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Learning Objectives

By the end of this section, you will be able to do the following:

Evaluate the effectiveness of price regulation and antitrust policy
Explain regulatory capture and its significance

Governments at all levels across the United States have regulated prices in a wide range of industries. In some cases, like water and electricity that have natural monopoly characteristics, there is some room in economic theory for such regulation. But once politicians are given a basis to intervene in markets and to choose prices and quantities, it is hard to know where to stop.

Doubts about Regulation of Prices and Quantities

Beginning in the 1970s, it became clear to policymakers of all political leanings that the existing price regulation was not working well. The United States carried out a great policy experiment—the deregulation discussed in Monopoly—removing government controls over prices and quantities produced in airlines, railroads, trucking, intercity bus travel, natural gas, and bank interest rates. The Clear It Up discusses the outcome of deregulation in one industry in particular—airlines.

Clear It Up

What are the results of airline deregulation?

Why did the pendulum swing in favor of deregulation? Consider the airline industry. In the early days of air travel, no airline could make a profit just by flying passengers. Airlines needed something else to carry and the Postal Service provided that something with airmail. And so the first U.S. government regulation of the airline industry happened through the Postal Service, when in 1926 the Postmaster General began giving airlines permission to fly certain routes based on the needs of mail delivery—and the airlines took some passengers along for the ride. In 1934, the Postmaster General was charged by the antitrust authorities with colluding with the major airlines of that day to monopolize the nation’s airways. In 1938, the Civil Aeronautics Board (CAB) was created to regulate airfares and routes instead. For 40 years, from 1938 to 1978, the CAB approved all fares, controlled all entry and exit, and specified which airlines could fly which routes. There was zero entry of new airlines on the main routes across the country for 40 years, because the CAB did not think it was necessary.

In 1978, the Airline Deregulation Act took the government out of the business of determining airfares and schedules. The new law shook up the industry. Famous old airlines like Pan American, Eastern, and Braniff went bankrupt and disappeared. Some new airlines like People Express were created—and then vanished.

The greater competition from deregulation reduced airfares by about one-third over the next two decades, saving consumers billions of dollars a year. The average flight used to take off with just half its seats full; now it is two-thirds full, which is far more efficient. Airlines have also developed hub-and-spoke systems, where planes all fly into a central hub city at a certain time and then depart. As a result, one can fly between any of the spoke cities with just one connection—and there is greater service to more cities than before deregulation. With lower fares and more service, the number of air passengers doubled from the late 1970s to the start of the 2000s—an increase that, in turn, doubled the number of jobs in the airline industry. Meanwhile, with the watchful oversight of government safety inspectors, commercial air travel has continued to get safer over time.

The U.S. airline industry is far from perfect. For example, a string of mergers in recent years has raised concerns over how competition might be compromised.

One difficulty with government price regulation is what economists call regulatory capture, in which the firms supposedly being regulated end up playing a large role in setting the regulations that they will follow. When the airline industry was being regulated, for example, it suggested appointees to the regulatory board, sent lobbyists to argue with the board, provided most of the information on which the board made decisions, and offered well-paid jobs to at least some of the people leaving the board. In this situation, consumers can easily end up being not very well represented by the regulators. The result of regulatory capture is that government price regulation can often become a way for existing competitors to work together to reduce output, keep prices high, and limit competition.

The Effects of Deregulation

Deregulation, both of airlines and of other industries, has its negatives. The greater pressure of competition led to entry and exit. When firms went bankrupt or contracted substantially in size, they laid off workers who had to find other jobs. In the airline industry, several major airlines, including Eastern, Pan Am, and Continental, all went bankrupt after deregulation. Market competition is, after all, a full-contact sport.

As a result, a number of major accounting scandals involving prominent corporations such as Enron, Tyco International, and WorldCom led to the Sarbanes-Oxley Act in 2002. Sarbanes-Oxley was designed to increase confidence in financial information provided by public corporations to protect investors from accounting fraud.

