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Competition and Regulation

APRIL 26, 2000

Thank you very much for that kind introduction. It is a great honor for me to be here at Eastern Connecticut State University.

I once thought about writing a book on regulation and I went to see a very prominent book agent a few months ago about this project. Someone referred me to a book agent and told me, "This is the book agent who really understands regulation and is very sympathetic to the idea of a book on regulation."

So I called him up to schedule an appointment and he said, "You want to write a book…. What's it on?"

I said, "Well, it is on regulation."

He said, "Books on regulation do not sell. I am really not interested in a book on regulation."

I responded, "Well, I am with the FCC. I think I have some new ideas about regulation."

And the agent said, "Look, kid, you want to write a book about sex, a book about health, I can sell that book--no one wants to read your book about regulation. Why don't you save yourself some time and photocopy your ideas and give them to your ten closest friends? They are the only people that would ever buy your book on regulation."

Needless to say, I am just glad I did not talk to the book agents who are not sympathetic to a book on regulation.

The topic today is about competition and regulation. Some might think that is an odd combination. In some views, competition is the antithesis of regulation. Purely competitive markets are absent regulation. Likewise, heavily regulated markets are absent competition. Economists know a great deal about the theory of competition and a great deal about the theory of regulation. Today, I want to talk about the practical side of regulation from an economist's perspective.

Bear in mind, it is tough to be an economist in Washington. Sometimes you feel like you have to park your brain at the beltway before you are allowed inside. There is a common saying in Washington, "We need regulation to promote competition." This idea grates on the nerves of a lot of economists. It is like saying, "We need cigarettes to promote a cancer-free society." Taken to its logical extreme, if everyone died from cancer, we would have no more human cancer. And if you regulate everything that is over-regulated anyway, there won't be any more competition.

I have not come here today to discuss the subtleties of regulation rhetoric, but I have come here to discuss the economics of regulation--how regulation is made and the resulting limits placed on competition. I am going to discuss regulation from an economist's perspective. I am going to suggest that there is a market for regulation with demand for, and supply of, regulation.

But first, we need a few simple definitions about what regulation is. To some extent, regulation is simply the government stepping in to markets to compel results that the market would not have otherwise reached. That is not necessarily bad. Sometimes it can even be good.

The government does this through four branches of government: the legislators who write the laws; the executive branch which enforces the laws; the judicial branch which resolves disputes; and a strange hybrid called "independent regulatory agencies" which combine elements of all three of the other branches.

Demand for regulation

What is the demand for regulation? The demand for regulation is not from consumers buying books about regulation, but there is demand from whenever there is a market failure. There are various externalities that may lead to consumer demand for regulation that you learn about in your economics courses. These include instances where there are high transaction costs, high enforcement costs, high litigation costs, or simply where consumers have a substantial degree of risk-aversion that can be mitigated or diffused as a result of regulation. In all four of these areas, the concept of regulation is to support basic property and contract rights, not necessarily to come up with something different.

Ultimately, consumers want regulation where the benefits of regulation exceed its costs. This simple idea has yet to arrive in Washington where the benefits of regulation are often touted but the costs are never tabulated.

There are some groups that claim they speak for all consumers on regulation. Frankly, however, it is impossible to speak for all consumers because each of us is different. Individuals have different demands and preferences. When a group says, "We are here to represent the consumer interest," that can be a little self-serving and sanctimonious because, in fact, they cannot possibly be there representing all consumers.

There is also a bureaucratic demand for regulation. There are a lot of bureaucrats who have jobs as regulators. They do not want to lose those jobs. It is also a source of power. There is a sort of realpolitik involved in regulation. People not only make careers out of regulation, but they do a lot of things -- some things good, some things not so good -- based on regulatory power.

There is a third source of demand for regulation. It is a constituency group, if you will, which advocates regulation. It is the service industry--the lawyers and the accountants whose job it is to interpret the regulations, to do lobbying on issues of regulation, to provide the public with ways of understanding how to deal with regulation. It is a huge industry in Washington and state capitals around the country.

Finally, businesses demand regulation. Some businesses favor regulation. Various forms of regulation may favor some businesses and may harm others. But businesses are a very large part of the need for regulation.

Economists look at the demand for regulation and note that there are three types of influences on demand: (1) the own-price effect; (2) the cross-price effect from other forms of regulation and; (3) the income effect. Let us examine each of these in turn.

