Antitrust, Rent-Seeking, and Regulation: The Past and Future of Otter Tail

• Author: Andrew N. Kleit,Robert J. Michaels
• Published date: 01 September 1994
• Date: 01 September 1994
• DOI: http://doi.org/10.1177/0003603X9403900303
• Subject Matter: Economic

The Antitrust Bulletin/Fall 1994

Antitrust, rent-seeking, and

regulation: the past and

future

of

Otter Tail

BY

ANDREW

N. KLEIT* and ROBERT J. MICHAELS**

I. Introduction

689

Prior to 1973 regulation and antitrust evolved largely along inde-

pendent

paths.

That

policy

equilibrium

was

changed

by

the

Supreme

Court's

decision

in

Otter

Tail

Power

Co. v.

United

States.' Faced with a clear refusal by Otter Tail Power Company

to transmit power (wheel) for a competitor, in 1971 the Federal

Power Commission (FPC) stated that it did not have the authority

to order wheeling under the Federal Power Act

of

1934 (FPA). In

*

Department

of

Economics,

Louisiana

State

University,

Baton

Rouge, LA.

**

CA.

Department

of

Economics, California State University, Fullerton,

AUTHORS' NOTE: We wish to thank Joe Kattan, John Morris,

and

Steve

Stockum

for

helpful comments.

410 U.S. 366 (1973).

©

!994

by Federal Legal Publications. Inc.

690

The antitrust bulletin

a

subsequent

ruling

in a

federal

antitrust

suit

over

the

same

refusal, the Supreme Court said that despite FPC regulation a

court could order wheeling as injunctive relief.

Scholars usually view Otter Tail as a decision fostering eco-

nomic efficiency.> Here we argue the opposite. Rather than pro-

moting

efficiency,

it

encouraged

a

wasteful

rent-seeking

competition for federal subsidies which were not available to all

competitors. Despite frequent citation of the case, the consensus

understanding

of

it provides an increasingly poor guide for policy,

especially in light of ongoing developments in electrical regula-

tion. Thus, the mistakes of Otter Tail continue to this day and may

well be magnified by the latest policy in this area.

In the next section, we discuss the economics of vertical inte-

gration and its applicability to the case. Section III describes the

electric utility industry and its legal environment. Section IV par-

ticularizes that discussion to the Otter Tail Company, and section

Vdetails the central events of the case. In section VI we summa-

rize the legal path and economic reasoning of the proceedings

between Otter Tail, the FPC, and the Antitrust Division of the

Department of Justice. Section VII gives an economic analysis of

the outcome and puts the case in the context of the recent evolu-

tion of electric utility regulation.

II. Why deny access to a rival?

An upstream monopolist's incentive to integrate into down-

stream production depends on the downstream industry's ability to

substitute against the high-priced monopolized input. When the

downstream firm cannot do so, the upstream monopolist can cap-

ture all available profits by controlling only upstream production

and charging awholesale price that maximizes its profits. The

retail price of the downstream product is effectively forced to the

2Even conservative commentators speak favorably

of

it. See, e.g.,

Judge Posner's decision in Olympia Leasing v. Western Union, 797 F.2d

365, 376 (7th Cir. 1986) and Judge Easterbrook's dissent in Fishman v.

Wirtz, 807 F.2d 520, 571 (7th Cir. 1986).

Otter tail 691

monopoly level, with the monopoly collecting its profits in the

input price. In this context, avertically integrated firm will deal

with its rivals on the same terms at which it "deals" with itself3

and vertical integration has no impact on welfare.

Changing

these

assumptions

changes

the

conclusions.

If

downstream firms can substitute against the monopolized input,

vertical integration can increase the monopolist's profits by induc-

ing efficient use of that input. The integrated firm charges itself

opportunity cost for the input rather than monopoly price, and

hence uses a mix of inputs that results in lower production costs,

with

ambiguous

welfare

effects."

If

an

upstream

monopolist

merges with a downstream monopolist, output and welfare will

increase and retail price will fall because the merger eliminates

the problem of double marginalization.'

Beyond

these reasons,

vertical integration might be efficient because it reduces the costs

of

coordinating

the two stages of

production

and

discourages

owners

of

highly specific assets from acting opportunistically."

Conceptually, intervention in vertical relationships may be on

firmer

ground

when

applied

to a

regulated

firm.

Consider

a

monopolist

whose

regulated

price

depends

on its

costs.

If

it

reports those costs correctly to regulators, price will be set below

the monopoly level.

If

so, the firm could profit by breaking the

link between price and cost. One way is to "sell" an overpriced

input to itself, possibly through an affiliate. If regulators force the

As occurred in the famous case U.S. v. Terminal Railroad Associ-

ation

of

St. Louis, 224 U.S. 383 (1912). See Reiffen &Kleit, Terminal

Railroad Revisited: Foreclosure

of

an Essential Facility or Simple Hori-

zontal Monopoly?, 33 J.

LAW

&ECON. 419 (1990) for details.

Vernon

&

Graham,

Profitability

of

Monopolization by Vertical

Integration, 79 1. POLIT. ECON.

924

(1971).

See Ross, On the Vertical Integration

of

Successive Monopolies, 7

REV.

INDUST. ORG. 375 (1992); and Spengler, Vertical Integration

and

Antitrust Policy, 68 J. POLIT. ECON. 347 (1950).

See Williamson, Assessing Vertical Market Restrictions: Antitrust

Ramifications

of

the Transactions Cost Approach, 127 U.

PA.

L.

REV.

953

(1979).