Designing Regulation for 21St Century Markets

Designing Regulation for 21St Century Markets

Designing Utility Regulation for 21st Century Markets[1]

W.H. Melody

Delft University of Technology, Netherlands

The question for the future then becomes our estimate of the extent to which market processes will threaten economic growth and stability and of the likelihood that the redress of market failures will lie within the political capabilities of a social order whose vitality lies in the accumulation of capital.

Robert Heilbroner

21st Century Capitalism

(Norton, 1993, at 114)

Introduction

The role of government regulation of private markets has varied over time in response to the particular economic and social problems of the day, and the perceived success of inherited institutional arrangements in addressing them. Changing circumstances, including technologies, demands and general economic conditions invariably have led to changing market and industry structures, which in turn have required a reconsideration of the appropriate public policies. New policies have been fashioned from the available knowledge of institutional relationships and the anticipated implications of specific institutional changes. As the economy of the 21st century begins to reveal the dominant characteristics of a new global information economy, it is apparent that many industries and markets are changing in quite fundamental ways. A new structure of private/public institutional arrangements will be required if economic efficiency, growth and other public policy objectives are to be achieved.

The challenge for economists and other analysts is to develop the theoretical and applied knowledge that will provide a foundation for designing effective regulation for the 21st century economy, its industries and markets. This paper explores some of the major characteristics of the 21st century economy and the implications for potential new forms of market regulation, building on 19th and 20th century experience. The paper focuses on the public utility infrastructure sector of the economy, and the telecommunication (telecom) industry in particular. Dramatic changes in technologies, demands and public policies are transforming the former telephone industry into a new information infrastructure that will provide the foundation for a future economy based increasingly on electronic commerce.

The Historical Framework

All the major schools of economic thought have addressed particular issues of government economic policy, generally attempting to build a case for a change in the government policy of the day, or to promote a particular structure of government/market relations. Adam Smith and the classical economists sought to reduce the all-pervasive government regulation of economic activity that existed in 18th and early 19th century Britain and Europe. They made a case that a greatly expanded role for private initiative, and thereby private markets in a mixed economy would stimulate economic activity, growth and the wealth of nations. By reference to today's classification of economic issues, the classical economists were attacking unduly restrictive over-regulation by government, including the widespread granting of privileged monopolies, as barriers to economic growth. The neo-classical school of the 19th and early 20th centuries extended the analysis to make a case against barriers to international trade, such as the corn laws in England, arguing that free trade (i.e., deregulation of international markets) would stimulate economic growth and national wealth – at least for Britain at that time.[2]

These developments can be seen as a fundamental long wave shift in the institutional structure of government/market relations in specific national and international markets that recognized the positive contribution liberalized competitive markets can make to economic growth. The theme was liberalization in all sectors of the economy where markets could function competitively. The policy changes being advocated were the dismantling of specific government regulations that were restricting economic growth and development.

The neoclassical economists attempted to establish a policy presumption in favor of liberalized markets. Government intervention should be only to facilitate the functioning of markets, to compensate for market failures and to provide public goods and services that the market would not. At the same time, imperfections and failures in many markets were recognized by both the classical and neoclassical economists, most notably with respect to monopoly and the provision of essential public services, including transport on roads, canals, bridges, ferries and rail. In Britain throughout the 18th and 19th centuries, and even earlier, a variety of legislative and common law judicial constraints on the market behavior of dominant firms in these and other important markets provided early evidence for an institutional approach to directing markets more closely to the economic and social objectives of public policy.

By the mid 19th century the US had succeeded Britain as the country where markets had been given the greatest free rein in economic development, with government policy more likely to promote and subsidize private markets, through land grants and other means, than restrict or regulate them. But with experience – sometimes bitter – market failures in some key industry sectors had become dramatically evident, and public policy was being developed to constrain, control and direct market activity in the economy generally, and in a range of industries specifically. From 1870, state legislatures were beginning to experiment with ways to constrain the railroads. The Interstate Commerce Act (1887) established federal regulation of railroads. The Sherman Act (1890) established the first antitrust law. State regulation of railroads and public utilities (primarily electricity, gas and telephones) by independent state commissions grew rapidly in the early 20th century. The Mann Elkins Act (1910) brought interstate communication under federal regulation.