Own-price effects

The own-price effect of regulation varies for different consumers. Consider the fuel efficiency standards for cars. The standards can be costless for some consumers who do not own a car, yet can be very costly for other consumers who own cars that expend large volumes of fuel. As the standard for fuel efficiency is tightened, the cost of the regulation to the consumer increases and consumer preferences for the regulation decreases. Still, for other consumers, the own-price effect of a regulation is unknown because the regulation only indirectly affects the consumer. The same can be said for practically every sort of regulation.

What is the own-price effect for businesses? Just as varied as it is for consumers and perhaps more so. This is because regulations directly affect businesses; regulations do not directly affect consumers. We cannot change a consumer's preference. We can tell businesses what they can or cannot do. That is what regulation is.

From an economist's perspective, regulation affects the supply side of the market. Let me assure you: businesses approach Congress and independent agencies early and often to lobby on various regulations. They always want less for themselves and more for their competitors. That is the nature of business.

Cross-price effects

What are the cross-price effects of the demand for regulation? Prices for some goods and services can affect the demand for certain regulations. For example, as the price of gasoline increases, consumer demand for larger automobiles decrease as does the incremental cost of fuel-efficiency standards on large cars. Conversely, as the price of gasoline falls, the more some fuel-efficiency standards become a binding constraint.

The cross-price effect which derives from alternative forms of regulation is perhaps the most interesting but least observable form of cross-price effects. These are even harder to observe than the own-price effects. Consumers are often unaware of competing forms of regulation that might be available and that might have the same or greater beneficial effects than the one that is actually in place. Consumers are even less aware of the price that might have to be paid in order to obtain the alternative form of regulation.

Large corporations that routinely lobby Washington have the clearest sense of the cross-price effects of the demand for regulation. As the likelihood of implementing alternative regulatory regimes fluctuate, corporations channel lobbying resources to increase the likelihood of adoption of regulatory structures most favorable to the corporation. In some sense, the shadow price of an alternative regulatory structure is the present discounted value of the cost required to get the alternative structure selected and implemented plus the ongoing maintenance cost for the regulatory structure once it is in place. The calculus of quantifying these costs and likelihood of implementation is necessarily very crude.

What are the alternatives to a specific form of regulation? Well, this turns out to be a very interesting question--perhaps the most interesting one on the demand side of regulation. In many cases, consumers do not have alternatives to a specific form of regulation because paradoxically, regulation is a government monopoly. Consumers must take it or leave it. They do not have a choice of saying, "I would like that regulatory structure over there please."

That is not the way it works.

There is, however, a limited extent of consumer choice on regulation in our federal system. That is, consumers can drive across the state boundary and go to Rhode Island or Massachusetts to purchase certain goods that may have a lower tax than applies in Connecticut. Or one can go on the Internet and make certain purchases without state and local taxes.

But if a consumer wants an alternative regulatory regime for the chemical treatment of the tap water to wash dishes in his home or apartment, there is not really a lot of choice on that issue. Consumers must accept the regulatory regime in place.

There are however, some services for which consumers have an increasing choice of regulation.

One example is long distance phone service--a heavily regulated business. Increasingly, however, consumers have the alternative of going to the Internet for equivalent services. This is true whether they are simply sending an email or using software to actually do voice-grade services over the Internet thereby avoiding a lot of regulations that affect long distance phone service as well as avoiding a lot of the access charges. In this case, it is very clear that the cross-price effect on the demand for regulation is quite substantial. That is to say that an increase of Internet regulation in all likelihood would increase demand for long distance phone services. Alternatively, regulation on the Internet is kept very low, demand for long distance phone services will decrease.

It is not surprising to see a lot of telephone companies come into the FCC to lobby for more regulation on the Internet precisely because the Internet is cutting into their business. As regulated businesses, they do what they do. Businesses also have another type of cost-price effect, that is, they always have the option of lobbying to have regulations changed and they do this every day. Thus, the cost and success of this lobbying effort in part determines what the cost-price effect is on demand on other forms of regulation.

Income effects

What are the income effects of the demand for regulation? As income increases, does demand for regulation wax or wane? No one knows for sure.

