are the merits of the alternatives to present regulation? What transitional problems might be faced in moving to alternatives?

The study is unique in a number of ways. It is the first attempt by Congress to address broad issues of the substance of regulation. It attempts to synthesize and evaluate a wide range of often highly technical economic literature to provide a useful and up to date picture of rationales, effects, and alternatives. It is also unique in scope, addressing not only standard or "old line" economic regulation, but also the "newer" regulation of safety, health and environmental problems.

While many of the costs of such regulation may be quite visible in government mandated capital investments and higher production costs, the benefits may be widely diffused and slow to materialize. These bencfits could include cleaner air and water, and less frequent injury and disease.

Heightened concern with costs and, it appears, with government intervention itself, has followed closely on demands for more government action. This tension is likely to be with us for some time. And as OSHA extends its inventory of health hazards, as the CPSC begins more vigorously to promulgate standards and ban hazardous products, and as the FTC begins more active use of its rule making powers in consumer protection areas, the tension between these competing objectives is likely to increase. Regulation's impact will become more visible to all workers, businessmen, and consumers.

And, as with economic growth, rising incomes, and new problems, many segments of society will come to demand greater protection of safety, health and environmental concerns, so many of the tradeoffs between these and other aspects of human welfare and living standards become more apparent.

This heightening of concern will bring increasing demands for Congressional action to reform regulation. Some will advocate extension and tightening of regulations; other, particularly in the business community, are likely to demand relaxation and greater reliance on "market forces." Effective response to these challenges requires clear Congressional understanding of the merits and failings of private market operation, the relative efficacy of present and alternative regulatory mechanisms, and problems of transition to new regulatory regimes. This report attempts to address these vital needs.14

Such an understanding of the underlying problems and alternative solutions is also needed so that Congress can design regulation to allow for and evolve with technical and economic change, which in turn renders many regulations obsolete or ineffective. Very often change requires reappraisal and modification of regulatory controls, and we hope this examination provides the framework Congress needs properly to design those alterations in regulation.

In spite of the large number of regulatory agencies and public enterprises the American economy is still preponderantly one of private

14 It is, of course, true that the need for procedural reform and streamlining will continue to be critically important. It is also frue that, by reducing delay and other prob lems, procedural reform can mitigate complaints of undue costs or failure to meet social objectives. The focus of this report is. concerns the basic issues of the proper scope and form of Federal regulation. Previous volumes of this Study address issues of delay, Congressional oversight, quality of appointments, overlap among Federal agencies, and public participation.

enterprise. Most consumption, production, and investment decisions are made by private firms and individuals operating on generally unregulated markets. Increasingly, these decisions occur in a context defined by explicit regulation governing such areas as the use of environmental resources, the health and safety aspects of working conditions, and product safety.

And in some markets-including railroads and oil-private decisions are supplemented or supplanted by explicit regulatory controls on prices, rates of return, investment, and product quality. The general topics of this report are the proper "mix" of private and public decisionmaking in the mixed economy, and the proper mix of alternative means of public decisionmaking. The stage for this discussion is best set by looking briefly at the case for unregulated private markets.

Reduced to fundamental terms, any society must provide answers to three basic economic questions: What shall be produced? How shall it be produced? For whom shall it be produced? Market organization is one way of providing answers to these questions. Other methods include tradition, and command or centralized planning. All societies use differing mixtures of these three basic methods. The United States, is in many respects close to a full market economy, though elements of tradition (for example, parents support their children) and centralized decisionmaking (for example, the activities of the Federal Reserve Board and federal setting of minimum wages) are also important.

There is a strong case for private decisions in free markets. When markets are competitive and participants well informed, firms are forced to produce those goods for which consumers are willing to pay, and to do so at minimum cost. Firms that do otherwise experience losses and, if they persist, bankruptcy. Products are offered in a range of varieties and qualities, as determined by consumer tastes and incomes and by costs of production. Shortages are eliminated automatically either through rationing by price or incentives offered to expand production of scarce commodities. The prospect of profits provide a strong inducement to find and exploit new products and techniques. More generally, decisions are made by those directly concerned, and by those with specific knowledge of the situation. The flexibility of the market system and its adaptability to change provides the most general case for private decisions on free markets.

However, the market economy cannot always work either perfectly or to the satisfaction of all concerned. First, the market may fail to achieve efficiency-to deploy society's scarce resources so that the most valued mix of products is produced at minimum cost. These "market failures" or failure of unregulated markets to achieve efficiencymay arise for a variety of reasons, including monopoly, costly or imperfect producer or consumer information, and externalities-that is, spillovers such as air pollution. As discussed later in this study, all of these conditions can lead to situations in which the private benefits or costs which direct the activities of firms and individuals differ from benefits or costs to all individuals and firms taken together. Yet, these total or "social" benefits and costs should guide economic activity. There is then a potential role for government action to correct the im

balance. These imbalances can be in a number of forms: monopoly can lead to underproduction of particular goods and services; so too, allowing free use of the environment for waste disposal leads, predictably, to overuse of this scarce resource and undue damage to public health and welfare and poor worker information on safety hazards can lead to employment under dangerous conditions. Some form of regulation is one means of correcting such "market failures,” though it is not the only option available.

