec. 1981).
Tire pressure
Scrapped proposal to equip vehicles with low-tire pressure indicators
(Aug. 1981).
Battery
Eased antitheft and locking steering wheel standards for open-body
vehicles (June 1981).
Streamlined semiannual reports of auto makers on their progress in
Tire ratings
Suspended rule requiring industry to rate tires according to tread wear,
traction, and heat resistance (Feb. 1983).
table continued on next page
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Page 771
Table 22.5 (cont.)
The Reagan Administration's Auto Reform Package
5-Year
Seatbelt
Rules with Uncertain Futures
Failed to revise Clean Air Act order ending weaker high-altitude emissions
standards in 1984; eased through regulatory changes.
Failed to revise Clean Air Act order to cut large trucks' hydrocarbon and
carbon monoxide emissions by 90 percent by 1984; standard was delayed
until 1985.
Failed to ease Clean Air Act order reducing nitrogen oxide emissions from
light trucks and heavy-duty engines by 75 percent by 1984. Regulatory
changes under study.
Delayed a proposal to scrap specific particulate standards for some diesels
in favor of an average standard for all diesels. Stiffer standards delayed
from 1985 to1987.
Delayed and then revoked requirement that post-1982 autos be equipped
with passive restraints; revocation overturned by Supreme Court in June
Cut from 5 to 2.5 mph the speed at which bumpers must resist damage;
change is on appeal.
Source:
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Page 772
Accident Rate Influences
analyzing the statistics in Table 22.6.
The Decline of Accident Rates
Since the 1930s, motor vehicle-accident death rates per 100 million miles driven have remained in roughly the 3-4
percent range except during the 1960s, when the rate of decline was somewhat less. It is noteworthy that for the
past sixty years motor vehicle accident rates on a mileage basis have been on the decline. The decline preceded the
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Page 773
Table 22.6
Principal Death Risk Trends: Annual Rate of Increase in Death Rates
(Per 100,000
Home
(Per 100,000
(Per 100,000,000 Vehicle-
-1.8
-0.2
-3.3
-2.3
-2.2
-4.0
-2.8
-2.1
-3.5
-1.2
-1.7
-0.8
-1.6
-2.7
-3.3
-3.7
-1.5
-2.2
Source:
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Page 774
1970
1980
1985
1988
1990
1992
Source:
A.M. Best and Co.,
Best Aggregate and Averages,
various years and Insurance
Information Institute,
The Fact Book 1994: Property/Casualty Insurance Facts
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Page 775
negligence doctrine has been replaced by a strict liability doctrine that requires companies to bear the costs of
product injuries in a greater share of situations. In addition, there has been a tremendous expansion in hazard-
warnings cases and in the concept of what constitutes a product-design defect.
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Page 776
Table 22.8
Medium
Low
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Page 777
Tracing Accident Costs and Causes
A danger enters with respect to our inability to distinguish which are the accident costs traceable to the product. In
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Page 778
Table 22.9
The Effect of Agent Orange Suits on the Value of Individual Firms
Change in Value ($ millions)
Same Day
Ten-Day Period
A. Yannacone files class action suit, January 8, 1979
Diamond Shamrock
-32.04
Dow Chemical
-60.74
-50.69
Hercules Inc.
-6.24
-30.82
-20.68
North American Phillips Corp.
-1.09
Uniroyal Inc.
-1.93
Total change
-55.65
-98.42
B. Judge Pratt rules federal common law applies, November 20, 1979
Diamond Shamrock
Dow Chemical
-178.83
Hercules Inc.
-2.12
Monsanto Co.
--14.52
-118.63
North American Phillips Corp.
-9.09
-18.71
Uniroyal Inc.
-8.74
Total change
-267.44
-32.49
-80.33
Dow Chemical
-220.68
Hercules Inc.
-0.94
Monsanto Co.
-9.33
North American Phillips Corp.
-5.12
Uniroyal Inc.
Total change
-9.78
-37.63
-18.11
-136.42
Dow Chemical
-80.98
-97.23
Hercules Inc.
-13.47
-64.49
-5.39
North American Phillips Corp.
-5.62
-15.81
Uniroyal Inc.
Total change
-151.11
-298.27
E. Judge Weinstein announces decision, May 7, 1985
Diamond Shamrock
-11.63
Dow Chemical
Hercules Inc.
North American Phillips Corp.
-16.567
Uniroyal Inc.
Total change
Source:
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Page 779
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Page 780
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Page 781
U.S. Chamber of Commerce to groups representing the construction industry, favor pain-and-suffering caps. In
contrast, labor and consumer groups generally oppose such caps because they limit the awards that the victims of
accidents can potentially receive. The debate over the pain and suffering cap proposals and the institution of these
caps by various states has been almost devoid of compelling economic reasoning. In the case of each party's
arguments, it has been the economic self-interest and the stakes involved that have driven the debate rather than
any underlying rationale concerning the appropriateness of particular pain and suffering concepts.
Risk Information and Hazard Warnings
0.3
0.5
-3,500
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Page 782
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Page 783
scientific evidence and the extent of the risk have long been a matter of dispute. Moreover, the benefits of the
product from the standpoint of reducing obesity and its associated risks have greatly complicated the debate over
the appropriate regulation of this product.
Similarly, in 1989 Congress mandated the warnings on all alcoholic beverages. The first warning alerts consumers
to the risk of birth defects from consumption of alcohol by pregnant women. The second warning notes the
presence of health problems linked to alcohol and the effect of alcohol on one's ability to drive and operate
These measures do not exhaust all initiatives of this type. Many states have also joined in with these efforts. Chief
among these state initiatives is California Proposition 65, which has mandated the labeling of all significant
carcinogens in food products. Many companies have avoided the stigma of labeling by reformulating their
products, such as Liquid Paper, which formerly contained carcinogens. Although the implementation of this
regulation remains a matter of debate, the proliferation of right-to-know measures of various kinds is a major
regulatory event of the 1980s.
Alternatives to Direct Command and Control Regulation
The rationale for employing an informational regulation rather than a direct command and control regulation is
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Page 784
Table 22.12
Effects of Drain Opener Labels on Precaution-Taking (Percentages)
No Warning
= 59)
= 59)
Wear rubber gloves
Store in childproof location
Source:
W. Kip Viscusi and Wesley A. Magat,
Learning About Risk: Consumer and
Worker Responses to Hazard Information
(Cambridge, Mass.: Harvard University Press,
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Page 785
remind consumers about desirable courses of action generally are not successful. The programs that have been
shown to be effective are those that provide new information to consumers in a convincing manner rather than
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Page 786
important considerations in making these institutional allocations, but another issue may also be the difference in
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Page 787
have begun to be raised, will remain a central component of the future regulatory agenda.
Questions and Problems
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Page 788
database for you, what factors would you ask them to assess so that you could test the Peltzman effect
conclusively?
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Page 789
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Page 791
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Page 792
even though the riverbed was dry. The tone has shifted. Strident criticism in the 1970s gave way to comparative
inattention in the 1980s. This inattention did not necessarily imply that the agency had been given a clean bill of
health. There has been no widely publicized reform of the agency. Moreover, unlike transportation, natural gas, oil,
and airlines, there have been no legislative changes or major administrative reforms. The decrease in coverage of
controversial OSHA policies occurred because a continuation of past policies, however ill-conceived, was simply
no longer newsworthy. Moreover, firms had complied in many instances, so that the decisions regarding the
standards were behind them.
In the 1990s the tone of public debate concerning OSHA has shifted. After decreasing its enforcement effort in the
early 1980s, OSHA became increasingly criticized for not doing enough. Instead of media coverage of apparently
frivolous regulations, attention shifted to the continuing death toll in the American workplace. The status of job-
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Page 793
workplace smoking and, by OSHA's estimates, would cost $8 billion per year.
Although these efforts rectified many of the more extreme deficiencies of OSHA's initial strategy, calls for reform
continue. Regulation of workplace conditions is a legitimate role for the government, but as with other regulatory
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Page 794

The





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Page 795
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Page 796

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Page 797
greater fuel efficiency, for the typical small car is less crashworthy than the average full-sized car. Moreover, the
order of magnitude of risks we regulate are not too dissimilar from those that we encounter in other activities. As
the data in Chapter 19 indicated, the accident risk posed by one day of work in a coal mine (a relatively hazardous
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Page 798
gree to which health hazards, such as cancer, are not reflected in the accident data. Particularly noteworthy was that
after the health hazards were excluded from consideration, the risk assessments equaled the accident rate for the
chemical industry.
These studies should be regarded as evidence of some reasonable perception of job risks by workers. They do not,
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Page 799
Table 23.1
Risk Premiums as a Percentage of Total Earnings in Manufacturing Industries
Risk premiums of 3% to 5%
Chemicals and allied products
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Page 800
Consider a situation in which a worker starts a job without full knowledge of the potential risks. After being
assigned to the position he or she will be able to observe the nature of the job operations, the surrounding physical
conditions, and the actions of coworkers. Similarly, during a period of work on the job the worker learns about
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Page 801
cisions based on this knowledge. The available evidence suggests that in many contexts workers have risk
perceptions that appear plausible, but these studies in no way imply that workers are fully informed. There is a
general consensus that many health risks in particular are not well understood, and indeed workers may be
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Page 802
Perhaps the most important constraint on individual mobility is related to the character of the employment
relationship. Once on the job, individuals acquire skills specific to the particular firm as well as seniority rights and
pension benefits that are typically not fully transferable. If workers had full knowledge of the risk before accepting
the position, these impediments to mobility would not be consequential. The basic difficulty, however, is that
workers may not have been fully cognizant of the implications of the position and will subsequently become
trapped in an unattractive job situation. Available evidence for chemical workers suggests that the extent of serious
job mismatches of this type is not high.
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Page 803
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Page 804

