Regulation of Industry
Regulation of Industry
Regulation of Industry
In its broadest sense the term “regulation” may be taken to comprehend all of the controls that government imposes on business of all kinds. In the narrower sense in which the term is used here, it is limited to control of the services provided and rates charged by private enterprises engaged in the provision of transport, communication, electricity, gas, and other utility services. In this sense, regulation is largely an American institution. Elsewhere in the world, industries rendering these services are usually owned and operated by government. Experience with regulation of such industries is thus confined, in the main, to the United States.
At one time, economists sought to distinguish industries that should be regulated by pointing out characteristics that made them naturally monopolistic—overcapacity, high fixed costs, a tendency toward destructive competition and eventual collusion—and attributed regulation to the consumer’s disadvantage in buying from monopolists. But today there are industries possessing these characteristics that are not regulated, as well as other monopolies that are not controlled, while transport, though increasingly competitive, has been increasingly controlled. At one time, too, the courts excepted the transport and utility industries from their general disapproval of regulation on the ground that these industries were peculiarly “affected with a public interest.” But this distinction was abandoned as long ago as 1934. No hard and fast line can now be drawn, in economics or in law, between the industries that should be regulated and those that should not.
Regulation was first attempted through provisions written into statutes, ordinances, and franchises permitting the use of city streets. But this method of control proved to be clumsy and ineffective. Legislatures then turned to the creation of administrative agencies, called commissions, charging them with responsibility for the enforcement of controls. The first of these bodies were set up by the states in the nineteenth century to regulate the railroads. The first such federal agency, the Interstate Commerce Commission (ICC), created in 1887, was also empowered to regulate this industry, and in 1914, when the courts upheld the right of the ICC to control intrastate as well as interstate operations, that commission came to dominate the regulation of railroads, and the state commissions were relegated to a minor role. At the same time, with the growing importance of electricity, telephone, and other utility services, the state commissions were given jurisdiction over these fields, being transformed from railroad commissions into bodies known as public utility or public service commissions. Such an agency is found in nearly every state today.
During the 1930s the federal government set up three other commissions with power to regulate transport and utility services and rates: the Federal Power Commission (FPC) with jurisdiction over hydroelectric installations on navigable waterways and over the interstate transmission of electricity and natural gas, the Federal Communications Commission (FCC) with jurisdiction over interstate and international telephone and telegraph services, and the Civil Aeronautics Board (CAB) with jurisdiction over civil aviation. Some of the duties of these agencies do not conform to the usual pattern of regulation. The FPC is empowered not only to fix the rates charged for the transmission of gas through interstate pipelines but also to regulate the price charged for gas at the wellhead. The FCC is required to allocate channels for broadcasting and to exercise some control over the character of broadcasts but does not regulate the prices charged to advertisers by the broadcasters. There are other federal commissions whose functions do not fall within the field of regulation, as narrowly denned. The Securities and Exchange Commission, for instance, and the Federal Trade Commission are concerned with the prevention of fraud but not with the control of services and rates.
The regulatory commission differs in form and in character from other agencies of government. The typical commission is composed of an odd number of members appointed by the executive, with representation assured to each of the major political parties, with terms long and overlapping, tenure legally protected, and decisions subject not to executive veto but only to judicial review. Its specialization and its independence are designed to put responsibility for regulation in the hands of experts, to permit the use of informal procedures, and thus to speed decisions. Its multiple membership and its overlapping terms are intended to assure soundness of judgment and continuity of policy. Its bipartisanship and its protection from political pressures are expected to ensure impartiality. The commission has sometimes been characterized as a fourth branch of government, not clearly to be classified as legislative, executive, or judicial. Exercising a function delegated to it by the legislature, it gives detailed substance to general policies prescribed by law. Located in the executive establishment, it is subject to administrative directives and constraints. Deciding disputed cases on the basis of general principles, it acts, in essence, as a court.
