Producer Protection, Prior Market Structure and the Effects of Government Regulation

 Introduction

The direct economic regulation of business by independent government commissions has a one-hundred year history on the North American continent. It is generally asserted that the purpose of such commissions is to protect consumers from exploitation by limiting the economic powers of certain firms having pervasive effects on the public interest (for example, transportation companies and public utilities). However, the findings of the relatively few em-pirical studies of the economic effects of regulation indicate that important differences actually do exist in these effects. The disparities in these findings raise the question of why the actual economic effects of regulation differ among industries despite the supposedly common, avowed purpose of regulation. They also question whether a single hypothesis is adequate to explain the diverse effects of regulation.

THREE HYPOTHESES REGARDING REGULATION

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• Consumer-Protection Hypothesis: This is the most popular of existing hypotheses. It implies that regulation will protect consumer interests by reducing prices until they equal marginal costs, by preventing discriminatory pricing, by improving service quality (at existing prices), by encouraging the entry of firms that are more efficient or that offer more preferred price/product combinations, and by reducing industry profits to the market rate of return. they often appear to promote the interests of regulated firms to the disadvantage of consumers. Despite the real purpose of regulation, the regulated industries have managed to pervert their regulators until the commissions become the protectors of the "regulated" rather than of consumers.
• No-effect Hypothesis: This hypothesis implies that regulation has no effect on regulated industries (other than to impose certain costs in the performance of regulatory procedures). This situation could result if
• an already powerful industry is able to control its regulators (the supplementary perversion hypothesis).
• if the market structure prior to regulation were competitive and the actual effect of regulation is to obtain competitive performance
• the prior market structure were monopolistic and the actual effect of regulation is to yield monopoly performance
• Producer-Protection Hypothesis: It says that the actual effect of regulation is to increase or sustain the economic power of an industry. Such a situation could result if regulation converted a formerly competitive or oligopolistic industry into a cartel (that is, if regulation helped previously independent producers form an agreement to act together9), if it increased the effectiveness of an existing cartel, or if it maintained an existing monopoly (or cartel) where rival firms would otherwise enter to provide competition in response to the growth of markets or the development of new technology.

Under this situation, one would expect to find regulation doing such things as increasing prices, promoting price discrimination, reducing or preventing the entry of rival firms, and increasing industry profits. The no-effect hypothesis does not appear to be generally descriptive of the effects of government regulation. The implications of the consumer-protection hypothesis also have a problem of reconciliation with available evidence and are quite inconsistent.

The implications of the producer-protection hypothesis do turn out to be consistent with much of the available evidence regarding the effects of government regulation, once recognition is given to the effects of the prior (non-regulated) market structures of various industries. The obvious way to test the ability of the producer-protection hypothesis to explain the apparently diverse effects of regulation within the context of prior market structure is to classify regulated industries into two groups on the basis of their non-regulated market structures, and then investigate the impact of regulation on industries within each group.

One group should include those industries whose prior market structure was a natural monopoly. This group would include electric utilities, natural gas pipelines, local gas distribution companies, telephone companies, etc. The second group should consist of industries having oligopolistic or competitive market structures prior to the implementation of regulation, for example, airlines, motor carriers, railroads, and water carriers.

If the producer-protection hypothesis is descriptive of the fundamental effects of regulation, one would expect to find regulation having little or no effect on the first group, whereas the second group would experience substantial changes following the effective implementation of regulation.

Natural Monopoly Industries

Among other things, effective monopolies are characterized by relatively high price levels, by extensive price discrimination, and by rates of return on investment exceeding those attainable if the firm operated in a competitive market structure. Thus, the producer-protection hypothesis implies that following the implementation of regulation over natural monopolies, the price level will be essentially unchanged and will be above marginal costs, price discrimination will continue to be widely practiced, and rates of return will remain above those which would exist under competition.

Price level

At least three studies have been made regarding the effects of regulation on electric utility price levels. Taken together, these three studies indicate that regulation has had a limited effect on lowering electric utility rates and that most of its benefits have been enjoyed by commercial and industrial consumers rather than the more numerous residential consumers. Also, it seems relevant that it took about 25 years for state regulation to be associated with any reduction in commercial and industrial rates, and around 45 years for it to be reflected in lower prices for residential consumers.

Davidson presented the price relatives of average gas rates charged by the Consolidated Gas Electric Light and Power Company of Baltimore from 1910. During the 43 years covered by these data, rates decreased from 1910 to 1918, then increased until mid-1923, decreased and then generally remained constant to 1947, increased sharply in two steps in 1947 and 1949, and then fell again in 1950. The Company was more active than the Commission in granting rate decreases, while the two instituted the same number of increases. Furthermore, it can be seen that the industrial users enjoyed proportionally more rate decreases than their proportional share of rate increases. Evidence shows that Company originated changes resulted in net rate decreases for all nine user categories with the major beneficiaries being the medium and large domestic users, and the large industrial users. In comparison, the Commission ordered or negotiated rate changes resulted in net rate increases for small and medium domestic users, and small commercial users, while the major beneficiaries of Commission actions were the large commercial and the small and medium industrial users.

