ECONOMICS OF REGULATION AND ANTITRUST Second Edition

W. Kip Viscusi John M. Vernon Joseph E. Harrington, Jr.

The MIT Press Cambridge, Massachusetts London, England

Contents

Preface to the Second Edition Introduction The Rationale for Regulation and Antitrust Policies Antitrust Regulation The Changing Character of Antitrust Issues Reasoning behind Antitrust Regulations Economic Regulation Development of Economic Regulation Factors in Setting Rate Regulations Health, Safety, and Environmental Regulation Role of the Courts Criteria for Assessment Questions and Problems Recommended Reading Appendix The Making of a Regulation State versus Federal Regulation: The Federalism Debate Advantages of Federalism Advantages of National Regulations The Overlap of State and Federal Regulations The Character of the Rulemaking Process The Chronology of New Regulations Nature of the Regulatory Oversight Process The Nixon and Ford Administrations The Carter Administration The Reagan Administration The Bush Administration The Clinton Administration The Criteria Applied in the Oversight Process Regulatory Success Stories Promotion of Cost-Effective Regulation Distortion of Benefit and Cost Estimates The Regulatory Role of Price and Quality The Impact of the Oversight Process The Cost of Regulation Other Measures of the Size of Regulation The Character of Regulatory Oversight Actions What Do Regulators Maximize?

xxi 1 2 4 4 5 5 6 6 8 9 10 11 11 12 13 14 15 16 17 18 19 23 24 25 27 28 28 29 29 30 30 32 32 33 33 36 38

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Contents

The Capture Theory Other Theories of Infiuence Patterns Comprehensive Models of Regulatory Objectives Conclusion Questions and Problems Notes Appendix. Trends in Regulatory Agency Budgets and Staff ANTITRUST Introduction to Antitrust Industrial Organization Analysis Concentration Entry Barriers Product Differentiation Antitrust Enforcement and Remedies Exemptions from Antitrust Summary and Overview of Part I Notes Appendix. Antitrust Statutes Sherman Act Clayton Act Federal Trade Commission Act Efficiency and Technical Progress Economic Efficiency Partial Equilibrium Weifare Tools Monopoly versus Competition Example Oil Industry Application Some Complications X-Inefficiency Monopoly-Induced Waste Estimates of the Weifare Loss from Monopoly Technical Progress Importance of Technological Change An R & D Rivalry Model Summary Questions and Problems Notes

Contents

Oligopoly, Collusion, and Antitrust Game Theory Example 1: Advertising Competition Example 2: Compatibility of Standards The Strategie Form of a Game Nash Equilibrium Oligopoly Theory The Cournot Solution Other Models of Oligopoly Product Differentiation Collusion A Theory of Collusion Cartel Problems Collusion: Railroads in the 1880s Antitrust Law toward Price Fixing Economic Analysis of Legal Categories Per Se Rule Cases Conscious Parallelism Summary Questions and Problems Notes Appendix A Game Theory: Formal Definitions Appendix B The Addyston Pipe Case The Opinion of the Court Market Structure and Strategie Competition Market Structure Concentration Scale Economies Entry Conditions Dominant Firm Theory Static Analysis Dynamic Analysis: Limit Pricing Strategie Competition Limit Pricing Investment in Cost-Reducing Capital Raising Rivals' Costs

97 97 97 99 100 101 102 102 108 109 112 113 117 121 122 123 125 129 132 134 135 138 138 139 139 141 145 145 145 152 155 164 164 166 171 171 179 183

Contents

Preemption and Brand Proliferation Summary Questions and Problems Notes Mergers Antitrust Laws and Merger Trends Reasons for Mergers Monopoly Economies Reducing Management Inefficiencies Other Motives Horizontal Mergers Benefits and Costs Cases 1992 Merger Guidelines Conglomerate Mergers Potential Benefits Anticompetitive Effects and Cases Summary Questions and Problems Notes Vertical Mergers and Restrictions Vertical Mergers Benefits Anticompetitive Effects Extension of Monopoly: Fixed Proportions Extension of Monopoly: Variable Proportions Cases Vertical Restrictions Resale Price Maintenance Territorial Restraints Exclusive Dealing Tying Summary Questions and Problems Notes Monopolization and Price Discrimination The Possession of Monopoly Power

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Contents

Intent to Monopolize Cases 1890-1940: Standard Oil and United States Steel 1940-1970: Alcoa and United Shoe Machinery 1970 to Present: Kodak, Cereals, IBM, and Others Predatory Pricing: Proposed Legal Definitions The ATC Rule The Output Restriction Rule Joskow-Klevorick Two-Stage Rule Price Discrimination and the Robinson-Patman Act Systematic Discrimination Unsystematic Discrimination Cases Summary Questions and Problems Notes 10 ECONOMIC REGULATION Introduction to Economic Regulation What Is Economic Regulation? Instruments of Regulation Control of Price Control of Quantity Control of Entry and Exit Control of Other Variables Brief History of Economic Regulation Formative Stages Trends in Regulation The Regulatory Process Overview of the Regulatory Process Regulatory Legislation Independent Regulatory Commissions Regulatory Procedures The Theory of Regulation Normative Analysis as a Positive Theory Capture Theory Economic Theory of Regulation Taxicab Regulation

