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Regulation Powered By Docstoc

      David Levinson
     (Based on notes
       by Tae Oum)
    Instruments of
Government Intervention
1. moral suasion;
    –   speeches, conferences, information,
    –   advisory and consulting bodies,
    –   studies/research
    –   reorganizing agencies
2. government expenditures;
    – grants
    – subsidies
    – public provision of facilities
3. regulation - economic regulation, other regulation;
    –   taxes, tariffs
    –   guidelines
    –   rules
    –   fines, penalties
4. government ownership and/or control of enterprise
    Objectives for
Government Intervention
• to achieve maximum            • socio-economic
  social welfare in the           objectives;
  presence of market               – to    achieve       desired
  failure;                           income distribution
  – natural monopoly               – mobility of handicapped
  – existence of externality;      – industrial policies
      • - positive                     • indirectly      subsidize
      • - negative                       certain industries
                                   – safety
• macro-economic
  objectives;                   other objectives;
  – controlling inflation          – national unity
  – maintaining employment         – national prestige
  – balance of payments            – national defense
  Economic Regulation
• an attempt by government to deliberately
  alter the allocation of resources and
  distribution of incomes away from that which
  would have occurred in the absence of such
• a means by which government can attempt to
  substitute its judgement of what constitutes a
  'proper' allocation of resources and
  distribution of income for the outcome yielded
  by the market;
• transportation had been a heavily regulated
  industry until recently;
  Types of Economic
Regulation in Transport
• The regulatory agencies are granted a broad
  power to regulate the following aspects of the
  – price regulation - maximum rate, minimum rate,
    rate structure
  – entry and exit regulation
  – rate-of-return regulation
  – antitrust (anti-combines) regulation including
    mergers and acquisition
  – regulation on financial arrangements and
    accounting practices
    Theory of Economic
There are two opposing theories on why
  economic regulations exist;
• Consumer Protection. The regulation is a
  device for protecting the public against the
  adverse effects of monopoly. (traditional and
  ideal view)
• Protection of Industry Interest.           The
  regulation is procured by politically effective
  groups (assumed to be composed of the
  members of the regulated industry itself), for
  their own protection. (more recent view).
Protection of Industry
• industry attempts acquire regulation mainly because
  regulation will help them generate economic rents;
  producers have a more vested interest in the industry
  than does individual consumer.
• producers are far more effective in pressuring
  government than are general interest consumer
• Stigler (1971) argues that producers essentially
  "capture" regulatory agencies. "as a rule, regulation
  is acquired by the industry and is designed and
  operated for the industry and not for the "public
  interest". Therefore, regulatory commissions end up
  "protecting" industry from consumers.
   Railway Regulation
Started regulation in 1887.
• railway monopoly in many markets: user
• need to provide services to uneconomic
  points: cross-subsidy
• some destructive competition; anti-trust need
• shortrun marginal cost seemed low relative to
  "full costs";
• political pressures to intervene;
  Trucking Regulation
• Started regulation in 1930s.
• began to question the efficacy of
  competition as a regulator of business;
• a strong push for "codes of fair
  competition" in society as a whole;
• start to regulate trucking although it was
  a competitive industry.
    Airline Regulation
Started regulation in late 1930s.
• to help create national network
• subsidization of the infant industry
• protection from competitive entry to
  effect cross-subsidization (taxation by
  regulation - regulatory inspired cross-
   Economic Rationale
     for Regulation
• The main objective is to maximize social
  welfare by correcting market failure.

