The Future of Market Regulation.

• Author: Sherman, Roger

Roger Sherman [*]

Market regulation is accomplished both by competition and by external government agencies, and the trend is toward greater reliance on competition. Economists have fostered this trend and have even invented markets to help overcome some externality problems. They have contributed to a steady improvement in antitrust policy, which currently reflects economic knowledge well. They diagnosed and demonstrated problems with external regulation of the airline industry and gave assurance that regulation by competition could work in its place. Success there led not only to deregulation of airlines but also deregulation of railroads, trucks, buses, and, in some ways, natural gas pipelines. Two other industries, telecommunications and electricity, are now following very ambitious paths toward less external regulation and greater dependence on competition. The Internet raises new issues, but there also, competition will play an important regulatory role.

1. Introduction

   Whether you want to buy a wireless phone or a loaf of bread, whether you click your order, telephone your order, use the mail, or travel to a store, your transactions, and indeed most economic transactions, are influenced by some form of market regulation. Imagining the present without such regulation is hard, and imagining the future without it is even harder. To predict what forms regulation will take in the future is not easy either--it is not even possible. But looking back over more than a century of market regulation in the United States, there are trends that suggest the course it will follow.

   In "market regulation," the word "regulation" usually connotes some extramarket, even administrative, guidance of the market. We'll call this external regulation to distinguish it from regulation by competition, which readers of this Journal know also regulates markets--raising price when supplies are scarce and lowering price when supplies are plentiful. External regulation supplements competition and comes in three main forms--antitrust, industry regulation, and social regulation like environmental protection. In the future, we should expect to see more reliance on competition as a regulating force and less, or more subtle, external regulation.

   First, it is clear that external regulation has been imperfect. Mistakes were made. When mistakes were made, economic lessons consistently followed and economic forces helped to bring about corrections. This is important because regulatory institutions have often been formed by legislation or by court decisions without sound economic foundation. Firms seek favors and politicians pursue votes, and that won't stop. Remedies for flaws have usually come from economists, whom--you should be pleased to know--are the heroes of this story.

   My discussion has five parts. First, in the area of social regulation, I note how saleable rights are being created. I use as an example pollution rights that are used to regulate what a firm releases from its smokestacks in the form of air pollution. These are essentially markets that economists have invented, usually to make other markets work better. Second, I'll use antitrust regulation to show how much we have improved in guiding markets. Early antitrust efforts involved some bad economics, but economics has gradually improved antitrust policy. Third, on industry regulation, I'll review how external regulation of airlines was flawed and how the analysis and recommendations of economists spawned a whole deregulation movement. Fourth, I'll turn to markets that are literally being devised right now to let competition work in industries like telecommunications and electricity where external regulation of monopoly firms functioned for years. When we focused on problems with existing institutions-like rate-of -return regulation--we found serious problems and worked out improvements. Changing technology has forced more fundamental change in these industries. Finally, I'll briefly consider the design of markets for cyberspace.

2. Social Regulation by Creating Rights

   Environmental problems, like pollution and congestion, are hard to solve. [1] Rights to pollute and rights to use highways can be created to help solve these problems, and they are examples of economic ideas in practice. They will not solve all problems or even the most difficult ones, but they show how creating new rights can regulate external effects by motivating their efficient reduction.

   Rights to Pollute

   Creating rights to pollute the air can--paradoxically--help control pollution. A right-to pollute solution for pollution control defines a right to pollute and allows that right to be bought and sold. Defining a right to pollute is difficult, of course, because it requires measurement and enforcement. But once that hurdle is overcome, the total amount of pollution-the total rights to pollute-can be specified. This means that the level of allowable pollution can be specified, as we now do, for instance, to limit sulphur dioxide emissions in the United States to combat acid rain. [2]

   Once pollution rights are defined and a given supply is established, a market price can be determined. Then those who can reduce pollution most efficiently, that is, for less than the value of a right to pollute, will reduce pollution and sell their rights to pollute to others. Those who face higher pollution abatement costs can buy the pollution rights and use them for permission to emit pollution. Thus, at a market equilibrium, the price of pollution rights reflects the marginal cost of controlling pollution to the level that the available pollution rights will allow.

   Rights to Highway Use

   We pay no price for highway use. We incur the private cost of a vehicle trip between two points, including not only fuel, oil, tire wear, and so on, but also the driver's (and passengers') time, and when congestion is serious, that time component goes up? [3] The familiar problem of excessive traffic congestion arises because each of us decides whether to make a highway trip on the basis of the average cost rather than the marginal cost of the trip to society. [4] An additional car can join a stream of cars on the highway and it will share in the average costs and delays of all the other cars. Yet that marginal vehicle causes delays to all the others, delays that the driver of the marginal vehicle does not take into account when joining the traffic stream.

   Roughly 40 years ago, Sir Alan Walters (1961) estimated the magnitude of a tax that would make road use more efficient in urban areas of the United States; in today's dollars, that tax would be about 20 cents per mile. If this charge was collected as a tax on gasoline today, it would be more than $2.50 per gallon. Even if we were to adopt taxes at this level, they would be inadequate as solutions to congestion, of course, because road use would cost the same whether the use came in the middle of the night or at rush hour, and the congestion problem comes only at rush hour (see Sherman 1971). A solution to the highway congestion problem can come from assigning a property right in road use--a right to delay others, like the right to pollute. Electronic devices exist now that will record time spent on a road. When placed in vehicles, these devices function like the electricity meter in your house, but they identify the time and location of your road use. [5] Technology and economics combine in these devices to make billing drivers for road use feasible, and that can avoid excessive congestion. Such devices and fees are in effective use in Singapore, [6] and many of us should expect to see them in our lifetimes.

   Thus, economists have invented markets to solve market problems. There are many other areas where social regulation was introduced in clumsy forms--consumer protection, for example--that are improving gradually, based on economic ideas that improve information and market function. To show this general process of gradual improvement in applying economics, we consider how economics has improved the efficiency of markets through antitrust.

3. External Regulation and Competition: The Example of Antitrust

   In 1890, western farmers felt they were suffering from the steadily falling general price level and the growing power of railroads and combinations of firms in other industries. Not far behind the railroads in ruthlessness were the efforts of trusts to control meat, oil, tobacco, steel, sugar, lead, whiskey, gun powder, and other industries. How to remedy this trust problem to obtain the benefits of competition was not at all obvious, particularly to Congressmen who were sympathetic to private business and a public that believed in private enterprise. Many states had adopted antimonopoly provisions but, with a few exceptions, they did not enforce them, either from lack of resources or from reluctance to drive large employers from their states.

   At the time, it was by no means obvious that legislation could solve the trust problem. Recall the famous line from Adam Smith: "People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices." [7] Smith's next sentence was "It is impossible indeed to prevent such meetings, by any law which either can be executed, or would be consistent with liberty and justice." That sentiment indicates why most economists of the time opposed passage of the Sherman Act. [8]

   In antitrust cases, courts follow either per se rules, under which certain facts determine guilt or innocence, or they examine circumstances more broadly and follow a rule-of-reason analysis to determine the appropriateness of the observed behavior. The per se procedure is quicker and easier, and of course it gives more precise guidelines to business firms, but it requires what lawyers call bright line, or clear, rules. The disadvantage of such per se rules is that...