Refining the Role of Government in the U.S. Market Economy

private enterprise. During most of the 20th century, government and markets were typically viewed as substitutes. Citizens and policymakers had to choose between government mandate and market forces.<br><br> As the 21st century ap- proaches, we see that market forces and public policy are less often substitutes than complements. The Telecommunications Act, the FERC 9s Order No. 888, and the ongoing Federal and State efforts to implement their principles and mandates show how judiciously crafted public policy can increase rather than decrease the role and effectiveness of market forces in the economy, and thereby improve the economic and social prospects for the American people.<br><br> Complementarity between markets and government extends in the other direction as well. Just as well-crafted government policy can make markets work better, so the introduction of market mech- anisms into the regulatory process can help government achieve so- ciety 9s goals. For example, to ensure that wireless technologies best 190 Box 6 31. 4The Benefits of Deregulation That deregulation produces economic benefits when it leads to effective competition is not merely a theoretical proposition.<br><br> Data from the field bear this assertion out as well. An assess- ment by a Brookings Institution scholar finds that deregulation not only has brought considerable short-run benefits, by mak- ing markets work better, but also has led to technical and op- erating innovations that promise even greater benefits in the long run. The table below gives some examples of this study 9s findings.<br><br> Industry Cost Reductions Innovations Airlines ................................................................. 24 percent decline in costs per unit of output Hub-and-spoke systems Computer reservations Trucking ................................................................ 30 335 percent decline in operating costs per mile Computer networking Coordinating with logistics firms Railroads ..............................................................<br><br> 50 percent decline in costs per ton-mile; 141 percent increase in productivity Better contracts Double stack cars Intermodal operations Natural gas .......................................................... 35 percent decline in operating and maintenance expense Computer planning Contracting through market centers Source: Clifford Winston, Brookings Institution. meet the public 9s demand for communication services, the Federal Communications Commission (FCC) has turned to auctioning off portions of the electromagnetic spectrum.<br><br> These auctions not only have been enormously successful in getting licenses quickly into the hands of those who can use them most efficiently, but have raised over $20 billion for the U.S. Treasury in the process. A sec- ond success story has been the use of market forces to provide greater flexibility in meeting environmental goals (e.g., tradable permits for sulfur dioxide emissions).<br><br> Last but not least, market forces can help improve the management, use, and disposal of pub- lic lands. MARKETS, GOVERNMENTS, AND COMPLEMENTARITY As a prelude to discussing the potential for complementarity be- tween private markets and the public sector, we review the pur- poses each serves in a primarily market-driven economy. 191 THE ADVANTAGES OF MARKETS The argument in favor of deferring to markets typically relies on the efficiency of their outcomes.<br><br> If markets are competitive and function smoothly, they will lead to prices at which the amount sellers want to supply equals the amount buyers demand. More- over, the price in any market will simultaneously equal the benefit that buyers get from the last unit consumed (the marginal benefit) and the cost of producing the last unit supplied (the marginal cost). These two conditions ensure efficiency: when they hold in all mar- kets, the Nation 9s labor and resources are allocated to producing a particular good or service if and only if consumers would not be willing to pay more to have those resources employed elsewhere.<br><br> This familiar story is profound and important, yet it understates the role of private markets in making economies work. Since at least the 1930s, economists have noted that in theory the govern- ment could reach efficient outcomes without relying on markets, if government officials had sufficient information and the right incen- tives. But it is markets 9 superior information-processing ability and preservation of individual incentives that explain their general su- periority to government management of the economy.<br><br> Markets allow transactions to be decentralized to the level where decisions are made by those most affected by them, in direct response to budget constraints and tradeoffs. Market participants themselves then have powerful incentives to generate and gather information and make the deals that best serve their interests. Information An insufficiently appreciated property of markets is their ability to collect and distribute information on costs and benefits in a way that enables buyers and sellers to make effective, responsive deci- sions.<br><br> Because market prices measure the marginal benefits of goods and services to consumers, firms that maximize their profits simultaneously maximize the difference between benefits and costs. Similarly, consumers look to market prices to decide which goods and services to purchase, and how to use their labor, resources, and financial wealth to generate the income to pay for them. As tastes, technology, and resource availability change, market prices will change in corresponding ways, to direct resources to the newly val- ued ends and away from obsolete means.<br><br> It is simply impossible for governments to duplicate and utilize the massive amount of infor- mation exchanged and acted upon daily by the millions of partici- pants in the marketplace. That markets normally process all of this information so well and so rapidly tends to be taken for granted. In light of all the invest- ments, hires, plans, purchases, marketing efforts, sales, contracts, and exchanges necessary to bring goods to market, the fact that the price system normally works as well as it does 4for instance, that 192 the products consumers want are usually on the shelves 4ought to be regarded as astounding.<br><br> Instead, it 9s literally business as usual. Incentives Even if the public sector could gather and quickly respond to all available information on changing consumer tastes and production technologies, private markets would still have the advantage of preserving the incentive to produce efficient outcomes. In private markets, buyers and sellers directly reap the benefits and bear the costs of their demand and supply decisions.<br><br> Each makes decisions aimed at achieving the greatest benefit, or economic return, net of cost. These incentives not only affect how resources are used today, but also lead to innovations that will increase the efficiency with which resources are deployed in the future and result in new prod- ucts that raise living standards. In contrast, the links between the government and the individ- uals who reap the benefits and who bear the costs of its decisions are frequently weak.<br><br> The nature of day-to-day legislative, execu- tive, judicial, and regulatory proceedings runs a risk of favoring or- ganized, established interests rather than the public at large. Ac- cordingly, government 9s role in the operation of the private econ- omy must be limited and judicious. Initiatives to increase our economy 9s reliance on markets, and to improve the efficiency of reg- ulation through market mechanisms, reflect an awareness of the tremendous benefits that market forces can bring to bear by em- ploying private incentives to achieve social goals.<br><br> WHY HAVE GOVERNMENT AT ALL? If markets generally outperform government, why not leave ev- erything to the market? To begin with, it is useful to remember that markets and governments can and do work together.