OSHA


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Page 805
dard.
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Page 806
OSHA has typically adopted uniform standards that attempt to prescribe the design of the workplace.
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Page 807
ment. In contrast, only a small fraction of the carcinogens in the workplace have been addressed by OSHA
standards. There are some health standards, such as those for radiation exposure, but for the most part the standards
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Page 808
Changes in OSHA Standards
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Page 809
Table 23.2
Workers' Response to Chemical Labeling
Chemical Label
-35%
Annual wage increase demanded
Change in fraction very likely or somewhat likely to
-23%
Source:
W. Kip Viscusi and Charles O'Connor, ''Adaptive Responses to Chemical Labeling: Are
Workers Bayesian Decision Makers?,"
American Economic Review
74, No. 5 (December 1984): 949.
Reprinted by permission.
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Page 810
the sodium bicarbonate label did not require any additional wage compensation to work on the job, whereas
workers shown the other three chemicals required amounts ranging from $1900 to $5200 per year in order to
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Page 811
nificant, constructive contribution to OSHA policy development. Such efforts are likely to put us on the frontier of
efficient regulatory policies.
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Page 812
ranking has remained virtually unchanged since OSHA's inception. Somewhat surprisingly, complaint inspections
produce few violations per inspection, which suggests that disgruntled workers may be using the OSHA inspection
threat as a means of harassing the employer.
This pattern is unfortunate, since the role of workers and unions in
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Page 813
water polluters roughly once per year. Moreover, there has been a substantial drop in the rate of coverage of
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Page 814
up to 30 percent if they made a serious effort to comply with the standards.
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Page 815
spector may not identify, and it will face few penalties if it makes the suggested changes. The elimination of the
expected losses from inspections suggests that OSHA will have little impact on the great majority of firms that are
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Page 816
signs) constituted about one-fifth of all violations. Many of these violations were for less important risks, some of
which were readily visible to workers as well. The roughly 50 percent drop in this category suggests that OSHA's
resources have been redirected from a less profitable area.
The two categories that displayed the greatest relative increases are health-related. The role of health and
environmental control (for example, noise, ventilation, and radiation) has risen to 8 percent, and violations for
toxic and hazardous substances (for example, asbestos and coke oven emissions) now include a similar amount.
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Page 817

Payoffs


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Page 818

Payoffs


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Page 819
with the regulation. Moreover, the level of stringency of the regulation is also of consequence, because if a
regulation is very tight many firms will choose not to comply at all, so that a very tight regulation that is ignored
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Page 820
Job-Related
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Page 821
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Page 822
rate performance during a pre-OSHA era, which is the injury-rate trend given by
AB.
One such model that could be
used to estimate this relationship would be
The dependent variable in the analysis is the risk level in some year
This equation is the same as the preregulation simulation equation (23.1) except for two differences. First, it will be
estimated using the
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Page 823
postregulation data rather than the preregulation data. Second, it includes variables that capture measures of the
effect of the regulation, where the principal variables that have been used in the literature pertain to the rate of
OSHA inspections for the expected penalty level. The equation indicated that a distributed lag on the OSHA
variable has been included to recognize the fact that it may take some time for an OSHA inspection to have an
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Page 824
The possibility of a favorable impact of OSHA on workplace conditions is also borne out in more refined studies of
workplace standards. One case study is that of the OSHA cotton-dust standard, which was the subject of a Supreme
Court decision. That standard was directed at controlling cotton-dust exposures in the workplace, because these
exposures lead to potentially disabling lung diseases. The promulgation of such a regulation was viewed by the
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Page 825
Agenda for Policy Reform Efforts
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Page 826
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Page 827
trarily large penalties were permitted by OSHA's legislation, would it be desirable to adopt such penalties? What
are the factors that you would want to consider in establishing the penalty level?
3. Suppose that a technological innovation has made it easier for firms to provide a safe work environment. How
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Page 828
(Cambridge: MIT Press, 1979); Lawrence Bacow,
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Page 829
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Page 831
Patents and Pharmaceuticals
In Chapter 4 we discussed the importance of technical progress (or dynamic efficiency) in comparison to static
Information is a commodity with peculiar attributes, particularly embarassing for the achievement of
optimal allocation. In the first place, any information
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Page 832
resolved. The patent gives the inventor property rights to the invention for a fixed period of time. But, as Arrow
has described, patents cannot solve all problems of appropriability:
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Page 833
Clearly, firms would not invest in inventions without expectations of rewards. Arrow suggested one way out of the
patent, the inventor must make an application to the U.S Patent and Trademark Office. The Patent Office must be
satisfied that the invention is
new, useful, and non-obvious.
The twenty-year life begins when the patent application
is made. In most other countries the patent life is twenty years also.
The idea of patents is quite old; the first patent law was adopted by the Republic of Venice in 1474, and the first
U.S. patent statute was enacted in 1790. The usual rationale for the patent includes the belief that the inventor is
entitled to his or her discovery, that the patent is a device for promoting invention, and that the patent system
encourages inventors to disclose their inventions to others. The granting of a patent in itself does not ensure the
inventor exclusive rights. Rather, the inventor must bring suit against anyone who infringes the patent, and the
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Page 834
Although patents are technically issued only to individuals, many large corporations engaged in R&D require their
employees to assign the right to any invention that they make to the company. Less than a quarter of the patents
issued today are assigned to individual inventors.
The holder of a patent may either make sole use of the discovery or license others to use the invention at a
mutually agreed-on royalty rate. For example, General Electric once licensed Westinghouse to produce electric
lamps at a royalty rate of 2 percent of Westinghouse's sales revenues. The rate jumped up to 30 percent once a
certain level of revenues was reached.
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Page 835

Incentives






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Page 836
To find the profit increase for the monopolist, and therefore its incentive, simply subtract the pre-invention profit,
which equals the small
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Page 837

Incentives






Tirole has described this lesser incentive in monopoly as the
replacement effect.
"The monopolist gains less from
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Page 838
= cost savings (
= a positive constant
The problem is now easily formulated. The inventor must choose the amount of cost savings,
that will maximize
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Page 839
life, because the stream of royalties will cease after year
It is easy to show that the present value of the stream of
royalties from the present to year
is:
= present value of royalties
= cost savings
= inventor's interest rate
= patent life
Figure 24.3 shows both
and
as functions of
B.
Notice that
PV
is just a straight line from the origin with its
slope dependent on the value of the patent life,
. Two patent lives are assumed in the figure:
= 10 years and
20 years. The inventor will choose the value of
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Page 840
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Page 841
but Area II is put off further into the future, thereby reducing the
present value
of the stream of Area II benefits.
The actual derivation of the optimal patent life requires one to choose the value of
that maximizes the present
value of Areas I and II, less the total R&D cost,
. Because the mathematical analysis becomes rather complex,
we shall merely indicate the result as the intersection of a marginal benefit curve with a marginal cost curve, as
shown in Figure 24.5. The optimal patent life is therefore
The marginal-benefit curve is a function of the patent life, and it declines as the life increases. The marginal
benefit from an additional year of patent life is the gain in social welfare generated by the ensuing larger size of