It is the central purpose of regulation to prevent the owners of regulated enterprises from obtaining monopoly profits. To this end the commissions control the rates that may be charged. But there are other activities that must also be controlled: entry into the industry, the availability, quality, and safety of service, financial practices, and accounting methods.
Entry of competing enterprises is restricted in order to safeguard the financial strength of those already in the field. Control over service is necessitated by the absence of competition. Extension of service may be required and abandonment of particular services forbidden. Standards to govern the quality of service may be established, though initiative here is usually left to industry, with the commissions acting only in response to customer complaints. Safety requirements, of minor importance in some fields, play a major role in the regulation of such industries as civil aviation and the generation of electricity from nuclear energy.
Control of financial operations is undertaken to maintain the credit of regulated companies and thus to assure their continued ability to attract capital and render service. In most cases, securities may not be issued without commission approval. Overcapitalization can thus be forestalled and a balanced capital structure required. Padding of costs and diversion of earnings are prevented by supervising transactions between related concerns.
Control of accounting is essential to the administration of the other controls. Rates cannot be effectively regulated, proposals for extension or abandonment properly appraised, or financial operations adequately supervised in the absence of accurate knowledge regarding company accounts. Commissions are therefore generally empowered to prescribe methods of accounting and to require periodic reports.
The regulation of rates has two aspects: control of the rate level and control of the rate structure. The rate level has to do with the size of a company’s earnings. Here, the commission must seek to attain equity as between investors and consumers. The rate structure has to do with the particular rates paid by different classes of customers for different units of service. Here, the commission must seek to prevent treatment that is unduly discriminatory, favoring some customers and harming others.
The general level of rates should be high enough, first, to cover the current costs of operation and, second, to yield an adequate return on the investment. Ideally, this return should be sufficient to be fair to past investors, avoiding impairment of the value of their property. It should also be high enough to preserve the credit standing of the regulated company so that it will be able to attract the capital needed if its service is to be improved and expanded.
Control of the rate level involves three different processes. First, it is necessary to control operating expenses. These expenses are usually the largest sum that must be covered in the rates. If they are inflated, the rates will be too high. Second, it is necessary to determine the rate of return on investment that is to be taken as fair to investors and as adequate for the maintenance of credit. This rate is expressed as a percentage of the value of the company’s property. Third, it is necessary to determine the value of this property, estimating construction or reproduction costs and making due allowance for depreciation.
The commissions have not been vigorous in controlling operating expenses. In general, they have taken the view that decisions respecting the wisdom of expenditures lie within the province of management and have refused to substitute the judgment of regulators for that of managers. Accordingly, they have never sought the power to require that budgets be submitted for approval before money could be spent. The most that they do is to examine reports on expenses incurred in the past, and, if certain items seem improper, they may warn the companies concerned that they will not include such items in computing future rates. But regulation may be so lax that such warnings will have little effect.
The rate base
In determining the rate of return to be allowed on investments, the commissions operate within the limits of the constitution as it is interpreted by the courts. Under the fifth and fourteenth amendments to the constitution, federal and state governments, respectively, are forbidden to deprive any person of property without due process of law. Applying this prohibition, the courts undertook, for many years, to review the rates that the commissions set. Their concern was to protect investors; their attention was focused, accordingly, upon the adequacy of earnings. Investors in regulated industries, they held, should be permitted a fair return upon a fair value of their investments. But the issues usually brought before them related not to the percentage adopted as a fair return but to the method used in determining fair value. Valuation of the rate base thus came to be the heart of the problem of controlling rates.
The points at issue in the valuation controversy had to do, in part, with the propriety of including intangible assets in the rate base and with the methods used in the treatment of depreciation. But these matters were overshadowed by the dispute between those who held that the properties should be evaluated on the basis of their original cost and those who would evaluate them on the basis of reproduction cost. With prices rising, reproduction cost would necessitate a higher level of earnings and of rates.