Overall, the largest users enjoyed the greatest rate reductions during the 43-year period, while the smallest users either had small increases or decreases. This leads to the conclusion that factors other than regulation were important in these rate reductions. And the above evidence shows that the Commission's regulation did not always result in lower rates, and that the Company was more active than the Commission in instigating rate decreases.

Price Discrimination

The literature regarding public utility pricing is unanimous in agreeing that discrimination is widely practiced by electric utilities, natural gas pipe-lines, local gas distribution companies, and telephone companies. Stigler and Friedland found that in 1917 and 1937 both the regulated and the nonregulated electric utilities discriminated against domestic (residential) consumers in favor of industrial consumers, with no difference existing in the degree of price discrimination after allowance was made for the relative consumption of electricity by the two classes of consumers in the various states.

Thus, they concluded that regulation had no detectable effect on price discrimination. Some studies indicate that in those years price discrimination might have been even greater under regulation. Since price discrimination is a matter of price structure, it is clear that, regulation has had little or no effect on any price discrimination. The existing studies all indicate that regulation has not significantly decreased the power of natural monopolies to practice extensive price discrimination.

Thus, the producer-protection hypothesis seems to be more applicable in describing this situation than the consumer-protection hypothesis with its implication of a reduction in or absence of price discrimination. It is not surprising to find discriminatory pricing consistently practiced by natural monopolies, be they regulated or non-regulated. So long as economies of scale result in decreasing long-run average costs, marginal costs will lie below average costs, and equating a single price for all customers to marginal cost will result in the eventual bankruptcy of the firm and the termination of service. Even given the usefulness of discriminatory, multi-part pricing in sustaining a natural monopoly without subsidy, it should still be possible for regulatory commissions to reduce the price discrimination practiced by regulated natural monopolies relative to that practiced by those that are not regulated. The available evidence indicates that this has not been achieved.

Rates of Return

There is some evidence that regulation has not significantly altered the rates of return of privately-owned electric utilities. Specifically, Stigler and Friedland found no effect of regulation on stock prices of electric utilities from 1907 to 1920. Continuing plant growth and continuing flows of investment funds should be proof-of-pudding tests that the Commission restrictions have not yet become excessive constraints. The success of utilities in general in selling bond and common stock issues, and the lack of bankruptcies in "recent years" are evidence that the rates of return of regulated utilities have been at least equal to the market rates of return. The regulated rates of return have been high enough to attract the capital necessary for rapid expansion by the electric, gas pipeline, and telephone utilities, but there is no indication of how much different the rates of return or the growth rates of these utilities would have been without regulation.

Oligopolistic Industries

The producer-protection hypothesis implies that regulated industries whose natural market structures were oligopolistic or competitive prior to regulation will experience substantial changes following the implementation of regulation. There should be significant increases in price levels, price discrimination should be greater, and rates of return improved. Perhaps crucially important, the producer-protection hypothesis implies that effective regulation will also restrict or delay entry into the industry in order to prevent new suppliers from capturing some of the regulatory benefits gained by existing producers.

Price levels

Airline passenger fares within California have been subject to regulation by the California Public Utilities Commission (PUC), but, in contrast to the complete regulation of both fare decreases and increases, through 1965 the regulation was limited to automatically approving all proposed fare decreases while imposing brief delays on the implementation of requested fare increases. The result of these differences in regulation was that coach fares within California were consistently lower than such fares in similar regulated markets.

The available evidence regarding the effects of regulation on price level for formerly oligopolistic industries is consistent and unambiguous. Regulatory actions and procedures have allowed the carriers in each industry to reach agreements regarding prices and to enforce adherence to these agreements. The result has been substantial increases in price levels for the interstate airlines, the freight motor carriers, and the railroads.

Without regulation prices would be from 9 to 50 per cent lower than they are with regulation, with many reductions in the long-run exceeding 30 per cent. Price Discrimination A consistent pattern also emerges regarding price discrimination by these three transport modes. Large differences have been found in the extent to which price discrimination has been practiced by the CAB-regulated interstate airlines (with their much higher price levels) compared with the relatively non-regulated California intrastate carriers.

The time honored use of the value-of-service method of pricing in establishing rates, the adjustment of the resulting rates in response to intermodal competition, the relatively low marginal costs of movements combined with large fixed costs, the extensive joint production and common costs, and the application of commodity rates to 85 per cent of all rail freight traffic, have combined to make the use of discriminatory pricing the norm among the railroads.

Over 100 years of development have resulted in a marvel of complicated discriminatory pricing. Given the pervasiveness of price discrimination in rail and motor transportation, the question arises whether regulation has significantly changed the degree and amount of discrimination. it does appear that personal discrimination has been reduced. Due to the usefulness of the regulation in sustaining rail-road rates, the need for personal discrimination was largely eliminated.