In terms of the trend of market developments in the economy of the time, the tide had turned for the new US economics profession, which came of age in the late 19th century. The primary task for economists was no longer making a case to dismantle specific government regulations that prevented economic growth and development, but rather the more difficult task of assessing market failures and devising regulations that would overcome them. The challenge was to design structures of private/public institutional relations that would promote efficient markets and other policy objectives.

Throughout the 19th and 20th centuries, the US economy, more than any other, has taken the neoclassical conception of competitive markets as a cornerstone of public policy and experimented with the liberalized market wherever possible. Even when market failures have become dramatic and self-evident, the preference of government has been to attempt to fashion a system for regulating the private market rather than displacing it with government supply. Nowhere has this been more evident than in the rail and public utility industries, the sectors that provided the fundamental infrastructure for the rest of the economy during the era of great industrial expansion. Whereas nearly all other countries chose to provide these essential public infrastructure services by government monopolies, the US fashioned a distinctive form of government regulation of private public utility operators, attempting to make maximum use of markets even under conditions of experienced, self-evident and generally accepted market failure.[3]

Institutional economists, most notably those working in the tradition of J.R. Commons, were instrumental in developing both the theory and methodology for this unique and distinctive institutional design of 20th century markets in the public utility infrastructure industries. In many respects they were following in the tradition of the classical and 19th century neoclassical economists, examining the functioning and effects of different market forms and structures. They studied specific market failures and designed public policy options to help markets in different industries function more efficiently in achieving public policy objectives. Government intervention in markets was seen as a vehicle for extending the scope of efficient markets, as well as using markets as an effective vehicle for achieving other government policy objectives (Commons 1931, 1934).

The US institutional economists of the early 20th century were pioneers in developing the foundations for structuring private/public institutional relations in many sectors of the economy. Their work covered a broad range of issues relating to the functioning of markets in general; including working conditions and labor relations, product and service quality enforcement and consumer protection, as well as the special issues associated with the infrastructure industries. Their work helped establish a tradition of studying the institutional foundations of markets, which has continued throughout the 20th century.[4] Within this historical framework, this paper focuses on one distinctive institutional structure, government regulation of privately owned and operated public utilities by independent government commission. US institutional economists in the early 20th century played a major role in shaping it, and it is now being reassessed for even broader application in early 21st century economies around the world. It is ironic that at a time when the US economy is reaping enormous benefits as a direct result of its unique and distinctive structure of 20th century public utility regulation, and countries around the world are adopting versions of it for the future, public utility regulation in the US has come under the most serious criticism in its entire existence, and is currently in retreat.

The Public Utility Model of Market Regulation

Commons and the early institutionalists began to unpack the multiple dimensions of markets in a systematic manner, to assess their distinct elements and characteristics, to identify the policy and regulatory underpinnings of different industries and types of markets, to assess market deficiencies and failures, and to identify where government intervention would enhance market efficiency and other public policy objectives. For example, they documented how the provisions and enforceability of specific property and contract rights shape market opportunities and the path of market development in all industries. For transport and public utility operators, greatly expanded property rights, including use of the government’s power of eminent domain, had to be granted and enforced before private markets could function effectively at all. But these rights had to be carefully circumscribed to protect the specific property rights of others and the affected public. Clearly a balance of rights and interests had to be fashioned by the government, and this balance determined the role, shape and effectiveness of this type of market.

The institutionalists demonstrated how government always has engaged in a wide variety of market shaping behavior, including both promotional and constraining activities and establishing market rules. They range from patent and copyright grants to R&D to agricultural subsidies, fair labor standards, consumer information, product liability, acceptable competitive contracting terms, natural resource conservation, environmental protection and more. This is all done under the presumption that market competition will be a viable force promoting efficient resource allocation in markets with clearly defined rules. Government establishes the appropriate ground rules and modifies them periodically based on experience and changing policy objectives. Government “tunes up” these markets, promoting and/or regulating the deficiencies away, and steers them into open water where they can function more efficiently so the benefits to society will be increased and/or the costs decreased.

The more difficult problem has been monopoly. This is a fundamental market failure that can’t be resolved by modest shaping and steering forms of government intervention. Much more company-specific and direct intervention is required to preserve or re-establish a viably competitive market. The antitrust laws can sometimes prevent monopoly from being established by merger or acquisition. But once monopoly power has been obtained, the only effective way to restore competition is to break up the monopoly. Good behavior agreements with monopolists rarely work as they are generally unenforceable, and the market remains dominated and overshadowed by monopoly power.

