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Lecture 2. Economic regulation and airline deregulationKey concepts:
- Market failure: market does not operate efficiently (something does not work well in
that market) For example, imperfectly competitive market the market cannot solve
this by itself (the market failure).
- Market concentration: market concentration is about how the market is distributed
over different players (Low concentration lot of firms).
- Market power: Market power is about the ability of a firm to set a price above
marginal costs (correlated with market concentration but it is not the same).
- Positive and negative externalities: the actions of a firm have a spillover effect on third
parties, which is not taken into account. For example, a negative externality for air
transport is pollution (emission) and the noise and a positive externality is better
business climate.
- Social (vs. private) benefit and cost analysis: private benefits and cost analysis is about
my own welfare (utility). Social benefit and cost analysis is the welfare of the society or
a bigger group. If there are externalities there is a difference between private and
social costs.
- Productive, allocative, dynamic efficiency: productive efficiency is about cost efficiency
in the short term, producing in the most efficient way by minimizing the costs.
Allocative efficiency is achieved when things are distributed in the right way, welfare is
maximized. Allocative inefficiency means that there is any kind of welfare loss.
Dynamic efficiency is about cost efficiency in the long term, meaning the capacity to
constantly reduce costs in the long term (through innovation, jumbo jets transport
more people). Critical view: do the companies have the right incentives to be
innovative to reduce the costs in the long term.
- Natural monopoly
Theory of regulation
Why is there regulation? Three different theories:
1. Public Interest Theory (PIT)
2. Capture Theory (CT)
3. Economic Theory of Regulation (ET)
Public Interest Theory (PIT)
According to the public interest theory we need regulation when the market does not work
well (if we don’t regulate). In case of market failure, we need regulation for correction.
Normative analysis as a positive theory. Two examples of situations where we need
regulation:
Example 1: Natural monopoly
At the socially optimum market equilibrium industry cost is minimized by having one firm
producing the good. Natural monopoly market has large, fixed costs relative to marginal
costs (large sunk costs, railways). The problem is that there is a conflict between productive
efficiency and allocative efficiency. To produce at the cheapest cost, we need one firm
producing it (productive efficient). However, they can set prices above marginal costs
through monopoly power leading to allocative inefficiency. Thus, according to the PIT theory
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,we need to intervene price and entry regulation. For example, price cap with fixed
margins they are allowed to make.
Example 2: Externalities (negative: Noise, pollution - positive: vaccinations, networks)
When the actions of agent A affect the utility/production function of agent B and agent A
does not care how his behavior affects agent B’s welfare. This can be both negative and
positive (and intervention is justified in both cases).
If we do not regulate this competition, this will lead to overproduction of negative
externalities and under production of positive externalities. We solve this with taxation for
noise, pollution, while on the other hand subsidization of vaccinations and networks.
Capture Theory
According to the capture theory regulation is pro-producer and aims at raising industry
profit. Regulation is not strongly correlated with the existence of market failures. For
example, the taxi industry (uber). When uber emerged, it presented a proposal to open the
market by offering more competitive rates. However, the taxi industry had a lot of resistance
and lobbied for more regulations, resulting in Uber being banned in various locations.
Different forms of regulation capture:
Regulation is supplied in respond to the industry’s demand for regulation (legislators
are captured by the industry) NS complains government does not open up the
market.
Regulatory agency comes to be controlled by the industry overtime (regulators are
captured by the industry) In case you are only speaking with Schiphol, they can
influence your vision and opinion away from the general welfare.
Interests of firms or political groups are much stronger than the interests of the
public.
Regulation capture may often lead to net welfare loss to society. For example, does
the noise of Schiphol lead to net welfare loss to society? People who live around
Schiphol will complain about the noise, but it is important to focus on the general
welfare the whole country is benefiting from Schiphol.
Economic Theory of Regulation (ET)
“The Theory of Economic Regulation” (Stigler, 1971): This theory combines insights from
both theories and captures them in one framework. It is a formal theory to predict which
industries will be regulated and what form regulation is likely to take.
Main insights:
Regulation tends to benefit relatively small groups with strong preferences at the
cost of large groups with weak preferences.
Regulation may be pro-producer, however, prices will not be set to maximize
industry profit because of the influence of consumer groups.