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Page 842
One simple result that the model predicts is that the optimal patent life should vary with the industry's demand
elasticity. For example, higher elasticities of demand imply that Area II in Figure 24.4 will be larger. This, in turn,
suggests that the primary effect will be to shift the marginal cost curve in Figure 24.5 upward (as is indicated by the
dashed curve). The result is an optimal patent life that is smaller.
Of course, there are a number of strong assumptions underlying the optimal patent life model above. We will
consider the relaxation of two important ones here. The first is the restriction of the analysis to a single inventor
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Page 843
tistical sense, the expected value of benefit is the "average" benefit if the race were repeated over and overit is just
the probability of discovery multiplied by the benefit amount, or
B.
The social objective function is then
, where
is social cost, or just the number of firms times the cost per firm.
Solving this maximization problem by differentiating the social objective function with respect to
gives the
marginal condition that marginal social benefit,
, should equal marginal cost,
In words,
is the marginal increase in probability of discovery brought about by adding another firm, times
. It is the expected increase in social benefit due to one more firm joining the raceand, at the social optimum, it
should equal the cost of that firm,
The socially optimum number of firms,
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Page 844
cost
R.
As long as
EP
is greater than
, firms will continue to join the patent race. Hence, the number of firms is
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Page 845
Furthermore, patent monopolies are often temporary and can be displaced quite early in their product lives by
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Page 846
the supplier of
keeps the price of
fixed even after the introduction of
N.
As shown, the quantity of
purchased decreases from
to
leading to profits that fall from
to
, or by the amount
or
Now, consider the question of how to measure the social benefit of the introduction of product
. Clearly, the total
economic surplus of
of consumer surplus, or
, and
of producer surplus, or
) is a major
component of the social benefit of
However, unlike the case we considered earlier in the optimal patent life
section, we must make an adjustment for the effect of
N
on the substitute product
The adjustment is that the loss in profit on
in Figure 24.7, must be subtracted. This is the ''business
stealing'' effect. The idea is that the firm introducing the new product does not internalize the loss of profit suffered
by its rivals. By itself, the effect suggests a tendency for too much innovation.
The social benefit,
, of the new product
of, say, area
. The answer is that the demand for
product
assumes the availability of product
at price
, and it therefore gives the
increment
to consumers'
willingness-to-pay due to the introduction of
N.
This is exactly what is desired.
The social benefit, given by equation 24.5, leads to another possibility for private investment in R&D being
socially too large or too small. Assuming that the two products are supplied by different firms, then the private
incentive to
inventor is simply
with
, it is clear that the private incentive can be either
larger than the social benefit (if
) or smaller than the social benefit (if
). Interestingly, the
portion of the social benefit not appropriated by the inventor (
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Page 847
Pharmaceuticals and the Role of Patents
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Page 848
required new drugs to be approved as safe by the Food and Drug Administration (FDA) before they could be
introduced into interstate commerce. And, in 1962, Congress passed the important Kefauver-Harris Amendments to
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Page 849

R&D



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Page 850
For example, health maintenance organizations (HMOs) are "firms" of health care providers that are quite cost
conscious because they sell care to patients for a fixed price per year. They often bargain with drug manufacturers
over prices and receive large quantity discounts. Their leverage is based on a "formulary," or list of approved drugs
for the HMO doctors. The HMO pharmacy committee's decision to include or exclude a drug is therefore very
important to the manufacturer. Government agencies such as Medicaid also employ various tactics to obtain lower
In addition, firms known as "prescription benefits managers" (or PBMs) have become quite important. These firms
are hired by large employers, insurance companies, HMOs, and other health care providers to lower drug costs.
Because they represent many customers, they can negotiate big discounts with manufacturers. In 1993 and 1994 the
three largest benefits management firms were bought by manufacturers. Eli Lilly bought the largest manager, PCS
Hence, the four-firm concentration ratio is relatively low at 22.8. However, if one considers the more meaningful
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Page 851
In addition to the research intensive firms listed above, there are many "generic" manufacturers. Biocraft, Mylan,
and Zenith are examples of generic firms that do little research; rather, they specialize in copying brand-name
products after the brand product's patent expires. For example, when the popular brand-name tranquilizer Valium
went off patent in the mid-1980s, some fifteen to twenty generic suppliers began selling the generic version of
Valiumknown as diazepamat large discounts. In 1993 the average generic price of diazepam was only 2 percent of
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Page 852
gastric acid in the stomach. This proved to be far superior to the use of antacids or surgery in the treatment of
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Page 853
Table 24.1
Average generic price index
Average ratio of generic price to
name price
Note:
Each value is an unweighted average of the values for the eighteen drug categories.
Source:
H. G. Grabowski and J. M. Vernon, "Brand Loyalty, Entry, and Price
discovered drugs. Several factors can be mentioned here. First, a firm must maintain a portfolio of R&D projects
because only one in four that enter clinical testing are
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Page 854
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Page 855