<br><br> For mar- kets to function effectively, deals must be enforced and fraud dis- couraged. Without a governmental legal system to guarantee prop- erty rights and enforce contracts, corporate organization and mar- ket exchange would be virtually impossible. Anarchy and the free market are not synonymous.<br><br> (Box 6 32 discusses the role of govern- ment in protecting property rights in information in an era of elec- tronic, global markets.) But government has other roles beyond refereeing private trans- actions. Markets left to themselves sometimes produce inefficient outcomes. For example, markets efficiently transmit information and provide proper incentives only when sellers compete with enough intensity to drive prices down to cost.<br><br> But in some cir- cumstances, firms can impede the forces of competition by agreeing among themselves to maintain high prices, or by merging to the point where individual production decisions substantially affect prices. The antitrust laws are the public policy instrument for pre- 193 Box 6 32. 4The Role of Copyright in an Electronic Global Economy The growth of telecommunications, computing power, and their joint progeny, the Internet, is revolutionizing the way in which information is created and shared. Whether by satellite or by fiber-optic cable, electronic telecommunications networks today transmit vast amounts of scientific and commercial infor- mation, and entertainment, around the globe in a heartbeat.<br><br> Since the 18th century, markets for the products of creative expression and technical innovation have been supported through copyright and patent laws, which extend private prop- erty rights to intellectual property. These laws have histori- cally attempted to strike a balance between enhancing eco- nomic incentives to create and promoting widespread use of the thing created. By preventing unauthorized copying, intel- lectual property laws allow creators and innovators to profit from their original works and inventions.<br><br> Strong copyright and patent protection can help provide the appropriate incentives to create, by allowing creators to cap- ture a greater share of the marginal benefit of their efforts. The cost of strong protection, however, is that prices to use copyrighted works or patents may remain high for some period of time. Ironically, because patents and copyrights build on the work of others, overly strong intellectual property protection today could discourage innovation and creativity in the future.<br><br> An increasingly important policy question is whether these traditional legal means for striking the balance between incen- tives to create and incentives to use will continue to apply in a global information-based economy. Difficult issues to resolve include: " rights to display copyrighted information on computer screens " the applicability of copyright to electronic data bases " 8 8fair use 9 9 rights and other traditional exceptions for the educational and research community, and " competition within broad-based collective copyright li- censing organizations. The need to coordinate our efforts with other nations makes the resolution of these crucial questions even more complex.<br><br> venting such anticompetitive collusion and mergers. Public anti- trust enforcement complements market forces by supporting condi- tions conducive to competition. A second important means of pro- moting competition in U.S.<br><br> markets is the reduction of trade bar- 194 riers and other distortions that deter entry by foreign providers of goods and services. There may also be a role for government when large firms have cost advantages that discourage entry by other firms and thus make sustained competition impossible. For in- stance, the government may directly regulate prices as a substitute for market forces in such circumstances.<br><br> Markets also produce inefficient outcomes when the prices that buyers and sellers agree on do not take account of benefits and costs falling on third parties. The result is called an externality, a textbook example of which is air pollution. It would be prohibitively costly to define and enforce property rights to the use of clean air.<br><br> Therefore, unless polluters can be made to pay a compensatory tax, purchase emission permits, comply with regulations, or face liabil- ities imposed by environmental or tort law, they do not take the cost of their pollution into account. This leads to excessive levels of undesirable emissions 4a negative externality. Externalities can be positive as well as negative, conferring benefits rather than im- posing costs on third parties.<br><br> For example, inoculations not only protect those who receive them from contagious disease, but may prevent its spread through the rest of the population. An important example of a public good with positive spillovers is basic scientific research, whose benefits can far exceed those real- ized by the firm or institution undertaking the research. In such cases, targeted Federal support can more than pay for itself through the technological innovations and product improvements bestowed upon the economy overall.<br><br> Investments in transportation and communications infrastructure are another example. Numer- ous recent initiatives, such as the Department of Transportation 9s programs to provide and leverage financing for public highways and private toll roads, can generate widespread benefits by promot- ing regional economic development. Information asymmetries, where one party to a transaction knows more than the others, can also undercut market efficiency.<br><br> Health insurance offers an instructive example. If consumers of health insurance know better than providers the chances of their falling ill in a given year, only those who know they are more likely to get sick might purchase insurance. As premiums rise to reflect the higher risk of the those buying insurance, the healthier among them 4for whom the insurance costs now exceed their expected care needs 4drop out of the market.<br><br> This process of adverse selec- tion can repeat itself to the point where the market collapses. One reason why the government, rather than private insurers, provides health insurance for the elderly through Medicare is that the elder- ly may have more knowledge regarding their health status than any private insurer, giving rise to an adverse selection problem (see 195 Box 3 31 in Chapter 3). Maintaining a population-wide risk pool eliminates the problem.<br><br> Finally, the efficiency standard is not the only basis for judging the performance of an economy. Probably the most frequent indict- ment laid against markets is that they can be consistent with sig- nificant inequality of opportunities and outcomes. Progressive in- come taxation, free public education, and numerous transfer pro- grams 4all acts of government 4moderate some of the inequality in our market-based economy.<br><br> Civil rights laws prohibit discrimina- tion that market forces may fail to eliminate. In addition, because markets are driven by the pursuit of personal, not collective, inter- ests, market transactions may not fully support our shared social values. Prohibitions on child labor, laws to preserve habitats for en- dangered species, and public support for the arts exemplify ways in which government seeks to give our important social values their due.<br><br> This list of potential limitations to the market is not meant to be exhaustive. And markets, of course, often can and do respond to these and other imperfections on their own. If a market is not competitive, firms may enter that market or buyers may begin pro- duction in-house rather than continue to deal with a monopolist.<br><br> Markets may internalize externalities in cases where it is possible to define property rights or to bring within the same organization all those who reap the benefits and bear the costs. In some cases, warranties and independent testing agencies can mitigate adverse selection and other problems resulting from imperfect information. The pursuit of goals other than efficiency, such as alleviating in- equitable distributions of wealth, is of paramount importance.