Who will deregulate the deregulators? …

                           Who will deregulate the deregulators?

                                       Edward J. López

                                [forthcoming in Public Choice]

                                       January 31, 2008



Abstract: A well-intentioned and fully informed regulator may determine that the optimal

policy is to deregulate the market, yet the regulator may be constrained from doing so. In this

condition, deregulatory policies originate in exogenous shocks to the regulator's choice

environment. Entrepreneurship in political and economic markets is a primary source of

institutional change that promotes deregulation.



Keywords: regulation, deregulation, entrepreneurship, institutional change

JEL Classifications: L43; D78



1. Introduction

A well-intentioned and fully informed regulator may determine that the optimal policy is to

deregulate the market, yet the regulator may be constrained from doing so. In this condition,

deregulatory policies originate in exogenous shocks to the regulator's choice environment.

       In their paper, "Deregulation Redux," Richard S. Higgins and Arijit Mukherjee argue

that the economics of regulation has not adequately analyzed the welfare gains from

deregulation, and conclude that generally understood examples of "deregulation" (viz.,

telecommunications, electricity, and railroads) are in fact mere reformulations of regulation.

Higgins and Mukherjee consider a particular market structure--a geographical network good

that features a natural monopoly in local exchange coupled with potentially competitive long




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distance carriage. The regulator maximizes welfare subject to a non-negative profit constraint

by choosing either to set local rates and long-distance rates simultaneously (vertical

integration), or to allow competition in long distance while still regulating the local

exchanges and determining the charges long-distance carriers must pay for accessing the

local monopolists' customers (vertical separation). Deregulation ensures no greater welfare,

and places no less information demands on the regulator, because the regulated access fee

impacts the competitively determined price of long distance service. The result holds up

under asymmetric information even if the regulator adopts an incentive-compatible contract

that successfully elicits truthful revelation of long distance carriers' private costs. Only

perfect competition in the long-distance market, which is counterfactual, limits the generality

of the theoretical result. Thus, the welfare gains from deregulation--presumed to be the

mirror image of the welfare costs of regulation--are recast as something of a chimera; in

equilibrium, a fully informed, publicly -interested social planner would still choose to

regulate.

        In addition to such deficiencies, regulators also face a dynamic environment of

changing constraints as political institutions evolve and transaction costs fall, some of which

interact with the regulator's limited information set. My argument in this short piece draws

on two claims. First the rent-seeking literature shows that political transaction costs and

institutions influence the market for regulation. Second, the dynamics of regulation can be

used to qualify and extend certain elements of equilibrium models. The regulator's

constraints are determined by cost and preference parameters in the relevant economic and

political markets. Thus the optimal regulation can shift with exogenous market shocks and

endogenous responses to existing regulations. In a few well-known cases, such shifts have

led to genuine deregulation (in the sense of reducing the role of the state, while increasing

that of the market, in allocating resources).


                                                                                   E. J. López    2
2. Institutions and politics

The regulator's choice set is constrained by political costs and benefits along multiple

margins. The non-negative profit constraint highlights the nature of regulation as a rent-

seeking process: price-entry regulation endows the regulated firms with market power, which

invites rent seeking. There are also groups that are harmed by such regulation, namely

consumers. The regulator, like the policymaker in a rent-seeking game, must balance the

demand for regulation against the political opposition mounted by consumers (Peltzman

1976; Wenders 1987). The democratic structure of policymaking--or the institutions of the

political marketplace--can also impose costs on the regulator. For example, regulators are

selected via an appointment-confirmation process and are responsible to an array of budget

and oversight committees. Regulators also share powers with other agencies, varying in

number and intensity of influence. The Kennedy and Reagan administrations reportedly both

wanted to end the domestic sugar program, "but apparently had not the political power to do

so" (Kreuger 1990: 196). Even absent such overlapping jurisdictional powers, regulators face

fundamental conditions of scarcity that limit their productivity in allocating rents. In short,

the political context within which rent seeking unfolds exerts influence over the paths and

outcomes that regulation produces (Dougan and Snyder 1993; Tollison 1997).

        Political transaction costs are a function of political institutions (Buchanan 1984;

North 1990). When faced with such political frictions, rent seekers change their optimal

strategies relative to a costless policymaking environment. For example, when there is greater

political opposition to a policy that creates and distributes a rent, firms will invest less

lobbying resources into attempting to influence the outcome of that policy decision; therefore,

rents are less than fully dissipated when political frictions are incorporated into the model

(Godwin, Lopez and Seldon 2006). Firms also attempt to avoid competition from other rent

seekers, preferring instead to seek out issue niches and areas of low political conflict


                                                                                    E. J. López   3
(Godwin, Lopez and Seldon 2008). Sunk rent-seeking costs and transitional gains are two

additional and related political frictions that constrain deregulation (McCormick, Shughart

and Tollison 1984; Tullock 1975). And since deregulation in the presence of organized

interests would entail significant lobbying costs, both the regulator and regulated firm(s) have

incentive to avoid the path of deregulation (Poitras and Sutter 2000).

