1991 Environmental Regulation Ver Schmalensee

8/10/2019 1991 Environmental Regulation Ver Schmalensee

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ALVIN K. KLEVORICKYale University

Directions and Trends in IndustrialOrganization: A Review Essay onthe Handbook of IndustrialOrganization

THEHANDBOOK F INDUSTRIAL RGANIZATIONs mistitled. At the veryleast, the volumes produced by Richard Schmalensee and Robert Willig

and their cadre of authors are a Two-hand book. Indeed, given theweight of each volume, it would be more appropriate to call the producta Two-arm book. (This is not to be confused with the two-armed banditof probability theory and consumer search theory, although those awareof the $157 price tag might question whether I have too quickly dis-missed the latter appellation.)

The substantial product admirably achieves the goal the editors ar-ticulate: Our purpose has been to provide reasonably comprehensiveand up-to-date surveys of recent developments and the state of knowl-edge in the major areas of research in this field as of the latter part ofthe 1980's, written at a level suitable for use by non-specialist econ-omists and students in advanced graduate courses. The two volumesof the Handbook will indeed serve as a source, reference, and teachingsupplement for industrial organization (or industrial economics).

I am grateful o my colleagues Bruce Ackerman, William Brainard, nd Richard Levinfor their helpful comments and discussions, and to the discussants Paul MacAvoy and SamPeltzman or their comments.

1. Both quotations n Schmalensee nd Willig (1989, vol. 1, p. xi).

241


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242 Brookings Papers: Microeconomics 991

To be sure, the two volumes are not equally weighty. Volume 1,which is overwhelmingly theoretical, as it contains surveys of the de-terminants of firm and market organization and the analysis of marketbehavior, is far larger-in weight and girth-than volume 2, whichsurveys more applied issues and includes pieces on empirical methodsand results, international issues and comparisons, and government in-tervention in the marketplace. The imbalance between theory and ap-plications is even greater than an eyeing or hefting of the volumesreveals. Although a few of the surveys in volume 1 discuss empiricalmaterial, the more applied volume contains a very heavy dose of theory

in the contributions of Ronald Braeutigam on Optimal Policies forNatural Monopolies and David Baron on Design of RegulatoryMechanisms and Institutions.

The predominance of theory in these surveys accurately representsthe character of recent research in industrial organization. It lends per-suasive support to the perennial plea of editors of journals concentratingin the field for more good applied papers. In their preface, Schmalenseeand Willig mention four exciting trends in the field of industrial or-

ganization that they believe make preparation and publication of theHandbook particularly timely. One among these is that new waves ofempirical and experimental work in industrial organization are gatheringmomentum, driven by clarified views of the limitations of the previousfocus on cross-sectional interindustry studies, and by the profusion ofnew hypotheses and possibly testable conclusions produced by the ex-plosion of theoretical work. 2 The relative attention that theory andapplications receive in the surveys accurately reflects that while em-pirical and experimental work may be gaining momentum, they are notyet fully up to the speed of theoretical developments. I shall try, laterin this review, to suggest an explanation for this unbalanced growth.

Given the division of labor between Franklin Fisher, in his compan-ion essay in this issue, and me, my remarks here will focus on parts1, 4, and 5 of the Handbook. These parts survey material on the de-terminants of firm and market organization, international issues and

comparisons, and government intervention in the marketplace. I shallconcentrate particularly on the first and the last of these three topicsand the connections between them.

2. Schmalensee nd Willig (1989, vol. 1, p. xi).


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Alvin K. Klevorick 243

Content and Style of the Handbook

The individual chapters are, on the whole, well written. There are,however, many more minor (probably typographical) errors than onewould ever want to have remain in such an important compendium.Misspellings, inaccurate cross-references to other chapters, and gram-matical slips are numerous. In some cases, as when negations are in-correctly inserted or inadvertently omitted, when (on one occasion)several sentences are omitted, or when important slips in equationsoccur, the errors significantly impede understanding. One hopes that

the upcoming second printing will find them repaired.The various authors use different approaches to present their material.The variety enhances the readability of the volumes taken as a wholeand shows the effectiveness of alternative ways of interpreting the sur-veyor's task. Some authors provide a systematic exposition of the ma-terial, as John Panzar does in Technological Determinants of Firmand Industry Structure. This essay is particularly useful in distillingthe contributions of the important monograph Contestable Markets and

the Theory of Industry Structure, coauthored by Baumol, Panzar, andWillig. Another skillful deployment of this most systematic approachis David Baron's tour de force in expositing the literature on regulatorymechanism design to which he has contributed so much.

Some authors more self-consciously take several steps back from thematerial they are surveying. This helps them to bring recent work intoperspective, to draw together different models, and to shape the centralissues currently addressed. It also enables the authors to bring intosharp focus the important questions for future research. Bengt Holm-strom and Jean Tirole very effectively adopt this approach in their finecontribution on the theory of the firm and its contractual basis.

A third type of lens is used by Paul Joskow and Nancy Rose in theiressay on the effects of economic regulation. Combining methodologicaland substantive views of their subject, Joskow and Rose begin with anexposition of alternative frameworks and empirical methodologies for

assessing the effects of regulation. They then survey the particulareffects of regulation on prices, costs, innovation, product quality, andwealth distribution that researchers have uncovered by using these meth-odologies.

Finally, in the chapter on the determinants and effects of vertical


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integration, Martin Perry successfully draws together several importantstrands of literature. He describes and assesses old and new theoreticalexplanations of why firms at different stages of the production processmight integrate their operations. But he also integrates an evaluationof the empirical research that bears on the alternative explanations.

Each chapter is written by a major player in the field, which assuresthat the reader is getting an expert's eyeview. The various authors alsostrive to provide a balanced view of the approaches to their subjects.Each writer tries to alert the reader to the problems as well as thecontributions of the theory or approach with which he or she is iden-

tified. Given the natural enthusiasm of a participant in a research pro-gram, however, a somewhat different structure might have been valuable.One or another chapter might have been written by a knowledgeable,but more critical, less sympathetic scholar. Alternatively, and probablyeven better, each chapter might have been accompanied by a criticalcomment prepared not necessarily to critique the survey itself but toprovide a different evaluative viewpoint on the material covered in thepiece. For example, the reader might have come away from the Hand-

book with a broader perspective if the volumes had contained a criticalassessment of the achievements of transaction cost economics by some-one who is less of an aficionado than Oliver Williamson, who indeedis its major prophet-, and a similar piece on the literature on regulatorymechanism design by someone who is less enmeshed in the subjectthan David Baron. I choose these examples not because I am unenthu-siastic about the work surveyed by Baron and Williamson, respectively,but, on the contrary, because I believe some contributions in these twoareas have been transformative.

There are two notable gaps in the parts of the Handbook that I amreviewing. Indeed, the footnotes in the preface suggest that Schmalen-see and Willig are as dismayed as this reader that one or another authordid not deliver the chapters, which had been planned for inclusion, thatwould fill these holes.

The first gap is the absence of a systematic treatment of empirical

work on the contractual nature of the firm. Such a survey would havenaturally complemented the Holmstrom-Tirole survey in the same wayas the Noll, Joskow-Rose, and Gruenspecht-Lave chapters on economicregulation and health, safety, and environmental regulation complementthe more theoretical contributions of Braeutigam and Baron. There is


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an empirical literature, however slender, on each of the four majortheoretical topics considered by Holmstrom and Tirole-the boundariesand character of firms, their capital structures, the role of management(and particularly the separation of ownership and control), and theinternal hierarchical organization of the firm. A chapter that told thereader what we know empirically about the various theoretical modelsthat have been proffered on these issues would have been valuable. Forexample, what effects of separation of ownership and control have beenidentified? How effective is the market for corporate control, and par-ticularly the instruments of takeover and merger, in generating efficient

managerial behavior? What evidence is there that executive compen-sation schemes provide effective internal discipline mechanisms or eventhat they succeed in closely linking pay and performance? Do the ex-ecutive compensation schemes that firms adopt follow the lines thatagency theory suggests? With regard to another of the issues that Holm-strom and Tirole treat in their chapter, which of the several argumentsabout determination of a firm's financing find support in empirical re-search? Is the debt-equity ratio chosen to provide optimal incentives to

management, or is it selected to signal to market participants infor-mation that the firm management possesses, or both? How importantare the control rights, rather than the residual return stream, that avoting share confers on its owner?