Effect







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Page 856
The act provides for an extension in effective patent life equal to the sum of the FDA review time plus one-half the
clinical testing time, subject to certain constraints. For example, there is a maximum extension of five years and no
extension beyond fourteen years of effective patent life. In Figure 24.10, the amount of patent restoration is
represented by the distance
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Page 857
which have often stymied each other's attempts to improve the law. The research-based drug industry
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Page 858
Table 24.2
Index of NPV for Average Drug under Alternative Assumptions (NPV
without Act in effect = 100)
3
1
Notes:
Patent extension is distance
be
in Figure 24.10. New loss to
generics is distance
in Figure 24.10.
Source:
H. G. Grabowski and J. M. Vernon, "Longer Patents for Lower
Imitation Barriers: The 1984 Drug Act,"
AEA Papers and Proceedings,
May 1986.
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Page 859
credit for increases
in R&D. The tax credit was reduced to 20 percent in 1986.
The 1983 Orphan Drug Act, which was passed to encourage firms to develop new treatments for diseases that
affect small numbers of people, provides for a tax credit equal to 50 percent of R&D expenses for clinical trials.
The trials must be for drugs that have been given orphan drug statusprimarily drugs that treat diseases or conditions
Senator Pryor:
From 1982 ... to 1992, 10 years, while the general inflation rate was just 46 percent in that decade,
prescription drug prices increased 142 percent....
Fortune
magazine, July 29, 1991, said the manufacture of
pharmaceuticals is America's most profitable business....
I would only say that today those profits are being made at the expense of the most vulnerable members of
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Page 860
In 1990 ... the average rate of profit for the Fortune 500 companies was 4.6 percent....What about the
Senator Bradley:
So, Mr. President, what I believe is a major concern about Senator Pryor's amendment is its effect on
investment, research, and innovation in this country. Senator Pryor has singled out one sector in the health
care economy that is the most heavily research oriented and funds a significant amount of all research on
health care....
Certainly, lower prices will help consumers to be able to afford prescription drugs. But the question is,
what are they going to be able to buy?
As is perhaps natural in a debate, the senators tend to focus on the extremesone on the monopoly pricing of existing
drugs and the other on the benefits of invention, or future drugs. However, there is a background issue that
deserves further analysis, and that is the question of the level of profits in this industry.
It is a complex issue and
we cannot devote the necessary space to it here. Hence, we will simply make a few key points here, and refer the
reader to several relevant articles.
Perhaps the most important point is that profit rates taken from the annual financial reports of firms can be very
misleading. The profit rates referred to by Senator Pryor from
Fortune
are of this type. We briefly commented on
some of these problems in Chapter 9. With regard to pharmaceutical accounting profit rates, the most serious
problem is that accountants expense R&D rather than capitalize and depreciate it as they do other plant and
equipment. R&D is the major form of investment for pharmaceutical firms and it clearly has economic effects that
last for yearsjust as plant and equipment do. However, accountants
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Page 861
revenues
VC
= variable costs
r&d =
current expenditures on R&D
= depreciation rates of
K, RD
K
= plant and equipment capital stock
RD =
R&D capital stock
As stated above, the accounting profit rate expenses R&D. The current expenditures on R&D appear in the
numerator. Economic profit rates depreciate the R&D capital stock just as physical capital is depreciated. Assume
for simplicity that the firm is in a "steady state" in which its R&D expenditures each year exactly equal the amount
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Page 862
An alternative to
firm
profitability is the profitability of new product introductions from an industry-wide
perspective. In a study
of the sixty-seven new drug introductions in the United States in the 1980-84 period, the
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Page 863
drugs are likely to correspond to the top decile or "blockbusters," restricting their prices to a breakeven level would
significantly reduce the attractiveness of investing in R&D.
If one regards R&D investment as somewhat like a
If profits were held to "reasonable" levels on blockbuster drugs, aggregate profits would almost surely be
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Page 864
Questions and Problems
1. If patents were no longer available under the law, would technical progress cease? Explain.
a. Find the initial price and quantity equilibria in the two cases.
a. What is M's incentive to win the race?
b. What is E's incentive to win the race?
c. Explain the intuition underlying this result. It can be argued that this so-called efficiency effect leads to the
"persistence of monopoly." Why?
5. A breakfast cereal product, Cheers, has demand
= 5 -
/2 and constant average cost of $1. Under existing
conditions, the supplier of Cheers charges $5.50. Now, a new product, Kips, is introduced by a rival supplier. After
equilibrium is reached, Cheers' price is unchanged at $5.50 and Kips'
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Page 865
price is also $5.50. Cheers' demand has shifted leftward and can be described as
= 4.25 -
Kips' demand
can be described as
= 4.25
/2 and its constant average cost is $1.
a. What is the social benefit resulting from the introduction of Kips? (Ignore R&D cost for now.)
b. What is the private benefit of Kips introduction?
c. If the R&D cost of introducing Kips is $6, what is the
answer to part (a). Compare this with the
d. Discuss the findings above from the perspective of welfare economics. In this instance, Kips would be
introduced even though it is not socially beneficial. Is this finding true in general? Explain.
6. This problem illustrates the possibility that excessive resources can be expended in search of a new product, say,
Panacea. For an excellent treatment-on which this problem is basedsee Chapter 17 of D. W. Carlton and J. M.
Perloff,
Modern Industrial Organization,
2nd ed. (New York: HarperCollins, 1994).
Assume that there are an unlimited number of firms that can each undertake one research project at a constant
marginal cost of $1. The probability
of discovery of Panacea by one of the
firms searching for it is an
increasing function of the number of research projects (firms). In particular,
-0.5085
c. Explain the intuition underlying this so-called common pool problem.
1. See, for example, "President Assails Shocking Prices of Drug Industry,"
New York Times,
February 13, 1993, p.
1. Arguments for both positions are also given by various senators in a floor debate in the
Congressional Record,
March 11, 1992, beginning at p. S3183. For a historical perspective on the public policy debate regarding
pharmaceuticals, see W. S. Comanor, "The Political Economy of the Pharmaceutical Industry,"
Journal of
Economic Literature,
September 1986.
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Page 866
2. K. J. Arrow, ''Economic Welfare and the Allocation of Resources for Invention,'' in NBER,
The Rate and
Direction of Inventive Activity
1 and its
duopoly profit with
. This is larger than the entrant's duopoly profit. For a specific example, see problem 4 at
the end of this chapter. Also, see R. Gilbert and D. Newbery, "Pre-emptive Patenting and the Persistence of
Monopoly,"
American Economic Review,
June 1982.
12. W. D. Nordhaus,
Invention, Growth, and Welfare
(Cambridge, Mass.: MIT Press, 1969).
13. The use of this cost function is based on exercise 10.4 in J. Tirole,
The Theory of Industrial Organization
(Cambridge, Mass.: MIT Press, 1988).
14. Nordhaus, p. 74.
15. Evaluate the integral
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Page 867
17. For further comparative static results and citations to recent literature on the Nordhaus model, see F. M.
Scherer and D. Ross,
Thus, the change in consumer surplus is simply total consumer surplus after N is introduced,
minus the total before N is introduced, or
This is simply
dbp',
or
24. Scherer and Ross, p. 606.
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Page 868
for chronic and degenerative diseases, which typically require longer and more expensive testing." See J. A.
Because it is generally more profitable for pharmacists to dispense a generic than a brand name drug, it is
interesting to consider why generic substitution is so low. One reason is that doctors frequently prohibit
substitution. For example, in states where doctors can prohibit substitution by simply signing their name on the
appropriate line, substitution was prohibited 41 percent of the time. In states where doctors must write
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Page 869
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Page 870
A description of price control systems in Europe is contained in U.S. General Accounting Office,
Drugs: Spending Controls in Four European Countries.
Report, May 1994.
. Congressional Record,
March 11, 1992, p. S3183.
. Congressional Record,
March 11, 1992, p. S3192.
57. In addition to the level of profits, there is a different point about the rate of increase in pharmaceutical prices