        When viewed through its political economy facets, as a rent-seeking process

deregulation is sensitive to political transaction costs and institutions. When the interests in

the regulatory status quo are multiple and diverse, and when the policymaking power is

distributed over many decision makers, the eventual outcome can be a severely whittled down

version of the initial deregulatory impetus (for example, telecommunications). When the

relevant interests are relatively homogenous and the policymaking authority is relatively

concentrated, then deregulatory moments usher in more substantive decreases in the role of

state allocation (for example, airlines). The distinction is testable, but for current purposes it

serves to introduce the importance of considering the dynamic environment in which political

frictions influence rent seeking, regulation, and deregulation.

3. Dynamics of regulation

In a dynamic setting, market agents (entrepreneurs) will respond to the regulator's chosen

policies. The greater the costs imposed on market agents, the more effort will be devoted to

mitigating the real effects of the regulations. In turn, regulators may find that market

responses have altered their choice set sufficiently to motivate a change of policy. Market

agents will respond to the new policy choice, and the regulation cycle continues. Dynamic

regulation cycles can explain shifts of the regulatory locus as in Higgins and Mukherjee.

        First, consider that regulators imperfectly anticipate and control the discovery of new

profit opportunities that price regulation creates. A binding price ceiling imposed on an

otherwise competitive market, for example, invites non-price adjustments by buyers and


                                                                                    E. J. López      4
sellers to avert the economic costs of the wedge. In a classic study, Cheung (1996 [1975])

richly describes the effects of a 1921 Hong Kong law that fixed the price of housing on

existing units but exempted newly constructed units. The regulators anticipated the incentives

for landlords to repossess their units by ejecting tenants and for tenants to offer side

payments. But as Cheung demonstrates, regulators were completely surprised by the

strategies landlords adopted to drive out tenants by creating nuisances (removing windows,

undertaking noisy construction projects, and so on) and by tenant strategies to sublet. Within

a year of the regulation taking effect, "substantial fines against these practices were promptly

inserted, and...the Ordinance had grown to 27 sections from the original 17" (Cheung 1996:

233). Regulators expressed even more shock at discovering that some landlords were tearing

down tenements in order to rebuild and free themselves from rent controls. While extreme,

tearing down rent-controlled housing is quite prevalent. In many cities today, like in the San

Francisco Bay Area, regulations prohibit sellers from raising rents by more than some fixed

percentage each year. During periods of low demand, landlords avoid reducing monthly rental

rates because doing so would limit their ability to re-equilibrate after demand recovers.

Instead, during downturns landlords alter the length of the rental contract, for example by

offering one month free on a 12-month lease, while leaving the de jure monthly rate intact.

Cities have not prohibited entrepreneurial adjustments of contract length. However, in a new

version of price controls known as "inclusionary zoning," the cat and mouse game is quite

evident. Price ceilings on new homes come pre-packaged with resale prohibitions (Means,

Stringham and Lopez 2007).1

        Entry restrictions also pose difficulties for anticipating and controlling market

responses. With telephony, it bears emphasizing that the good in question is voice carriage,

irrespective of particular technology. Over time, new technologies have been introduced to

supply the same good and consumers have responded with substitution. As of late 2007, there


                                                                                   E. J. López   5
were approximately 14 million US households with wireless only telephone service, and

broadband carriers accounted for 13% of all wireline voice subscribers (Britton and

McGonegal 2007). Such modal competition questions the very notion that local exchange

carriage is a natural monopoly (Sidak, Singer and Teece 1999). As for airlines in the mid

1970s, entrepreneurs entered to fill the profit gaps left by the route and rate regulation of the

Civil Aeronautics Board (CAB). By 1975, intrastate carriers like Southwest Airlines were

selling seats at half the regulated carriers' rates and turning a profit.2 At least one prominent

regulator of the era counts such entry as one of only a few major factors that contributed to

airline rate and route deregulation (Barnum 1998).

        Regulators respond to the regulation-averting strategies employed by market agents.

Consider the adaptive learning process by which the Interstate Commerce Commission (ICC)

converged on railroad rate regulation, and subsequently moved to controlling competition on

non-price margins. Established in 1887, the ICC initially had the power only to prohibit

specific rates, leaving railroads free to file rates very close but not equal to a rate the

Commission would reject. Congress had to enact new legislation for the ICC to catch up.