Beginning in 1898 the courts insisted that some weight be given to reproduction cost, rejecting a number of rate determinations on the ground that the weight accorded was insufficient. But they never stated what the proper weight would be, accepting a lower weight as adequate in one case and rejecting a higher weight as inadequate in another. As a result, rate determinations were held up by protracted litigation. The commissions, instead of taking formal action, sought to obtain such rate concessions as they could through informal negotiation. For nearly half a century the effectiveness of regulation was seriously impaired.
This situation was ended in 1944, when the Supreme Court declared that the method of valuation was to be left to the discretion of the commissions and that consideration, accordingly, need no longer be given to reproduction cost. Since that time, valuations made by the federal commissions and most of the state commissions have been based on original cost. Fair value, however, is still based on reproduction cost in a minority of states.
The rate of return
With settlement of the controversy over valuation, more importance has come to be attached to determination of a fair rate of return. Here, recognition has been given, first, to the fact that earnings need to be high enough to enable regulated companies to attract new capital. But no rules have been established for ascertaining the level of earnings required for this purpose. The nature of a company’s capital structure, though relevant, is not taken into account. The return required to ensure a market for common stocks is uncertain. Earnings can always be set at a level that will make such stocks attractive, but this may involve a larger return than is in fact required. Recognition is given, second, to the need for a return that will be fair to past investors. Here, the courts have said that earnings will be fair if they are equal to those obtainable in other industries with comparable risks. But this rule is rendered inoperable by the absence of industries with similar risks. The earnings needed to attract new capital, moreover, are likely to differ from those required for fairness to past investors. According to the one standard or the other, the return allowed will thus be too high or too low.
Other issues raised by the rate of return have been ignored. Earnings might well be averaged over time; they are calculated for a single year. Earnings might be adjusted to afford an incentive to efficiency; such adjustments have been made, but they are exceptions to the general rule. In practice, the commissions and the courts announce the percentages of return they hold to be fair, running from less than 6 per cent to as much as 8 per cent (or more in the case of airlines)—these figures varying from state to state, industry to industry, and year to year. But they do not disclose the considerations that have led to their decisions. The principles, if any, that govern the determination of a fair return are thus unknown.
The level of transport rates
In controlling utility earnings, fair return on fair value is still the rule, but, in the case of transport, this rule has long since been abandoned. Public utilities, in general, enjoy monopolies of essential services. Utility rates designed to yield a specified return can usually be relied upon to do so. Railroads, on the other hand, have always competed with one another. A fair return could not be separately fixed for each competitor but had to be established as an average for those in a competing group. Railroads have come to be faced, moreover, with the competition of other transport media. There is no assurance that a return adopted as fair for them will actually be obtained.
In 1920 Congress directed the ICC to set railway rates at a level that would enable the roads to earn an average return of 5½ per cent. This goal was never attained. In 1933 Congress enacted, in the Interstate Commerce Act, a new rule of rate making. The commission was now directed “to give due consideration … to the effect of rates on the movement of traffic; to the need … of adequate and efficient transportation service at the lowest cost consistent with the furnishing of such service; and to the need of revenues sufficient to enable the carriers … to provide such service” (sec. 15a). The new rule made no mention of fair value. It called only for a return that would enable the railroads to attract new capital. Recognizing the existence of growing competition with increasing elasticity of demand, it acknowledged that the desired level of earnings in transport might not be attainable by raising rates. This rule was applied, within the next few years, not only to railroads but also to carriers by highway, by water, and by air.
Regulation is applied to the rate structure in order to control discrimination among consumers. The rates charged by transport and utility enterprises for various units of service are highly differentiated; railroads, for instance, charge different rates per ton-mile for carrying different commodities, or for the same commodity between different points; electric companies charge different rates for different uses and for different hours. These differences are to be explained, in part, by differences in cost. But they are also to be attributed, in large measure, to differences in demand. Where demand is elastic, rates are low; where it is inelastic, they are high.