The problem of self-evident market failure, in the form of unstable oligopoly or natural monopoly over essential infrastructure services that must be accessible by everyone, cannot be addressed within the framework of traditional market theory. There is no natural market solution. By the late 19th and early 20th centuries, the transport and public utility industries had demonstrated market failure in many respects:

  1. monopolies and cartels had arisen from collusion and destructive competition;
  2. there were continuing major instabilities of supply and prices;
  3. extreme forms of price discrimination had developed;
  4. segments of the population had been deliberately excluded from essential services;
  5. virtually all classes of consumers were unhappy with the services provided and were petitioning their governments for action;
  6. high fixed costs and significant economies of scale in supply had become evident;
  7. even larger economies of co-ordination in these network industries had become apparent;
  8. these industries required the use of significant public resources, e.g., rights of way;
  9. the existence of significant positive externalities meant that private markets would not extend these services anywhere near the limits of economic efficiency, or provide universally accessible services.

In infrastructure industries that provide services on which the rest of the economy depends, demonstrable market failure and massive inefficiency could not be allowed to persist. Nearly all the rest of the world (including Britain) chose, either in advance or after observing the unfolding experience in the US, to establish government monopolies over the essential infrastructure industries. In contrast, the dominant response in the US was to try to preserve private markets to the extent possible. As it was obvious that the antitrust laws could not hope to solve these massive market failures, a new institutional model of direct government regulation of private markets was developed.

Much innovative research and analysis on the issue was provided by Commons and his colleagues, students and successors at the University of Wisconsin (Commons 1924, 1934). In 1907 Wisconsin and New York were the first states to establish state Public Utility Commissions(PUC) with the legal authority to regulate these important infrastructure industries. Within a decade most states had established PUCs. During the 1930s, federal regulation was expanded by strengthening the Interstate Commerce Commission (ICC) powers over transport, and by creating new federal regulatory commissions in securities, banking, electricity and gas, communications, and airlines. The regulatory agencies were the institutions at the frontier of market development. They were often referred to as the law's substitute for competition in the public utility industries.

The public utility model of market regulation was unique in both structure and function. The regulatory agencies were established under general laws expressing government policy objectives and providing fairly wide discretion to the agencies in interpreting and implementing them. Independent regulatory commissions were seen as superior to either legislative or judicial regulation because they could acquire greater specialized expertise, monitor industry developments in detail, make more informed decisions, and make them more rapidly. Their decisions would be objective and credible because they would be independent of narrow political or corporate special interests. Their remit would be to act in the public interest.

The regulatory agencies would have special information gathering and fact-finding powers. They would be required to follow specified administrative procedures to ensure the participation rights of all affected parties. They would be structured to be independent of backdoor political or industry influence, and required to justify their decisions both procedurally and substantively. Their decisions could be appealed to the courts. Commissioners would be appointed on the basis of qualifications for a fixed-term of significant duration. Most commissions would have several commissioners with different professional backgrounds and qualifications. Commissions would be publicly accountable to the legislature for performance in meeting the specified policy objectives and to the public via annual reports. Budgetary controls would be the same as other branches of government. This unique structure should lead to regulations, and a regulatory environment, that will stimulate a better market performance than any other institutional structure, and where both economic and social policy objectives can be achieved efficiently and effectively through the market.

This model of public utility regulation left ownership and management of the utilities in the private sector, which has some distinct advantages from the perspective of a market economy. The firm attracts its capital, labor, equipment and other resources from presumably competitive resource markets where prices and conditions will be determined by private sector market negotiations, and comparisons with competitive market results in other firms and industries can be made. Prices to consumers are more likely to reflect the economic cost of providing services, as this will be necessary if the public utility is to continue to attract the resources necessary to supply the services.

What bounds then must be placed on the public utility by the regulator to ensure the market failures are at least mitigated, if not eliminated? Essentially, the guidelines for regulation came straight out of the neo-classical competitive model. The focus was almost entirely on price. According to the “boilerplate” clauses of virtually all the legislation establishing regulatory agencies, prices must be “reasonable” and “not unduly discriminatory”. The social policy objective of public utility regulation is equally straightforward, i.e., a universal service should be established to the extent practicable. In implementing these responsibilities, regulators have broad powers to examine other aspects of utility operations, including costs and quality of service. But the essential criteria around which public utility regulation has revolved are the reasonableness of prices and the universality of service coverage. It is on this skeleton regulatory framework that a little meat and an enormous amount of fat has been hung during the last century.