being excessive. We have reason to believe that the government pharmaceutical price index is flawed and
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Page 871
AUTHOR INDEX
Beilock, Richard, 599n15
Benham, Lee, 542, 550n12
Berndt, E. R., 870n57
Bernstein, Marver H., 348n18
Bertrand, Joseph, 109, 136n9
Besen, Stanley, 450n12
Best, Samuel, 600n36
Carlton, Dennis, 749n8, 867n19
Cassady, R., Jr., 450n2
Caudill, S. B., 409n3
Caves, Douglas W., 571t, 588t, 868n39
Cervero, Robert, 349n40
Chamberlin, E. H., 81, 82, 95nn6, 7, 137n13
Darnay, Arsen, 516nn18, 19
Davies, David, 468, 472t, 474n14
DeAlessi, Louis, 468, 470t, 474nn7, 13
De Chazeau, Melvin, 651n8
Delorme, Charles D., 349n34
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Page 872
Ellsberg, Daniel, 684n 11
Gaskins, Darius, 166, 192n28
Gatti, James F., 313t
Gautschi, Frederick, 829n35
Gegax, D., 411n26
Gibbons, Robert, 135-36nn1, 2, 3
Gilbert, Gorman, 349n36
Gilbert, Richard, 192n32, 866n11
Goldberg, Arthur, 251
Gottlieb, Paul, 450n12
Grabowski, Henry, 757t, 759f, 788n4, 867n27, 868n38, 869nn42, 43, 46, 47, 870nn59, 61
Graham, D. A., 263n8, 376n20,
Graham, David R., 583f, 600n38
Graham, John, 788n5
Gray, Wayne, 829n38
Green, Edward J., 137n15
Greene, W. H., 404, 410n19, 474n9
Harrington, Winston, 40, 43n20
Hatch, Orrin, 856-57
Hausman, J., 302n49
Haveman, Robert, 549n8
Hay, George A., 138n42
Jensen, Michael, 202, 222n4
Johnson, L., 387-90, 410n7
Johnson, Leland L., 451n27
Jordan, William A., 348n17
Joskow, P. L., 289, 302n44, 385, 387, 390, 409n4, 410nn9, 17, 411n23, 549n9
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Page 873
Kaufman, Irving, 265, 280
Keeler, Theodore E., 349n32, 598n3, 599n14, 600nn23, 38, 768t, 788nn5, 6, 789n10
Lindsay, Cotton, 459, 473n4
Mendeloff, John, 827n2, 829nn29, 34
Meyer, R. A., 404, 410n18
Meyers, N. L., 651n14
Milgrom, Paul, 193n38
Mintrom, Michael, 600n36
Mishan, E. J., 708n3
Montgomery, David, 651n20
Moore, Thomas Gale, 464, 474n10, 467, 565t, 598nn3, 13, 600nn22, 27, 37, 601nn42, 43, 45
Moran, Mark J., 43n19, 349n30
Morrall, John F. III, 70t, 709nn10, 14
Morrison, Steven A., 580f, 582t, 585f, 586t, 587t, 591f, 592t, 601nn51, 55, 602nn62, 63, 869n41
Muellar, W. F., 300n12
Mueller, Dennis, 85-86, 95n14, 870n59
Mulsolf, Lloyd, 473n1
Murphy, R. D., 153-54
Myerson, R. B., 376n19
Nader, Ralph, 751, 788n1
Nadiri, M. Ishaq, 515n12
Olson, Mancur, 330, 348n21
Ordover, J. A., 192n32, 232-34, 262n5
Ostas, James R., 550n13
Oster, Sharon, 788n3
Owen, Bruce M., 348n12, 391, 410n10, 434, 450n12
Owen, Diane S., 43n10
Pacey, Patricia, 349n35
Panzar, John, 162-63, 192n24, 375nn5, 7, 386-87, 409n6
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Page 874
Pescatrice, Donn, 467, 474n12
Rogerson, William P., 95n 11
Rose, Nancy L., 410n17, 549n9, 590f, 600nn25, 32, 601n53
Rosen, Sherwin, 708n7, 709n9
Ross, D., 89, 92, 96n19, 243, 263n12, 867nn17, 24
Rubinovitz, Robert, 444; 452n43
Rucker, Randal, 348n22
Ruser, John, 829n37
Russell, Clifford, 742t, 743t
Russell, Milton, 626, 651nn17, 18
Rutledge, Gary L., 74t
Saft, L. F., 264n29
Salinger, Michael A., 95n12, 191n8
Salkever, D. S., 869n40
Saloner, G., 192n32, 232-34, 262n5
Salop, S. C., 68n6, 193n40, 232-34, 262n5, 264n37
Samuels, Robert, 349n36
Schwartz, Marius, 192n26
Schwert, G. William, 549n10
Shapiro, Carl, 68n2, 132n10
Sharkey, William W., 356, 375n6, 500, 516n30
Shavell, Steven, 789n 11
Shenefield, John H., 211, 223n22,
Shin, Richard, 516nn31, 32
Sibley, David S., 376nn13, 15, 17, 410n12; 583t
Sickles, Robin, 652n42
Singal, Vijay, 602n66
Slovic, Paul, 828n 11
Smiley, R. H., 404, 410n19, 474n9
Smith, Adam, 795, 828n3
Smith, Richard A., 120, 137nn16, 17
Smith, Robert S., 708n7, 827n2, 829n31
Snow, John, 599n12
Solow, Robert M., 87, 96n15, 534, 549n6
Sonnenfeld, Jeffrey, 137n14
Spady, Richard, 599n19
Spence, A. Michael, 789n13, 866n16
Spiller, Pablo, 349n29
Spulber, D. F., 375n9
Stackelberg, Heinrich von, 108, 136n8
Stanley, Linda R., 569f, 600n24
Statman, M., 868n34
Stauffer, T. R., 869n43
Stocking, G. W., 300n12
Stokey, Edith, 684nn7, 8, 708n2
Stone, Alan, 347n1, 348n9
Streitweiser, Mary, 651n42
Sultan, Ralph G. M., 68n8
Suslow, Valerie, 137n18
Swanson, Joseph A., 571t
Sweeny, George, 549n7
Sylos-Labini, Paolo, 172, 192n33
Taylor, Lester, 488, 515n7, 516n24
Taylor, William E., 516n24
Teitelbaum, Perry, 650n4
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Page 875
Telser, Lester G., 263n11, 450n4
Temin, P., 867n26
Teske, Paul, 600n36
Thaler, Richard, 708n7
Thayer, M., 709n12
Thomas, L. G., 869n46
Thomas, Lacy, 829nn28, 33
Thompson, Herbert, 349n34
Thompson, Rex, 600n33
Thurman, Walter, 348n22
Tirole, Jean, 136n10, 192nn32, 36, 349n29, 866nn11, 13
Train, K. E., 375n9
Trapani, John, 467, 474n12
Tullock, Gordon, 95n10
Turner, D. F., 283-85, 301n37
Tussing, Arlon, 641f, 645f
Tversky, Amos, 828n11
Uri, Noel, 600n28
Vernon, John M., 263n8, 376n20, 757t, 759f, 788n4, 867n27, 868n38, 869nn42, 43, 46, 47, 870n61
Warren, Melinda, 45-54t, 320t
Waterson, Michael, 190n6
Waverman, Leonard, 491, 515nn4, 10
Webb, G. Kent, 434, 436, 440t, 450nn9, 12, 451n15
Weil, Roman, 600n33
Weiner, Robert J., 651nn20-22
Weingast, Barry R., 3n19, 349n30, 788n9
Weiss, Leonard, 276, 301nn27, 33, 320t
Westfield, F. M., 263n8
Whinston, M. D., 263n22, 549n4, 868n39
White, Edward, 248
White, Lawrence J., 68n6, 223n25, 768t
Wiggins, Steven, 650n7, 651nn8, 11, 869n46
Wildavsky, Aaron, 684n4
Williamson, Oliver, 124, 132, 137nn22, 138n43, 203-5, 216, 222n7, 223nn10, 26, 286, 302nn41, 42, 424-26, 428,
Willig, Robert, 95n2, 162-63, 192n24, 375nn5, 7, 450n7, 507, 515n3, 516n20, 517nn39, 42, 573, 600nn29, 31, 34
Wilson, James Q., 39, 43n18, 319, 348n10
Wilson, Richard, 659t, 673t, 828n5
Wines, Michael, 770-71t
Winston, Clifford, 348n5, 553t, 580f, 582t, 585f, 586t, 587t, 591f, 592t, 598nl, 599nn5, 19, 600nn20, 21, 601nn51,
Wolf, Charles, 42n1
Wyzanski, 270
Ying, John, 516nn31, 32, 599n14, 600n30
Zecher, Richard, 549n 11
Zeckhauser, Richard, 684nn7, 8, 708n2, 729f, 827n2, 829nn26, 27
Zerbe, Richard, Jr., 349n41
Zimmermann, Erich W., 650n7, 651nn8, 12
Zupan, Mark A., 349n28, 443, 451nn29-31, 35, 452n40, 679, 684n14
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Page 877
SUBJECT INDEX
of independent regulatory commissions, 319
of public enterprise, 453-54
of regulatory agencies, 181-9
Addyston Pipe. See United States v. Addyston Pipe & Steel Co.
Adjustment costs, 175
exclusive dealing, 240, 246
territorial restraint, 240
AIC.
See
Average incremental cost (AIC)
Airline Deregulation Act (1978), 316, 576
Airline industry
deregulation, 316, 575-76, 589-97
hub-and-spoke system, 583-86
pricing practices litigation, 118
public and private airlines, 468-72
regulation, 574-76
antitrust litigation, 493, 503-5
in computer industry, 506
divestiture, 65, 280-81, 386, 503-5
as dominant firm, 164
effect of technological change on, 488-93
if fully deregulated, 495-96
as monopoly, 487
as regulated monopoly, 500-501
of conglomerate mergers, 215-20
of foreclosure, 228-32
Antitrust law
enforcement and remedies, 64-66
exemptions, 67, 558
post-deregualtion of airlines, 589-97
state-level, 64
trucking industry exemption, 558
Antitrust policy
intent, 4
legislation comprising framework of, 62-63
using concentration indices in, 151-52
Appalachian Coals, Inc. v. United States
(1933), 126
Areeda-Turner predatory pricing rule, 283-85
Aspen Skiing Company v. Aspen Highlands Skiing
(1985), 283
ATC (average total cost) predatory pricing rule, 285-86
English, 414-17
of spectrum for PCS, 499, 508-9
See also
Franchise bidding
Automobile industry
brand proliferation and brand loyalty as, 281, 851, 852-53
debate over definitions, 160-62
definition and significance, 60
definitions of, 158-59
patents as, 851-52
scale advantages of R&D as, 851, 853-55
to sustain monopoly price, 274
converting to present value, 670-72
horizontal mergers, 203-7
marginal, 667-68
in oversight of social regulations, 664-67
in regulatory oversight, 30-32
in perspectives of risk, 661-63
toward small producers, 328
in workers' perception of risk, 797-802
Block booking, 248, 250-51
Brand proliferation, 184-87, 281
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Page 878
Brooke Group v. Brown and Wlliamson Tobacco
(1993), 289
Brown Shoe Co. v. United States
(1962), 63, 207-10, 229, 239
Bubbles (emission trading), 731-32
Bush administration
federalism of, 15
regulation oversight process, 28
social regulation standards, 64
Business Electronics Corp. v. Sharp Electronics Corp.
(1988), 243-44
Bus Regulatory Reform Act (1982), 316
Cable Communications Policy Act (1984), 444
Cable television
FCC regulatory policy for, 430
franchise bidding, 437-42
growth of industry (1976-93), 430-31
as natural monopoly, 432-37, 446
scale economies, 433-37
technology of, 432-33
Addyston Pipe
case, 125, 139-44
collusive practices, 117-21
Carter administration
OSHA policy review, 792
regulation oversight process, 25-27
social regulation standards, 664
Celler-Kefauver Act (1950)
as amendment to Clayton Act, 62
enforcement, 275
merger provisions, 197
partial text of, 69-71
price discrimination provision, 290
and subsequent amendments, 62
vertical restrictions under, 240
See also
Celler-Kefauver Act (1950); Robinson-Patman Act (1936)
Clinton administration
OSHA policy, 792
regulation oversight process, 28-29
social regulation standards, 664
Coase Theorem
as bargaining game, 713-16
for externalities, 711-13
relevance to regulatory economics, 717-18
devices in coordinating, 117-20
hypothesis, 151-52
theory, 113-17
See also
Cartels; Cournot model
Common pool, oil industry, 617-23
Communications Act (1934), 429, 487
Compensation, wage, 795-802
Compensation principle, 74
advertising, 97-99
among firms for rents, 83-84
in Becker model of regulation, 334-36
behavior with existence of externality, 324
for cable television franchises, 439-42