Under certain circumstances there is a case to be made for discrimination. There must be idle capacity so that output can be increased. There must be high fixed charges so that cost per unit can be reduced as output grows. The added output must be salable only at the lower rates. These rates must be high enough to contribute to overhead. The general level of rates must be regulated to keep earnings reasonable and discrimination within bounds. Given these conditions, discrimination may result in lower prices for each class of customers and for each block of sales. It may bring about a fuller utilization of resources and a wider consumption of services.
Discrimination by regulated utility monopolies may thus have a generally beneficial effect. Discrimination by competing transport companies is unlikely to do so. The establishment of lower rates for goods that otherwise would not move at all may be of general benefit. But rates are also set lower on hauls where railroads compete for traffic and higher on hauls where they do not. Traffic that is attracted by the lower charges is diverted to one carrier from another. The one gets more revenue; the other gets less. With the former, unit costs are lowered; with the latter, they are raised. Shippers who use competing lines are benefited; those who use noncompeting lines are handicapped. It cannot be said that such discrimination is of benefit to the community as a whole.
Regulation of the rate structure
The law does not forbid discrimination as such but only that discrimination which may be held to be undue or unreasonable, giving one user of service an unfair competitive advantage and placing another under an unfair handicap. It is thus the function of the commissions to determine when discrimination is to be permitted and when forbidden. This work has taken a large part of the time of the ICC. It has been given little attention by the state utility commissions.
Initiative in setting individual rates is taken by the regulated companies, the commissions acting only in response to customer complaints. In the case of rail transport, such complaints have been numerous. In dealing with them over the years, the ICC has developed a body of precedent to which it adheres. In general the commission has sought to prevent discrimination among competing shippers. But it has also permitted discrimination where this was necessary to enable one carrier to compete with another for particular commodities and hauls. When the two principles have been in conflict, the latter has prevailed. The resulting structure of rates has been highly discriminatory.
The rate structure established by the utility companies has typically involved the use of classifications and differentials that have been based in part on differences in cost but in larger part on differences in the elasticity of demand. In the case of electricity, for instance, the low rates have gone to industry, where demand was elastic because it could produce its own power, and the high rates have been charged to householders, whose demand was inelastic because they could not. The commissions have accepted this pattern, subjected it to little scrutiny, and made little effort to have it modified.
Regulation of utility monopolies
In general, the regulation of utility monopolies has been lax. Control of service and the structure of rates has been minimal. Attention has been directed primarily to the rate level. But here, operating expenses have not really been controlled. The rate base, long inflated by reproduction-cost valuations, may now be tied to original cost. But the rate of return allowed is determined arbitrarily, without reference to stated criteria. Control of earnings is neither tight nor continuous. The earnings permitted have been well above those required to enable the utility companies to attract new capital. A rate case, moreover, may be brought as infrequently as once in a decade. In the meantime, if demand has grown and costs have declined, excessive profits have been realized and retained.
Regulation of transport competition
In the case of transport, regulation has come to have a different purpose and effect. Here, monopoly has given way to competition. It should have heen possible, accordingly, to relax controls. Instead, they were intensified. It came to be the purpose of regulation not to protect shippers against monopolistic carriers but to protect competitive carriers against one another. The pattern of control developed for the railroads was extended to the other modes of transport. Control of entry and of rates came to be employed to make sure that each of these modes retained its accustomed share of the traffic. Entry into the trucking business was curtailed and routes were restricted. Emphasis in the control of rail rates shifted from the imposition of maxima to the imposition of minima. The railroads, in practicing discrimination, were permitted to meet the lower rates of other carriers but not to undercut them, even though still lower figures would have more than covered their out-of-pocket costs. As a result, the allocation of traffic came to be influenced less by the comparative economic advantages of the different transport media than by the regulations imposed by the ICC. It was not until 1958 that policy began to move in the direction of relaxing controls so that competition could be given somewhat freer play.