Similar to the effects of deregulation, a lack of regulation can also have negative impacts on the market. For example, investors need reliable information when deciding whether or not to purchase stock in a corporation. They need to know how risky that decision is. Financial markets work best when investors have good information about risk and return. Historically, some of this information is provided when a corporation is audited by an outside accounting firm. However, prior to 2002, those same accounting firms were also paid large fees for consulting work. Therefore, there was the potential for conflict of interest. In order to maintain their lucrative consulting work, the accounting firms may have had an incentive to downplay, or not report, any risk associated with the firms they were auditing. Thus, investors did not receive the information needed to make the correct investment decision.

The Great Recession began in late 2007 and was caused, at least in part, by a global financial crisis, that began in the United States. A significant factor that contributed to the financial crisis was various financial innovations created for the mortgage industry. Information technology facilitated the introduction of several types of new and unregulated financial assets that seemed safe at the time of their implementation. These nascent assets included collateralized mortgage obligations (CMOs, a type of mortgage-backed security), and credit default swaps (CDSs, insurance contracts on assets like CMOs that provided a payoff even if the holder of the CDS did not own the CMO). Many of these assets were rated very safe by private credit rating agencies, such as Standard & Poors, Moody’s, and Fitch.

The collapse of the markets for these assets precipitated the financial crisis and led to the failure of Lehman Brothers, a major investment bank, numerous large commercial banks, such as Wachovia, and even the Federal National Mortgage Corporation (Fannie Mae), which had to be nationalized—that is, taken over by the federal government.

One response to the aftermath of the precipitous decline in the housing and financial markets was the passage of the Dodd–Frank Wall Street Reform and Consumer Protection Act, known as the Dodd-Frank Act. In order to avoid another financial crisis, the bill took several steps. It examined and increased the regulation of companies offering mortgages and it gave the FDIC the power to intervene in troubled commercial banks. The Dodd-Frank Act also created an oversight council that would attempt to identify market bubbles as they were taking place.

While some argue that the Dodd-Frank Act will protect the US economy from experiencing another financial crisis like in 2007-2009, others contend that it is responsible for the slow economic growth that followed the recession. These critics argue that the bill contained too much regulation and hampered financial markets. We will explore the financial crisis and subsequent Great Recession in more detail in the macroeconomic chapters of this book.

All market-based economies operate against a background of laws and regulations, including laws about enforcing contracts, collecting taxes, and protecting health and the environment. The government policies discussed in this chapter—like blocking certain anticompetitive mergers, ending restrictive practices, imposing price cap regulation on natural monopolies, and deregulation—demonstrate the role of government to strengthen the incentives that come with a greater degree of competition.

Bring It Home

More than Cooking, Heating, and Cooling

What did the Federal Trade Commission (FTC) decide on the Kinder Morgan / El Paso Corporation merger? After careful examination, federal officials decided there was only one area of significant overlap that might provide the merged firm with strong market power. The FTC approved the merger, provided Kinder Morgan divest itself of the overlap area. Tallgrass purchased Kinder Morgan Interstate Gas Transmission, Trailblazer Pipeline Co. LLC, two processing facilities in Wyoming, and Kinder Morgan’s 50 percent interest in the Rockies Express Pipeline to meet the FTC requirements. The FTC was attempting to strike a balance between potential cost reductions resulting from economies of scale and concentration of market power.

Did the price of natural gas decrease? Yes, rather significantly. In 2010, the wellhead price of natural gas was $4.48 per thousand cubic foot; in 2012 the price had fallen to just $2.66. Was the merger responsible for the large drop in price? The answer is uncertain. The larger contributor to the sharp drop in price was the overall increase in the supply of natural gas. More and more natural gas was able to be recovered by fracturing shale deposits, a process called fracking. Fracking, which is controversial for environmental reasons, enabled the recovery of known reserves of natural gas that previously were not economically feasible to tap. Kinder Morgan’s control of 80,000-plus miles of pipeline likely made moving the gas from wellheads to end users smoother and allowed for an even greater benefit from the increased supply.