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THE GENERAL CONDITIONS OF DESTRUCTIVE COMPETITION

Senator KENNEDY. What about the other side of the coin, though, what about the destructive competition? Don't we have the most elaborate service of air transportation in the world, and probably the safest? That is certainly worth something to the traveling consumer. How can we be so sure that if you allow competition you will not get destructive competition and uncertainty and unrealiability ?

Mr. Kaun. Those are real questions which explain my qualification at the beginning, I am not going to be able to give you decisive answers. But I do have a few suggestions of places to look.

First, no businessman protected from competition ever believes com* petition is anything but destructive. In the same way, he does not use the word "competitor" he uses "chiseler.”

Second, there are conditions which are conducive to destructive competition, and you have to see if they apply in this case. Where you have very heavy capital costs, or enormous economies of scale such that marginal costs are typically way below average costs you will have a tendency for competition to drive rates down to that level. You will want to look and see whether that is really true in this industry. Third, is capital immobile? Once it is there, does it tend to get stuck and not be able to get out!

Well, in trucking, of which I have a greater knowledge, I emphasize that trucks are very mobile, they can move from one market to the next. Moreover, a large part of your costs are variable; so prices cannot go down very far. If you can move, especially with transportation equipment, you can move to another market, competition in any market cannot be destructive.

Fourth, is entry likely to be excessive? Well, I am very skeptical that you will have rapid entry into airline markets. It is not an easy thing, where you have product differentiation in these markets and the attractiveness of known brands, I am skeptical of that.

Look at some areas where you have unregulated competition. You have probably heard the story of California and Texas. I would look very carefully at those instances. It appears they have effective competition, and it is not destructive.

Senator KENNEDY. Do you think it would be useful to have somebody on the regulatory commission who is an economist?

Mr. KAHN. Why I think it would be marvelous. No, I really believe that, Senator Kennedy. It is amazing to me how few economists there are. I think it might be fatal if they are all economists. There is a perspective that an economist brings that is very important. An economist tends to think in terms of benefits versus costs, and every decision we make in our society today is a benefit-cost measurement, whether we like it or not.

Senator KENNEDY. Thanks very much. I hope you make your plane. It was very interesting and very helpful. [The prepared statement of Mr. Kahn follows:]

PREPARED STATEMENT OF ALFRED C. KAHN, CHAIRMAN, NEW YORK STATE PUBLIC

SERVICE COMMISSION

I am honored by your invitation to testify before your subcommittee on the regulation of the airline industry. I trust I do not appear here under faise pretenses. I have for many years been a student of the economics of regulation, and now find myself a practitioner, but I do not consider myself sufficiently expert on the airline industry to presume to give you specific recommendations about how it should be regulated, or whether it should be regulated at all.

And yet, whi.e it is true that each regulated industry is in some degree unique and the policy with respect to it must be designed in the light of its own peculiar characteristics, it is also true that regulation manifests certain tendencies and raises certain problems common to all industries. I hope therefore that, by describing to you those general tendencies and problems that seem to me particularly pertinent to airlines, I may be of help to you in your effort to assess the system of regulation that we apply to that industry today in the United States.

The first observation I would like to make is that competition and the kind of regulation we practice in the public utility industries—and that is the only kind of regulation I am concerned with in this testimony!—are inherently antithetical. While the choice between these two control mechanisms is rarely absolute, as I will point out presently, society typically must in each individual instance choose whether to rely on regulation or on competition to protect the public interest; it cannot typically have both. It is commonplace that direct regulation becomes necessary where competition is not feasible; regulation is imposed because competition is throught to be ineffective. And it is now also commonplace that regulation has a strong inherent tendency, in turn, to control and eliminate competition that would otherwise prevail.

This is so not only for the superficial reason that regulation, by definition, typically involves the imposition of limitations on competitive entry and independent competitive action in the determination of price. It is also because regu

1 Government influences the functioning of the economy generally in a wide variety of ways, for example, by regulating the supply and availability of money, enforcing contracts, providing subsidies or tariff protection, prohibiting unfair competition, imposing standards for packaging and product contents, licensing entrants into various trades and professions on the basis of qualifications, and in the case of airlines. licensing pilots and imposing various other rules in the interest of safety. But all of these instances of regulation, at least in principle, are intended not to supplant the competitive market as the principal instrument of social control, but to supplement it to remove its imperfections, in theory to make it work better. The regulation that I am concerned with in this testimony is the kind that is practiced in the public utility sectors of the economy, and in considerable measure in civil aviation, and has as its central purpose the direct prescription of industrial structure and performance, by such devices as restricting entry into the market to the number that some government commission determines is desirable and imposing on the certificated firms an obligation to serve all customers under reasonable conditions, directly fixing price, and prescribing the quality and conditions of service.

lation tends inherently to place a heavy emphasis on protecting the companies it is also supposed to be controlling. I do not mean here to repeat the vulgar popular notion that regulators are typically "in the pockets of the utility companies," and somehow untrue to the public interest that has been entrusted to them, though there are undoubtedly many examples of this. The tendency is one that will inevitably affect also honorable and dedicated public servants.

