Chapter 16: The Regulation of Potentially Competitive Markets: Theory and Estimation Methods

Issues:

1. If there is no market failure, why is there economic regulation (usually in the form of price or entry/exit controls) of potentially competitive markets (such as elements of the transportation industry-railroads, airlines, trucking)?
2. What are the effects of regulating potentially competitive markets (price, service, market structure, productivity, dynamic efficiency)?

Direct Effects of Price and Entry/Exit Regulations: The Competitive Model

Very simplified case-assume that in an unregulated environment the industry structure would be a competitive equilibrium.

In a long-run competitive equilibrium all firms are operating an output level such that market price P* equals marginal (and average) cost at the minimum point on the average cost curve. Thus both allocative and economic efficiency are realized. For a given technology and market demand there will thus be a static number of firms N.

Regulation sets a price Pr > P*, and imposes a barrier to new entry: What happens is similar to the displacement of a long-run competitive equilibrium by a permanent increase in demand combined with a barrier preventing new entry. With Pr > P* we first find the market-clearing quantity Qr. Next we assume that each of the incumbent firms (possessing identical technology and thus identical costs) simply produce qr = Qr/N units of output, which is less than q* (why?). In the short run each firm is now operating at a point on its AC curve to the left of the minimum point (why?). Thus in the short run this form of regulation yields a failure of allocative efficiency (Pr > MC) and thus a deadweight social loss of [Q*-Qr]*[Pr-P*), as well as a failure of economic (or productive) efficiency because AC(qr) > AC(q*) and thus a welfare loss rectangle of [AC(qr)-AC(q*)]*Qr. NOTE: If regulators retained the regulated price Pr but removed the entry barrier, would free entry increase or decrease welfare as measured by total surplus? HINT: entry continues until profit is zero (Pr = AC); what does this imply about how production scale of each firm and how the total market-clearing quantity Qr is divided up? Does this affect economic efficiency? What about allocative efficiency?

What if firms can engage in non-price competition in an attempt to differentiate their product from that of other firms? In the case described in the preceding paragraph we have firms earning above-normal economic profits, but restrictions on entry prevent the bidding down of those economic profits. Nonprice competition-image advertising, improved product quality-can provide an alternative avenue by which firms compete away positive economic profits, in this case by raising average costs up to price.

When price is set above the competitive level and there are entry restrictions, unions are more likely to extract some of the economic rent by negotiating above-normal wages. Firms can respond in part by shifting toward more capital-intensive production technologies. The result may be a cost structure that is higher than what would occur if labor were priced based on its economy-wide opportunity cost.

What if Pr is set below P* and there are Exit Restrictions?

To allow firms to charge sub-market prices and survive, regulators may engage in cross-subsidization, meaning that they allow the regulated firm to make up its losses by charging above-market prices in other markets. This used to be the way that the telephone monopolies could afford to charge sub-market prices for rural service-by charging above-market prices for urban service. In both cases there is a welfare loss due to allocative inefficiency. In the subsidizing market Pr > MC too little produced; in the subsidized market Pr < MC too much produced.

When sub-market prices are set by regulators, the economic value of the firms in this industry are reduced. The firms will have to offer higher interest rates on bonds (because of higher bankruptcy risk), and will have to offer a larger number of shares of stock, in order to acquire capital financing.

Regulation and Innovation:

Regulation can impair innovation by limiting entry by new firms, and by reducing the imperative for competition. On the other and, if innovation is fostered by positive economic profits (Schumpeter hypothesis), then regulation can boost innovation. In environmental contexts, technology-forcing regulation is generally seen as impairing incentives for innovation in cost-efficient pollution-control technologies.

Price-cap regulation with lags between the setting of new price caps provides an incentive for regulated firms to engage in cost-reducing technology innovation. The reason is that the firm can keep the positive economic profits that might occur upon successful innovation, at least until the next rate hearing, at which regulators are likely to downward-adjust rates to reflect the new technology.

Entry and Imperfect Competition:

Under competitive conditions, new entrants are small in size relative to the overall market and so each individual entrant has no impact on market price. Thus entry by a single firm does not affect other firms' profits or consumer surplus. As a consequence, entry that is privately efficient is also socially efficient.

This is not the case with oligopolistic industries, where minimum efficient scale is large relative to the market and individual firms can affect market price by their output decisions. Entry that is privately efficient (profitable) may not necessarily be socially efficient because one must take into account the impacts of new entry on other firms' profits and on consumer surplus. It may seem counterintuitive but it is possible that entry that drives price down can lower the profit of firms faster than the increase in consumer surplus, thus lowering total surplus and welfare. People studying Cournot oligopoly have found that with identical products and a fixed entry cost (e.g., promotion) and free entry, too much entry occurs, leading to lower total surplus than if entry were restricted. In the same circumstance if firms produce differentiated products and consumers value product diversity, then free entry can lead to too few firms and inefficiently low product diversity. The point is that in oligopoly there is no assurance that the private interests of profit-maximizing firms coincides with social welfare under unregulated conditions.