<br><br> Chapter 5 of this Report discusses an array of policies for address- ing inequality, from transfer payments to progressive taxation to the earned income tax credit. Because reducing inequality is so vital a concern, we need to recognize that few strictly regulatory decisions will have much of an effect on the distribution of wealth or income. The controlled pricing of telephone service, electricity, or other products of regulated firms may promote other social objec- tives, but it is unlikely to have much effect on the prevalence and intensity of poverty.<br><br> Efforts to reduce inequality will be more effec- tive if directed at wages, taxes, and other determinants of dispos- able income, rather than at prices for particular products, espe- cially those that make up only a small fraction of household budg- ets. However, firm and even-handed enforcement of broad public health, environmental, and other regulatory protections can help to ensure that low-income and minority communities are not dis- proportionately affected by pollution and other activities that gen- erate harmful spillovers. 196 MARKETS AND PUBLIC POLICY AS COMPLEMENTS The conventional emphasis on markets and governments as sub- stitutes, rather than complements, has often led well-meaning, thoughtful people to take extreme positions on the role of the pub- lic sector in the economy.<br><br> Proponents of a strong government role frequently compare real market failures with an idealized vision of a government possessing unlimited information and purely benefi- cent objectives. Opponents of government often fall prey to the op- posite fallacy, contrasting the qualities of an ideal market with the behavior of real governments, which must act upon limited infor- mation and often with distorted incentives. Both institutions have limitations; neither measures up to the ideal.<br><br> A more useful approach is to compare real markets with real pol- icy effects, to understand when and where lines between the public and the private sectors should be drawn. Finding this boundary is difficult; reasonable people can and do differ on its location. Com- paring the actual performance of markets and governments also helps us see how public policies can make private markets work better, and how using market incentives can improve the perform- ance of the government.<br><br> Nineteen ninety-six saw the realization of major initiatives to es- tablish and extend competition in two markets where it had long been absent: local telephone service and electricity generation. Last year 9s Economic Report of the President examined the future of de- regulation of those two industries in detail. When that Report was written, these initiatives were optimistic prospects.<br><br> Now the com- plex task of implementing the visions behind them has begun. Pol- icymakers are working to devise ways to bring about competition while protecting against the undue exercise of market power. Much of the responsibility for maximizing competition in electricity sales and telephone service falls to State government.<br><br> As we report below, the States have not shied from the task. Markets also help the government do its job. A profound innova- tion of the last few years has been the use of market mechanisms to help the government achieve its goals at least cost to consumers and taxpayers.<br><br> Even where the case for government intervention is persuasive, policymakers have been able to exploit the advantages of the market so that public policies generate greater benefits at lower cost. Three examples of that success are especially noteworthy. The first is the use of tradable emission permit programs, in which the government distributes rights to emit some pollutant and then al- lows firms to allocate those rights across their plants and to buy and sell them among themselves.<br><br> Programs such as these encour- 197 age abatement of pollution at least cost. The second example is spectrum auctions. Here the policy goals are twofold: get spectrum into the hands of communications service providers who can gen- erate the greatest economic benefit from it, and raise funds to re- duce the need for taxes to cover government expenses.<br><br> The third example is the use of market-based prices to lead to more efficient use of public lands for mining, grazing, timber, and water supply, while protecting their environmental value. The remainder of this chapter discusses all three examples and concludes by looking at the limits to transferring public responsibilities to the private sec- tor. USING PUBLIC POLICY TO BRING COMPETITION TO REGULATED INDUSTRIES In light of the Federal Government 9s success in introducing com- petition into airlines, banking, trucking, and natural gas, its delay in deregulating the telephone and electricity industries may be puzzling.<br><br> The reasons for the delay explain why government is like- ly to be a complement to the development of competitive markets in these industries for some time to come. REASONS FOR THE DELAY IN DEREGULATING ELECTRICITY AND TELEPHONE SERVICE Jurisdictional issues have made it legally and politically more difficult for the Federal Government to deregulate electric and tele- phone utilities than other industries. Much of the regulation of these industries takes place at the State level, through public util- ity commissions.<br><br> The Federal Government generally regulates only those portions that involve interstate commerce. (Box 6 33 discusses some of the economic issues involved in assessing whether regula- tion should take place at the State or the Federal level.) In the telephone industry the FCC has traditionally asserted authority over long-distance calling between States, wireless services, and interstate access services that local telephone companies provide to long-distance carriers. In electricity, the FERC 9s jurisdiction covers wholesale power sales, the transmission of electricity for resale to final customers, and (it asserts) transmission service to retail buy- ers where such transmission service is unbundled from the power itself.<br><br> A more fundamental difficulty is the widespread presence of sub- stantial economies of scale, which create natural monopolies. A nat- ural monopoly occurs when a good or service can be provided at lower cost by one firm than by two or more. With a few exceptions, the industries first deregulated in the 1970s (e.g., trucking and the airlines) were not natural monopolies.<br><br> This choice was by design. 198 Box 6 33. 4The Economics of Federalism in Regulation Historically, responsibility for regulating electricity and tele- phone service has been divided between the States and the Federal Government. As a legal matter, the scope of Federal authority depends upon interpretations of the commerce clause of the Constitution, which says (Article I, Section 8), 8 8The Con- gress shall have Power .<br><br> . . [t]o regulate Commerce .<br><br> . . among the several States .<br><br> . . . 9 9 Economics, however, can inform these interpretations by examining a variety of factors, including: " Economic effects that cross State lines.<br><br> When problems are local, solutions in general should be local. The case for leaving matters of economic regulation or policy to the States is stronger if a State 9s policy choices do not impose costs on residents of other States. For example, if a State chooses to regulate in ways that raise prices, the strength of the Federal interest should depend on whether consumers in other States are affected by those high prices as well.<br><br> A second important example involves environmental effects that cross State borders, such as airborne pollutants. A State may fail to impose sufficient pollution controls on plants within its borders if those in other States incur the damages. " Economies of scale in regulation.