The reason is this : Under competition, in principle, no government official and no single company is responsible for the continuity of supply; no company has an obligation to serve. The consumer's protection comes from the impersonal functioning of the competitive market itself, from the rivalry among companies, from the fact or threat of competitive entry. Regulation, instead, relies on chosen instruments. A specific company is given a franchise; and that company and the regulating agency, instead of the market itself, bear the direct responsibility for serving and protecting the public. That responsibility weighs heavily on the regulator. I feel some direct, personal responsibility for seeing to it that the lights will still go on when people in New York flick their switches in 1985. Since it takes six to twelve years to install new base-load generating capacity. I have to be concerned about the ability of the franchised electric companies in my State to begin taking the steps today that will assure that result a decade from now. And that means, to complete the explanation, that I have to be solicitous of the financial health of those chosen instruments. So every responsible airline regulator, similarly, will emphasize his heavy responsibility for the continued provision of ample, safe, and economical air service in every part of the country.

And that responsibility, in turn, inevitably breeds a distrust of competition. Price competition, particularly in times of excess capacity, is a threat to the financial health of the chosen instrument company. Competitive innovations, introduced without restraint, may suddenly render obsolete the utility company's investment in as yet in completely depreciated equipment, leaving the residual of depreciation somehow to be recovered from its other customers, if it is to retain the financial health and ability to attract the capital necessary to provide continued service. Competitors have an inherent tendency, in the words of regulators and regulatees, to skim the cream off the market—which is only to say, very roughly, to compete for business where prices are far above costs, and to leave to the chosen instruments the markets where costs are far above price. How, the regulated company and regulator will protest, are they supposed to provide continued service in bad weather as well as good, in the winter as well as in the summer, over lightly-traveled as well as heavily-traveled routes, if competitors are to be free to come in and skim off the profits from the latter that have been financing service on the former? To the regulator, then, competition is disruptive and threatening, it interferes with orderly planning, it upsets stable markets; it is something to be restricted, confined, prohibited.

You will not need my help in seeing manifestations of this tendency in the airline industry.

This does not mean that competition has no useful role to play in regulated industries. On the contrary. Regulated monopoly is a very imperfect institution. The authority of the regulatory commission is essentially negative; at best, it serves only as a check on the exercise of private monopoly power; prevents excessive profits and excessive discrimination. It is extremely difficult for it to take major initiatives. A regulator cannot risk his own capital, and the 14th amendment puts severe limits on his ability to force the companies under his supervision to risk theirs. He cannot force a company to be progressive, to innovate, indeed, even to be efficient. He cannot do what a good management can do, and there is very little he can do about what poor management does. In short, he cannot supply the dynamic stimulus that in other industries is supplied by competition. There is, therefore, a very respectable body of opinion that regulation really has very little effect. This view merges with the other, which I have already characterized, that regulators tend, almost inevitably, to associate their conception of the public interest with that of the companies they are supposed to be regulating, typically protecting them against competition and supplying no alternative effective stimulus. Paradoxically, according to this view, regulation has the greatest effect in areas, like transportation, where competition could otherwise prevail, and there, because of its tenuencies to protectionism and cartelization, it tends to do a great deal of harm; and elsewhere, in the presence of monopoly, its effects are not discernible.

For these reasons, where it can be permitted without intolerable loss of efficiency competition can play a very useful supplementary role even in the most tightly regulated industries. In my judgment, for example, while the basic interconnected, national communications network is probably something like a natural monopoly, competition can and should play an important role in the manufacturing industry that supplies equipment for attachment to that network at the subscriber's end. Similarly, I believe that such competition as we have permitted in the passenger airline business has, on balance, improved its performance.

Still, to return to my first major point: because of the inherent conflicts and contradictions between competition on the one hand and regulation on the other, and because of the inherent tendencies of regulation toward conservatism, protectionism, and cartelization, society must periodically reexamine the premises on the basis of which it decided to impose on the public utility status of an industry, and consider whether a return to essentially unregulated competition might not be preferable, as this Committee is doing today. This is especially important in those industries, like transportation, where a competitive structure may well be feasible that is, consistent with the individual suppliers achieving most or all of the available economies of scale. Transportation is not a natural monopoly. It is precisely in such situation that it becomes essential for us periodically to ask whether regulations may not be doing more harm than good. In my own judgment, transportation is the leading example of an area in which a substantial dose of dereguation, and perhaps something close to complete deregulation, is long overdue.