circumstances for influence of mergers on, 195-96
economic surplus, 74-78
in franchise bidding, 414, 417-20
incentives to invent with, 834-37
perfect, 73
post-deregulation in airline industry, 589-97
with price regulation, 528-32
strategic, 171
through product differentiation, 109
See also
airline industry, 590-93
Herfindahl-Hirschman Index as measure of, 149-51, 214
measurement of, 146-48
relation to economies of scale, 152-55
relation to entry conditions, 155
Concentration ratio
four-firm, 59-60
to measure concentration, 147-49
Conscious parallelism, 129-32
Consumer surplus
defined, 75-76
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Page 879
franchise bidding with recurrent, short-term, 424-26
Coordination devices in collusion, 117-20
Cost advantage, 183-84
Cost-benefit analysis.
See
Benefit-cost analysis
Cost effectiveness criterion, 29-30
Cost function
adjustment costs with, 176
learning curve effect, 177-78
equity capital, 383-85
oil industry regulation, 635-36
product liability, 774-81
reduced flexibility, 226
regulations to reduce risk, 705-6
Cost structure (natural monopoly), 480-82
Council of Economic Advisers, 26
Cournot model
in analysis of effects of price regulation, 525-28
firm collusion in infinitely-repeated version, 113-17
formulation and specification, 102-4, 132-33
Cournot solution
derivation of Nash equilibrium in, 104-6
firms' prices, 106-8
Creamskimming, 484, 486
Cross-subsidization
airline industry, 576-77, 581
definition of and explanation for, 337-38
occurrence and implications, 484-86
with price regulation, 532-33
as property of regulation, 328
Crude oil industry
benefits and costs of price control
removal, 78-79
effect of price regulation, 628-36
Mandatory Oil Import Program regulation, 624-26
price controls, 626-36
regulation, 610-36
regulatory history, 613-15
Windfall Profits Tax (1980), 615
CT.
See
Capture theory (CT)
Decentralization, 14-16
airline industry, 575-76, 583-86
environmental regulation, 741-42
natural gas industry (1978), 638-39
1971-89 period, 315-17
predictions of regulation theories, 340-41
in regulatory process, 318
surface freight rates and efficiency, 561-74
taxicab industry, 342-45
trucking industry, 555
Development, industrial, 89
Differential efficiency hypothesis, 152
Diffusion, 89
of scale, 153
of scope, 356-57
dynamic analysis, 166-71
static analysis, 164-66
Dominant firm theory, 164
Dr. Miles Medical Company v. John D. Park & Sons
(1911), 243
comparison of public and private enterprises, 468-70
measurement of firm's economic tasks by, 73
Economic surplus
compensation principle to yield, 74
See also
Consumer surplus
applied to regulation of Cable television, 430
critique of, 339-40
prediction of deregulation, 340-41
related to surface freight transportation, 557-74
taxicab regulation, 342-45
of density in cable television systems, 433-34
as reason for merger, 200
of scope in natural monopoly, 356-57
with vertical integration, 227
See also
Economies of scale
cable television, 436
economies of density, 433 34, 436
in natural monopoly, 355-57, 476-77
of R&D as barrier to entry, 851, 853-55
relation to concentration, 152-55
allocative, 464-67
effect of price regulation on firm's, 531-32
effects of regulation on airline, 588
oil industry regulation effects on, 634-35
of price discrimination, 293-95
as reason for merger, 200-202
See also
Differential efficiency hypothesis
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Page 880
Efficiency, economic
as objective in antitrust decisions, 63-64
See also
effect of regulation on surface freight, 567-72
public and private utilities, 467-68
Electric power
peak-load pricing, 396-403
regulation and deregulation of, 403-7
Electric utilities, municipal, 463-68
Ellsberg Paradox, 675
antitrust law, 64, 211-12
environmental regulations, 740-46
OSHA strategy, 811-24
Enterprise, private
comparison with public enterprise, 461-63
managerial model of, 458-59
Enterprise, public
comparison with private enterprise, 461-63
managerial model of, 459-62
positive theory of, 456
as solution to natural monopoly pricing, 371-72, 453
theories of behavior, 459-61
uses for, 454-55
Entitlements program, oil industry, 627-28
costs of, 155-57
regulation of taxicab industry, 342-45
See also
Barriers to entry
Entry and exit regulation
airline industry, 577
in economic regulation, 309-10
railroad and trucking, 559-60
static and dynamic effects, 520-41
theory, 520
Environmental contexts, 720-21
Environmental issues, 733-37
Environmental Protection Agency (EPA)
enforcement of regulations, 740-46
regulatory role, 711
Environmental regulation
economic models of policy, 676-80
enforcement and performance, 740-46
EPA.
See
Environmental Protection Agency (EPA)
EPAA.
See
free-entry, 155-57
monopoly, 266-67
political, 335-36
See also
Nash equilibrium
Estimating regulation effects, 537-47
court decisions related to, 246-47
practice of, 240-41, 246
Exit regulation, 309-10
Coase Theorem for, 711-13
conditions for existence, 324
multiperson decision making with group, 737-38
negative, 324-25
auctions of PCS spectra, 499, 508-9
cable television regulation, 430, 444-45
Celler-Kefauver Act (1950) phone policy, 499
Computer II decision, 507
establishment (1934), 315, 429, 487
price cap regulation of, 386, 494
regulation of AT&T, 487, 506-7
regulation of interstate telephone service, 377
regulation of local-exchange telecommunications, 499
regulation of television broadcasting, 429-30
Specialized Common Carrier decision (1971), 492, 501, 504-5
Federal Deposit Insurance Corporation (FDIC), 315
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Federal Energy Regulatory Commission (FERC)
regulation by, 377, 405-6
advantages, 15-16
transfer to state- and local-level regulation, 14-15
Federal Power Commission (FPC), 637-38
Federal Power Commission v. Hope Natural Gas Co.
(1944), 384
Federal Trade Commission (FTC)
antitrust enforcement by, 64, 211-12
legislation (1914), 63, 71
shared monopoly theory, 281
Federal Trade Commission v. Morton Salt Co.
(1948), 297
economic performance measurement, 73
efficiency, 531-32
managerial model of, 456-58
in oligopoly, 99-100
pollution control efforts, 742-44
profit maximization, 456
regulation of behavior of, 310-11
See also
Dominant firm theory; Enterprise, private; Enterprise, public; Mergers; Monopoly; Oligopoly
regulation oversight process, 24-25
social regulation standards, 664
Ford Motor Co. v. United States
(1972), 239
Foreclosure with vertical merger, 228-34
Franchise bidding, 370
assessment of, 428-29
defined, 413
English auction as, 414-17
process for cable television, 437-38
rent-seeking behavior with, 422-24
supplementary contracts with, 424-27
theory of, 413-14
variables changing effectiveness of, 417-22
Franchise owners, 427-28
Free-entry equilibrium, 156-57
Free-rider effect
Becker model of regulation, 335-36
in Coasian bargaining game, 717
Stigler/Peltzman model of regulation, 330-31
Fully distributed cost (FDC) pricing, 392-94
Game theory
application and terminology of, 100-101
duopoly compatibility of standards, 99-100
formal definitions, 138-39
Nash equilibrium, 101-2
Gas industry.
See
Natural gas industry
Glass-Steagall Act (Banking Act of 1933), 315
Global warming, 733-35
Goldfarb v. Virginia State Bar
(1975), 127-28
Government intervention
circumstances for potential, 324-25
in natural monopoly, 446, 519
as regulator, 307
See also
Grinnell
case.
See United States v. Grinnell Corps.
influences on workplace, 791
objectives and regulatory agencies of, 8-9
as concentration index, 149-51
in 1992 merger guidelines, 214
See also
antitrust suit against, 123, 280-82
as dominant firm, 164
Ideal pricing, natural monopoly, 358-67
Incentive regulation
performance standards, 386
price cap, 386-87
sliding scale plan, 385-86
in franchise bidding, 417
gas industry regulation effect, 646
to invent, 834-37
judicial decisions effect, 9
oil industry regulation effect, 635
perverse, 387-91
price regulation effect, 533
of regulatory agency employees, 320-21
regulatory lag effect, 535-36
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Page 882
Incentives (cont.)
regulatory policy impacting R&D incentives, 855-63
in workers' compensation, 791
Industrial organization
analysis, 57-62
antitrust exemptions, 67, 558
below and above cost pricing in, 532-33
efficiency of, 60-62
as natural monopoly, 351-52
predictions of regulation for, 331-37
See also
Airline industry; Automobile industry; Computer industry; Crude oil industry; Firms; Natural gas
industry; Railroad industry; Surface freight transportation; Telecommunications industry; Trucking industry
sources of monopoly, 80-84
X-inefficiency, 83
hazard warnings as, 808-10
in regulatory process, 322
of risk for workers, 797-802
Inherent effect, 123
effect of regulatory lags on, 535-36
OSHA regulatory policy, 808-11
with technological change, 89
Innovation, technological
computer industry, 505-7
effect of price regulation on, 533-36
effect on local-exchange telecommunications, 498-99
influence in monopoly regulation, 482
in transformation of telecommunications, 488-91
See also
Technological change
entry into, 509
regulation, 486-98
Interest groups
Becker model of regulation, 333-37
capture of regulatory agency by, 38-39
pressure to regulate Cable television, 430
in product liability debate, 780-81
role in environmental regulation, 676-80
Stigler/Peltzman model of regulation, 330-31
International Salt Co., Inc. v. United States
(1947), 257-58
International Telephone and Telegraph (ITT), 216
Interstate Circuit, Inc. v. United States
(1939), 129
Interstate Commerce Act (1887)
effect of Staggers Act on, 555-56
enactment, 312, 554
Interstate Commerce Commission (ICC)
railroad regulation by, 554-57
regulation of airline industry, 574
regulation of interstate telephone service, 487