<br><br> Just as the economy gains by having firms compete in the marketplace, it may also gain by having government jurisdictions com- pete in the form and content of their regulations. In some cases, however, effective regulation may require the devotion of considerable resources and specialized expertise to gathering and providing information, assess- ing costs, evaluating the state of competition, estimating environmental effects, and overseeing compliance. It may be more efficient for one entity 4the Federal Gov- ernment 4to undertake these responsibilities than to have them divided among the 50 States, the District of Columbia, and other jurisdictions.<br><br> The case for Federal regulation is stronger if considerations determining the best way to regulate vary little from State to State. " Comparative performance of government institutions. Public institutions may have incentives to act in accord with special interests rather than those of the public at large.<br><br> When this problem is more prevalent at the State level, the Federal level is likely to be the better venue in which to vest regulatory authority. 199 In both electricity and telephones the most important natural mo- nopoly was the local distribution network. It was believed wasteful to lay a parallel set of electric cables or telephone lines through cities and towns to enable different sellers to compete for cus- tomers.<br><br> The value of having everyone on the same network further argued at the time for a local telephone monopoly. Accordingly, electricity and telephone service used to be provided by companies that managed virtually every important aspect of the industry from top to bottom. Telephone service was largely the province of the American Telephone and Telegraph Co.<br><br> (AT&T), which provided most local networks, long-distance service, and tele- phone equipment. The electricity industry was more complex, but the dominant form of organization was the vertically integrated in- vestor-owned utility. These utilities generated power and transmit- ted it over high-voltage lines to their local distribution networks, which in turn delivered it to homes, offices, and factories.<br><br> Technological change and new forms of organization in the last two decades have eroded the natural monopoly characteristics of both these industries. Combined-cycle gas turbine generators re- duced the scale necessary to produce electricity at low cost, increas- ing the potential for competition in power production. The tele- phone industry has seen the development of wireless technologies, along with reductions in the cost of fiber-optic transmission lines and of the computers and software that may someday route tele- phone calls over alternative pathways such as cable television sys- tems.<br><br> These innovations have encouraged some to believe that entry into local telephone service, the last telecommunications mo- nopoly, may soon take place on a massive scale, but such entry has not yet occurred to a substantial degree outside of specialized mo- bile and business services. Elimination of natural monopoly in the physical distribution and transmission of electricity may take longer. It remains generally uneconomical to build overlapping sets of power lines for the local delivery of electricity.<br><br> Long-distance power transmission also has monopoly characteristics. Because directing electricity along a par- ticular transmission path is prohibitively costly, current supplied into a grid will take all available paths between two points and therefore affect power loads and congestion on many lines. Con- sequently, the interconnection of independently owned trans- mission lines 4a practice to promote reliability of the system as a whole 4tends to convert the separate grids into a single entity.<br><br> Experience with structural change in these industries has com- plemented these technological developments in opening utility mar- kets to competition. In electricity, public policies that have created an independent power producing industry, mostly to promote co- generation (production of electricity by factories as a by-product of 200 manufacturing) and renewable technology, had the side effect of demonstrating the feasibility of relying on nonutility generators for power supply. The analogues in telephones were the 8 8equal access 9 9 rules, imposed on the local telephone companies created in 1984 by the AT&T divestiture, to give all long-distance carriers equivalent technical interconnection, telephone numbering, customer subscrip- tion, and billing arrangements.<br><br> The divestiture created distinct local and long-distance companies, and compliance with the equal access rules provided valuable experience in how to interconnect separately owned and managed facilities. Interconnection is, as we discuss below, a crucial prerequisite for competition in local tele- phone service and in electric power generation. THE TELECOMMUNICATIONS ACT OF 1996 The Telecommunications Act of 1996 outlines the route that com- petition and deregulation in the telecommunications industry will follow.<br><br> It first takes on the challenge of facilitating competition in local telephone service. New competitors may fall into any of three categories: providers with facilities offering all aspects of local tele- phone service; partial facilities-based carriers that would purchase unbundled network elements, such as switching capacity, from the incumbent local carrier; and resellers that would purchase local service at wholesale and resell it at retail, often as part of a 8 8one- stop shopping 9 9 package of local and long-distance telephone service. (Box 6 34 discusses some other aspects of the Telecommunications Act.) The Telecommunications Act requires each incumbent local tele- phone company to allow facilities-based competitors to interconnect with its networks so that customers on both networks can call each other.<br><br> Responsibility for interconnection rests initially with the car- riers themselves, who can negotiate nondiscriminatory terms and conditions, subject to State Government mediation and arbitration. Incumbent local telephone companies must make network elements and wholesale local service available to competitors. To eliminate unnecessary entry barriers, they must also adopt technology to per- mit customers to keep their phone numbers when switching car- riers, and must provide information necessary for network inter- operability.<br><br> The Telecommunications Act also charges the States and the FCC with devising competitively neutral policies to pro- mote universal service, that is, to ensure that telephone service is reasonably available to all income groups and geographic areas in the United States. The Telecommunications Act also eliminates court-imposed rules keeping the regional Bell operating companies (RBOCs, the re- gional telephone companies created by AT&T 9s breakup) out of other communications businesses, most notably long-distance tele- 201 Box 6 34. 4Telecommunications Policy Is Not Just for Telephone Companies The Telecommunications Act covers much more than the cur- rent set of firms in the telephone industry. It also expands the number of radio and television stations a single firm may own, simplifies license procedures, and sets policies applicable if the FCC grants existing broadcasters rights to additional spectrum for tomorrow 9s advanced digital television services (while giv- ing the FCC the power to reclaim those additional rights or even those that broadcasters currently have).<br><br> But because the act also loosens FCC rules on concentration of radio and tele- vision station ownership, such concentration may raise anti- trust concerns. Increasingly, radio and broadcasting mergers are now being scrutinized by the Antitrust Division of the U.S. Department of Justice.