In the rest of these comments, I will suggest to you why I think this kind of reevaluation is particularly necessary in an industry like airline transportation.

Before doing so, I should like to emphasize that competition in the real world is also a very imperfect institution. Consumers are rarely adequately informed about the choices available to them, and as a result the competitive advantage often goes to the more effective saleman, or the less scrupulous advertiser, rather than the most efficient producer or the seller who gives the best value for the dollar. The greater the number of independent suppliers, the more likely mistakes are to be made, and capital committed to ventures that should never have been undertaken. Competition is often wasteful, and produces instability and uncertainty. But most of us regard the competitive market in much the same way as we regard democracy—it is a manifestly inefficient system that is better than any available alternative. To the extent competition is imperfect, our preferred remedy is to try to diminish its imperfections, rather than to supplant it with monopoly or socialized enterprise.

But public utility-type regulation in industries that are potentially and structurally competitive tends to produce the worst economic results of all-worse than regulated, franchised single-form monopoly, on the one hand, and worse than unregulated competition, with all its possible wastes and imperfections, on the other. There are so far two major reasons, and both spring from the fact that in industries of this kind, of which transportation is the leading example, regulation specifically involves preventing, controlling and limiting competitionrestricting competitive entry, and prohibiting rivalry in price and service-in brief, to use the proper term, it involves cartelization.

In principle, a cartel need be no less efficient than a pure monopoly. Singlefirm monopoly has both the incentive and the opportunity to produce at minimum cost, to take fullest possible advantage of economies of scale, to adopt the most efficient technology, to limit capacity to the amount required to supply the market at minimum cost, to concentrate production in the lowest-cost plants, and to operate them at the most efficient rates. In theory a cartel could do all these things, too, producing the cartel-determined output at minimum cost, pooling, the industry's profits, maximized in this fashion, and distributing them according to some formula among the cartel partners.

But no cartel in history, regulated or unregulated, has to my knowledge ever done these things. The typical practice, instead, is to maintain price by imposing output quotas on the several members, efficient and inefficient alike. Indeed, where cartels have been in a position to make distinctions, they have regulated production more often by cutting back the output of the lowesë-cost producers than the other way around, in order to leave room in the market for the highercost firms, whom competition would otherwise have driven out of business. The result has been gross inefficiency in production. We have had the abundant examples of this phenomenon among regulated cartels. Parity price supports in agriculture were accompanied by the imposition of acreage limitations across the board. In petroleum prorationing, production allowables were cut back, at their lowest point, to eight days a month for the typically highest-volume and lowestcost wells, while exempted from all such restraints were the highest-cost, lowvolume marginal or stripper wells, and deeper wells were typically granted larger production quotas than shallow wells, precisely because they were higher-cost ! And in transportation, the Interstate Commerce Commission has placed limitations on the ability of railroads, by cutting rates, to reach out for traffic that they were in a position to serve at lower incremental costs than competing trucks or barges.

Moreover, cartels have been typically incapable of imposing full controls on investment and entry. By holding prices at non-competitive levels, instead, they have tended to encourage new competitive entry, particularly, in areas outside their control; and where they have succeeded in restricting entry, they have typically been incompletely successful in restricting the making of additional investments by firms already in the market-for example, the drilling of grossly excessive numbers of developmental wells in the oil industry, in quest of additional production quotas. Maintaining prices in the face of these artifically stimulated increases in production capacity has in turn necessitated further cutbacks in output quotas, forcing producers in turn to operate at even more grossly suboptimal levels, with correspondingly higher costs, and further preventing the distribution of the business to the lowest-cost suppliers. In these important ways, cartels foster inefficiencies far more gross than either single-firm monopoly or unregulated competition.

The resulting inefficiencies are in no sense purely theoretical. The wastes in transportation, for example, have been estimated as running to billions of dollars annually; and the wastes of excessive developmental oil well drilling in the late 1950's and early 1960's in this country were estimated by knowledgeable industry sources as running on the order of $12 billion a year,

Second, and for exactly the same reason, cartels promote waste in another way that is particularly pertinent to the airline industry, by encouraging excessive non-price competition or service rivalry.

Perhaps the simplest way of explaining this is to set forth the economics that underlie both of these two tendencies toward inefficiency. I will do so in the form of a series of propositions, but then I will give you enough illustrations to demonstrate that I am talking about the real world. If regulation limits competition, it must be because some competition would otherwise be feasible: the ability and will to compete are therefore present. And if the regulation is effective, it will hold price above the costs of at least some producers or potential producers. I have already described how this sets up persistent temptations for firms already inside the cartel to expand their capacity and output, and for firms outside the market, and possibly outside the boundaries of the cartel, to enter, increasing the aggregate capacity hanging over the market and creating the necessity for

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