Public Policy Measures Teat Stimulate Efficient Operation of Markets

Lawrence Shepard, University of California, Davis
ABSTRACT - This paper outlines recent attempts to enhance efficiency by altering public policies that have been in force for more than 40 years. It is argued that deregulation of markets promises substantial gains in market efficiency. Examples are drawn from the federal agencies, fair trade retailing, and state licensing of professional groups.
[ to cite ]:
Lawrence Shepard (1980) ,"Public Policy Measures Teat Stimulate Efficient Operation of Markets", in NA - Advances in Consumer Research Volume 07, eds. Jerry C. Olson, Ann Abor, MI : Association for Consumer Research, Pages: 192-194.

Advances in Consumer Research Volume 7, 1980     Pages 192-194

PUBLIC POLICY MEASURES TEAT STIMULATE EFFICIENT OPERATION OF MARKETS

Lawrence Shepard, University of California, Davis

[The author is Associate Professor and Economist in the Experiment Station and on the Giannini Foundation, Department of Agricultural Economics, University of California, Davis.]

ABSTRACT -

This paper outlines recent attempts to enhance efficiency by altering public policies that have been in force for more than 40 years. It is argued that deregulation of markets promises substantial gains in market efficiency. Examples are drawn from the federal agencies, fair trade retailing, and state licensing of professional groups.

INTRODUCTION

"Consumer efficiency" speaks to the ability of consumers in a market to maximize the satisfaction they derive from a given endowment of resources. The determinants of consumer efficiency include the availability of market alternatives from which to choose, the quality of the information available about those alternatives, and the ability of consumers to process such information. Clearly such policies as those involving truth-in-advertising, unit-pricing, and product labeling promise to increase consumer efficiency by augmenting both the quality and quantity of information forthcoming in the marketplace. By the same token, government-sponsored consumer education policies increase the public's mastery of the consuming arts, enhancing our ability to make choices that maximize welfare. However, in the past other public policies, generally falling under the rubric of "market regulation'', have decidedly reduced market efficiency by restricting information and by narrowing consumer choice.

This paper has as its goal identification of recent measures that have attempted to increase consumer efficiency by overturning outdated regulations. After reviewing the history of market regulation in the United States, it discusses three examples where deregulation by Congress and the courts has made markets more efficient from the consumer's perspective. Throughout, the paper argues that because preferences naturally vary among consumers, policies that increase the number of alternatives available in the market tend to enhance consumer efficiency.

DEVELOPMENT OF REGULATION IN THE UNITED STATES

While regulation is usually justified as protecting consumers, much if not most of the federal market intervention prior to the 1960's was initiated by producers. For example, during the 1930's, the period of most prolific growth of regulation, producers facing waning demand and falling prices sought insulation from competitive forces. As we know today, this deflation was a symptom of a malady that had as its cause diminished consumer and investor confidence, widespread bank failure, and misguided monetary and fiscal policy. Despite the fact that falling prices were merely a symptom of the underlying economic distress and in fact served to restore real purchasing power, policy makers during the Depression yielded to producer attempts to fix prices through the use of regulation.

Abandoning the basic tenets of the Sherman Antitrust Act, Congress in 1933 passed the National Industrial Recovery Act endorsing price agreements, collusion, and industrial mergers in order to maintain prices. Similarly, the Miller-Tydings Act of 1937 created exemptions in the Sherman Act and the Federal Trade Commission Act in order to permit manufacturers to vertically fix prices in a practice euphemistically called "fair trade." Creation of public agencies with the power to fix and enforce minimum prices in the trucking, airlines, communications, power, banking, insurance, securities, and agricultural industries also occurred during the Depression. Even the Supreme Court appears to have temporarily abandoned competitive principles in its anomalous Appalachian Coals decision which upheld cartelization measures. Due to these policies, market parameters have been set by government fiat rather than by competition in a significant portion of the economy since the 1930's.

A considerable body of evidence bears testimony to the fact that regulatory price fixing has worked very much like privately organized cartels. In this connection, it is interesting to examine which industries are regulated. Were the purpose of regulation to protect consumers, one would expect the regulated industries to be those that structurally approximate cartels due to small numbers of large firms. However, note that no federal agency sets prices in the most concentrated American industries including the automobile, metals, chemical, plateglass, tobacco, electric appliance and computer industries. While those concentrated industries have their own private cartels, the more competitive industries involving hundreds and thousands of firms such as agriculture, banking, brokerage, airlines, trucking, and the professions have no such concentrations of market power. Instead, firms in those industries appear to have used regulation to create a cartel in markets that are otherwise too diffuse to support privately inspired minimum price agreements.