In the course of their discussion of theoretical issues, Holmstromand Tirole do provide a few brief references to related empirical work.Furthermore, Panzar in his discussion of the econometrics of multi-product cost functions, Williamson in his review of empirical studiesin transaction cost economics, and Perry in his discussion of empiricalstudies of vertical integration all provide some assessment of what weknow empirically about firm formation and organization. But it wouldhave been useful to have these several strands and others-for example,work on labor contracts, capital structures, and executive compensationstructures as they reflect the contractual basis of the firm-drawn to-gether. The chapter that Schmalensee and Willig intended to include

showing how theoretical and empirical tools from modern financialeconomics have illuminated issues in industrial organization would havehelped here.

The second major omission is the absence of a chapter providing ananalysis of antitrust policies and their enforcement. Several chapters


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take up the slack as Perry and Williamson in part 1 and Ordover andSaloner, Varian, and others in part 3 discuss various aspects of antitrustpolicy. But a more unified treatment of the theory and practice ofantitrust law and policy would have been valuable. Such a chapter couldhave examined the interplay between theory and policy in a number ofsignificant recent developments.

One of these developments is the more sophisticated approach thathas been taken to market power, its significance, and its measurementacross the spectrum of antitrust law. Another phenomenon of interestis the changing role and content of per se rules against specific prac-

tices-price-fixing, for example-and the corresponding expansion inthe breadth of application in substance, if not in name, of rule-of-reasonanalyses. The chapter on antitrust policy could have analyzed the changesin merger law in the last decade and linked them to our new under-standing of firm behavior and organization. Two other areas in whichrecent developments in industrial organization could have been relatedto antitrust policy are, first, our more sophisticated understanding ofvertical restraints and the law's more lenient treatment of them so long

as the prices are not involved, and, second, the insights (if any) thatwork in information economics and strategic behavior provide for theassessment of information exchanges among firms and related facili-tating practices. Finally, such a chapter could have taken up issues ofantitrust enforcement and, in particular, questions about the role ofprivate litigation, which a number of economists have studied in thelast decade or so.

Just as there are gaps in coverage, so there are overlaps as well. Butthese multiple coverings of the same ground are illuminating, as whenHolmstrom and Tirole, Williamson, and Perry all treat the issue ofvertical integration-indeed, when they discuss the same work-butfrom somewhat different points of view.3 For Holmstrom and Tirole,it is essential that a theory of the firm be able to explain the occurrenceand extent of vertical integration if the theory is to address one of thefundamental issues within its domain, namely, the scale and scope of

firms. Williamson treats vertical integration as the paradigm problemof transaction cost economics; he believes that an understanding of

3. Grossman nd Hart 1986); and Williamson 1971, 1975, 1985).


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vertical integration illuminates much more general issues of complexeconomic organization.

While Holmstrom and Tirole and Williamson locate their analysesof vertical integration squarely within the incomplete-contracting model,Perry surveys a broader range of explanations of vertical integration,in particular those in which market imperfections are featured. (Allthree essays briefly mention technological economies that may give riseto vertical integration.) The greater breadth of Perry's treatment isappropriate, of course, because the subject of his chapter is preciselydefined as the determinants and effects of vertical integration.

Similarly, Noll, Joskow and Rose, and Gruenspecht and Lave alldiscuss aspects of the interplay between politics and economics in reg-ulatory settings. For Noll, that interplay is the focal point of his inter-pretative survey on the politics of regulation. The other two chapterstreat political economy issues within the context of the particular typeof regulation they are examining. Joskow and Rose view the politicaleconomy approach to regulation, with its emphasis on the interactionamong interest groups for whom particular regulatory measures carry

different costs and benefits, as a framework within which to assess theeffects of economic regulation. They pay particular attention to whatresearch on the political economy of regulation has revealed about thedistributional effects of regulation and deregulation. Gruenspecht andLave attend to the political origins of health, safety, and environmentalregulation. They also describe how the political economy approachilluminates the formulation of goals for agencies and the rents that suchsocial regulation generates.

The various overlaps in coverage are useful because they providedifferent perspectives on the same phenomenon or at least demonstratedifferent contexts in which it is relevant. But the overlaps are alsointeresting because they identify several Schelling points, as it were,of work on the theory of the firm and government regulation of themarketplace.

Trends that Motivated the EditorsOne does not know, of course, whether the several trends that Schmal-

ensee and Willig identify as coming together to make the Handbook's


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appearance so timely were ones they sighted before or after they saw thepapers. But all of these trends are salient in the three parts of the HandbookI am reviewing here.

I have already mentioned the gathering momentum of empirical andexperimental research to which the editors refer. A second principal de-velopment they cite is the recent and ongoing revolution that is re-examining all microeconomic phenomena as strategic interactions withexplicitly-specified (and often asymmetric) information structures, whichthey observe is particularly focused on industrial organization.4 The sur-veys of the determinants of firm and market structure and government

intervention in the marketplace make abundantly clear the large formativerole the information economics revolution, and especially analysis of theeffects of asymmetric information, has played in deepening our under-standing of the economics of the firm and the economics of regulatoryinteractions. As Holmstrom and Tirole emphasize, for example, it wasthe development of information economics in the 1970s that provided thebasis for the recent analysis of the organizational structure of firms, which

has centered on an improved understanding of how one goes about

contracting when people know different pieces of information of relevancefor the organization as a whole. 5

Similarly, the centrality of information economics and strategic analysisto the literature on the design of mechanisms to govern firm-regulatorinteractions is announced by Baron at the outset of his contribution: Thefocus of this chapter is the design of regulatory policies that take intoaccount the opportunities for strategic behavior provided by incompleteand limited observability on the part of the regulator.' Whether or notadoption of the information-economics perspective constitutes the replace-ment of one Kuhnian paradigm by another, because of developments ininformation economics we now view both firm organization and regulatoryinteractions very differently than we did twenty years ago, and there isno turning back.

The third trend to which the editors allude is the blurring of the tra-ditional boundaries between historically different fields of economics.

They observe that the perfectly competitive model, which had been central

4. Schmalensee nd Willig (1989, vol. 1, p. xi).5. Schmalensee nd Willig (1989, vol. 1, p. 64).6. Schmalensee nd Willig (1989, vol. 2, p. 1349).


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to fields such as international trade and macroeconomics, is being replacedby imperfect-competition models drawn from industrial organization. Thisdevelopment is certainly apparent in the literature Paul Krugman surveysunder the heading of Industrial Organization and International Trade.Models of Chamberlinian monopolistic competition as well as models ofduopoly in which firms deploy various tools of strategic behavior areprominently featured in this literature and in Krugman's review.

Finally, Schmalensee and Willig observe that developments in the pol-icy arena have contributed to the excitement of industrial organization.

[A] bevy of significant policy issues squarely in the domain of industrial

organization has been at the forefront of public and political attention inrecent years, they write.7 Among the issues the editors mention aretakeover and merger activity, the movement toward deregulation, and theincreasing globalization of competition. Not only do these issues drawresearchers directly into the policy arena, but they also provide an im-portant impetus to theoretical and empirical research.

The links between policy issues and research developments, both the-oretical and empirical, are apparent not only in the chapters directly fo-

cused on the politics and economics of regulation but also in the moretheoretical contributions. For example, much of the work that Panzarsurveys on technological determinants of firm and market structure wasstimulated by antitrust and regulatory cases in the 1970s that involvedlarge multiproduct firms. A good bit of the literature on the design ofregulatory policies and mechanisms, which is reviewed in the Baron andBraeutigam chapters, had its origins in some of those same cases and,with respect to material Baron covers, in concerns about controlling pol-lution by firms that have different production technologies and more in-formation about those technologies than the regulators possess. Manytheoretical inquiries that introduced imperfect-competition models in in-ternational trade, of the type reviewed by Krugman, were stimulated bythe increasing globalization of competition, accompanying concerns aboutthe competitiveness of U.S. industry, and complaints about the restrictivetrade practices of various countries. The conceptual developments in the

theory of the firm, and transaction cost economics in particular, wererelated to policy concerns about mergers, takeovers, and other corporaterestructurings. The policy-research agenda nexus would have been even

7. Schmalensee nd Willig (1989, vol. 1, p. xii).


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more clearly illuminated had the Handbook contained the missing chapterson antitrust policy (for example, vis-'a-vis mergers, facilitating practices,and predation) and financial economics contributions (with regard to issuessuch as mergers and takeovers and the market for managers).