It is a little hard to tell. There are some societies that have very high incomes and have a lot of regulation--the Scandinavian countries for example. There are other economies that have high incomes but do not have nearly as much regulation, and the United States probably falls into that category. There are a lot of economies in the world that do not have much regulation at all. A lot of them tend to be poor, and they tend to have informal rather than formal regulation. In general, it is difficult to associate increases in income with a specific regulatory scheme.

Other demand characteristics

I talked briefly about the economic characteristics of demand for regulation. Let me discretely mention some other types of consumer demand characteristics for regulation. First is transparency. It is important to know how choices are made and implemented. Second is predictability: It is important to know how regulations are going to be applied. For example, citizens like to know before they go to the state department of motor vehicles exactly how one should apply for a driver's license. People generally like to know what the booklet says before going to take the test--lest they arrive at the DMV and only to discover "Oops, they have a different set of questions today." Thus we need to know that the process is going to be both predictable and applied in a consistent manner. Third, it is also important to know that there is certain rationality for it--that the benefits will exceed the costs.

Nondiscrimination in the regulatory process

A final characteristic--and I'm going to discuss this in some detail--is regulations should be applied in a nondiscriminatory manner. That is, we would like to know when we are at the department of motor vehicles that the clerk is going to treat us no differently than the person ahead of us or behind us. This turns out to be a very important concept to regulation and it becomes particularly important when there is some concern that regulations may be applied in different ways depending on the political views of the people who might be regulated.

Americans are an opinionated lot. We have personal views on politics and just about anything including the weather. We like to express our views but we do not necessarily expect other people to change their behavior based on our particular personal views.

Try this experiment the next time you are in a grocery store: Strike up a conversation with the cashier and say what your personal views are on environmental policy and see if the cashier will reduce your bill. Needless to say, your efforts will probably be unsuccessful. Of course, there will be no difference in the amount charged. A few comments might provoke a smile or a frown but little else.

Americans demand and expect to be treated the same as every other American. Now, flip the experiment around. Suppose the cashier strikes up a conversation with you and says, "These are my views on the environment" and offers you a 10% discount if you will sign a petition supporting the cashier's view on the environment. Additionally, the cashier says she will charge you 10% more if you refuse. Would you be offended? Of course you would. Quite possibly you would march to the manager's office and demand that that cashier at least refrain from this practice, if not be fired on the spot.

When it comes to business dealings, Americans expect to be treated the same as anyone else regardless of the policy viewpoints we hold or the policy viewpoints that other people may hold. Businesses that treat customers differently tend to go out of business.

Expectations of nondiscriminatory treatment based on viewpoint extend not only to business dealings but to government activities as well. A parent would be dismayed if the principal of the school set school rules that favor or disfavor children based on the political viewpoint of the child or the parent. A property owner would be offended if the county council set property taxes based on the political viewpoint of property owners.

Americans are not so naïve as to believe that lawmakers and rulemakers have no political views. Of course they do--whether they are members of the Congress, state legislature, county council or the local school board. But Americans do expect the laws and rules that such entities write to apply equally to individuals and businesses. Citizens also do not expect laws or rules to single out individuals for reward or punishment based on viewpoints that they may hold.

Our expectations of neutrality also extend to those who enforce laws and those who adjudicate disputes. Do not expect a sympathetic view on an environmental policy issue the next time a police car stops you for speeding on the turnpike. The traffic officer is simply going to write a ticket regardless of your viewpoint. Do not expect the traffic court judge to be sympathetic with your environmental policy either. It will not help to explain your environmental policy viewpoint in an attempt to get out of the ticket.

Again, it would be equally shocking if the experiment were reversed. If a person was stopped on the interstate for speeding and the policeman said, "You know, here is my view on the environment. Sign this petition or I will give you a ticket." We would be outraged. Similarly, it would be shocking if the judge said, "You know your stock of good will in this court has been greatly diminished because you wrote to your Senator requesting support of environmental legislation with which I personally disagree. You should do something to improve your good will for parking in the no parking zone."

Americans expect government officials - whether federal, state or local - to treat everyone anonymously. It is not expected that behavior in unrelated matters will be held against us by government officials.

Now, why have I gone through this lengthy discussion about nondiscriminatory application of regulation? I have gone through it because all too often regulators in Washington would say, "You know, you want these licenses transferred so your merger can be approved. Well, we have a little problem over here that is unrelated to the license transfer, but maybe we can work something out."