Its demise is not therefore surprising. Since regulation provides such rate control, it appears to have made possible the pervasive and long-lived commodity price discrimination practiced by the railroads and to have supported their extensive use of locational discrimination. An even greater effect on price discrimination has resulted from the application of regulation to the motor carrier industry.

Since monopoly power is a necessary condition for price discrimination, and since regulation appears to be necessary for monopoly to exist in the motor carrier industry, it follows that regulation has been the primary cause of price discrimination in this industry, and that much less discrimination would exist without regulation. In total, the above analysis shows that regulation has been the essential ingredient for long-term price discrimination in those transportation industries whose nonregulated market structures would be oligopolistic or competitive.

Rate of Return

It proved difficult to estimate whether public utilities have been able to obtain higher than market rates of return under regulation. This is also the case for the transportation industries. Since regulation has clearly resulted in increased price levels and greater price discrimination among the airlines, motor carriers, and railroads, one would expect increased rates of return to be a result. Data indicate that railroad profits did increase during the period that effective regulation was being developed, and prior to the beginning of the railroad's decline.

This conclusion is supported by the history of the railroad's rates of return on book investment from 1890 to 1968. Just as monopoly power is no guarantor of excess profits, it can be seen that regulation does not guarantee the achievement of greater than market rates of return by an industry, especially one that is in secular decline. from 1956 to 1965, the most successful of the California intrastate carriers (Pacific Southwest Airlines) had returns on stockholder equity of from 0. 0 to 227. 2 per cent, with most returns being between 30 and 45 per cent. 4 On the face of it, this indicates that while the CAB has approved liberal rates of return and that such returns have been achieved in some years by the regulated airlines, the most successful non-regulated airline has enjoyed generally higher returns. Overall, the above evidence is quite inconclusive regarding whether regu-lation has raised the rates of return for these regulated industries. Entry Control There was no need to consider entry control in the case of the public utilities since, as natural monopolies, only one firm can operate efficiently in any market.

Therefore, the most regulation can do is to decide which one of several alternative firms should be allowed to provide the desired service in various markets. Assuming comparable operating efficiency, this is a matter of a wealth transfer between individual firms with little effect on fundamental economic results. Wherever two or more firms can survive in a market, how-ever, entry control is vitally important for the maintenance of a monopoly or cartel. Without such control, any larger than normal profits will attract new suppliers to the industry, thereby reducing the benefits available to the exist-ing producers.

Thus, an indication of producer protection by regulatory com-missions is their effectiveness in limiting entry into an industry. It is important to note, however, that while regulation has served to re-strict entry and hold down the number of regulated airlines and motor carriers, it has failed to limit the inflow of resources into these industries because of two fundamental imperfections in the regulatory framework. The first imper-fection results from there being little or no control over the amounts of re-sources each existing carrier can bring into the industry.

The second stems from the fact that the CAB and the ICC have no power to assign specific market shares to individual carriers where two or more carriers are authorized to provide comparable service. Since regulation prevents the carriers from utilizing price rivalry to obtain larger market shares, they turn to service-quality rivalry in their endeavors to obtain increased shares of the cartel benefits available in each market. The result is chronic over capacity despite (or because of) regulation.

Conclusion

The evidence presented above has not always been clear and unambiguous, but the essential thrust has been consistent with implications derived from the producer-protection hypothesis, once the effects of prior market structure were taken into consideration. In important respects, regulation has not had significant impact on public utilities (whose non-regulated market structures are natural monopolies), whereas it has substantially influenced the transportation industries (having oligopolistic or competitive non-regulated market structures). With regard to price level, regulation has clearly increased the prices charged by airlines, railroads, and freight motor carriers. In contrast, it ap-pears to have had only limited and long-delayed effects in lowering electric utility rates, with most of the few regulatory benefits going to industrial and commercial consumers, that is, to the consumers who already possess consider-able market power and whose large use of electricity makes it worthwhile to seek to influence regulatory decisions. In addition, the evidence from one local utility shows that gas rates were increased and decreased by both regulatory and company actions, with no clear pattern of regulatory effects. There was a similar pattern of effects regarding price discrimination. Little change in this practice resulted from regulating the natural monopolies, except for those cases where discriminatory prices appeared.

On the other hand, industries whose prior market structures were oligopolistic or competitive were able to practice extensive price dis-crimination with regulation, while they had difficulty doing so without it. The evidence regarding rates of return is quite inconclusive. Overall, remarkably little of the available evidence suggests that consumers are protected by regulation. The producer-protection hypothesis yields implications that, by and large, are consistent with what is found to have occurred as a result of regulation. It follows that wherever substantial monopoly power exists in a non-regulated market structure, regulation should have relatively little impact; and, where there is little or no monopoly power in the prior market structure, regulation should have an important impact by help-ing formerly independent producers form a cartel for their benefit and protection. It is probably incorrect to conclude that the producer-protection hypothesis is the most predictive of all possible hypotheses regarding the effects of government regulation.

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