Market results may be unacceptable even when no "failures to achieve efficiency" exist. Efficient market results based on willingness to pay and on production costs may appear unfair if, for example, rural consumers must pay more for phone service than urban, or if owners of oil and natural gas properties gain from OPEC price escalation. So too, consumers and workers may collectively demand more protection from health or safety hazards than might seem perfectly efficient in market terms. Such demands may seek to lessen the burden of decision making costs, or protect particular segments of the population. Private market actions may not take sufficient account of national concerns, such as energy independence or security needs. As with problems of "market failure" to reach efficiency, regulation of some form is but one of several available options.

CHAPTER Two

THE CONDITIONS FOR REGULATION

A. MARKET FAILURES: CONDITIONS UNDER WHICH REGULATION CAN INCREASE EFFICIENCY

Unregulated competitive markets can, under proper circumstances, result in an efficient allocation of resources. The firms competing in such markets will produce those goods on which consumers place the highest value in the quantities that consumers are willing to pay for and by methods that minimize production costs. Yet, the real world economic system contains many cases of market failure-cases where markets do not operate efficiently for one or more of several reasons. A common response to such market failure, both actual and perceived, has been regulation, though there have been other reasons for regulation as well. The purpose of this section is to review the major justifications for Federal regulation.

1. Natural monopoly

The classic case for regulation is natural monopoly. If in some industry cost per unit output falls until the efficient size of operations fills all or most of the market then competition may not be workable. Competition is apt to be short lived and unstable because even if there is more than one producer in the market at one time, the larger firm will enjoy lower costs and will be able ultimately to win the entire market from its smaller, less efficient rivals. Moreover, from the point of view of efficiency, monopoly is probably preferable to competition in a decreasing cost industry. This is true, because an industry made up of a number of small firms would have higher cost per unit than a single monopolist would.1

However, most people find unregulated monopoly unacceptable. A monopolist may be able to set prices well above cost, which has two undesirable effects: It enriches the monopolist at the expense of the rest of society, and it may also result in too little output. Consumers would be willing to pay the cost of additional output, but the monopolist may be unwilling to reduce his price enough to sell the extra output. In addition, an unregulated monopolist might find it profitable to discriminate in price. That is, he might charge higher prices for those whose demand is relatively unresponsive to price. The public has often objected to such price discrimination as unfair; however, by providing incentive to expand output, discrimination could alleviate the efficiency effects of monopoly restrictions.

Thus, decreasing cost industries present society with a dilemma. Competition in such industries is unstable and inefficient, but unreg

1 Some might object to attaining efficiency at the cost of high profits to the monopolist. And, shielded from competitive pressures, monopolies may become soft and inefficient.

ulated monopoly can result in high prices and discrimination. Regulation is a common means of resolving that dilemma. Its presumed purpose is to permit or even require monopoly, while controlling prices to avoid excessive profits und undesirable price discrimination.

Decreasing costs occur in many regulated industries. Commonly, the economies are attributable to high density of service along a pipeline or wire or route. More than one firm offering service along the same route may very well result in duplication of facilities and higher costs per unit. On the other hand, a monopoly on a given route need not require firms that are absolutely large, or that dominate entire national markets. And, as demand grows, the market may expand sufficiently to hold several efficient firms.

Some of the most widely accepted cases of decreasing cost industries are local distribution utilities such as electricity, gas, water, telephone, and cable TV, where parallel distribution systems would entail duplication and presumably higher costs as a result. Cost per unit is lower the more electricity, gas, water, and so forth is sold per mile of line. Even in these cases, however, large absolute size is not usually required. Small monopoly systems serving small communities appear to lose little or nothing compared with those serving large communities. Moreover, related lines of business such as natural gas production and electric generation are probably not natural monopolies.

Outside of local distribution utilities, which are generally regulated at the State rather than the Federal level, the main cases of "natural monopoly" are oil and gas pipelines, electricity transmission and, to an extent, long distance telephone service. For example, total pipeline construction costs are roughly proportional to the circumference of the pipe and therefore to its radius, while the volume of gas or oil the pipeline can transmit is proportional to the pipeline's crosssectional area and therefore to the square of its radius. Since the square of the radius increases more rapidly than the radius, it follows that cost per unit decreases continuously as the pipeline's capacity increases. Indeed, this understates the economies of large diameter pipe because friction in transmitting oil and gas is also reduced as capacity grows, and because the amount of right-of-way needed is practically the same regardless of pipe capacity."

The natural conclusion is that the lowest cost way to transmit oil or gas between two points is through a single large diameter pipeline. However, there may still be room for some competition if a consuming center is supplied from more than one gas- or oil-producing area.

The case of electric transmission is similar. Transmission line construction cost rises approximately proportionately with voltage while transmission capacity rises with the square of voltage so that unit transmission costs fall as capacity rises. Moreover, line losses also decline as voltage increases. It follows that the lowest cost of transmission between two points is with a single high voltage transmission line and that the possibilities of competition in transmission are therefore extremely limited.

In other areas, technical change has eliminated natural monopolies that once existed. The economies of scale in railroading are mixed. A

Leslie Cookenboo. "Crude Oil Pipelines and Competition in the Oil Industry." Harvard University Press, 1955. pp. 8-32: Alfred E. Kahn, "The Economics of Regulation," vol. II, John Wiley and Sons, 1971, p. 153.

Federal Power Commission, “1970 National Power Survey," p. I-14-15.