Inward to the New Frontier

Three other tendencies seem to me to mark recent developments inthe literature surveyed in the substantive bookends, parts 1 and 5, of

the two volumes of the Handbook. First, much recent research on thetheory of firm and market organization and on government interventionin the marketplace has systematically unpacked the concepts we had,for the most part, previously taken as primitive to our analysis. Anotherway to describe this development is to say that recent literature inindustrial organization has taken as a major concern the treatment ofmicroeconomic structures and relations as endogenous or at least asmore endogenous than they were treated before.

The firm in today's industrial organization discourse is a muchricher concept than it was twenty-five years ago. And this is so eventhough leading contributors to the literature, such as Holmstrom andTirole, characterize this field of inquiry as still young and immature. 8The firm is no longer a lifeless production or cost function with amanager facing spot prices and mechanically selecting the profit-maximizing input-output combination from the technologically feasibleset. The relations among the firm's owner(s), its manager(s), its work-ers, and its capital and materials suppliers are now to be understood asthe result of optimization decisions by agents making choices withinthe technological and transactional environments (including informationstructure and human characteristics, like bounded rationality and op-portunism) they face.

Similarly, our understanding of regulatory constraint is muchdeeper than it was. This greater depth is an awareness not just of the

unintended (as well as intended) effects that imposing regulation canhave but of the complexity of what it means to impose a regulatoryconstraint on a firm. Regulatory policies are modeled not as simple

8. Schmalensee nd Willig (1989, vol. 1, p. 64).


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constraints imposed on a mechanically responsive firm but as endog-enous outcomes of the interactions among political constituencies, leg-islators, regulators, and the regulated entities. Again each player isviewed as making its decision within a well-specified technological andstrategic (particularly, information) environment.

To be sure, these more profound understandings of basic conceptsin industrial organization and regulation did not spring full-blown inthe last period of time. Each set of developments had its precursors.For example, Oliver Williamson's chapter on Transaction Cost Eco-nomics traces the origins of that literature's contribution to our

understanding of firm formation to the work of Coase, Commons, Barnard,and Llewellyn in the 1930s. Roger Noll, in his chapter on EconomicPerspectives on the Politics of Regulation, also cites, though briefly, theprecursors of George Stigler's seminal 1971 article, The Theory of Eco-nomic Regulation. Arguably, however, it was Stigler's contribution thatstarted he surge in literature on the political economy of regulatory policy.9

Overall, this emphasis on examining and understanding entities andrelations that we had taken as given-the firm, the regulatory constraint-

pervades the recent literature on which the Handbook contributors focus.The mission of the industrial organization literature remains to understandthe behavior of a particular set of economic agents and the implicationsthat behavior has for market structures and processes, economic perfor-mance, and public policies toward the marketplace. But we now developexplanations and predictions of those agents' behavior starting from amore microanalytic level than we had before.

The Interdisciplinary Reach of Recent Research

A second characteristic of recent research on the theory of the firmand government intervention in the marketplace is its interdisciplinarycharacter. The work of Williamson and others on transaction cost eco-nomics explicitly combines the insights of legal scholarship and or-

ganization theory with those of economics to explain the origins andfunctioning of firms and other economic institutions. Strong links be-tween economics and accounting have also been forged as theories of

9. Stigler (1971).


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firm structure and hierarchies have focused on incentive mechanismsand monitoring n principal-agent elations. The confluence of the con-cerns of designers of modern accounting systems and those who seekto explain incentive structures n firms is apparent n the Holmstromand Tirole chapter on the theory of the firm.

Despite the importance of concepts such as bounded rationality andopportunism n these modern heories of the firm, the Handbook chap-ters on this subject contain virtually no citations to the recent literatureon individual psychology. Several pieces do cite Herbert A. Simon'sseminal work Models of Man, published n 1957, for its discussion of

bounded rationality and its implications. Insofar as the theories of thefirm aim to explain the structure and governance rules of organizationswhen individual agents are less than the omniscient, fully rational char-acters of more traditional models, it would seem that the insights psy-chologists have to offer into human behavior, particularly with regardto gathering and processing information and acting upon that database,would be pertinent. 0

Some research of cognitive psychologists is noted by Gruenspechtand Lave in their discussions of risk assessment and the setting of risk-reduction goals. Furthermore, n recent work, Roger Noll and JamesKrier have brought some of the learning of cognitive psychologists tobear on the demand for and supply of regulation of risk.11 But thereseems to be much more scope for infusion of ideas from these psy-chologists in industrial organization and especially in new theories ofthe firm. For example, conventional expected-utility maximizers emainthe central actors in many formal models in the modern contractualtheory of the firm. Some cognitive psychologists have found, however,that people systematically depart from the conventional mode of de-cision analysis when they make choices under risk and that some com-mon kinds of mistakes occur n the assessment f the relevant probabilities.What are the implications of these findings for the formal contractualmodels and the theories that build upon them? Can the observed de-partures rom conventional analysis be incorporated o yield new pre-

dictions about firm structure?As the Noll, Joskow-Rose, and Gruenspecht-Lave hapters all make

10. See, for example Kahneman, lovic, and Tversky 1982).11. Noll and Krier 1990).


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clear, work on economic regulation has increasingly oined with workin political science and law in trying to understand better the originsas well as the effects of regulatory policy. The effort has been aimedat developing a sound, microeconomically based theory of the politicalbehavior that leads to the creation and direction of regulatory nstitu-tions. This is neither an intellectually mperialistic attempt o take overthe political scientists' and legal scholars' understanding f regulationand ts origins nor a desertion of the field of concerns with the economiceffects of regulation.

The intensified nteraction with political science and law is, instead,

a natural consequence of the broadening, n the last twenty-five yearsor so, of the issues that are understood o lie within the domain of theeconomics of regulation. As more effort has been devoted to askingwhy a particular set of regulations has been put in place and thoseregulations are administered he way they are, the desirability of draw-ing upon political scientists' theories of interest-group olitics and egalscholars' understanding f the administrative rocess s apparent. Thedetails of political and economic institutions and how they affect both

distributional nd efficiency consequences of policies have become acentral issue in modern theories of regulation.12

As the evaluative reviews by Noll and by Joskow and Rose makeclear, these inquiries into the political economy of regulation are stillat an early stage, and the theory in this area leads by a considerablemargin our accumulated quantitative results. Furthermore, s Joskowand Rose emphasize at the end of their chapter, The work on thepolitical economy of regulation must inevitably be carefully related tothe effects of economic regulation and the way economic regulation saccomplished. The politics and economic consequences of regulationare intertwined n complex ways. 13

The Role of Law in Theories of the Firm and Regulation

Reading parts1

and5 of the Handbook

together suggestsa third

additional heme, albeit one less explicit than any of the others I have

12. Schmalensee nd Willig (1989, vol. 2, p. 1262).13. Schmalensee nd Willig (1989, vol. 2, p. 1498).


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discussed. It is the convergence of the literatures of the theory of thefirm and government ntervention n the marketplace.

One might begin by noting the commonality of the references n partl's chapters on the theory of the firm and the works cited in the moretheoretical chapters on regulatory nstitutions. In part hat commonalityreflects the fact that both topics fall within the field of microeconomics.Hence, both have been dramatically ffected by the recent information-economics and strategic-interaction evolution that is still going on inthe study of microeconomic phenomena. But the set of specific refer-ences that the recent literature on the theory of the firm shares with the

work on government ntervention s broader. For example, the samemultiproduct ost function concepts that John Panzar presents and thenapplies to the determination of firm and industry structure are centralto Ronald Braeutigam's presentation of the analysis of Optimal Pol-icies for Natural Monopolies.