270 271 271 275 280 283 285 286 289 290 290 295 296 298 298 300 305 307 307 308 308 309 309 310 311 311 312 317 317 318 319 321 322 323 327 328 342

Contents

Summary and Overview of Part II Questions and Problems Notes Theory of Natural Monopoly The Natural Monopoly Problem Permanent and Temporary Natural Monopoly Subadditivity and Multiproduct Monopoly Alternative Policy Solutions Ideal Pricing Franchise Bidding Actual Solutions Regulation Public Enterprise Summary Questions and Problems Notes Natural Monopoly Regulation The Rate Case Accounting Equation Regulatory Lag The Rate Level Rate Base Valuation Cost of Equity Capital The Sliding Scale Plan Price Caps and Performance Standards Averch-Johnson Effect Rate Structure FDC Pricing Undue Discrimination Peak-Load Pricing Costs of Power Production Peak-Load Pricing Model Regulation/Deregulation of Electric Power Effectiveness of Price Regulation Trend toward Competition Summary Questions and Problems Notes

345 346 347 351 351 351 353 358 358 370 370 370 371 372 372 375 377 378 378 379 381 381 383 385 386 387 391 392 394 396 396 399 403 403 404 407 407 409

Contents

Franchise Bidding and Cable Television Theory of Franchise Bidding Competition at the Bidding Stage Contractual Arrangements for the Postbidding Stage Assessment of Franchise Bidding Cable Television Historical/Regulatory Background Cable Television as a Natural Monopoly Franchising Process Assessment of Franchise Bidding Is Government Intervention Welfare-Improving? Summary Questions and Problems Notes Public Enterprise General Background Positive Theory of Public Enterprise Managerial Model of a Firm Managerial Model of a Private Enterprise Managerial Model of a Public Enterprise Comparison of Public and Private Enterprise Municipal Electric Utilities Pricing Behavior Allocative Efficiency Comparison Productive Efficiency Comparison Assessment of Private versus Public Utilities Airlines Summary Questions and Problems Notes Dynamic Issues in Natural Monopoly Regulation: Telecommunications Transformation of a Natural Monopoly Basis for Natural Monopoly Regulation Sources of Natural Monopoly Transformation Regulatory Response Intercity Telecommunications Market Local-Exchange Telecommunications Market

413 413 414 424 428 429 429 432 437 438 446 448 448 450 453 454 456 456 458 459 462 463 463 464 467 468 468 471 473 473 475 475 476 478 483 486 498

Contents

Separation of Regulated Monopolies and Competitive Markets Benefits and Costs of Separation Breakupof AT&T Telecommunications and Computers The Future of the Telecommunications Industry: Digital Convergence Industry Forces Technology and Regulation Policy Issues Summary Questions and Problems Notes The Regulation of Potentially Competitive Markets: Theory and Estimation Methods Theory of Price and Entry/Exit Regulation Direct Effects of Price and Entry/Exit Regulation: The Competitive Model Direct Effects of Price and Entry/Exit Regulation: The Imperfectly Competitive Model Some Indirect Effects of Price and Entry Regulation Some Indirect Effects of Price and Exit Regulation Regulation and Innovation Methods for Estimating the Effects of Regulation Overview of Estimation Methods Intertemporal Approach Application: New York Stock Exchange Intermarket Approach Application: Advertising of Eyeglasses Counterfactual Approach Application: State Usury Laws Summary Questions and Problems Notes Economic Regulation of Transportation: Surface Freight and Airlines Transportation Industry Surface Freight Transportation Regulatory History

500 501 503 505 507 508 510 511 513 514 515 519 520 520 525 528 532 533 537 537 537 539 540 541 542 544 547 548 549 551 551 553 553

Contents

Description of Regulatory Practices Effects of Regulation Airlines Regulatory History Description of Regulatory Practices Effects of Regulation Competition and Antitrust Policy after Deregulation Summary Questions and Problems Notes Economic Regulation of Energy: Crude Oil and Natural Gas The Theory of Price Ceilings Price and Quantity Regulation of the Crude Oil Industry Regulatory History Oil Prorationing Regulatory Practices Rationale for Prorationing Solutions to the Common Pool Problem Effects of Prorationing Mandatory Oil Import Program Regulatory Practices Effects of Regulation Crude Oil Price Controls Regulatory Practices Effects of Price Regulation Price Regulation of the Natural Gas Industry Regulatory History Regulatory Practices Effects of Price Regulation Summary Questions and Problems Notes HEALTH, SAFETY, AND ENVIRONMENTAL REGULATION Introduction: The Emergence of Health, Safety, and Environmental Regulation Risk in Perspective The Infeasibility of a No-Risk Society