<br><br> The Telecommunications Act also reduces price regulation of some cable television systems, while maintaining for 3 years regulations on cable systems that do not face effective competi- tion. Cable television shares the wire-based network character- istics that have made local telephone and electricity service natural monopolies, but it arguably faces greater competition from other video media such as broadcast television, video- cassettes, and direct broadcast satellite service. To encourage telephone companies to compete with cable operators, the Tele- communications Act establishes a common-carrier 8 8open video systems 9 9 framework that local telephone companies can use to provide cable television service with substantially less regula- tion.<br><br> In addition, the act amends the Public Utility Holding Company Act of 1935 to permit public utility holding compa- nies to acquire or maintain an interest in 8 8exempt tele- communications companies 9 9 (ETCs), which could provide tele- communications or information services in competition with in- cumbent providers. Since the act was passed, the FCC has ap- proved a number of petitions for determination of ETC status. Other major provisions of the act seek to control the avail- ability of obscene and indecent material to minors via the Internet and require that televisions with screen sizes exceed- ing 13 inches include a so-called V-chip, which when activated blocks programs with ratings designed to inform parents of sexual, violent, or indecent content that their children might see.<br><br> As of this writing, several Federal courts have ruled that the content provisions regarding indecency on the Internet vio- late freedom of speech. 202 phone service (Box 6 35). The act replaced these rules with a long- distance entry approval procedure administered by the FCC.<br><br> For an RBOC to receive FCC authorization to provide long-distance service to its local service customers, it must have an approved interconnection agreement with a facilities-based competitor, or, if no competitor has made a good-faith request for interconnection or network elements within a specified time, it must have an ap- proved statement of terms and conditions under which it will pro- vide interconnection. In either case the RBOC must offer inter- connection under terms and conditions that meet a 14-point statu- tory checklist. The FCC then must determine whether granting the RBOC 9s application to provide long-distance service 8 8is consistent with the public interest. 9 9 In making its determinations, the FCC is required to consult the regulatory commissions of the relevant States to verify compliance with the checklist, and to solicit and grant substantial weight to the Department of Justice 9s evaluation of the application.<br><br> The Antitrust Division of the Department of Jus- tice has long experience in competition analysis, and thus has the expertise to judge the effects of an RBOC 9s provision of long-dis- tance service. Similar prohibitions against manufacturing of telecommuni- cations equipment by the RBOCs are repealed, effective when the company obtains approval to provide long-distance service. The Telecommunications Act prohibits RBOCs from discriminating against competitors in areas such as procurement and access to technical network information.<br><br> To protect against anticompetitive discrimination and the possibility that local telephone customers will end up paying for the RBOCs 9 ventures into long-distance serv- ice, manufacturing, and other new enterprises, these offerings must be provided by separate subsidiaries for a minimum of 3 years. Yet creating competition is not simply a matter of legislative dec- laration; controversies regarding market power and dominance will persist for some time. Exemplifying both the complexity of the is- sues and the case for regulatory oversight is the FCC 9s First Report and Order implementing the local competition provisions of the Telecommunications Act.<br><br> Table 6 31 summarizes some of the con- troversy and the FCC 9s decisions. As of this writing, the 8th Circuit Court of Appeals has stayed implementation of parts of the order, holding that the FCC went beyond its jurisdiction in prescribing prices and pricing methods for network elements and wholesale telephone service. While the courts consider these issues, State regulators continue to mediate, arbitrate, and approve interconnection negotiations between incum- bent local telephone companies and new entrants.<br><br> The FCC will still have to make decisions regarding whether the RBOCs have met the prescribed conditions for being allowed to offer long-dis- 203 Box 6 35. 4Why Were the Regional Bell Operating Companies Kept Out of Other Markets? The RBOCs are the local service companies spun off by AT&T in 1984 as part of the settlement of the antitrust case brought against it by the Department of Justice. The divesti- ture was premised on the economic harm created when a regu- lated monopoly can evade controls on prices and profits by op- erating businesses in other unregulated (or less tightly regu- lated) markets.<br><br> In U.S. v. AT&T, the regulated monopolies in question were AT&T 9s local service companies, and the rel- atively unregulated businesses were its long-distance service and its telecommunications equipment manufacturing subsidi- ary.<br><br> The leading concerns were: " Anticompetitive discrimination. A regulated local tele- phone monopolist that also provides long-distance serv- ice might, for example, provide delayed or inferior con- nections to other long-distance competitors. If long-dis- tance companies can only complete calls through the local network, those competitors cannot turn elsewhere for adequate connections.<br><br> This boosts demand for the monopolist 9s own long-distance service, allowing it to raise long-distance prices. " Cross-subsidization. A regulated local telephone com- pany might purchase equipment and labor to provide long-distance service and record these purchases as costs of providing local service.<br><br> It could then cite these added costs to justify to its regulator an increase in its local telephone rates. Because it has a local service monopoly, customers cannot turn elsewhere and must pay the high- er rates. The profits show up on the books of the unregu- lated long-distance service.<br><br> In the 1970s and early 1980s the local telephone monopoly appeared permanent and regulatory approaches ineffective. The Department of Justice 9s Antitrust Division therefore pressed AT&T to divest its local operations, creating the RBOCs. To prevent anticompetitive discrimination and cross- subsidization from recurring, the RBOCs were kept out of long- distance service and other markets.<br><br> Enacted 12 years after that divestiture, the Telecommunications Act of 1996 reflects technical change that has made the prospect of local competi- tion more realistic, and gives the RBOCs a reasonable oppor- tunity to meet conditions under which their provision of long- distance service would promote rather than inhibit competi- tion. 204 T ABLE 6 31. 4 The Interconnection Debate Entry method Entrant side Incumbent side FCC policy (absent a negotiated agreement between the parties) Facility-based total service providers Incumbent would preserve monopoly by refusing to interconnect. Act left interconnection to bilateral negotiation; FCC intervention will give too little weight to local market consider- ations.<br><br> Set basic rules for inter- connection between existing local telephone companies and new end-to-end providers. Purchase of 8 8network elements 9 9 Incumbent would offer too few elements at too high a price. Entrants demand ineffi- cient slicing of net- work; rates based on forward-looking costs will not provide enough revenue to pay for past investments.<br><br> Determine the 8 8network elements 9 9 (loops, switches, other compo- nents) incumbent carriers should make available; specify cost- based methods for set- ting their prices. Resell incumbent 9s service at retail; own no facilities Wholesale discounts below retail rates are necessary for profitable retail competition. Resellers should not get service at prices discounted from retail rates that, because of regulation, are below the cost of providing service.