Blogging the 2016 ASSA conference. How to regulate a market?
According to Friedrich Hayek markets
are based upon rules and habits and a culture. And it is, considering ingrained habits and the established culture, quite difficult to establish which rules are best. Harry Trebing was good at this and one of the sessions at the 2016 ASSA conference is titled: “Institutions and the Public Interest: Session in Honor of Harry M. Trebing“.
The deregulation of telecommunications and energy has produced the first and second largest bankruptcies in U.S. history together with widespread evidence of executive fraud and price manipulation. The Sarbanes-Oxley Act of 2002 creating the Federal Accounting Oversight Board is heralded by many persons as a major step in the solution of these problems. This presentation argues that greater transparency and better reporting, however commendable, do not address the deeper problems of deregulation that are tied to the structure and performance of these industries. Four dimensions of market failure will be addressed: the persistence of centers of discretionary market power, the inability to establish a credible trading market, the absence of acceptable levels of consumer protection, and the continuing externality and social-value problems. These failures, in turn, demonstrate the deficiencies of transitional “light” regulation and current merger policies. A program for regulatory reform will be proposed.
In Harry Trebing’s classic article, “Regulation of an Industry: An Institutionalist Approach,” he writes that policy recommendations for public utilities should “follow from the inherent features of the industry,” and that an Institutionalist does not “accept a transition to pervasive competition as inevitable or probable.” Throughout the last quarter of the twentieth century, Trebing was the intellectual leader of the State Public Utility Commissions. Novice regulators attended his two-week summer camp at Michigan State University, during which they learned the fundamental steps in establishing the cost-of-service. Then they were exposed to some of the more complex topics in regulation, such as pricing structure and levels, demand forecasting, and energy conservation. More advanced students attended his winter conference in Williamsburg. Unlike the Lansing summer course, this venue was open to utility employees. Year after year, the conference hosted presentations by leading academics, commissioners, and utility officials, who spoke about the current problems in public utility regulation. These first-rate presentations were annually published as a book by Michigan State. Trebing challenged neo-classical economics at both the summer course and the winter conference. Trebing’s attitude regarding Ramsey Pricey was one example of his unwillingness to accept blindly economic models. While he understood the calculus which underlay Ramsey Pricing, he was skeptical that it could be applied successfully in all conditions. Trebing was particularly concerned about the blanket use of the inverse elasticity rule, which stated that where marginal cost pricing would lead to a deficit, the largest mark-up above marginal cost should be placed on the products with the lowest elasticity of demand. Trebing was doubtful that the inverse-pricing rule would actually maximize welfare. He was concerned that some commissions might lack the ability to measure accurately the difference between marginal costs and the revenue requirement. He also questioned the efficacy of using a theory that had been designed to price individual goods, as a method for establishing the revenue requirement for a basket of goods, such as long-distance calling, private lines, and telephone handsets. He was especially concerned that the inverse-elasticity rule could lead to an outcome in which monopoly services would be subsidizing competitive products. Furthermore, Trebing criticized Ramsey Pricing on ethical grounds. Ramsey pricing emerged from a model that implicitly assumes that the marginal utility of an additional dollar of income is the same for all individuals. More sophisticated models assumed that taking a dollar from a low-income household would have a different welfare impact than removing the same amount of money from a wealthy family. For this reason, Trebing observed, that when Ramsey Pricing takes the form of the inverse-elasticity rule, it results in a disproportionate recovery of costs from the customers who have the fewest options. Therefore, he concluded “the equity implications of such a practice are offensive no matter what the long-term efficiency gains.” Trebing questioned the pervasive feeling in economics that the market provided sufficient protection in most capital-intensive industries, and that there was, therefore, a limited need for regulation. Many economists, especially those affiliated with AT&T, such as William Baumol, were writing that there was no need for regulation in markets in which barriers-to-entry and sunk costs were low. They believed that any market in which an entrant could enter the market with a price below that of the incumbent could potentially capture the entire market, which would make government oversight unnecessary. They believed that where hit-and-run entry was feasible, prices above the competitive level would be unsustainable, and that, therefore, economic profits would by necessity “be zero or negative.” The theoretical proposition that the threat of competition drives the market price to the competitive level is logical, but the reality of the market adjustment process is glaringly missing from that viewpoint. As noted at the beginning of this article, Trebing’s professional focus was public utilities, and he was skeptical that “pervasive competition (w)as inevitable or probable” in utilities. Competition is more likely to emerge in industries where there are not substantial fixed costs, and public utilities are characterized by significant fixed costs. This lack of competition would make regulation seem advisable. In order to illustrate that the movement towards a competitive outcome can be a slow process, even in an industry without substantial fixed costs, this paper will examine an industry with trivial fixed costs. The remainder of this article will address the evolution of the pricing and economic profits in the taxi business, an industry that is not characterized by high-fixed costs. The recent large scale entry of transportation network companies (TNC), such as Uber, Lyft, and SideCar, into the hackney business provides an interesting narrative on the market adjustment process.