The Theory of the-Firm and the Legal Structure

More fundamentally, however, the two literatures are convergingbecause the ideas that have become central o the literature n the theoryof the firm implicate a legal and regulatory framework. A definingcharacteristic of the recent research on why firms exist and how theyare structured s its emphasis on incomplete contracts and, in one ap-proach, property rights. The concept of what is contractible s centralto recent analyses of the choice between relying on arrangements withina firm versus depending upon market ransactions. An attractive eature

of Martin Perry's chapter on the determinants and effects of verticalintegration s his effort to relate the concept of incomplete contractsinvoked in the literature n the theory of the firm o features of contractlaw, to wit, treatment by the Uniform Commercial Code and the courtsof conditions precedent and indefinite contracts. A paper by AlanSchwartz, Legal Contract Theories and Incomplete Contracts, ex-plores n greater depth he connections between he incomplete contractsof theorists' models and the doctrines of contract aw as the courts applythem. 4

Furthermore, discussions of hierarchical elations within firms nec-

14. Schwartz (1990).


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essarily draw upon ideas about authority and rely on assumptions aboutwhich actions by occupants of different evels of the hierarchy will andwill not be enforced. Holmstrom and Tirole include in their survey abrief discussion of the role of authority, particularly ts delegation, inthe internal hierarchy of the firm. Previewing the subsection, they cau-tion the reader, though, that their discussion makes little reference tomodels for the simple reason that there is almost no formal work onthe topic and that their remarks on it are intended to bring attentionto a big gap in formal theorizing about the firm. In the discussionitself Holmstrom and Tirole remark that authority-its scope and

entitlements-is a rather elusive concept. 15Incomplete contracts, authority relations, and related concepts, andthe approaches hat build upon them, presuppose a legal structure or aset of social norms that establishes what rights individuals and groups)have and how those rights will be enforced. Although recognition oflegal constraints has always been an essential part of the economics ofregulation, the central role of legal rules in the theory of the firm isnew-a far cry from the features on which the standard textbook)

neoclassical theory of the firm focused.To see how important legal structure s to the new economic theory

of the firm, consider the two major necessary conditions for contract-ibility of a transaction: observability and verifiability. Each of theserequirements ntails the physical capacity to undertake particular ct.As to observability, a party must be able to determine, by some sensorymode, whether a particular vent has occurred; with regard o verifia-bility, one or another party must be able to display to a third party whathas transpired nd that outsider o the transaction must be able to discernthat reality. There are not only physical requirements or each of thesepreconditions o contractibility, but resource requirements as well. Ittakes resources, at least some time and effort, to observe an action,and it surely requires resources for parties to a transaction o providethe necessary data to a third party and for that third party to reach ajudgment about what has, in fact, occurred.

Observability and verifiabilityalso take as

givencertain features of

a legal system. That is transparent n the case of verifiability. A thirdparty whether a court or another dispute-resolving nstitution) must be

15. Schmalensee nd Willig (1989, vol. 1, pp. 107, 123).


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provided, rules must be set for how the third party will go about ver-ifying what occurred, and all parties must share an understanding fwhat force the third party's verification will have. But the role of thelaw is as important with regard o the essential element of observabilitybecause the set of legal rules or social norms will determine what canand cannot be observed, what information economic agents need torecord and to make available, and what entitlements o nondisclosureone or another party possesses.

Indeed, the asymmetry of information hat gives rise to the problemof observability s itself a function of the legal system or set of social

norms governing the society. The significance of the informationalasymmetry, and particularly whether it gives rise to what Williamsoncalls information impactedness, depends, as he has stressed, on thecosts of achieving nformational arity. But those resource costs dependon the assignment of rights to information hat the legal system makesand the mode of protection t provides. The cost of achieving symmetryin the information available to the parties depends on what the lawstipulates about the conditions under which and the terms upon which

one party will be able to secure information rom another. The infor-mation base itself may well depend on the kinds of data the law requiresa party to obtain and to retain about itself.

Regulation and the Legal Structure

As recent work in industrial organization has unpacked central con-cepts in microeconomics-in particular, he firm-some of the moreprimitive concepts have thus turned out to be laden with legal content.Central eatures of our modern understandings nd heories of the firm-contractibility, commitment, authority-are rooted in the legal struc-ture. As I shall illustrate by focusing on parts of David Baron's chapter,this is even increasingly the case in regulatory economics, which hasalways had to be attentive to the character of the public regulatoryintervention.

Since regulatory nteractions are now more explicitly analyzed asequilibria of well-specified games, as noted in the literature Baronsurveys, it becomes even more important o specify with great care

the authority granted o the regulator, for it is this authority and the


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limits on it that dictate important parts of the game's structure.16 ur-thermore, as the regulator's ncomplete information about the firms itregulates and the regulator's limited ability to observe those firms'actions take a central place in the theory of designing regulatory nsti-tutions, the legal structure s once again implicated, just as it is in thenew theory of the firm. This involvement is most apparent when theregulator has the authority o command certain information rom thefirm and to monitor he firm's performance, a realistic situation depictedin a set of models that Baron reviews. But consider, more generally,regulatory chemes that are intended to provide the subject firms with

a fair return or adequate profits. As Baron writes, In regulatory con-texts with informational asymmetries, the adequacy of the profit of afirm must be relative to information hat both is observable by all partiesand is verifiable by a third party with enforcement powers. s 17 In short,a regulatory scheme that guarantees the firm a fair return must becontractible, and hence such an arrangement resupposes a legal struc-ture the same way a privately contractible ransaction does.

Baron also stresses the difficulty of designing regulatory mechanisms

and institutions n a multiperiod setting, which is the situation mostactual regulators ace. The problem s how to avoid, or at least to limit,opportunistic ehavior on the part of the regulator and the firm and theinefficiencies that attend such behavior. Opportunism will arise on theregulator's part because the regulator wish[es] to design the mecha-nism to be responsive to the evolution of information nd performanceas uncertainty s resolved and demand and technology conditions hange.

This requires some means of committing not to act opportunisticallywhen doing so would result in ex ante inefficiency, Baron writes.18

Baron believes that attaining commitment is particularly difficultwhen governments or public agencies are players. He is dubious thatthe regulator has means of endogenously generating commitment hatare comparable o those the parties have in private contracting. Barongoes on to explore the possibility that the regulator and the firm mightbe motivated to reach a voluntary arrangement n which the firm is

16. Schmalensee nd Willig (1989, vol. 2, pp. 1349, 1351).17. Schmalensee nd Willig (1989, vol. 2, p. 1411).18. Schmalensee nd Willig (1989, vol. 2, pp. 1391, 1392).


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offered some protection from the actions of the regulator and, in ex-change, limits its ability to withdraw rom the arrangement. He usesthe term fair to characterize a regulatory relationship n which thefirm forgoes its right to withdraw from the relation and the regulatoris required to choose policies that are compensatory given the infor-mation revealed by the firm in earlier periods.' '19 Apart from that re-striction, the regulator s unconstrained; ach period the regulator canchoose a policy that is optimal given the information t has.

In an example Baron presents, which he and Besanko devised, theregulator and the firm both prefer he fairness arrangement o what they

can attain with no commitment. The result, however, is not a generalone, as Baron notes. He also observes that despite the difficulties agen-cies and governments have in making commitments, legal structuresand institutions-common law precedents, statutes setting out bothsubstantive and procedural equirements, egislatures, and courts-pro-vide another way to create fair regulatory relations. By providing aframework hat raises each party's level of commitment-the regula-tor's to provide an adequate eturn, he firm's to remain n the market-

the legal structure reduces the parties' need for inefficient sinking ofresources to demonstrate heir commitment. Note, furthermore, hateven if the fair regulatory arrangement were arrived at voluntarily, asin the Baron and Besanko example, a need would still exist for abackground et of legal institutions o enforce the agreement over time.

Another potential convergence of some work on the theory of thefirm and the literature on regulation s suggested by Baron's use of thewordfair to describe a regulatory elation with particular haracteristics.Although the characteristics he ultimately associates with the term-adequate profit for the firm and no exit by the firm-more plausiblydescribe outcomes than processes, Baron's motivation is to constrainthe opportunism ach party can exercise. In that sense, he is concernedwith aspects of the process itself, not just with the outcomes t generates.