Regulation more likely to occur in relatively competitive or monopolistic industries.
Regulation more likely to occur in the presence of market failure.
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,Economic regulation
“A state-imposed limitation on the discretion that may be exercised by individuals or
organizations, which is supported by the threat of sanction (fine if you don’t meet the
regulation).” (Stone, 1982)
Government can control firm behavior in industries characterized by a lack of competition
with different instruments of regulation:
- Control of price: price cap (telecommunication or rail)
- Control of quantity: how much somebody is allowed to product (crude oil)
- Control of entry and exit: no open market (licenses)
- Control of other decision variables: quality regulation company must meet certain
performances. For example, the NS must have a certain number of trains operating
each hour.
Social Welfare Analysis
To decide how much regulation is necessary (optimal amount) we need a simple framework,
focussing on the social welfare. This includes the benefits and costs of a specific regulation.
The formule below shows the net present value of a given project and the value of the
proposed regulation today taking the future into account.
Benefits of regulation are an increase in CS through lower prices, higher quality, more
quantity. In the case of air transport this refers to lower airfares, improved service quality,
better network (more destinations). Costs of regulation are a decrease in PS through lower
profits or extra costs associated with compliance to the regulation, implementation costs
and externalities. For example, Apple must change the whole production to adapts to the
USB ports. On the other hand, the regulator also has costs to check if firms are behaving
right. In the case of air transport: administrative costs of price regulation, monitoring and
applying sanctions, externalities in network planning and competition.
Regularity challenges
One of the regularity challenges is that the social welfare analysis framework is not always
easy. For instance, it is difficult to choose the right discount rate, and often difficult to
quantify the benefits and costs to society because of conflicting interests. This also
introduces problems like political constituencies, budget constraints and regulatory capture.
Another regularity challenge is perverse incentives, meaning that it is physically impossible
for a regulatory agency to perfectly monitor firms/consumers. For example, under airline
regulation the government focused on controlling price rather than quality, leading to shift
from price to quality competition. Airlines could not set their own prices, so they don’t care
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, about the price so much and shifted to quality competition (service, food, seating) to
differentiate themselves. This led to high price and high-quality product.
Case study: Regulation and deregulation of the US airline industry
US Airline industry deregulation – Timeline
After the Great Depression people were pessimistic about the free market. This led to the
Civil Aeronautics Act and the CAB, whereby the airline industry was under federal
regulation. Overtime the industry was under pressure due to the oil crisis and economic
stagnation. This led to more regulation as firms wanted to be protected. This is a regulatory
capture because the airlines wanted to be protected from the bad economic circumstances.
This changed later when people started to be more pro-open market because there came
more information about the benefits of deregulation. For example, research showed that
the prices were a bit to high. The deregulation in Europe happened later as they first
watched. Most evidence was positive, leading to Europe and the rest of the world following
US and also deregulate.
The Civil Aeronautics Board (CAB)
Controlling prices seemed necessary for the CAB to promotion of adequate, economical, and
efficient service by air carriers at reasonable rates. Powers of the act revealed the overall
pessimism towards a free market that pervaded at the end of the Great Depression.
Economic regulations given by the Civil Aeronautics Act (1938):
- Control entry into the industry and entry of carriers into new or existing routes
- Control exit by requiring approval before cassation of services
- Regulate fares based on specific rate-making provisions
- Award direct subsidies to carriers (small route or islands) Is still happening today
- Control mergers and inter-carrier agreements (Is still happening today)
- Investigate deceptive trade practices and unfair methods of competition (Is still
happening today)
- Initially also responsible for safety regulation and control
Industry performance under regulation
Under regulation many inefficient firms would stay in the market because it was difficult to
enter and exit the market, for instance bureaucratic procedures were seen as a barrier to
entry. This causes lower productivity growth. Notable example World Airway’s
application to enter the route JFK-LAX as a low-fare carrier was rejected by the CAB after 6+
years of examination.
Moreover, under regulation there was a high price and high-quality product. Price
regulation induced different competitive conduct. Lower prices introduced new people to
the market which led to catering of more people which leads to more social welfare. But
there are two sides.
Dynamic considerations:
- Regulation focused on productive and allocative efficiency, what about dynamic
efficiency?
- Do firms have an incentive to innovate?
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