This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research Volume Title: American Economic Policy in the 1980s Volume Author/Editor: Martin Feldstein, ed. Volume Publisher: University of Chicago Press Volume ISBN: 0-226-24093-2 Volume URL: http://www.nber.org/books/feld94-1 Conference Date: October 17-20, 1990 Publication Date: January 1994 Chapter Title: Economic Regulation Chapter Author: Paul L. Joskow, Roger Noll, William Niskanen, Elizabeth E. Bailey Chapter URL: http://www.nber.org/chapters/c7757 Chapter pages in book: (p. 367 - 452) 6 Economic Regulation 1. Paul L. Joskow and Roger G. No11 2. William A. Niskanen 3. Elizabeth Bailey 1. Paul L. Joskow and Roger G. No11 Deregulation and Regulatory Reform during the 1980s According to political and journalistic rhetoric, the United States relies on a market economy to allocate economic resources. Thus, the forces of supply and demand, largely unfettered by government intervention, are regarded as determining the quantities, qualities, and prices of goods and services that are produced in the domestic economy. The roots of this belief probably lie in two distinctive features of the US.economy: (i) the extent of private ownership of capital combined with relatively little public (nationalized) enterprise and (ii) the absence of strong, centralized economic planning. Nonetheless, this common belief is largely a myth. Through civil law and regulation, federal, state, and local governments have a substantial effect on almost all industries. Civil law limits property rights, defines contractual obligations, and sets quality standards for goods and ser- vices through tort law. Regulatory policy takes two general forms. “Economic” regulation controls profits, sets prices, and determines who can participate in a market or use a particular resource. “Social” regulation controls polluting by-products of production, sets health and safety standards for products and workplaces, restricts the content of information provided by sellers through advertising and other means of describing products to consumers, and estab- lishes requirements to protect buyers from fraudulent, discriminatory, or in- competent behavior by sellers. All these policies profoundly affect prices, 367 368 Paul L. Joskow and Roger G. No11 costs, product quality, the dynamics of business competition, and the allocation of resources in the economy. From approximately 1970 through 1990,’ federal regulatory policy in the United States experienced profound and far-reaching change. The period is defined by the passage of perhaps the two most economically significant regu- latory statutes in the nation’s history: the Clean Air Acts of 1970 and 1990. The 1970 act was quickly followed by a five-year succession of bills regulating workplace safety and health, water quality, product safety, the price of oil, the environmental effect of all construction projects requiring federal approval or expending federal funds, the safety of consumer products, the management of employee retirement funds, and the operation of futures markets. The cumula- tive effect of these acts was to expand regulation dramatically-a change in policy that is comparable to, or perhaps even exceeds, the regulatory policies enacted during the mid- 1930s under the administration of Franklin Roosevelt but that was accomplished under the putatively conservative administration of Richard Nixon. After a decade of no significant new social regulatory statutes, the Clean Air Act of 1990 again substantially expanded environmental regula- tion by enacting strict new policies regarding acid rain, auto emissions, and airborne toxics. As the ink dried on the expansive environmental, health, and safety regula- tory statutes of the 197Os, the scope of economic regulation began to recede. Price, profit, and entry controls in transportation, communications, energy, and finance were either eliminated or dramatically relaxed. By the early 1980s, much of the Roosevelt-era system of economic regulation was gone; however, the Nixon-era reforms in social regulation remained largely in place. By the late 1980s, considerable experience with relaxed price, profit, and entry con- trols had accumulated. The specter of reregulation loomed over some indus- tries. The rationales, causes, and consequences of “microeconomic” regulatory interventions have always been the subject of considerable political and intel- lectual controversy. The dramatic policy changes of the period reflect these disputes. This chapter examines the nature, causes, and consequences of changes in economic regulation during the 1980s. (Kip Viscusi’s essay in this volume covers environmental, health, and safety regulation.) We begin with a discussion of the economic and political theories of eco- nomic regulation. We then summarize the major changes in economic regu- lation during this period. Finally, we offer our conclusions about which economic and political variables appear to be responsible for stimulating eco- nomic regulatory change during this period. The industries affected by the reg- ulatory reform movement have diverse characteristics, so the fact that changes occurred in so many industries at about the same time is almost certainly more 1. All choices of dates to demarcate an era are somewhat arbitrary. 369 Economic Regulation than mere coincidence. Yet simple explanations for the question, “Why now?’ are elusive. 6.1 Economic and Political Theories of Price and Entry Regulation The task of theories of economic regulation is to explain and predict which markets will be regulated and with what effect. Any such theory must deal with both the economic and the political spheres of human behavior. Presum- ably, the performance of a market generates the desire to change the behavior of those who participate in it. The actions that change market interventions are taken by political actors: civil service bureaucrats, political appointees (who manage regulatory agencies), Congress and the president (who collaborate on regulatory legislation and budgets), and the courts (which interpret statutes and determine the legality of regulatory agency decisions). Thus, a theory of economic regulation must account for why the events in a market lead to the political act of policy change. Economics and political science offer several explanations of changes in regulatory policy. Each discipline has a purely normative or “public interest” version, which starts with the proposition that regulatory policy is designed to advance public welfare. Likewise, the two disciplines contain several “posi- tive” theories (i.e., purely predictive and free of normative motivation, al- though not free of normative implications). We will begin with the normative theories and then describe the positive ones (for a more complete discussion, see No11 [1989]). 6.1.1 Normative Economic Theory The traditional economic “public interest” rationale for price and entry regu- lation turns on perceived failures of unregulated markets to yield reasonably competitive behavior and performance in certain circumstances. Although markets can fail if consumers are poorly informed, historically “natural mo- nopoly” or “natural oligopoly” has been the most important rationale for intro- ducing price and entry regulation (Schmalensee 1979). Specifically, when production is characterized by significant economies of scale and sunk costs, market structure, behavior, and performance may depart significantly from the perfectly competitive ideal. Industries with these characteristics will “natu- rally” evolve toward monopolies or oligopolies, with adverse efficiency and distributional consequences. Dynamically, in the absence of price and entry regulation, industries with these characteristics are said to be characterized by at least one of several problems: excessive entry, costly duplication of facilities, either monopoly exploitation or unstable prices and “destructive competition,” excessive investments to deter competitive entry, and a variety of other perfor- mance failures. Several distinguished nineteenth- and early twentieth-century economists argued that, in industries with these characteristics, performance would be im- 370 Paul L. Joskow and Roger G. No11 proved by having a single firm supply the service and subjecting its prices to government regulation (Sharkey 1982,12-28). It was argued that entry restric- tions would ensure that the efficiencies associated with economies of scale were achieved and that cost-based price regulation would pass on the effi- ciency gains to consumers. Since the seminal article by George Stigler (1961), economists have devel- oped a comparably rich literature on the performance of markets in which consumers are poorly informed. Even when such markets are structurally com- petitive, some firms may be able to sustain monopoly prices, and firms may be inefficiently small. Normally, informational requirements are the recom- mended solution, but complex products with arcane characteristics may re- quire price regulation to prevent monopoly pricing. These market failure stories have several flaws as either a normative or a positive theory of regulation. First, once any significant degree of informa- tional imperfection or economies of scale and sunk costs is incorporated in market models, market outcomes will depart from the perfectly competitive ideal. But these models provide no clear way to identify industries where, in the absence of regulation, industry performance will be sufficiently