The more empirical surveys of regulation also reflect the concern ofthis branch of industrial rganization with issues of process n specifying

regulatory goals, enacting regulatory statutes, and administering reg-ulatory rules. For example, Gruenspecht and Lave observe that in thearea of federal health, safety, and environmental egulation, Congress

19. Schmalensee and Willig (1989, vol. 2, pp. 1405-6, 1410, 141 1).


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has not legislated clearly stated goals but has, at least implicitly, reliedon administrative procedures and decision frameworks, which it hasdelineated, to generate he goals. Congress has engaged, as Gruenspechtand Lave characterize t, in defining social goals through process. 20When taken together, requirements hat agencies give notice of con-sideration of particular egulations, receive the views of the public, andexplain their decisions specify a process from which emerge not onlyparticular ules but also the goals of regulation n the area.

In his chapter on the politics of regulation, Noll reminds us, however,that legislators may not always have high-minded motives for leaving

goal articulation o the interstices of regulatory agency decisions. Herefers o Morris Fiorina's point that he elaborate act-finding proceduresin regulatory statutes may be a device for lifting the responsibility ordifficult, conflict-laden decisions from the legislators' shoulders andplacing it on those of the bureaucrats. The only definite policy pref-erence expressed by the coalition responsible for the statute may be

that the issue be resolved in an adversarial, evidentiary process thatis constructed to reach some sort of compromise. 21 The legislators

can, and do, specify procedural details to control the policy outcomeby determining, for example, who will be represented n the decisionprocess. Noll's discussion of the effects of the procedural equirementsof the National Environmental Protection Act of 1970 convincinglyillustrates he use of procedural etails o shape policy outcomes. Viewed,complementarily, from the perspective of an agency administering astatute, changes in the stringency of regulation an be effected by subtlechanges in process and need not await the passage of dramatic egis-lation.

Characteristics of process-for example, openness, fairness-arevalued for themselves as well as for their role in specifying goals andproducing programs. It is noteworthy, therefore, that one of the de-velopments Oliver Williamson sees in prospect n transaction ost eco-nomics is that transaction cost arguments will be qualified to makeallowance or process values such as fairness hat now appear n a rather

ad hoc way. 22

20. Schmalensee nd Willig (1989, vol. 2, p. 1532).21. Schmalensee nd Willig (1989, vol. 2, p. 1279).22. Schmalensee nd Willig (1989, vol. 1, p. 178).


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The Imbalance between Theoretical and Empirical Work

The convergence between the analysis of the firm and ts organizationand the analysis of regulation suggests one possible explanation or theimbalance between theoretical and empirical research n industrial or-ganization in recent years. Observe that most of the empirical workreviewed in the Handbook is a set of studies of firms interacting nmarkets. Although a large number of the studies surveyed proceedwithin the conventional structure-conduct-performance aradigm, asubstantial segment of the work-in particular, hat which Bresnahan

labels the new empirical industrial organization draws on the re-cent outburst of theoretical analysis of market behavior. There is muchless empirical work that capitalizes on new developments n the theoryof the firm.

One of the major lessons of research on economic regulation, es-pecially as reviewed by Noll, Joskow and Rose, and Gruenspecht andLave, is that in analyzing the effect of regulation, the researcher mustbe exceptionally attentive to institutional detail. It does not sufficesimply to represent he firm subject to regulation as the paradigmaticneoclassical firm subject o an additional onstraint. Furthermore, whenthe effects of regulation are explored by empirical comparisons withunregulated irms or unregulated periods, it is imperative, as Joskowand Rose stress, to be precise in defining what legal institutions com-mon law, franchising, etc.) actually exist in the 'unregulated' regime.'Unregulated' markets may in practice be markets ubject to a differentform of regulatory estrictions e.g. municipal ranchise egulation atherthan state commission regulation), not markets ubject o no regulationat all.''23

To the extent that legal institutions and regulatory rameworks erveas foundations for our models of firms and our understandings f howthey are formed and organized, the lesson of research on regulationapplies with force and makes high-quality empirical research more dif-ficult than ever. To be sure, some high-quality work is going forward.

As one example, Paul Joskow's several studies of contracts n energy-related industries stand out, I believe, for the attention he pays toinstitutional detail.



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In several related papers, Joskow carefully-indeed, microscopi-cally-studies the structure of transactions between electric utilitiesand coal suppliers.24 The analysis requires that attention be paid tothe specific terms in contracts, the character of investments in differ-ent assets, and the details of internal firm structure as well as tomore customary firm- and market-level measures. The payoff to thistransaction-level xamination s an understanding f the very importantrole that relation-specific nvestments play in determining he verticalstructure of this industry. We learn how such investments affect thechoice between market contracting and vertical integration and how,

when the former mode is selected, those investments influence theselection of terms n the contract between a utility and he firm supplyingit with coal. Joskow's work also shows how contracts n the industrycan be and are written to protect idiosyncratic investments of bothbuyers and sellers. The protection s incomplete, however, and carrieswith it the potential costs of impeding efficient adaptation o changesin market conditions.

The challenge is not simply to understand he important eatures of

legal and economic institutions but to distill that knowledge into ob-servations about variables hat can be used for empirical esting. Movingfrom the theoretical formulation to empirical investigation, the re-searcher has to develop operational measures of concepts that are centralto the new theories of the firm-for example, the concept of assetspecificity n transaction ost economics. The difficult conceptualizationinvolved in performing hese tasks, not to mention the hard work ofbasic data collection itself, was bound to slow the pace of empiricalwork in industrial organization as these new theories appeared.

The information-economics evolution has generated yet another setof problems for those who would put modern theories of industrialorganization-particularly work on the theory of the firm and govern-ment regulation-to the test. The explicit specification of informationstructures and sequencing of agents' moves has become an essentialelement of microeconomic modeling. Hence, empirical researchers who

would test such theories must be equally explicit about nformation etsand strategies n their empirical models and data. The econometricianmust carefully distinguish between the information hat was available

24. Joskow 1985, 1987, 1988, 1990).


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to the parties when they acted and the data he or she observes and usesin the empirical analysis. Just ascertaining what information economicagents had at some time in the past is no simple task; indeed, in somecircumstances it may be impossible. In modeling dynamic interactions,the econometrician must also be explicit about how information unfoldsover time.

Not only are the formulation of the empirical model and the collectionof data more difficult when the information structure is critical, but theinterpretation of results and the drawing of inferences are more com-plicated. The appropriate conclusion may well depend on what the

parties knew at the time they acted. Baron provides a cogent example:Suppose that, after the fact, the econometrician had data on actual costsand the price that had been set in a period. If the price were equal to theactual marginal cost yet information had been incomplete at the time theprice had been set, the conclusion that should be drawn s that regulationwas inefficient, since price should have been above marginal ost (exceptin the case of the lowest conceivable cost). Similarly, if the price hadbeen above actual marginal cost, the econometrician ould not conclude

that regulation had been inefficient.25Hence, the conclusions drawn from the comparison of price and actualmarginal cost that would be appropriate if information had been sym-metric could be quite misleading if, in fact, the regulator and the firmdid not have a common information set. Of course, as Baron goes onto observe, the econometrician may be able to use other data to assessthe efficiency of regulation. In static situations, data on rents earned

bythe firm could be

used,and in

dynamic settingsthe time

pathsof

prices and costs could help.Hence, econometric modeling and estimation of models with com-

plicated, evolving information structures is more demanding than thekind of empirical work that was required to test earlier theories of firm,market, and regulatory behavior. Because of the multiplicity of diffi-culties-including reducing theoretical concepts to operational terms,ascertaining the relevant information sets of different agents at various

points in time, and interpreting the results-there are serious questionsabout the feasibility of the enterprise. Moreover, while it is unclear



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how much any one such study will illuminate, it is even less certainhow far we will be able to go beyond specific case studies. The scopefor generalization seems severely limited when the empirical modelmust be so finely tuned to the specific information and strategic struc-ture.