Next the ICC was empowered by Congress to set maximum rates. As railroads competed

under conditions of significant scale economies, which provided incentives for "cutthroat"

pricing, the ICC was then authorized to set minimum rates. Finally, moving up the regulatory

learning curve, exact rate regulation emerged (Benson 2002: 241­242). When trucking

became a viable competitor, railroads demanded protective entry regulation and the ICC

evolved from a rate-making body into a controller of substitute surface transportation modes

(Shughart 1990).

        Regulations on price and entry margins can simply be reformulated into regulation on

non-price margins, such as quality, safety, conservation and other objectives that become the

locus of public interest regulations. In the years surrounding the Airline Deregulation Act of


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1978, the Federal Aviation Administration (FAA) took on increased powers to set standards

for air passenger safety, air traffic control, and noise pollution. Lamar Muse, long time

president of Southwest Airlines, reputedly used to quip, "you spell competition P-R-I-C-E."

The same spelling would not seem to apply to the word deregulation.

4. Deregulating the deregulators

Overcoming constraints to deregulation is a dynamic process of institutional change. Within

the parameters of the regulator's rational choice environment, the regulator encounters

institutional change in the form of shifting constraints due to shocks in the relevant political

and economic markets. One category of market shocks is technological--for example, the

emergence of wireless and broadband competition for voice service discussed earlier.

Another source can be called ideological shifts--or what Douglass North describes as

updates to ingrained mental models--in the sense of changing policy preferences among key

policymakers. The Federal Trade Commission is thought to have significantly reduced its

antitrust enforcement activities after 1979; some scholars attribute the shift to dramatic

turnover on the relevant congressional oversight committee, while others attribute it to

changing views within the administration. At the Federal Communications Commission

(FCC), staff gradually became more accepting of Ronald Coase's ideas on property rights in

spectrum, and advances in the economics of auction design provided mechanisms for

allocating rights that could be substituted for the old regulatory regime. Judicial shifts can

also force regulators to liberalize market conditions. In the late 1970s, the D.C. Court of

Appeals cast serious doubt on the FCC's position that there be a single cellular provider per

area that is vertically integrated with the local exchange carrier.3 The FCC later changed its

stance and allowed two cellular systems, one of which was unintegrated, eventually spurring

wireless penetration and making it a significant competitor to wireline.




                                                                                  E. J. López      7
        Finally, and perhaps most fundamentally, deregulation-inducing institutional change

is brought on by entrepreneurship, in both political and economic markets. When Delta

Airlines pioneered the hub-and-spoke system and others (including cargo carriers like

Federal Express) followed, policymakers loosened their grip on old ideas of cost and

structure and saw that airlines could operate profitably and safely at market prices. Senator

Edward Kennedy's political entrepreneurship contributed to the deregulatory shift by co-

opting the hearings on deregulation into the Senate Judiciary Committee, which he chaired.

The effect of entrepreneurship further complicates the regulator's uncertainty. While

regulated firms have private information on their own costs, which can be elicited via

incentive-compatible contracts, entrepreneurial innovations present regulators with true,

structural uncertainty. As a consequence, deregulation is sometimes left to chance, like the

presence of key individuals in the right place at the right time. Bob Tollison, a consummate

entrepreneur in the intellectual sense, has empirically modeled the racial integration of sports

leagues in the mid-twentieth century (Goff, McCormick, and Tollison 2002). The results

showed that it was not the losing sports teams that first broke the color barrier. Instead, the

successful teams were the ones to initiate integration--the winning teams that had better

managers and coaches who were more alert to the profit opportunities from adding black

athletes to their rosters. Complete integration took a little over a generation, just about the

time it took for new managers and owners to replace those of the previous era.

Acknowledgements. I thank Bobby McCormick and Melissa Yeoh for organizing this

festschrift, and Richard Higgins and Arijit Mukherjee for instigating this line of inquiry with their

excellent paper. I also thank Wayne Leighton for helpful comments and Bill Shughart for serving

as a wise and patient editor. To use a phrase I learned from RDT, the usual caveat applies.



Endnotes


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1.      Inclusionary zoning ordinances in California cities, where the policy originates, typically

        require housing developers to sell between 10 and 20% of new units at controlled, below-

        market rates. Cities that use inclusionary zoning apparently have ignored or mistakenly

        calculated the non-negative profits constraint. According to Means, Stringham and Lopez

        (2007), the price controls have reduced construction of new housing by an estimated ten

        percent.

2.      According to his obituary in The New York Times, Southwest Airlines President Lamar

        Muse "cut the [regulated] fare of $26 between Dallas and San Antonio by half. He also

        gave travelers the option of paying $26 and getting a free fifth of whiskey. Soon the

        planes carried an average of 75 people, up from an average of 17, winning passengers

        from Braniff International and Texas International, and making Southwest profitable"

        (Wald 2007).

3.      National Association of Regulatory Utility Commissioners v. Federal Communications

        Commission, 525 F.2d 630 (1976).



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