• 1. To force monopolies to produce the level
  of output that maximize social welfare;
• 2. To encourage the infant industry to get off-
• 3. To prevent "destructive (cut-throat)
• 4. To correct for externalities;
• the industry is inherently "monopolistic"
  because of economies of scale, limited
  markets, or requires high initial
• existence of high fixed (indivisibilities),
  common and/or joint costs;
     Infant Industries
• a combination of regulation on entry,
  quantity supplied, subsidy
• usually the nation sees existence of a
  large external benefits
• or important non-economic benefits to
  the nation.
Cut-Throat Competition
• instability in supply prices - regulate to
  smooth out output prices
• uneconomic rate levels;
• predatory pricing
  – immature pricing behaviour - oligopolists
    overreaction to competitive event
  – high fixed cost with slow adjustment - short run
    pricing below total average costs, especially in
    recession when there are a lot of excess capacity
• higher      prices to  induce   less
  production/consumption    of    bad
• eg., pollution
       Entry Regulation
Entry into industry;               • Entry onto routes;
   – certificate   of    Public
     Convenience            and      – route         licence
     Necessity (PCN)                   required
   – burden of proof (of need        – more relevant for air
     for new services) is on
     applicant;                        and truckers
   – being replaced by Fit,          – licence may restrict
     Willing and Able criteria;        carriers to certain
   – no need to show need for
     new service                       commodities        or
   – common              carrier       classes of service
     obligation - must serve all
     requests from public;
        Exit Regulation
• Pre-Deregulation            • Post-Deregulation
                                 – can      apply    to     the
  – was            almost          regulatory agency to
    impossible           to        abandon branchlines or
    abandon                        exit from a route;
                                 – the      agency       either
    uneconomic routes              approve or give direct
    or branchlines;                subsidy     to     maintain
  – carriers were                  uneconomic services;
                                 – Usually required advance
    required to cross-             notice for a certain period
    subsidize between              before abandoning or
    profitable and                 exiting;
    unprofitable routes;
        Price Regulation
• Pre-deregulation period
   – carriers apply to regulators    • Post-deregulation
     for any rate change               period
   – regulatory agency can             – carrier simply files
     approve, deny or vary the
     changes                             proposed         fare
   – generally     no    inflation       changes, and make
     adjustments were built in           fares available for
     rates                               customers to look at.
   – burden is on the carrier to       – Regulator        can
     prove need for changes              disapprove or vary
   – unjust and unreasonable             changes in 'basic
     rates not allowed;
       • - e.g. youth fares can be
                                         fare    level'  upon
         judged as justly high           complaints
         monopoly or predatory
         prices can be judged as
       Rate of Return
• Regulatory authorities explicitly or
  implicitly used rate-base rate-of-return
  for the carrier when they examined
  proposal for fare change. If the carrier
  made more than fare returns, fare
  change proposal may not get approved.
  Condition of Service
• e.g.,  airline  regulation    in      pre-
  deregulation Canada included;
  – capacity offered
  – type of aircraft used
  – frequency of service
  – stopover condition;
  – e.g., PWA had to stop between Calgary &
  Effects of Economic
     Regulation 1
• Lack of competitive pressure to due
  regulatory protection
  – (entry regulation)
  – induces x-inefficiency in the industry - gold
    plating, fetter-bedding, etc.
  – encourages transfer of economic rents to
    organized input suppliers;
     • e.g., labour union, aircraft manufacturers.
  – dissipating economic rents the industry hopes to
   Effects of Economic
      Regulation 2
• Price Regulations
• leads to excessive quality competition
  – e.g., Douglas and Miller's work on airline quality
• the industry repeated vicious cycle of
  regulatory game.
• makes the system much less flexible and far
  more inefficient.
  Effects of Economic
     Regulation 3
• Cross-subsidization from profitable
  to unprofitable routes
• society as a whole loses as the total
  welfare gets reduced as compared with
  the following alternative solutions;
  – no cross-subsization
  – direct subsidy, by raising money from
    government general or through air
    transport tax.
   Effects of Economic
      Regulation 4
• Some regulatory commissions specify a rate-of-return
  constraint to guide decisions concerning raising or
  lowering prices. That is the regulatory authority
  allows a fair rate of return on the value of the assets
  ("rate base") required to produce the services.
• This gives incentives for the firm to increase its "rate
  base" by investing more on capital input relative to
  labour input; In other words, the firm under rate-of-
  return constraint has relatively more capital vis-a-vis
  labour than is required to produce any given output.
• This is an important source of allocative inefficiency
  caused by the regulation.
 Industry Performance
• Note that if market failure does not exist, there is no
  economic need for any economic regulation.
  Numerous studies have investigated the effect of
  regulation on the airlines, highway trucking, intercity
  bus, and taxicabo industries. In all four cases there
  is an ample body of empirical evidence which
  suggests that in the absence of regulation the market
  mechanism would yield an output close to a
  competitive equilibrium.       For these industries,
  economic regulation has become a prime cause of
  market failure, far from being a remedy for market
• Therefore, the impact of regulation on price and
  quantities traded in these industries can be assess by
• highly inefficient production and operation - x-inefficiency;
     – d(e.g., 16% cost increase due to this and crown ownership of
       carriers - see Gillen, Oum and Tretheway, JTEP, 1990);
• permitted artifically high price for labour input;
• some transfer of monopoly benefit to equipment manufacturers
  (eg. aircraft manufacturers)
• services not responsive to customer needs;
• allocative inefficiencies;
     – over-capitalization (A-J effect)
     – misallocation of traffic across modes
•   high cost of regulatory administration;
•   carriers lost dynamism - lack of innovations;
•   static welfare loss (deadweight) loss;
•   caused distortions elsewhere in the economy;
      Deregulation and
• early economic criticisms, 1940s and 1950s;
• growing number of academic researchers
  criticized during 1960s;
• critiques plus empirical measures of the
  economic cost of requlation in 1970s;
• deregulation gained political support in
• deregulation became a formal policy in the
  U.S. in late 1970s;
• deregulation of airlines in 1978, railroads and
  trucking in 1980;
Theory of Contestable
• Baumol, Panzar and Willig formalized the
  conditions under which natural monopolies
  could be expected to reach efficient equilibria
  without regulation, an idea put forward by
  Harold Demsetz earlier.
• broadening the areas in which the outcome of
  perfect competition applies;
• a broader condition supporting deregulation
  than perfect competition;
      Concept of
  contestable market:

• potential competition can replace actual
• single firm (monopoly) behave like
  competitive firm
• crucial conditions: free entry and exit
         Conditions for
(Levin, p.404);
• equal excess to scale economies and
• no sunk costs. a firm can enter and exit
  without entry and exit costs, including
  operating losses resulting from predation.
  – free entry: no entry barrier
  – costless exit
• price sustainability, there is a set of prices
  that can occur after the entry of at
         Implications for
• little need for regulation    Airline studies:
  if sunk costs low             • several studies pointed
• design regulation to            out (e.g., Bailey and
  focus on sunk costs;            Panzar).
   – regulate sunk facilities      – airline market is only
     only                            partially constable
   – modify institutional          – existence      of   actual
     arrangements for sunk           competition      is  more
     assets.                         effective than potential
• can        rely         on         competition
  contestability     theory        – fares in the markets with
                                     potential competition are
  only     partially       in        lower than completely
  deregulated        airline         monopoly market but
  markets;                           higher than the markets
                                     with actual competition.

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