Some Implications for Policy

The recent directions in industrial organization research have im-

plications for policy analysis and for microeconomic policy itself. Isuggest just two here.First, our deeper understanding f the nature of the firm mplies the

need for greater attention to the complexity of firms when designingpolicy. We have long known that when the imposition of regulatorycontrols is contemplated, the policy analyst must take account of theways in which the firm will respond. The recent literature uggests theimportance of recognizing the legal structure hat provides the back-

ground against which those adjustments will take place. For example,in assessing the effects of switching to or from an automatic adjustmentmechanism for one or another type of cost in utility rate-setting, it isimportant o take account of contract aw provisions that circumscribethe way the firm can respond. Similarly, the ways in which utilitycommissions decide allowable costs of suppliers will affect firms' choicesabout vertical integration and the kinds of contracts hat regulated irmswill enter with suppliers. But those contracts and integration decisionswill also be affected by the background ules of contract aw. Further-more, as relevant background egal rules evolve over time-for ex-ample, product iability law, environmental aw, contract aw-thesedevelopments will affect regulated firms just as they do other enter-prises, and these effects may reverberate on the firms' responses toregulation.

Second, the contemporary iew of the firm as a mode of organizationthat s

endogenouslychosen raises

interesting questionsabout he firm's

role as the central unit of antitrust analysis. The Supreme Court mostrecently faced this issue in Copperweld Corporation v. IndependenceTube Corporation, a 1984 case in which the Court held that a parentcorporation could not conspire with its wholly owned subsidiary in the


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legal sense contemplated by Section 1of the Sherman Act. Lower courtshave since considered, and divided on, the issue of whether such con-spiracy could occur between a parent corporation and another corpo-ration that it partially owned.

Given that we now better understand he firm as a single endoge-nously chosen point on a continuum f relations among economic agents,why should that type of organization be the starting point for analysisof antitrust ssues? And if the answer, as in Copperweld, s that some-times the corporate veil should be pierced in antitrust aw, what im-plications does that have for the relation between antitrust and other

areas of law-for example, tort-where the apparent eparateness ofcorporate entities (and the limitation on liability it implies) is generallyrespected?


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Commentsand Discussion

Comment by Paul MacAvoy: Alvin Klevorick's appraisal s meth-

odologically definitive as well as impressively comprehensive. I amleft only with issues of content. Specifically, Klevorick strongly ap-proves the linkage from policy to new theory. My disapproval resultsfrom my being unable to find linkage in the opposite direction.

Having been occupied as a business school dean in the 1980s, I cameto the Klevorick paper, and ultimately to the Handbook of IndustrialOrganization, without having read the recent research literature onindustrial organization.26 My perspective s that of someone seeking to

determine rom these sources the causes and effects of regulatory re-form. Beyond that I am looking for more efficient management prac-tices of regulators o be found in the new theory.

In the 1970s, regulation had new, significant mpacts on importantsectors of the economy. The process of controlling ariffs n the energy,transportation, nd communications ndustries became ncreasingly de-structive as the regulatory agencies severely constrained price increasesduring periods of high inflation.27 At the same time, equipment stan-

26. If any professor believes that functioning as dean is compatible with keeping upwith the ournal iterature, hen I invite him or her to apply-there are fine deanships penin the top thirty business schools each year.

27. Joskow and Rose in their essay on empirical indings do not focus these findingson the relationship f regulation o general economic conditions. Instead hey describevarious analyses of the effects of regulation by industry. But on p. 1467 they concludethat regulation oth increases and decreases prices, depending n the context; eferring othe business cycles of the 1970s, they find that regulation eems to bind most whennominal rices are rising quickly. In the conclusion of their article hey note that macro-economic disturbances f the 1970's . . .have been characterized s the most severe dis-ruptions ince the 1930's . . . [and hese gave rise to] the recent wave of Federal egulatoryreforms. Their supporting vidence for this last, and most important, onclusion s scant.See Schmalensee nd Willig (1989, vol.2 pp. 1467, 1497).

265


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dards to meet health, safety, and environmental equirements educedGNP growth rates by one-half to 1 percentage point a year in the 1970sin the eight most regulated manufacturing ndustries.28 There were nocommensurate conomywide benefits from either holding down pricesin the utility industries or adding to costs and price increases in thenewly regulated health, safety, and environmental HSE) industries.29

To construct theory that explains this pattern requires determiningwhether t was caused by either the method or the purpose of regulating.All the agencies limited company or average industry revenues to thelevel of book costs plus a return on investment set by discounted cash-

flow estimates of earnings in other industries. The lag of book costsand comparable ndustry earnings rates behind current ong-term mar-ginal costs during periods of rapid inflation caused consistent appli-cation of this system to result in regulated prices set too low. Even so,this method conceivably was second-best in the absence of full infor-mation with large case-by-case transactions costs. But in this periodthe agencies were also pressured by new special interest groups whosemeasure of success was a constant nominal price level. The public

interest theory provides the first description, but the interest grouptheory establishes the second description. The five essays related topublic regulation do not select and order he available evidence to allowthe reader to confirm one or the other.

Similar problems arise in developing theory to describe HSE regu-lation in the 1970s. The adoption of design or equipment tandards orcompliance with health standards could be excused as a second-bestadjustment o a significant ack of information about relationships be-tween health conditions and ndividual company production, tack emis-sions, and so on. But interest groups directly benefited from cost

28. The magnitudes f GNP growth effects from regulation re not assessed for eco-nomic regulation n Joskow and Rose, although hey are cited for health, safety, andenvironmental HSE) regulation n Gruenspecht nd Lave. There are numerous ongres-sional staff reports, studies done for testimony n hearings, and submissions before theregulatory ommissions hat assess GNP effects sufficiently o allow the analyst o determine

these effects, however. One has to look elsewhere han n the Handbook.29. Gruenspecht nd Lave state that results to date indicate that the predominantbenefits of HSE regulation ome from mitigating human health problems. They go ononly to discuss hemethodological roblems f measuring uchbenefits. They do not reviewprominent stimates n other mportant ources. See Schmalensee nd Willig (1989, vol.2, p. 1534).


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advantages mposed by equipment requirements or by avoiding whatotherwise would have been the direct costs of performance tandards.It was not by chance that the air pollution control process set stringentor militant goals at the federal level, while implementation ccurred atthe local level where the state regulator had encountered he negativefeedback in employment reductions and therefore had to moderate en-forcement. Perhaps Gruenspecht and Lave did not have sufficient ev-idence to establish whether he high-cost, low-benefit results from HSEregulation n the 1970s were a mistake because of a poorly functioningregulatory system operating in the pubic interest or were results that

could be expected when specific interests of members of Congress areserved.During the 1980s these regulatory effects practically ceased. Prices

for utility and common carrier ransportation ervices increased at ratesimplying cash-flow parity with other industries, and price increases inthe most regulated HSE industries moderated ommensurate ith greatlyreduced annual cost increments from regulation in th.ose parts of theeconomy. (To be sure, prices in the automobile and construction n-

dustries still were sharply affected by cost increases related to regu-lation.)

The explanation could be that substantial reductions took place inthe scope of regulatory activities. There was a virtual disappearance fregulation of interstate ransport, energy production and distribution,and telecommunications.30 ederal HSE regulatory enforcement wasreduced to nonexistence during the Reagan administration. But regu-lation within the states was not cut back-there was no deregulationor suspension of commission operations n the state governments.

If one searches the Handbook for explanations about ess federal butmore state regulatory activity, one can find some clues. Noll's devel-opment of the public interest theory implies that deregulation shouldbe observed when the costs of regulation exceed those of decontrol.Certainly he regulation-induced hortage of natural gas and deterio-rating rail service imposed costs that qualified these industries to be

first n line for deregulation. But the pathbreaking eregulatory ctions

30. A Federal Communications ommission egulation f interstate ong-distance ele-phone services will probably not be eliminated until price caps on AT&T rates exceedprices set by companies.


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were in airline passenger service and stockbrokerage, where the resultsfrom controls were much less costly (and the transactions costs ofdecontrol were not dissimilar). Further, he most costly and least ben-eficial regulatory process has been in emission controls on industrialand electricity production. That process was recently made worse bythe Clean Air Act of 1990, an act which is perhaps he most compre-hensive law yet passed based on production imits that impose new,very large costs without reference to benefits. Without reviewing allthe cases, the theoretical deregulatory priority ordering by net regu-latory costs seems to have been reversed in practice.

