inheres in regulatory institutions would be delegated to any bureaucracy without subjecting the decisions to judicial review and without giving affected individuals the right to plead their cases before decisionmakers.

To safeguard the rights of individuals against capricious and arbitrary decisions of an agency requires establishing decisionmaking procedures that normally cause decisions on important issues to be protracted. This can create serious problems in three types of circumstances: when rapid inflation pushes costs up and firms can not respond to cost increases by raising prices until a protracted regulatory review has been completed, when a technological development that would lower costs and improve service quality can not be fully exploited without regulatory review, and when an innovative new firm seeks to enter a regulated market but must first win the approval of the regulators. The last two effects significantly reduce the incentive to the firm to be innovative, since to all the risk and costs of innovation are added the expense in time and resources of a regulatory proceeding, while the risk of a more innovative competitor capturing a superior market position is reduced.

The second major dilemma of regulatory institutions reflects the trade-off between an expensive regulatory process and a process that is insulated from the individuals affected by its outcomes. In part because the preservation of accountability and due process through judicial review makes participation in the regulatory process expensive, and in part because the vast majority of persons who are affected by regulatory decisions are not effectively organized to represent themselves in regulatory proceedings, the flow of information and proposed rules to the agency is one-sided. A passive agency that relies upon the evidence supplied by participants in the process will inevitably make decisions based upon incom-s plete assessments of the issues at hand; an agency that can generate its own, preped

independent flow of information on every important case will be much more ex

pensive to operate. In fact, none of the federal regulatory authorities engaged in fules.

price and profit regulation devotes anywhere near the resources to generating information for use in regulatory proceedings that is committed by the industries they regulate.

The recent debate over the regulation of cable television is an illustrative case in point: the final regulatory rules were worked out by a coalition of broadcasters, cable system owners and program producers. While each of these groups cast their arguments defending their own positions in terms of the beneficial effects a system satisfying them would have on society at large, and while the FCC devoted some staff resources to investigating the stake of viewers in the issue, nevertheless the final compromise was hammered out exclusively by the well-represented special interests, and was adopted by the FCC explicitly because none of the three groups would appeal the compromise, legally or politically.

These endemic problems of regulation do not necessarily lead to the conclusion that under no conditions should industry be regulated. All that they imply is that certain inevitable costs are to be expected. Generally, these costs will be higher if: 1) the sophistication required to determine the true technical and economic conditions of the industry is greater, 2) the greater the portion of the effects of regula tion that is diffused over a large, heterogeneous group that is unlikely to be effectively organized, and 3) the more uncertain and rapidly changing the economic environment in which the regulated firms operate, such as is the case during a period of rapid inflation or deepening recession.

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*

*********er, tenebra så neg.ation *... tense.

*** 7 the argument for regulation of most industries is more complex maranse aintance de monopollatis practises. In the use of domestic air1*quation has a pain promotional feature, owing to the affects at*roved to an exomalne alt rate structure on economie devel:pment, the dis** avion de minemia ad olty and national defense. Witbort decating the merits **ang bangetone xtic are, of coche, eminently delatalle—the issue re*** which polig instrument an most effectively generate the desired route **white. The difcity with the regulatory approach is that this explicit proMika With Cres the rez,atory authority an even greater industry-orientation man the inantariona, dhemmas would normally produce. On the industry's part, VUUTTAAN, ORADA VZLADry policies generate overly optimistic investment DIALE RIDOR the incentive for investment is heightened by the belief by firms that regulatore will act to ameliorate at least some of the financial losses that will 14 effered if an investment plan proves too optimistic. On the agency's part, finawial tale of a reg ilated firm is at best an embarrassment and at worst a RATIO IR probem: the fallure may be attributed to the decisions of the agency, and, in any event, will, at least temporarily, cause the pattern of service to fall short of the promotional objective that led the agency to acquiesce to overinvestment in the first place. The result is a continuing spiral of overly optimistic expansions too many new planes flown too frequently over too many routes— followed by policies, propounded by regulators to bail out their charges.

Deregulating a competitive industry will undoubtedly have some significant adjustment effects. Prices and profits will probably fall, dramatically so in the short run, some routes will be abandoned or be subjected to sharp service curtailments, and some firms may face bankruptcy and reorganization. But in the long run, more and better service and normal profits can be expected and at reduced prices, as firms learn to operate more efficiently and as the price system is used as a signaling device for tailoring service to user tastes.

If the resulting route structure is judged to be somehow unsatisfactory by the political process, competitive bidding for contracts to serve unprofitable routes

or to fly unprofitably large and fast aircraft into some cities will prove a far more efficient mechanism for promoting the industry than regulation. The key to the contract alternative is its reliance on the natural forces of competition in all markets, including the subsidized ones. Even if Congress desires to promote a more developed route structure than the competitive market would yield but without paying subsidies from general revenues-a circumstance which plausibly suggests that a subsidy should not be paid in any event—an explicit intraindustry transfer, retaining the competitive market structure, is still feasible and subsidized routes could be financed by a tax on airline tickets, for example.