<br><br> Set a default wholesale discount of 17 325 percent below retail, based on estimates of incumbents 9 costs related to retailing that incumbents would avoid. Source: Council of Economic Advisers, based on Federal Communications Commission interconnection order. tance service, in accord with the checklist and the 8 8public interest 9 9 standard in the Telecommunications Act.<br><br> While the interconnection issue is pending, the Joint Board of FCC and State Public Utility Commissioners has adopted rec- ommendations for funding universal service subsidies for telephone service to low-income or high-cost (generally rural) areas through competitively neutral contributions from interstate telecommuni- cations service providers. The proposal defines universal service as including basic voice telephone service and ancillary services. The current practice of subsidizing universal service through 8 8access charges 9 9 (fees that long-distance companies pay the local incum- bent to originate and terminate calls) is neither transparent nor likely to be sustainable in a competitive environment, as the entry of new telephone companies fosters bypass of the payment system.<br><br> In December 1996 the FCC initiated proceedings to reform access charges. It is proposing to prescribe specific changes in access charges and/or to grant a local telephone company different degrees of pricing flexibility depending upon whether it faces potential entry, actual competition, or substantial competition. One question in addressing universal service and access charges is whether, after deregulation, the earnings of incumbent telephone companies will suffice to cover the infrastructure costs mandated under prior regulatory regimes.<br><br> As last year 9s Economic Report of the President argued in the context of 8 8stranded costs 9 9 of electric utilities (which are discussed further below), recovery of costs le- 205 gitimately incurred pursuant to regulatory obligations would be warranted. Such recovery should be limited, however, to invest- ment expenses not already recovered through past earnings. It is also crucial that any such recovery be accomplished in a manner that is competitively neutral 4for example, creating neither artifi- cial price nor cost advantages for the incumbent carrier.<br><br> The years of debate that preceded passage of the Telecommuni- cations Act are likely to presage additional years of regulation and litigation to realize its goals. These complex issues will require ac- tive policy oversight to ensure a proper outcome. EXPANDING COMPETITION IN ELECTRICITY: FEDERAL ORDERS AND STATE INITIATIVES Telecommunications was not the only industry during the past year to be the object of procompetitive policy initiatives.<br><br> Major reg- ulatory decisions by the Federal Energy Regulatory Commission, along with ambitious State initiatives, are already opening markets in electric power generation to competition. Legislation to increase competition in electric power markets is under active consideration by the Congress and the Administration. (Box 6 36 discusses the important role of merger enforcement during the transition to com- petition in the electricity and telephone industries.) The 1992 Energy Policy Act authorized the FERC to order a transmission-owning utility to provide wholesale transmission serv- ice.<br><br> This enabled generators owned by the transmission utility, by other utilities, or by independent power producers to compete to sell power to local distribution companies or anyone else engaged in the resale of electricity. Opening up wholesale markets and interstate transmission networks to the panoply of generating com- panies should lower prices and will be necessary for effective retail competition. State regulators are now determining the extent to which competition in electricity may extend to retail markets.<br><br> The key provisions of the FERC 9s Order No. 888, issued April 24, 1996, require public utilities to file nondiscriminatory 8 8open access 9 9 tariffs for the interstate transmission of electricity sold at whole- sale. Order No.<br><br> 888 also requires 8 8functional unbundling 9 9 by utili- ties of generation from transmission, with separate rates for whole- sale power, transmission service, and other ancillary services. These tariffs are intended to ensure that the utility treats nonaffili- ated power companies the same way it treats its own generators in terms of prices and service options. To implement these proce- dures, Order No.<br><br> 889 mandates the creation of Open Access Same- Time Information Systems (OASIS) to provide all generators with up-to-the-minute data regarding power flows and congestion in the transmission network. The thrust behind these two orders is the 206 Box 6 36. 4Mergers During the Transition to Competition At the same time that the FERC, the FCC, and State gov- ernments are engaged in designing regulations to facilitate competition in telephone and electricity markets, these indus- tries are seeing considerable merger activity. Mergers may en- able firms to exploit economies of scale, but they can also en- gender concerns that competition will be reduced.<br><br> The Hori- zontal Merger Guidelines promulgated by the Department of Justice and the Federal Trade Commission point out that mergers can lessen competition by making it easier for firms to collude and, in some cases, by giving monopoly-like power to the merging parties. A crucial consideration in evaluating mergers is what anti- trust experts call market definition: identifying who is in the market and who is not. All else being equal, the more sellers that remain in the market after a merger, the less likely it is that the merger will reduce competition.<br><br> As the industries have been structured up to now, mergers between local telephone companies, or between electric utilities, might have little anti- competitive effect, because the two would by law and econom- ics be in separate markets. Following the Telecommunications Act of 1996 and Order No. 888, however, the concern is that these mergers might reduce potential competition in the fu- ture.<br><br> The effects of a merger in these industries depend on how those initiatives are implemented and how the industries re- spond. We do not yet know how the markets will turn out 4 whether two, three, or ten companies will compete to provide electricity or local telephone service to customers in any par- ticular area. Moreover, the mergers themselves may reflect the firms 9 belief that they should merge now before authorities can prove that the mergers would reduce competition.<br><br> In principle, mergers can be a way for firms to reduce costs and improve their ability to compete. However, efforts to block anticompetitive mergers are crucial if legislative and regu- latory efforts at all levels of government to promote competi- tion are to realize their full potential. creation of institutional arrangements that will support greater competition in the industry.<br><br> Among the many complex issues to be resolved in managing the transition from regulation to competition in electric power genera- tion, two stand out. One is the degree to which more stringent forms of separation between generation and transmission will be necessary to prevent discrimination. Order No.<br><br> 888 did not require 207 strict corporate separation between transmission companies and generators. A widely discussed alternative is to create so-called independent system operators (ISOs). An ISO would operate (but not own) a transmission grid, keep power supply equal to use, and manage responses to emergencies and blackouts.<br><br> The FERC recog- nizes the need to prohibit conflicts of interest between ISOs and power providers and has set forth principles that ISOs must sat- isfy. However, the agency has left the development and implemen- tation of ISOs to the utilities and the States. A second major issue involves what are known in the electricity industry as stranded costs.