But there is another heory. Noll states that as regulation becomesmore complex with more groups receiving favors the opportunity rises(for the destruction of the process] at the higher level of overall pol-icy. 31 He suggests that new technology causes this increased com-plexity and reduces the cost of deregulatory transactions. But hisinteresting essay provides no linkage of technological change to airline,railroad, brokerage, or trucking deregulation (and telephone deregu-lation, which can be linked to new technology, is the least complete at

both federal and state levels). Joskow and Rose review the studies ofprice changes after decontrol hat indicate gains by some and losses byother groups, but they do not bring together these findings to supportan interest group theory of regulatory reform.

Much the same pattern of adverse effects in the 1970s, followed bydecontrol n the 1980s, took place in the antitrust ourts n this country.Given the federal cases brought against AT&T, IBM, and EastmanKodak in the 1970s, it appeared as if growth of dominant irms by useof new technology or from marketing advantages would be foreclosed.But these cases collectively failed to penalize the dominant irm, andlower court decisions since then have essentially closed out such pro-ceedings. Since antitrust s the most comprehensive regulatory systemin this country, one might ask why this reversal took place in the lastdecade. Indeed, it is difficult even to determine what institution getscredit for changing policy. The Antitrust Division set other terms for

terminating he trials in the AT&T and IBM cases, and Judge Kaufmanon appeal reversed that part of the decision against Eastman Kodak on



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the conduct of the dominant irm. There is no foundation n the Hand-book for developing an explanation for current relaxation of antitrust.

Of course, it may be premature o ask the Handbook to provideeconomic insights into the causes for changes in public policy. But thenew theory of the firm should help one anticipate he development ofmarkets (isn't that what the theory is about?). Spot field markets fornatural gas and futures markets or baseload electricity have developedfrom nonexistence to the multibillion-dollar evel each year in the pastthree or four years. Markets for display rights in airline passengerreservation systems and for transportation f electric power or natural

gas have produced types of contracts never before seen in these nowpartially regulated industries. Some of the new contracts have beenmore than mperfect, with high transactions osts relative to sales pricesand terms determined by suppliers with market power. Did these in-novative institutions become a cause for deregulation, or were they aconsequence? Baron's essay provides some new clues to an answer,with respect to the new spot and futures energy markets. Both replaceregulatory agreements n which the regulators had developed patterns

of highly opportunistic pricing behavior, and both operate as much aspossible outside of regulation.

The answer may help us understand why markets for pollution re-duction credits have not developed, even though they were proposedby economists to reduce regulatory osts fifteen years ago.32 The CleanAir Act of 1990, while requiring costly reductions n emissions fromeastern power plants, supposedly reduces costs partly by allowing trad-ing in emission rights among these sources (so that those with advancedstack cleaning technology can reduce their pollutant emissions cheaplyby more than what is required, so as to sell off the excess reductionsto others). But what if such markets do not develop because of toohigh transactions costs owing to regulatory requirements or tradingor because of the market power of a few large electric power producers?What mperfections does it take to prevent a new market rom emerging?

32. Gruenspecht nd Lave indicate hat extensive trading n rights has occurred onlywhen the expansion of emission sources has been called for. See Schmalensee nd Willig(1989, vol. 2, p. 1538). (The Hahn and Hester (1989) article in the Yale Journal onRegulation ndicates he almost otal ack of development f market mechanisms lsewherein such rights.)


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I looked for both theoretical and applied work that would form abasis for evaluating the new policy instruments hat have come ontothe stage in the regulatory heater n the last few years. During the late1970s and early 1980s Congress was flooded with proposals or genericprocess for reducing excessive regulation. There were to be zero-based appraisals of agencies that would either renew the legislativemandate or abolish the agency on a time schedule. Other plans calledfor moving the agencies to the Executive Office with presidential (orcongressional, or court) vetting authority over agencies' major deci-sions. These plans have not had the same public exposure in recent

years. Is there theory in public regulation or accumulated experiencewith generic reform that can explain why these policies disappeared?There have been fairly widespread experiments at the state level andin the United Kingdom with price caps by which ceiling prices areset in the public utilities and then adjusted periodically by the differencebetween the inflation rate and a designated productivity growth rate.Are solutions to problems n managing rate base regulation n inflationconsistent with interest group theory? The use of fines or charges for

exceeding standards has been widely advocated and recently adoptedin the 1990 Clean Air Act. Would charges and fines be more effectivethan equipment equirements r emissions limits in achieving the (what-ever) goals of HSE regulation?33

Perhaps he search or positive theory or policy analysis s misguidedand should be put aside in favor of focusing on the development ofmore effective regulatory agency procedures. This work is describedin Baron's essay. Although impressive for its originality and rigor, itcan scarcely be described as ready for implementation. There may bemistakes in judgment on what to abstract. The approach s to constructa highly abstract model of the firm, with an even more abstract modelof government, but to add realistic depictions of the states of informationand of the interaction patterns between firm and government. Further,it realistically depicts strategies for the regulator with less informationthan the regulated. But the model of the regulatory process is so limited

33. Gruenspecht nd Lave discuss Weitzman's methodology or answering hat ques-tion, but they make no references o the empirical work necessary o determine he criticalelasticities of the supply and demand unctions or bad reductions o be achieved moreeffectively by the use of fines or by emissions imits.


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on regulation. Specifically, I will refer to two very good summaries nthe Handbook, one by Noll and the other by Joskow and Rose. I wantto use these summaries o indicate just what methods are in fact usedby the leading empirical researchers n the field, at least those whomerit inclusion in these two surveys. By method I mean the overallmodeling strategy in the terms set out by Klevorick. That is, do theygo beyond a setup with the profit-maximizing, cost-minimizing firmsubject to or not subject to some exogenous deus ex machina called

regulation 9?.

By and large the answer to that question is no. There doesn't even

seem to be, at least in my reading of these surveys, any significantmovement toward a more sophisticated conceptualization. will closeby indicating why I think naivete prevails in the empirical work andwhat some of its advantages might be.

I begin with Noll's survey of tests of interest-group heories of pol-itics. He identifies two main strands n that empirical iterature. Beforeabout 1970, the tendency was to look at outcomes, of prices, profits,and so forth, in regulated markets. If these were arguably closer to a

monopolistic than to a competitive equilibrium, that would lead tosuspicion that interest groups were dominating he process. More re-cently, Noll says, researchers end to look at politics. For example, docongressional representatives ote with the main interest groups n theirconstituencies? Do the regulatory agencies respond to the preferencesof Congress and interest groups in specific cases?

Here, there clearly has been some increase in sophistication n thatthe political context in which interest groups and regulators unction isgiven explicit recognition. But that shift in attention has more of thecharacter of substituting one black box for another. In the earlier lit-erature, regulation was the black box on the right-hand ide of theregression. The appropriate oefficient meant that regulation generatedresults favorable to interest groups. The newer literature puts variablessuch as roll call votes on energy policy on the left-hand side of aregression, and on the right-hand ide it puts some measure of interest

group strength such as how much coal or oil gets dug up in a state.When one gets to the empirical bottom line, neither he older approachnor the newer one pays much attention to process or complex inter-actions. That is not meant as criticism, it is just a fact.

Joskow and Rose survey the effects of regulation. This is a larger


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literature, although it overlaps the one that Noll reviewed. It is alsomore diverse. The primary question here is, What is the effect of reg-ulation on X, where X could be prices, profits, wage rates, innovation,and so forth? Joskow and Rose distinguish four techniques that havebeen used to answer this question, of which two dominate. I will limitmyself to those two.

One of these is a comparison of regulated, as opposed to unregulated,firms. This can be done either cross-sectionally, or it can be done beforeand after some regulatory change. The other important approach sstructural modeling or simulation of regulated firms or markets. This

tends to be applied to cases in which all the firms or all the marketsare subject to a similar kind of regulation. For example, one might ask,Is there overcapitalization n the utility industry? One way this questionhas been addressed s to estimate a production unction, then combineestimates of marginal products and factor prices to deduce whetherthere is too much capital in the industry.

How is regulation reated n these studies? By and arge, very naively.In the first approach-the comparison of regulated and nonregulatedfirms-regulation is typically a dummy variable in regression. In thesecond approach, some prior theoretical belief about the effect of reg-ulation, for example, something like the Averch Johnson hypothesis,is applied directly. There is usually no attempt o cope with the actualcomplexity or variety of regulatory agency procedure.