Regulation of civil aviation
Control of civil aviation is a case by itself. Here, safety regulation is in the hands of the Federal Aviation Agency and economic regulation in the hands of the Civil Aeronautics Board (CAB). It is with the latter that we are here concerned.
Air carriers, unlike surface carriers, derive their revenues predominantly from passengers. Until after World War II, airline revenues fell short of expenses and all the lines were subsidized. The government was concerned less with the regulation of fares than with determination of the subsidies. After the war, however, the trunk (longhaul passenger) lines gradually went off subsidy and the CAB undertook to develop a policy to govern regulation of the level of fares. Under this policy, as made public in 1960, the trunk lines are to be allowed a weighted average return of 10.5 per cent on their investment; the local feeder lines from 9 to 12.5 per cent depending upon the character of their capital structures, with 5.5 per cent allowed on their bonds and 21.35 per cent on their common stock. It is obvious that such rates of return will not make for tight control of earnings. As for the structure of fares, no study has yet been made and no policy announced.
The CAB has maintained strict control over entry, permitting no new trunk lines to be established since it was created in 1938. It has encouraged the creation of local feeder lines, keeping them in existence by subsidization. Most of the board’s time has been devoted to passing on applications for the right to fly particular routes. Here it has sought to ensure the existence of competitive services and, by granting added routes to weaker companies, to equalize the profitability of the airlines. The board has used its control of routes to stimulate the modernization of equipment and increase the frequency and speed of flights. At the same time, its control has delayed adaptation of routes to changing needs and has discouraged diversity in types of service. It may be questioned whether the resulting pattern of routes and complement of services is superior to those that would have obtained in the absence of regulation.
Regulation of broadcasting
In the case of radio and television, the Federal Communications Commission (FCC) is concerned primarily with the allocation of channels for broadcasting. Licenses conveying rights to exclusive use of channels, their value running into millions of dollars, are granted to broadcasters without charge. These grants are made on the basis of stated criteria. But the criteria are imprecise, subjective, inconsistent, and inoperable. They are given lip service but in practice are ignored. The real grounds for action are not disclosed. Commissioners have been subjected to improper pressures and have succumbed, in some cases, to bribery. Critics of the licensing process have proposed that licenses, instead of being given away, be auctioned off to the highest bidder. Such a change would put an end to the ambiguity and the temptation to corruption inherent in the present method of licensing. But, in itself, it would do nothing to improve the quality of programming.
It is here that regulation has failed most seriously. Its licensing power gives the FCC control over the structure of the industry, over contractual relations between the networks and their affiliated stations, and over progress in the adoption of new technology, but only nominal control over the character of programming. The commission has reserved a number of channels for educational broadcasting, authorized experimentation with pay television, and sought to curb the broadcasting of lotteries and of obscenity. But it has not revoked licenses or refused renewals on the ground that the programs presented have failed to fulfill the broadcaster’s promise to serve the public interest. Commission chairmen have admonished the industry from time to time to raise the general quality of their programs and to avoid the crasser abuses of advertising. But in the face of powerful political pressure, the commission has lacked the courage to order them to do so.
There are a few regulatory commissions that have consistently maintained a record of vigorous action in the public interest and a few that have taken such action upon occasion. But, by and large, the agencies have fallen short of the performance * they had promised. They have not anticipated changing conditions or developed broad policies to guide control but have waited for cases to be brought before them, permitting policy to emerge from the processes of adjudication. They have not sped decisions through informal action but have delayed them by adhering to cumbersome procedures. They have not fulfilled their promise of independence and impartiality. The commissions are dependent on the executive for appointments, for budget requests, and for political support; on the legislature for jurisdiction, for powers, for confirmation of appointments, and for appropriations. Lacking insulation from political pressures, they have been unable to take an independent line.