Or: "You are pushing for this legislation up on Capitol Hill. It would help you and this agency, if you did not push that legislation."

Or: "You are involved in this litigation over at that court. Things might happen a little speedier over here if you drop that litigation."

Actually, people in Washington are quite public and brazen about it. An irate official in my agency recently admonished a major Washington trade association. The official said, "The stock of good will of this trade association has gone down because of their lobbying activities on Capitol Hill."

Now stop and think about that. What does it mean to have good will at a regulatory agency? Does it mean you get treated differently than the other people waiting in line at the agency? Does it mean that regulators treat people or groups differently depending on how much good will they have? And how do you get good will? And how do you lose it? Must you check your First Amendment privileges at the door when you walk into a regulatory agency?

Supply of regulation

But let me just move on to the supply of regulation. I have spent most of my time talking about the demand for regulation. The question is whether federal regulators supply regulation. Keep in mind my earlier point that regulators are monopolists. We are the only game in town. In economic terms, that means regulators are not price savers. We do not look out into the marketplace for regulation and say, "Well, this is the price for this type of regulation."

In economic terms, there is simplicity in having monopolists set marginal revenue and marginal costs. What does this concept mean for the monopoly supply of regulation? Whose revenue and whose costs does the government consider when setting prices? Is revenue defined as cash revenue to the government or some other certain social welfare function? Who knows what that is? Are the costs those incurred by the government, the regulated entities, consumers, or some combination of the above? Is it the same calculus of regulation, and the same process for its development, at all government agencies?

If regulation were competitively supplied, one would like to believe that, on balance, only regulation for which benefits exceed costs would survive in the marketplace. But in part, because of the nondiscriminatory principle that I just described, there would have to be a single set of regulations applied equally to everyone. It is likely that, even in a competitive market, some regulations would have costs that exceed benefits for some individuals and not for others.

Some political scientists think that all regulators are captured by some industry group. I do not think that is accurate, but certainly it can be said that different industries are regulated in different ways, and that businesses within the same industries are regulated in different ways. The net effect of this is something that is far different from uniform regulation.

What else do regulators do on the supply side? They can and do write extraordinarily complex regulations--regulations that favor the service industry. They favor all the lawyers, accountants, lobbyists, and even economists who make their livelihood based on interpreting regulations. If it were too simple and transparent there would not be anything for these people to do.

My favorite example is a cost model for telephone service that the FCC developed. Now, I do not know if any of you are computer programmers. You do not really have to be a computer programmer to understand this example. The FCC came up with a cost model to predict the costs to provide telephone service anywhere in the United States and the cost model takes 180 hours to run--not 180 minutes, not 180 seconds, not 180 nanoseconds--180 hours. That is more than a week to get one run out of this computer.

Now, in my formative years, I used to actually be a computer programmer. Even in the Dark Ages years ago, if a program ran for more than 18 seconds, it was probably broken--there was something wrong with the program. 180 hours. I cannot tell you how much it costs the government to pay these bright computer programmers to write a cost model that takes 180 hours to run. Let me assure you it probably cost a lot of money because no self-respecting computer programmer would possibly write such an ill-conceived program.

But that is not the end of the story because the FCC insists on using this cost model that everyone in the world knows does not work. No one believes the results that come out of this cost model but the FCC insists on using it in lots of different proceedings. It is mind-boggling that this occurs; but it helps promote the service industry. Lawyers, accountants and now computer programmers who specialize in writing computer programs that do not work have greater job security.

Guiding principles of regulation

There are four potential guiding principles for regulators. The first is to simply follow the laws as written. That is what I always say, just "follow the law" - when in truth, the law is often vague. So, what do you do then?

Well, another guiding principle might be "deregulate." What if that is contrary to the law? Sometimes the law requires regulation, and then you must regulate. But other times, regulation is neither required nor contemplated in the law. Ultimately, both regulation and deregulation must be based on the law. So, even if you believe in deregulation, I think it has to be sort of a secondary principle to the primary one of following the law.

The third principle that we all hear about is to "protect the consumer." Again, this is best accomplished by either following the law or by something within the purview of the Federal Trade Commission.