557 560 574 574 576 578 589 597 597 598 603 606 610 613 615 615 617 621 623 624 624 624 626 626 628 636 637 639 641 648 649 650 653 655 656 658

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Contents

Wealth and Risk Irrationality and Biases in Risk Perception Policy Evaluation Regulatory Standards Marginal Analysis The Role of Heterogeneity Discounting Deferred Effects Present Value Uncertainty and Conservatism The Role of Risk Ambiguity The Role of Political Factors Economic Models of Environmental Policies Voting Patterns Summary and Overview of Part III Questions and Problems Recommended Reading Notes 20 Valning Life and Other Nonmonetary Benefits Policy Evaluation Principles WiUingness-to-Pay versus Other Approaches Variations in the Value of Life The Labor Market Model Empirical Estimates of the Value of Life Value of Life for Regulatory Policies Survey Approaches to Valuing Policy Effects Valuation of Air Quality Exploratory Nature of the Survey Approach Sensitivity Analysis and Cost Effectiveness Risk-Risk Analysis Establishing Prices for Health, Safety, and Environmental Regulation Questions and Problems Notes Environmental Regulation The Coase Theorem for Externalities The Coase Theorem as a Bargaining Game A Pollution Example Long-Run Efficiency Concerns Transactions Costs and Other Problems

660 661 663 664 667 668 670 670 672 675 676 676 679 680 682 683 683 683 686 688 691 693 697 699 701 703 704 704 705 706 707 708 711 711 713 715 716 716

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Smoking Externahties Special Features of Environmental Contexts Selecting the Optimal Policy: Standards versus Fines Setting the Pollution Tax The Role of Heterogeneity The Role of Uncertainty Pollution Taxes Cost Heterogeneity for Water Pollution Control Current Market Trading Policies The Future of Market Approaches Global Warming and Irreversible Environmental Effects Assessing the Merits of Global-Warming Policies How Should We React to Uncertainty? Multiperson Decisions and Group Externalities The Prisoner's Dilemma The N-Person Prisoner's Dilemma Applications of the Prisoner's Dilemma The Enforcement and Performance of Environmental Regulation Enforcement Options Enforcement Trends Environmental Outcomes and Enterprise Decisions Summary Questions and Problems Notes Product Safety Emergence of Product Safety Regulations Current Safety Decisions Changing Emphasis of Product Regulation Premanufactunng Screening: The Case of Pharmaceuticals Weighing the Significance of Side Effects Drug Approval Strategies The Behavioral Response to Product Safety Regulation Consumer's Potential for Muting Safety Device Benefits The Costs of Product Safety Regulation: The Automobile Industry Case Trends in Motor Vehicle and Home Accident Deaths The Decline of Accident Rates

718 720 721 723 724 726 727 729 730 731 733 734 735 737 737 737 738 740 740 741 742 746 747 748 751 751 752 755 755 756 757 761 762 767 769 772

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Contents

The Rise of Product Liability The Negligence Standard The Strict Liability Standard Events Study Evidence on Liability Costs Escalation of Damages Risk Information and Hazard Warnings Self-Certification of Safe Products Government Determination of Safety Alternatives to Direct Command and Control Regulation The Future of Product Safety Policy Questions and Problems Notes 23 Regulation of Workplace Health and Safety The Potential for Inefficiencies How Markets Can Promote Safety Compensating Wage Differential Theory Risk Information On-the-Job Experience and Worker Quit Rates Inadequacies in the Market Informational Problems and Irrationalities Externalities OSHA's Regulatory Approach Setting OSHA Standard Levels The Nature of OSHA Standards The Reform of OSHA Standards Regulatory Reform Initiatives Changes in OSHA Standards OSHA's Enforcement Strategy Inspection Policies Trivial Violations OSHA Penalties Enforcement Targeting The Impact of OSHA Enforcement on Worker Safety OSHA Regulations in Different Situations OSHA and Other Factors Affecting Injuries Agenda for Policy Reform Efforts Questions and Problems Notes

774 775 776 777 779 781 782 782 783 785 787 788 791 793 793 795 797 799 800 800 802 802 803 805 807 807 808 811 812 813 814 815 816 818 819 825 826 827

Contents

Patents and Pharmaceuticals Economics of Invention and Patents Background on Patents Incentives to Invent: Monopoly versus Competition Weifare Analysis of Patents Pharmaceuticals and the Role of Patents Industry Structure The 1984 Drug Price Competition and Patent Restoration Act Other Policies That Affect R&D Incentives Summary Questions and Problems Notes Name Index Subject Index

831 831 833 834 837 847 847 855 858 863 864 865 871 877