economics of, 831-34
incentive for, 834-37
in process of technical change, 89
Investment, firm, 311
Jefferson Parish Hospital Dist. No. 2 v.
Hyde
(1984), 258-59
Joskow-Klevorick two-stage predatory pricing rule, 289
Kodak
cases.
See Berkey Photo v. Eastman Kodak Co.
(1979);
Eastman Kodak v. Image Technical Services, Inc.
LDDS Communications, 494, 497
deregulatory (1971-79), 315-17
in regulatory process, 317-19
restraint on federal rulemaking, 18-19
Interstate Commerce Act (1887), 312
1887-1940 period, 314-15
Legislators as interest group, 330-33
Lerner index, 266-67
Leveraged buyouts, 198-99
Limit pricing
as barrier to entry, 171-72
dominant firm, 168-69
theories of, 175-79
See also
Bain-Sylos model of limit pricing
Linear marginal-cost pricing, 359-62
regulation, 498-500
Loeb-Magat proposal (for natural monopoly pricing), 368-69
Mandatory Oil Import Program (MOIP), 614
Mann-Elkins Act (1910), 313, 487
Marginal cost rule of predatory pricing, 286-88
in natural monopoly transformation, 479-80
with technological change in telecommunications, 488-91
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factors contributing to, 3
potential for government intervention with, 325
as alternative to integration, 226
definition in monopoly, 268
in environmental contexts, 720-21
limits defined, 146-47
1992 merger guideline definition, 212-14
as natural monopoly, 323
nonregulation of intrastate, 579, 641
substitution and new entry in, 147
for trading pollution emission rights, 685-86, 730-33
concentration, 145-46
entry conditions, 145, 155-64
in industrial organization analysis, 57-62
with vertical merger, 234
Mark-up pricing rules, 118
Matsushita v. Zenith
(1986), 274, 289
MCI (Microwave Communications Incorporated)
pricing of service, 493-94
Merger guidelines
criteria for challenge to potential merger, 219-20
enforcement agency issuance, 211-12
on facilitation of collusion, 234-35
1992 version, 211-12
Merger Guidelines (1992), 239
under Celler-Kefauver Act, 198
Clayton Act provisions, 197
conglomerate, 215-20
merger waves, 196-99
monopoly extension, 235-38, 248-49
reasons for, 199-202
Sherman Act provisions for, 197
Mergers, conglomerate, 195
categories of, 215-16
costs and benefits of, 216-17
effect of, 195
social benefits and costs, 203-8
social costs and benefits of
Brown Shoe,
207-10
Mergers, vertical
costs and benefits, 225-28
effect of, 195-96, 225
successive monopolies, 227-29
Message-toll service (MTS), 492-93
Miller-Tydings Act (1937), 244
Alcoa
(1945) decision definition, 278
antitrust cases brought as, 64
rule of reason test for, 123, 195, 241, 245, 266-79
economic surplus, 74-78
economies of scale with, 80-83
equilibrium, 266-67
estimates of welfare loss from, 84-87
extension with fixed- or variable-proportions production, 235-38
extension with tying, 248-49
incentives to invent in, 834-37
as reason for merger, 199
regulation of, 311-12
shared, 281
See also
Natural monopoly; Successive monopolies
Monopoly power
measured by Bain index, 267-68
measured by Lerner index, 266-67
Monsanto Corporation v. Spray-Rite Service Corp.
(1984), 243-44
Moral hazard, 777
Morton Salt
case.
See Federal Trade Commission v. Morton Salt Co.
Motor Carrier Act
1935 legislation, 318, 554-55
1980 legislation, 316, 555-56, 561, 563-64, 567
MTS.
See
Message-toll service (MTS)
Munn v. Illinois
(1877), 311-12
Myopic pricing (dominant firm), 168-71
Nash equilibrium
defined, 101-2
derivation in Cournot solution, 104-6
for infinitely-repeated Cournot solution, 113-17
Natural Gas Act (1938), 637-38
Natural gas industry
decontrol, 648
effects of price regulation, 641-47
organization and transportation, 636-37
regulation, 637-48
Natural Gas Policy Act (1978), 637-38
Natural Gas Wellhead Decontrol Act (1989), 638-39
Natural monopoly
basis for regulation, 476
cable television as, 432-37
economies of scale and regulation, 79-81
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Natural monopoly (cont.) entry regulation, 446-48
factors in transformation of, 478
franchise bidding, 370
local-exchange telecommunications as, 499-500
normative analysis to assess potential regulation, 325-27
permanent and temporary, 351-53
problem of, 351
proposed policy solutions for, 358-72
railroads as, 556
rate cases, 378-79
rate-level and rate-structure problems of, 379, 381
regulation with changes in status as, 483-86
subadditivity and multiproduct, 353-57, 476
theory of franchise bidding in, 413-14
effect on innovation, 534-35
of gas pipelines, 647
with price regulation, 529-31
Nordhaus patent life model, 838-46
Normative analysis as positive theory (NPT), 323-25, 337
prediction of deregulation, 340-41
Northern Pacific Railway Company v. United States
(1958), 258
Northern Securities Co. v. United States
(1904), 196-97
NPT.
See
Normative analysis as positive theory (NPT)
creation and operation (1971), 791-92
enforcement, 811-19
penalties, 814-15
proposed policy reform, 825-26
regulatory analysis, 667-68
regulatory approach, 802-7
standards and proposed reform of standards, 807
regulatory oversight role, 36-38, 664
role in regulatory process, 19-23, 27-28, 36-38
collusion, 112-21
recognized interdependence of, 102
theory, 81
See also
Collusion; Herfindahl-Hirschman Index (HHI); Product differentiation
Oligopoly models
Bertrand model, 109
Cournot solution, 102-8, 112
Stackelberg model, 108-9
OMB.
See
Output restriction predatory pricing rule, 286-88
of political equilibrium, 336
economics of, 831-34
optimal patent life model, 838-46
pharmaceutical industry, 847-63
Payoff function (game theory), 100-101
PCS.
See
Personal communications services (PCS)
Peak-load pricing, 396-99
Peak-load pricing model, 399-403
Peltzman model of regulation, 332-33
Per se rule, 123
applied to professions, 127-28
resale price maintenance cases, 244
Socony- Vacuum
case, 127
Trenton Potteries
case, 126
tying under modified, 241
Personal communications services (PCS)
FCC auction of spectrum for, 499
planned FCC auction, 508-9
Pharmaceutical industry
premanufacture product screening, 755-61
regulation of, 847-48
role of patents in, 847-63
Political equilibrium (Becker model), 335-36
Political support (Stigler/Peltzman model), 31-32
Pollution control
pollution tax for, 727-29
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private firm efforts, 742-44
standards or fines, 721-29
trends in control of emissions, 742-45
Pollution rights
trading of, 685-86, 730-33
value of, 720-21
Predatory pricing, 171
alternative rules to identify, 283-89
defined, 217, 272
as price discrimination, 265
profits and losses with, 273-74
Standard Oil
(1911) case, 271-75
Preemption, 184-87
legislators', 339
in Stigler/Peltzman model of regulation, 330
Present value
converting benefits and costs to, 670-72
in valuation of program benefits, 689
Price cap regulation
for natural monopolies, 386-87
in regulation of AT&T, 494
sling-scale-price caps, 386-87
Price ceilings theory, 606-10
Price control
crude oil industry, 614-15, 626-36
deregulation of oil and natural gas prices, 316
efficiency losses for oil industry (1970s), 78-79
natural gas multitier, 640
oil industry multitier, 626-28
as regulatory instrument, 308-9
See also
Clayton Act provisions, 290
first-degree, 291
monopoly, 249-55
by private utilities, 466-67
Robinson-Patman Act provisions, 290
second-degree, 291
systematic and unsystematic, 290-98
third-degree, 291-93
See also
Block booking; Tying
Price fixing
under antitrust law, 122-32
court view of resale price maintenance as, 240-41
Price leadership, 117-18
Price regulation
airline industry, 576-83
stabilization in railroad cartel agreement (1879), 121-22
of surface freight transportation, 557
See also
decontrol of natural gas, 648
implicit in social regulation, 685-91, 706-7
limit pricing, 168-69, 171-72
monopoly control, 5
price path in dynamic analysis of dominant firm, 167-71
Ramsey, 365-67
regulatory role in system of, 32
static analysis of dominant firm, 164-66
tests for subsidy-free, 394-95
See also
Limit pricing; Myopic pricing; Value of life; Willingness-to-pay
collusive, 112-21
public enterprise, 463-64
railroad cartel agreement (1879), 121-22
See also
effect of collusive, 112-21, 158
mark-up pricing rules, 118
myopic, 168-71
nonlinear, 362-65
peak-load pricing, 396-403
predatory pricing, 171, 217, 265, 271-75, 283-89
proposals for efficient natural monopoly, 358-70
public utility tariffs, 362-65
Pricing, natural monopoly
FDC pricing, 392-94
Loeb-Magat proposal, 368-69
Prisoner's Dilemma
applications of, 738-40
explained, 737
N-person, 737-38
Private-line service (PLS)
extension with technological change, 492-93
free-entry (1969), 501
Product differentiation
price game, 109-12
input and output with fixed-proportions production, 235-36
input and output with variable-proportions production, 237-38
Product liability
influence of, 774-75
negligence standard, 775-76
strict liability standard, 776
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emergence and application of, 751-55
influences on, 752-55
proposed informational, 783-85
response to, 761-67
effect of surface freight regulation on, 572-73
maximization by firm, 456
measured by Bain index, 267-68
Property rights (in bargaining game), 713-17
Prorationing, oil industry
effects of, 623-24
historical, 613-14
rationale, 617-23
regulation, 615-16
Public interest, 311-12
Public interest theory, 323
See also
Normative analysis as positive theory (NPT)
Public Utility Regulatory Policy Act (PURPA) (1978), 406
Pure Food and Drug Act (1906), 847
Railroad industry
deregulation (1980), 316
regulation, 553-57
Railroad Revitalization and Regulatory Reform Act (1976),
Ramsey pricing, 365-67, 393
Rate cases
rate base valuation, 381-83
role of, 378-79
cable television, 443-46
effect of regulation on surface freight, 561-67
Civil Aeronautics Board authority, 575-77