Economists (myself included) blanch at most any proposal to engage in government promotion of an industry, especially when financed by the profitable activities of the industry. Such "cross-subsidization" extracts its own costs in terms of efficiency of the economic system, and these are not trivial. But the point remains that the economists' arguments for unregulated competition are not dependent upon their position on cross-subsidization, and the two issues should not be confused. Regulating a competitive industry inevitably generates costs but provides no benefits, except that in the short run existing firms in the industry that have overinvested in response to perverse regulatory incentives experience losses when the protective shield of regulation is removed. The efficient way to promote an industry, or to force it to respond to considerations not normally reflected in the marketplace, is to do so directly through taxes, subsidies and performance standards tied specifically to the policy concern of the government.

Mr. BREYER. I think it will be 2:30 when we reconvene this afternoon.

[Whereupon the subcommittee adjourned at 1:25 p.m., to reconvene at 2:30 p.m. that same day.]

AFTERNOON SESSION

Senator KENNEDY. The subcommittee will come to order.

Our next witness is Mr. Alfred Kahn, chairman of the Public Service Commission, State of New York, who taught economics at Yale University and served as a senior staff member of the economic advisers, and is presently on leave from Cornell University. He has written extensively in the area of economic regulation.

Mr. Kahn.

STATEMENT OF ALFRED E. KAHN, CHAIRMAN, NEW YORK STATE PUBLIC SERVICE COMMISSION

Mr. KAHN. I am very honored by your invitation to testify here. I have been asked to hold my testimony to 10 minutes, which means I will have to talk terribly fast. I will make no effort to read my

statement.

Part No. 2: Although there are many ways in which it makes sense 9% ce competition into a regulated system, still fundamerta competin and negation are antithetical.

Į Malik, Vesing the airline industry performs better than it would og vime of the presence of some competition in it. But fundamentally, Mere la ameting inherent in regulation that makes it hostile to wagestion.

By the way, this has nothing to do with honesty or corruption or irresponsibility of regulators. It has to do with the fact that under competition nobody is responsible for supply, no single firm has an | oongation to serve. The protection of consumers, the assurance of supp.y comes from the impersonal functioning of the competitive market. In a regulatory situation, in contrast, we rely on chosen instruments, identifiable firms and the regulator himself.

As a result, I. as chairman of the Public Service Commission of New York, feel a kind of direct personal responsibility for seeing to it that lights will go on in 1985 when people flick on the switches. That means that I have to be very solicitious of the financial health of those chosen instrument companies. Similarly, every responsible airline regulator will undoubtedly tell you that he has an enormous responsibility for the continuation of ample, safe, and economical air

service. That inevitably produces a distrust of price competition. It is a nuisance, a threat to the financial health of the chosen instruments. Competitive innovations may suddenly render obsolete a whole bunch of equipment. Competitors have an inherent tendency, in the words of regulators and regulatees, to skim the cream off the market, which is only to say they tend to go in naturally where prices are high, and they stay out where costs are high relative to price. So the regulator will ask you how they are supposed to supply continued service in bad weather as well as good, in the winter as well as the summer, over lightly-traveled as well as heavily-traveled routes, if competitors are allowed to come in and skim off the cream off the profitable operations that support the unprofitable. So, to a regulator, competition is a nuisance.

This means that where you are dealing with an industry that is structurally competitive-the brokerage business on security exchanges, trucking-regulation typically involves cartelization. It means holding prices up, not down, it means preserving market shares of existing firms. Now, that is a distinction not often made. Ask yourself when you look at a particular instance of regulation: Is it functioning to keep price down, which I think is my job in New York State, or to keep prices from falling, which often happens in transportation? Or again, is it trying to hold the quality of service up, or is it trying to hold service competition down, as I think you will find in the airline industry. That is my second point. There is a basic antithesis here. You have to choose.

REGULATION PRODUCES CARTELIZATION AND INEFFICIENCY

No. 3, in these structurally competitive situations, regulation and the cartelization that goes with it, it is terribly inefficient in terms of producing at the lowest possible cost. In some ways, it is the worst of all possible worlds. It is worse than single-firm monopoly; it is worse than competition, no matter how imperfect competition is.

It is hostile to letting business go into the most efficient firms. Instead, it tries to preserve the market shares of all firms, high-cost and low-cost. Think of the ICC and its limitations on competition by the railroads, often when they can reach out and take business at a lower incremental cost, not letting them do so. Think of the prorationing of crude oil. To the extent they cut back output, they did not cut back equally, but instead they imposed stringent controls on the lowcost wells, at the extreme of holding them down to 8 days of production a month, and exempted the high-cost marginal producers. They had higher quotas for deep wells, because they were more costly."