How are firms or markets reated n this literature? Also, fairly na-ively. The firms are, by and large, profit-maximizing, ost-minimizingentities of the type that Klevorick tells us the theorists have long sincepassed by. This is especially important n the structural modeling, sim-ulation branch of the literature hat Rose and Joskow review. For ex-ample, if the question s, Is there overcapitalization? he answer comesfrom estimating a departure rom cost minimization and attributing hatto a regulatory constraint.

In reading this very good survey of the literature, I did not discernany broad tendency to move to more sophisticated conceptualizations

of the problem. If there is a trend, it is toward more sophisticatedtechnique; and that occurs in several dimensions. Possibly, there is atendency toward more of the structural modeling and away from re-duced-form, dummy-variable approaches. There is possibly a trendtoward he simulation of more complete models and away from standard


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modes of regression analysis. For example, one might use some existingestimate of the relevant elasticities to calibrate a model of a market,and then subject that model to some regulatory shock.

Another trend, and this is common to all of the empirical ndustrialorganization iterature, s the use of financial-market ata to summarizethe effects of regulation in an effort to cut through some of the com-plexities. For example, one might ask a question, such as, Were therailroads orced to dissipate wealth via excess capacity when they weremore regulated? One answer could be derived by modeling of therailroad-capacity ecision. Another increasingly common approach s

to examine the behavior of railroad-stock prices when, for example,events that increased the probability of deregulation occurred and thendraw some inferences from the stock price behavior about what theeffect of the regulation was on those railroads.

In summary, the broad picture is, we have an increasingly sophis-ticated theoretical understanding f the problem of regulation, coupledwith more sophisticated measurement echnique. But the basic concep-tualization of the problem remains pretty much what t was twenty years

ago.One reason for this primitive conceptualization, believe, has to do

with how progress s currently being made in the empirical analysis ofregulation. It is much more than we would like to believe via a steadyaccumulation of well-organized facts, rather han through straightfor-ward hypothesis testing. Consider, as one example, the effect of reg-ulation on wages, which is one of the subliteratures hat Joskow andRose summarize. There is no highly worked-out heory of the effect ofregulation on wages, just some hunches guided by several theories.(Joskow and Rose list four hypotheses that might lead to an effect ofregulation on wages.) In a case like this one, the tendency is to applya variety of techniques to the problem. There are cross-sectional wagestudies with a regulatory-dummy ariable added. There are comparisonsof pay for the same jobs in regulated irms and, say, nearby unregulatedfirms. There are time-series studies, sometimes combined with cross-

sectional data,which take

advantageof the

regulatory hangesthat have

occurred, most prominently he deregulation f the late 1970s and early1980s. Inevitably, this literature produced conflicting results, but anoverall pattern emerged suggesting that, on average, workers benefitedfrom regulation.


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To the extent that there is progress here, it comes from this steady,incremental accumulation of results, and the process would, I think,be impeded, rather han promoted, f researchers didn't have a commonlanguage. At least for the foreseeable future, that language needs to befairly simple if one is going to find any intelligible patterns. A faircharacterization f the way that this literature n the effect of regulationon wages treats regulation s that usually regulation s regulation. It isnot a series of processes, each with its own peculiarities. Similarly,not too much attention s paid to the internal tructure f firms or unions.Basically, firms are firms, unions are unions. Every firm and every

union has pretty much the same goal as any other, to the extent thatresearchers even explicitly recognize goals as a problem.If that common language had been dropped after the first few con-

flicting results, the fact-building process probably would have beenimpeded, or it might even have dissolved into separate ines of inquiry;for example, one might focus on the structure of unions and firms andanother on the interactions of components of regulatory agencies, andso forth.

Progress does not, of course, require researchers o use the simplestcommon anguage. There s, sometimes, a gain to recognizing hat firmsare not firms or that regulatory agencies differ. But even at this level,it probably helps if the distinctions are easily incorporated nto the workof successive researchers. Thus one might distinguish firms by someeasily measured attribute uch as their size or might distinguish regu-lation by some broad characterization f the mode of regulation.

At some point, perhaps, deeper subtleties may prove useful pointsof departure or empirical research, but I have a strong suspicion thatthis is not going to happen soon. I think that, for the foreseeable future,empirical research on regulation will continue to be an enterprise ofbuilding facts organized around a fairly simple theoretical superstruc-ture, which is little affected by a recent advances n theory. This is not,of course, an altogether appealing prospect.

For example, consider the literature on the effects of airline regu-lation. This is a long literature

and,as such

things go,a

deep onein

the economics of regulation. It was initially conducted within a simpletheoretical ramework hat yielded some very fruitful predictions aboutthe effect of deregulation on prices and quality. But this simple frame-work also failed to predict other salient characteristics of the industry


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that emerged after deregulation. There were, for example, changes inthe structure of prices and the firm-structure f the industry hat couldnot have been predicted rom that earlier, very simple, conceptualizationof the airline market.

One would like to think that the missed results would be inspiringa lot of theoretical work on things like transportation etworks or pricingstrategies, which then feeds back to further empirical work. By andlarge, however, this is not happening. Instead, he empirical researcherstend to tweak the existing theory more or less as an excuse to get onwith fact building. Progress n this field is likely to continue to be slow

unless the hiatus between theoretical and empirical work is narrowed.

General Discussion: Several participants isagreed with Franklin Fish-er's negative assessment of the state of theory in the industrial orga-nization field. While Fisher had questioned the usefulness of theoriesthat are only applicable in specific cases, Lawrence White said thatthere should be suspicions about any theories that apply to all cases.He claimed that in such a situation we are dealing with a tautology,

not with [a] theory. White noted that for such a practical applicationas antitrust work, universal theory was not necessary.

Steven Salop claimed that industrial organization heory has beenvery successful in telling stories to explain how various phenomenaoccur. He cited as examples the explanations for how firms competein the presence of switching-costs, how information exchange affectsthe degree of competition, how price competition differs from quantitycompetition, and how firms can profitably deter entry.

Commenting on Fisher's advocacy of more industry studies, MikeScherer quoted George Stigler's half-humorous observation that twosuch studies made in the same industry may yield widely varying con-clusions when produced by two different parties. As an example, Scherermentioned studies surrounding he IBM antitrust ase. In two differentstudies, there was little similarity n the analysis, facts, or conclusions.Scherer suggested that getting good empirical nformation s part of the

solution to this problem.Martin Baily also noted the manner n which industrial organization(10) theory has ignored empirical information. As an example, Bailysaid that there is convincing empirical evidence that the social returnto research nd development s higher han he private eturn. He claimed,


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however, that if one examines 10 theoretical iterature, one could con-clude that we have no idea whether [the] social return s higher thanthe private return, that we are just as likely to get competitive R&Dgames that will mean that there is too much R&D as (ones that meanthat] there is too little.

In agreeing with Baily, Ralph Landau aid that another problem withtheoretical approaches n 10 is that firms are treated in ways that donot reflect the real world. This fact, he said, has been exacerbated bydramatic hanges n the world economy. He said that n order o competeagainst foreign firms n world markets, American irms must engage in

practices that might once have been considered oligopolistic. Whilethose practices might have once been viewed as having a negative effecton social welfare, today they might have positive welfare benefits forthe country because of the manner n which competition has changed.Landau was concerned that 10 theories had not taken changes in thenature of competition into account and that these theories would beused in antitrust aw in a manner hat would have negative consequencesfor the national economy.

Michael Whinston agreed with Fisher's claim that 10 models maymiss the richness of real-world situations. He said, however, that hefelt that the field was moving in the right direction on this issue. Asan example, he noted that while the Cournot model is incomplete n itsapplicability to many industries, developments such as the Kreps-Scheinkman model have shed light on how to relate the applicabilityof the model to actual industry conditions.

Michael Katz claimed that not as much progress has been made withrespect to 10 theory as some of the participants had argued. He saidthat while theories have undergone refinement over the past twentyyears or so that might make their logic clearer, he doubted that therehad been much progress made in the explanatory ability of theory. Asan example, he said that while theories of information exchange mayhave improved our understanding of theories as theories, they havedone little to improve our understanding f the way in which the world

operates.Several of the participants

Documents

1991 Environmental Regulation Ver Schmalensee