The fourth principle and perhaps most dangerous is called "promoting social values." That is fine if that is what the law tells you to do. If it is not, then it is an uncontrolled license to go off and do "good" things. It is important for the government to do good things, but it is more important for the government to do that in a way that is consistent with the law--not just what some individual happens to believe at any given point in time.

If one follows the first two principles, one has a realistic chance of having regulation that does not prevent competition. Competition is very important, and more is always better than less. Some agencies are assigned by law specific responsibility for competition in certain aspects of certain markets, and this is certainly the case for the Federal Communications Commission. Our mandate for competition, however, is not unbounded. Nor can just any form of regulation be rationalized under the broad rhetoric of "competition." Indeed, in its purest form, competition occurs only in the absence of government intervention. Consequently, it is difficult to craft regulations that create government intervention for the ostensible purpose of promoting competition. The most rational form of such regulation indeed is often to dismantle other forms of government interference that inhibit the development of competition. Ultimately "competition" as an objective of regulation is about following the law.

Techniques of regulation

Even if one has the right principles of regulation, what techniques can regulators follow? The ultimate aim of these techniques is to minimize arbitrary discretion. There are three elements necessary to meet this goal.

The first is to have simple, visible rules.

The second is to have a transparent process. The Department of Motor Vehicles is a prime example of a good, well-run agency. Many think it is grossly inefficient. There may be a long wait in line, but everyone is treated the same. The process is very predictable, everyone knows how it works. DMV's handle millions of people all the time.

The third element would be nondiscriminatory treatment--ensuring that everyone is treated equally.

Following these three techniques results in benefits that are greater than costs. There is, however, another approach.

Maximizing agency discretion

A different type of technique might be to maximize the discretion of an agency This is the bureaucrat's dream. A lot of agencies try to maximize the discretion of the agency. One might wonder how this is accomplished.

First of all, there would not be written rules. One might say, "well of course, they would have certain rules." This is not the case at the FCC. The Commission does not have written rules about a lot of things. For example, there are not written rules about how license transfers are reviewed. There are hundreds of thousands FCC licenses out in the world. Tens of thousands of these are transferred between parties every year. But there are not any rules about how the Commission will review those. Instead, the FCC has a "public interest standard." This ultimately means that 99% of licenses get transferred without any questions and 1% of licenses get pushed into a separate category for special treatment.

The second way to maximize discretion is not to have a transparent process. Do not let the public know what is going on.

The third is to have discriminatory treatment--to treat different parties, different industries, different businesses differently depending on who they are. Promote the idea that there is such a thing as good will at the agency. Capitalize the agency. Apply its criticisms and threats and never calculate the costs or benefits of regulation.

If you take a class on public finance here at the University, one of the first things taught is cost/benefit analysis. There is a lot written by economists on how to perform cost/benefit analysis. I regret to tell you that there is not a single agency in Washington who does cost/benefit analysis on many regulations promulgated by that agency. At the vast majority of agencies in Washington, absolutely no cost/benefit analysis is ever attempted. The FCC is one of these agencies.

When I worked with the House Commerce Committee, each year I would send out a form to every agency requesting a list of all the regulations for which the agency had conducted cost/benefit analysis. That would go to about 20 agencies overseen by the Committee. Not a single agency came up with a list. Most--probably 18--had none, and only a couple had done one or two cost-benefit analyses.

Hence, this is how agency jurisdiction and discretion is maximized. You say that you have the authority to do whatever you want to do. The net result of this maximization of discretion is that there is no way to know if the benefits of regulation are going to be good.

Let me just conclude with a story that is a little bit too close to home. There was a broadcaster who was trying to get a license transferred at the FCC. He was having a lot of problems. The broadcaster went to visit a regulator who showed him all sorts of forms that had to be filled out, all sorts of fees that had to be paid, all sorts of taxes that had to be paid, and all sorts of petitions that had to be filed.

The regulator asked him, "Do you know how to do this? Do you know how to fill out these forms?"

The broadcaster was stunned and kept saying, "Well, I do not know. The good Lord has looked after me, and I am sure the good Lord will see me through this."

At the end of the day, the regulator shakes his head and goes to see one of his colleagues and says, "Well, I have good news and I have bad news. The bad news is this broadcaster has no idea how this agency works, no idea how we expect broadcasters to behave. The good news is, he thinks we're God."

With that I will close and open for questions.