effect of Civil Aeronautics Board's, 578-83
of natural monopoly, 378-81
railroad and trucking industries, 557-59
regulations, 6-8
by regulatory commissions, 378-83, 391-92
Reagan administration
federalism of, 15, 18
OSHA policy review, 792, 810
regulation oversight process, 27-28
social regulation standards, 664
Reciprocal dealing, 217
Reed-Bulwinkle Act (1948), 558
Becker model of, 333-37
control of entry and exit as instrument of, 309-10
control of price as instrument of, 308-9
development of economic, 6
expanded scope of, 312
growth (1940-70), 315
by Interstate Commerce Commission, 312
as limitation of firm behavior, 310-11
normative analysis to assess requirement for, 325-27
overlap of federal and state, 17-18
quantity control as instrument of, 309
as solution to natural monopoly price problem, 370-71
Stiglerian approach, 329
Stigler/Peltzman model, 329-33
1930s wave of, 314-15
of taxicabs, 342-45
theory of, 322-23
trends in, 312-14
underlying policy and influences on, 13-16, 38-41
volume and cost of, 33-36
See also
Capture theory (CT); Cross-subsidization; Deregulation; Incentive regulation; Normative analysis as
positive theory (NPT); Rulemaking
Regulation, federal-level
chronology of new, 19-23
delegation to states of, 16-18
executive branch oversight, 23-38
Regulation, state- and local-level, 13-18
Regulation effects
costs (1970-95), 45-54
creation and powers, 318-19
employees in, 319-20
Joint Executive Committee as, 554
social regulation objectives, 663-64
use of sustainability concept, 358
See also
Regulatory Calendar, 28
Regulatory commissions
independent, 14, 319
regulation of natural monopoly by, 37
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state-level, 14-15, 377-78
See also
Federal Communications Commission (FCC); Federal Energy Regulatory Commission (FERC);
Federal Trade Commission (FTC); Interstate Commerce Commission (ICC); Securities and Exchange
Commission (SEC)
Regulatory Impact Analysis (RIA), 19
Regulatory lags
impact on innovation, 535-36
with price regulation, 308-9, 379-81
Regulatory oversight
actions taken in process of, 36-38
criteria applied to, 29-32
development of executive branch process for, 24-29
objective, 32-33
Regulatory policy
Becker model of regulation, 333-36
benefits and costs of separation, 501-3
evaluation principles, 686-88
for natural monopoly with status changes, 483-86
objectives in regulatory legislation, 319
for pharmaceutical industry, 847-49
proposals to correct natural monopoly inefficiency, 358-72
reform of and innovation in OSHA, 808-11
standard and fines for pollution control, 721-23
with technological change, 510-11
uncertainty of effects of, 10-11
value of life for, 699-703
See also
Environmental regulation
Regulatory process
deregulation, 318
implementation, 318
legislative initiatives, 317
strategies in, 321-22
See also
Regulatory lags
in bargaining game, 714
defined, 422
Rent-seeking behavior
defined, 422
factors in, 83-84
Resale price maintenance (RPM)
defined, 240
illegality of, 243-44
under Sherman Act, 240
Research and development (R&D)
basic and applied, 89
regulatory policy influencing incentives for, 855-63
rivalry model, 89-93
scale advantages of, 851, 853-55
See also
Innovation; Inventions
Resource Conservation and Recovery Act (1976), 741
pollution, 685-86, 721, 730-33
property rights, 713-17
Risk analysis, 30-32.
See also
Benefit-cost analysis
Risk premium
decisions related to, 226-27
wage compensation as, 795-99
Risk-risk analysis, 705-6
ambiguity, 675-76
costs of regulations to reduce risks, 705-6
of death, 656-58
home and auto, 769-74
increasing risk of death, 658-60
perception of, 661-63
proposed concentration of, 721
uncertainty of, 672-74
wage compensation for, 795-99
workers' perception of, 800-802
workplace, 693-99
Rivals' costs
cost advantage in raising, 183-84
raised as result of vertical merger, 232-33
Robinson-Patman Act (1936)
as amendment to Clayton Act, 61-62
cases brought under, 296-98
price discrimination in, 290, 293
regulatory agency approaches to, 321-22
role of producers and consumers being regulated, 321-22
Rule of reason
application of, 123
exclusive dealing under, 241
inherent effect and intent in monopolization cases, 266-79
merger consideration under, 195
territorial restraint cases, 245
Safe harbors (1992 merger guidelines), 214-15
airline, 588-89
impact of OSHA on, 821-25
workplace regulation, 791
See also
AT&T divestiture, 503-5
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Page 888
Separation (cont.)
FCC policy, 506-7
factors influencing passage of, 62
merger provisions, 197
partial text of, 69
Section 1, 62, 122-23, 197
Section 2 on monopoly and monopolization, 62, 197, 265, 271
vertical restrictions under, 240
of monopoly or efficiency loss, 76
of tying practices, 254-55
implicit prices in, 685-91, 706-7
objectives, 663-64
policy evaluation, 686-91
standards and oversight, 664-72
tradeoffs, 685-86
See also
pricing of service, 493-94
Stackelberg model, 108-9
Staggers Act (1980), 316, 555, 561, 563
Standard Fashion Co. v. Magrane-Houston Company
(1922), 246-47
Standard Oil Company of California v. United States
(1949), 247
Standard Oil of New Jersey v. United States
(1911), 271-75
of performance as regulation for natural monopolies, 386-87
product liability, 775-77
social regulation, 664-72
EPA guidelines, 722
of cost function in natural monopoly, 357, 476
to define natural monopoly, 353-54
distinct from economies of scale, 355-56
Successive monopolies, pre- and post- merger, 227-29, 241
Superfund program, 741
Supreme Court
decision in
Hyde
tying case, 259
decision in
Kodak
tying case, 259-60
decisions in conglomerate merger case, 218-19
decisions in horizontal merger cases, 207-10
decisions related to economic regulation, 311-12
Munn
(1877) decision, 311-12
opinion in
Addyston Pipe,
141-44
rulings on tying, 248
rulings related to predatory pricing and
monopoly power, 271-75
using rule of reason in
Grinnell
case, 266
view of block booking and tying agreements, 251
Surface freight transportation
deregulation, 554-56, 573-74
regulation, 553-54, 556-73
Sustainability concept (in natural monopoly), 357-58
Switching costs, 177-78
Tampa Electric Company v. Nashville Coal Company
(1961), 247
linear marginal-cost pricing, 359-62
nonlinear public utility pricing, 362-65
for pollution control, 727
by regulatory mechanism, 3, 337-38
Taxicab regulation, 342-45
Technical progress
elements of, 87-93
R&D rivalry model, 89-93
Technological change
convergence in telecommunications, 507
regulatory policy with, 510-11
Solow analysis, 87-88
Telecommunications industry
current status, 508
See also
American Telephone and Telegraph Company (AT&T)
computers in, 505-7
deregulation of intercity, 492-93
effect of technological change, 488-93
entry into intercity, 509
question of entry into, 511-13
question of full deregulation, 496-98
services of intercity, 486-87
simultaneous regulated and unregulated; 501-3
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Page 889
See also
defined, 240
effects of, 245
Theatre Enterprises, Inc. v.
in Coasian bargaining game, 716-18
defined, 226
nature of, 226-27
Transportation Act (1920, 1940, 1958), 554-55
Transportation industry
deregulatory legislation, 316
regulatory history, 553-57
See also
Natural gas industry; Railroad industry; Trucking industry
Trucking industry
deregulation (1980), 316
price regulation of, 558-59
unregulated era of, 555
to avoid price controls, 257
explanations for, 248-49
Kodak
case, 225, 259-60
leverage theory of, 248-49
practice of, 240-41, 247
to prevent substitution, 257
variable- and fixed-proportions production as, 247-48
with variable-proportions production, 252-54
of environmental degradation, 733-37
related to effects of regulatory policy, 10-11
antitrust case (1911), 271, 275
formation through merger, 196, 199
United States v. Addyston Pipe & Steel Co.
(1899), 125, 139-44
United States v.
Aluminum Co. of America
(1964), 210
United States v. Aluminum Co. of America
(2d Cir. 1945), 265, 270, 275-76
United States v.
American Tobacco Co.
(1911), 123, 271-75
United States v. Container Corp. of America
(1969), 123
United States v. Continental Can Co.
(1964), 210
United States v. E.I. duPont de Nemours and Co.
(1956), 268-69
United States v.
United States v. United States Steel Corp.
(1911), 275
United States v. Von's Grocery Company
(1966), 211
Unitization, oil industry, 622
Usury laws, state-level, 544-47
Utah Pie v. Continental Baking
(1967), 296-97
contingent, 701-2
present value, 670-72
rate base, 381-83
through surveys of policy effects, 701-3
Value of life
empirical estimates, 697-99
for regulatory policies, 699-701
studies of, 697
variations in, 691-93
willingness-to-pay concept, 686-88, 690
Vertical integration
exclusive dealing as, 240, 246
resale price maintenance as substitute for, 240
Wage compensation (risk-related), 795-802
Water pollution control, 729
WATS.
See
Wide-area telephone service (WATS)
Wealth distribution
in Becker model of regulation, 334-36
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Page 890
Wealth distribution (cont.)
Stigler/Peltzman model of regulation, 330-33
use of cross-subsidization for, 338
Webb-Pomerene Act (1918), 67
Welfare effect
of airline regulation, 586-88
with cross-subsidization, 532-33
implications of price ceilings, 606-10
loss from monopoly, 84-87
of natural gas industry regulation, 644-46
of oil industry regulation, 631-34
of rail and trucking regulation, 560-74
in regulation of telecommunications, 513-14
of rent-seeking, 83-84
Wide-area telephone service (WATS), 487
Willingness-to-pay
concept, 75
in evaluation of regulatory policy, 686-88
for government program benefits, 688-91
Windfall Profits Tax (1980), 615, 628
Xerox Corporation, 280
X-inefficiency, 83
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