<br><br> As discussed in last year 9s Economic Report of the President, electric utilities facing competition from new, low-cost power suppliers may be unlikely to recover substan- tial amounts of their undepreciated investments in high-cost power plants. A second source of stranded costs is long-term contracts with high-cost renewable power suppliers. Such contracts were mandated by Federal laws intended to promote purchases of such power by utilities at their avoided costs of new plant construction.<br><br> Over time, however, those contract prices have probably turned out to be higher than the projected cost of power under deregulation. Allowing utilities to recover prudently incurred investment and contract costs is important. Investors in regulated enterprises need to be reasonably confident that the government will not renege on its commitments by arbitrarily denying the investors any oppor- tunity to recover their upfront costs.<br><br> At the same time, however, regulated firms may engage in wasteful investments if recovery is guaranteed unconditionally. To avoid creating this incentive, a pre- sumption in favor of cost recovery should apply only for costs in- curred to comply with specific regulatory mandates or before com- petition became a significant prospect. In its recent Order No.<br><br> 888, the FERC granted utilities the right to seek recovery of costs stranded when a former wholesale cus- tomer purchases power from new suppliers. The FERC 9s rule only covers contracts established prior to July 11, 1994, the day the agency published its stranded cost rulemaking in the Federal Reg- ister . It served notice that it would not consider a request for wholesale stranded cost recovery for contracts entered into after that date.<br><br> Much of the potentially stranded costs, perhaps over 90 percent, fall under State jurisdiction, however, and are being re- solved by the various States in different ways. States across the country are also expanding competition in elec- tricity. New Hampshire has already undertaken a pilot program in which 16,000 randomly selected customers were allowed to choose their electric company.<br><br> In response, over 30 power companies have offered a variety of flat rates and usage discounts, rebates and other inducements, and promises of environmental sensitivity. In 208 February 1996 the Wisconsin Public Service Commission submitted a proposal to the State legislature describing a 32-step plan to bring retail competition to consumers there by 2001. In September 1996 California enacted a plan that would offer consumers a choice of power providers as early as January 1998, with deregulation of retail power prices by 2002.<br><br> These initiatives illustrate how complementarity between public policy and private markets holds at the State level as well as for Federal regulation. The existing statutory and regulatory framework may make it difficult to resolve the complex issues, such as ensuring system re- liability, that are sure to arise as competition in electricity evolves. Accordingly, the Administration is considering a variety of legisla- tive proposals to modify existing regulatory frameworks.<br><br> Such leg- islation could promote competition and efficiency in the electricity industry by permitting more flexible industry structures and clari- fying the jurisdictional boundaries between State and Federal Gov- ernments. MARKETS COMPLEMENTING GOVERNMENTS The Telecommunications Act, the FERC 9s open access orders, and State and Federal actions to implement them illustrate how gov- ernment policy can facilitate the development of responsive, com- petitive markets. The street goes both ways, however.<br><br> Recent policy developments regarding pollution control, spectrum management, and land use show how government can use market forces to help achieve important social objectives. (Box 6 37 indicates how ad- vances in telecommunications are making the government more ac- cessible to the public.) EMISSIONS TRADING: APPLICATIONS TO AIR POLLUTION Concerns about environmental degradation and resource deple- tion have led to an intensified search for innovative, cost-effective solutions. One fairly new approach is emissions permit trading.<br><br> Proposed at least as long ago as the 1971 Economic Report of the President, emissions trading is now often regarded as the preferred policy approach to a range of environmental problems. By giving polluters a financial incentive to reduce emissions in the least ex- pensive possible way, emissions trading reduces the costs of envi- ronmental protection. Firms with high abatement costs can pur- chase permits from firms with low abatement costs, which thus find it profitable to reduce their emissions and sell their surplus permits.<br><br> As a result, greater responsibility for reducing emissions is allocated to those firms that can do so at least expense. 209 Box 6 37. 4Bringing the Government to the People via the Internet An important advance in the use of telecommunications tech- nology to promote democracy is the expanding availability of government information via the World Wide Web on the Internet. Any citizen with access to a computer and a tele- phone line at home, work, or the public library can now search this vast hoard of information.<br><br> To get to these sources of information, one enters a website address (formally called a uniform resource locator, or URL) in a World Wide Web browser program. The URL usually takes the form: http://www.name.gov/ where in place of 8 8name 9 9 the user specifies the site. Some of the leading government websites are: Library of Congress loc White House whitehouse Department of Agriculture usda Department of Commerce doc Department of Education ed Department of Energy doe Department of Health and Human Services dhhs Department of the Interior doi Department of Justice usdoj Department of Labor dol Department of State state Department of Transportation dot Department of the Treasury ustreas Department of Veterans Affairs va Environmental Protection Agency epa Federal Communications Commission fcc Federal Trade Commission ftc Government Printing Office gpo National Aeronautics and Space Administration nasa National Science Foundation nsf Within the Library of Congress website, a useful source of information on the Congress and on Federal legislation is the Thomas data base.<br><br> From the White House website, one can use the 8 8Interactive Citizens 9 Handbook 9 9 to find websites for other Executive Office agencies, including that of the Council of Eco- nomic Advisers, which includes an electronic edition of this Report . 210 Emissions Trading in Practice Much of the enthusiasm for emissions trading is due to its suc- cess in attaining mandated reductions in sulfur dioxide (SO 2 ) emis- sions from electric utilities, at lower-than-expected costs. The Envi- ronmental Protection Agency (EPA) implemented emissions trading as part of its Acid Rain Program.<br><br> That program, instituted under the 1990 Clean Air Act Amendments, called for major reductions of atmospheric SO 2 and nitrogen oxides (NO x ), the pollutants that cause acid rain. To hold SO 2 emissions to a targeted maximum total level, the EPA issued each polluter a number of permits based on fossil-fuel usage in the mid-1980s. (Box 6 38 discusses the rel- ative merits of giving away emissions permits, auctioning them to the highest bidder, and charging emissions fees.) After the initial distribution, permitholders were allowed to buy or sell permits or use them to offset excess pollution in other parts of their own oper- ations.<br><br> During the debate over the Clean Air Act in the 1980s, utilities warned that annual compliance costs could exceed $4 billion by the year 2000, and SO 2 pollution allowances were predicted to trade at prices ranging from $170 to almost $1,000 per ton of emissions. By the end of 1995, however, the price of SO 2 permits was around $80 per ton. Some preliminary analyses suggest that several factors 4 deregulation that reduced the cost of shipping Western low-sulfur coal by rail, improvements in fuel blending technology, and sub- sidies for the installation of equipment (called 8 8scrubbers 9) to filter out emissions from smokestacks 4reduced demand for and thus the price of SO 2 permits.