More than this, the commissions have come increasingly to serve the interests of the industries they were set up to regulate. When first established, through popular demand for reform, they had the support of the executive and the legislature and thus were able to embark with some zeal upon their regulatory duties. In time, however, public attention has shifted to other problems. Executives have made poor appointments and have failed to provide political backing. Legislatures have denied adequate jurisdiction, powers, and appropriations. The commissions, lacking any other clientele, have turned to the regulated industries for support. Working day in and day out with industry officials, they have become immersed in industry’s problems and have come to share its point of view. The consumer’s interest has been lost from sight.
Inherent limitations of regulation
The commissions’ powers could be strengthened, their personnel improved, and their appropriations increased. But there are limitations inherent in the pattern of regulation that such reforms could not remove. Regulation cannot itself prescribe quality, force efficiency, or require innovation; to do so, it would have to duplicate the central functions of management. Nor does it offer a reward for good performance or impose a penalty for poor performance in these respects. On the contrary, rate regulation involves cost-plus pricing. If management is diligent in cutting costs, rates will be reduced; if it is indolent, they will be increased. If regulation were tight there would be no incentive to efficiency or to progress. If such an incentive does, in fact, exist, it is because regulation is lax.
Regulation could conceivably prevent monopolistic enterprises from charging monopoly prices and obtaining monopoly profits. But it does not attempt to maximize consumption by setting rates at the lowest level that will yield a fair return. Regulation is backward-looking. The necessary level of rates is computed by multiplying price per unit by past demand. Elasticity of demand is not taken into account. The possibility that lower charges might be justified by growth of demand or by innovations in technology is ignored. As a result, the level of rates, even if monopoly profits are excluded, is higher than it needs to be.
Regulation is inevitably slow. It must satisfy the requirements of due process: investigate, give notice, hold hearings, study the record, make findings, issue orders, permit appeals. All this takes time and delays action. In some cases, delay may be harmful, as when it permits earnings to rise well above or to fall far below the return required to attract new capital. In other cases, it may be helpful, as when it brakes an inflationary spiral of wages and prices. But here, the merit of regulation lies not in its efficiency but in its inefficiency.
Regulatory agencies tend to become industry-minded, seeking to protect the regulated industry against low rates and impaired earnings. This orientation makes, too, for regulation-mindedness. Where effectiveness of the regulator’s controls is weakened by the freedom of firms beyond his jurisdiction, he seeks wider jurisdiction. Where the applicability of his controls is lessened by changing circumstances, he seeks tighter controls. Thus, in transport, where monopoly has given way to competition, the original purpose of regulation might have been better served if jurisdiction had been narrowed or controls relaxed. But policy, over the years, has favored expansion of coverage and elaboration of detail.
The regulated industry comes, in the end, to have two masters: its own management and the regulatory agency. Managerial decisions are reviewed. Where the regulatory agency finds them to be wise, it allows them to stand. Where it finds them to be unwise, it exercises a veto power. Negotiation between the managers and the regulators takes time; decisions are inevitably delayed. Division of authority diverts energy from the solution of external problems to the prosecution of internal disputes. At the same time, it dissipates responsibility.
The ICC is required, for instance, to consider the probable effect of the rates it sets upon the volume of traffic. In doing so, it may substitute its own judgment for that of railway managements. If earnings fall, there is no one whom the owners of the roads can hold responsible. The managements are deprived of power; the commission has power but lacks responsibility. Even if managements are not reversed, decisions may be so delayed that substantial losses are sustained. In cases such as this, the management escapes responsibility by blaming the regulators. But the regulators cannot be held accountable.
Bernstein, Marver H. 1955 Regulating Business by Independent Commission. Princeton Univ. Press.
Bonbright, James C. 1961 Principles of Public Utility Rates. New York: Columbia Univ. Press.
Caves, Richard E. 1962 Air Transport and Its Regulators: An Industry Study. Harvard Economic Studies, Vol. 120. Cambridge, Mass.: Harvard Univ. Press.
Locklin, David P. (1935) 1966 Economics of Transportation. 6th ed. Homewood, III.: Irwin.
Phillips, Charles F. Jr. 1965 The Economics of Regulation. Homewood, III.: Irwin.