<br><br> The flexibility provided by the emissions trad- ing system, however, is credited with promoting competition in coal markets and encouraging innovation that led, at least in part, to these cost reductions. Whatever the linkage, as market-based methods reduce the costs of abatement, more stringent environ- mental standards become easier to justify. The first phase of SO 2 emissions trading, affecting 110 plants, began January 1, 1995.<br><br> Phase II of the Acid Rain Program is slated to begin in 2000, when an additional 700 fossil fuel-burning plants will be subject to emissions caps. Moreover, analysts expect that permit trading will play a greater role in other ways as the market expands. The EPA is examining ways to respond to increased com- petition following the FERC 9s Order No.<br><br> 888, which according to the EPA 9s analysis will increase the market share of relatively high emission coal-fired plants. A trading system for NO x is a strong contender. Emissions Trading and Climate Change Policy In July 1996 the Administration announced that the United States would support an international effort to set reasonable and attainable, binding emissions-reduction targets for greenhouse 211 Box 6 38. 4Taxing Pollution Versus Giving Away Emissions Trading Permits Versus Auctioning The first emission permits under the EPA 9s Acid Rain Pro- gram were issued to utilities without charge.<br><br> But handing out tradable emissions permits for free is not the only way to intro- duce markets into environmental protection. Other policy op- tions include placing fees on emissions, and auctioning rather than giving away permits. By changing relative prices, and therefore incentives, all of these policies seek to improve upon traditional command-and-control methods that specify pollu- tion limits for each plant and, in some cases, even the tech- nologies to be used to achieve those limits.<br><br> Market-based incen- tive policies tend to increase efficiency by imposing a marginal cost on firms for polluting, through either paying more fees, purchasing more permits, or forgoing the opportunity to sell permits to someone else. Facing these costs gives firms the in- centive to reduce pollution most at plants where it costs the least to do so, and by developing and using less expensive abatement technologies. Economically, the choice between fees and marketable per- mits is of secondary importance.<br><br> If it is crucial to set some ab- solute limit on the quantity of pollution introduced into the en- vironment, permits together with stringent enforcement can ensure that that limit is not exceeded. If the incremental social cost from adding pollutants is known to be relatively constant, the theoretically better approach would be to set fees equal to that cost. Collecting emissions fees, and auctioning rather than giving away permits, also raise revenue that can be used for deficit reduction or to cut other, more distortionary taxes.<br><br> Whether regulators give away permits, auction them off, or impose pollution fees, anything that forces firms to abate pollu- tion or cut back output is sure to raise the cost of supplying the goods and services those firms produce. These higher costs translate into higher product prices. Higher prices, however, lead consumers to take pollution costs into account when mak- ing their own purchasing decisions.<br><br> gases 4the gases whose emission is believed to cause global warm- ing. The possible effects of global warming include risks to coastal areas from rises in sea level; changes in rainfall and agricultural productivity; and increased incidence of diseases such as malaria, yellow fever, and cholera. Combustion of fossil fuels, primarily coal and oil, is the main source of elevated levels of carbon dioxide, the most prevalent of the greenhouse gases.<br><br> 212 The United States has called for flexible and market-based ap- proaches for reducing these emissions, one of which may be domes- tic and international greenhouse gas emissions trading systems. Extending trading internationally is especially intriguing. An inter- national trading system would be able to take advantage of green- house gas reductions in those participating nations where the mar- ginal cost of reducing emissions is relatively low.<br><br> Other Implementation Issues Determining the initial distribution of emission permits can be contentious. The alternative to allocating permits through the mar- ket by auctioning them is to rely on a formula, which may be based on past and current pollution. Such formulas can be controversial because recipients of permits are given a scarce and valuable re- source.<br><br> Moreover, companies anticipating an allocation based on current practices have an incentive to delay actions to limit pollu- tion or other environmentally harmful activities, in order to qualify for more permits. This incentive can be partially neutralized by linking reductions to some prior historical baseline. However, this approach can make the choice of allocation formula more difficult, since participants will realize that a distribution of permits based on historical practices penalizes those who were the first to under- take actions to improve the environment.<br><br> In cases where the incremental harm from emissions is relatively constant over time, the efficiency of emissions trading can be en- hanced, at least in the short run, by allowing polluters to bank and borrow permits. Under such a system, polluters could defer their use of a permit, or borrow against future allowances, as their costs dictate. Where workable, this can allow the emissions trading mar- ket to allocate reductions over time in a more efficient manner.<br><br> Timing flexibility can reduce compliance costs through better co- ordination of emissions reductions when replacing old facilities with less polluting technology. In the first year of the EPA 9s SO 2 trading program, emissions reductions were about 40 percent greater than the target level, as utilities 8 8banked 9 9 allowances for future years. A problem can arise when the damages from emissions are not distributed evenly over the geographic area in which firms can trade permits.<br><br> If polluters with high abatement costs 4the ones most likely to buy permits 4are geographically concentrated, a 8 8hot spot 9 9 area that is persistently in serious noncompliance may result. Hot spots are a potential problem with SO 2 , but they may be more serious with regard to NO x . Better market mechanisms for dealing with hot spots should be developed.<br><br> Despite these and other complications, interest in emissions trad- ing remains strong, primarily because of the potential cost savings and efficiency gains. The EPA estimates that meeting possible SO 2 , 213 NO x , and mercury targets through an emissions trading program with banking would reduce abatement costs in 2005 by almost two- thirds compared with a traditional command-and-control approach. Researchers at the Stanford Energy Modelling Forum have pre- dicted that international emissions trading for carbon dioxide could reduce costs as much as 50 percent below the minimum achievable using purely domestic programs 4and as much as 80 percent if flexibility in the timing of emissions reductions is allowed.<br><br> These cost savings do not conflict with considerations of intergenerational equity, because they take place within a program designed to en- sure that concentrations of carbon dioxide never exceed critical tar- get levels in any year. SPECTRUM AUCTIONS Auctions of rights to use publicly owned resources can allocate those resources efficiently, as well as generate revenues to help cover the costs of government programs. The chief example in 1996 was the FCC 9s auctions of rights to use parts of the radio spectrum for personal communications systems (PCS).<br><br> By virtuall

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