It is also significant that recent attempts to deregulate have met strong opposition from the industries and the unions involved. For example, during the lengthy debate of the Airlines Regulatory Reform Act of 1975 the vast majority of carriers argued that the price fixing authority of the Civil Aeronautics Board was not only desirable but crucial for the survival for the industry. By the same token, representatives of major national brokerage houses strongly opposed deregulation of securities brokerage rates in 1975 just as manufacturers fought bitterly for the protection of fair trade price fixing later in the decade. Not surprisingly, one empirical study after another substantiates that prices are significantly higher in regulated markets than in their unregulated counterparts. [See, for example, studies contained in (Phillips 1975), (Kahn 1970), and articles appearing regularly in the Journal of Law and Economics.] This has tended to reduce consumer efficiency in regulated markets as has the propensity of regulation to narrow the spectrum of consumer choice.

Regulatory Reform: The Federal Commissions

In an effort to improve market efficiency, there has been in the 1970's a move toward deregulation. The earliest example of deregulation occurred on a federal level and involved the Securities and Exchange Commission. Since its founding in 1935, that agency had strongly upheld the principle of fixing minimum prices charged by stockbrokers. Beyond merely condoning rate fixing by brokerage firms, commission members actively participated in setting prices and disciplining industry participants who were so bold as to price competitively. With commission rates fixed at monopolistic levels, member firms of the New York Stock Exchange were compelled to engage in extensive nonprice competition. That is, with prices fixed at high levels, firms had a strong incentive to expand the market share but were proscribed from doing so through price competition; accordingly, they attempted to expand their business by providing "free" services to customers such as security clearance, free banking services, large numbers of sales people to assist customers, extensive networks of brokerage houses and so on. A discernable cycle over time emerged in which rate hikes approved by the SEC led to higher brokerage profits which in turn motivated brokers to engage in more extensive nonprice competition to expand market share and such nonprice competition raised broker costs reducing profits to their ordinary levels, justifying further rate hikes (Shepard 1975). This seven year cycle illustrates an axiom in economics that where prices are fixed by a private or government sponsored cartel, competitors will engage in nonprice competition until costs rise to meet price. This industrial scenario had relatively few benefits for the industry involved and no benefits for the private investors or individual citizens who consumed brokerage services through their participation in insurance and pension funds. On the whole, brokerage rates were estimated to be 15 to 20 percent higher due to the nature of federal regulation, reducing consumer efficiency. The ability of consumers to maximize utility was also reduced by the fact that consumers had to pay for a rich mix of auxiliary services whether they desired them or not.

Deregulation of the brokerage industry occurred on May 1, 1975 when, under pressure from Congress, the SEC gave up its price fixing role. Since that time commission rates on many transactions have fallen dramatically. Most importantly, the industry has been differentiated into several subindustries with some brokers specializing in "cash and carry" discount brokerage service, others providing a moderate mix of "free" services at somewhat higher prices, and still other firms offering a full mix of services to meet the needs of the "carriage trade." Given the fact that consumer preferences vary, deregulation has been successful in increasing consumer efficiency by providing more market alternatives from which to make choices.

Deregulation of the airline industry has followed a similar path. Since its inception in 1938, the Civil Aeronautics Board prevented price competition on any interstate domestic airline route. Moreover, the CAB failed to certificate any new trunk carrier on those routes during the last 40 years despite unparalleled growth in the industry. With prices fixed and entry by new firms blocked, an industrial scenario emerged that parallels closely that seen in the securities brokerage industry: after receiving rate increases, airline companies earned unusual profits motivating them to engage in extensive nonprice competition through advertising, buying the latest vintages of aircraft, hiring attractive flight attendants, and offering more and more flights on the same route. As a result of this "service competition," the costs of interstate carriers rose dramatically over time, leading the CAB to grant further fare increases.

According to several studies that are mutually consistent, this combination of noncompetitive prices and nonprice competition raises the fares and operating costs of interstate carriers to a level 40 to 60 percent higher than those of intrastate carriers, accounting for differences in length of routes, types of aircraft, and populations served (Keeler 1972; Shepard 1977). It comes as little surprise, then, that deregulation of the domestic interstate network has lead to pronounced fare reductions, increased passenger travel, and significantly higher load factors on airplane flights. Deregulation in the airline industry, thus, has increased consumer efficiency by making air travel more readily available and more efficiently produced at prices and levels of service that more nearly meet the needs of passengers.

Like the CAB and SEC, the Interstate Commerce Commission also forbids price competition within the market it oversees, the domestic trucking industry. Moreover, the ICC discourages entry into the industry by new firms and further stifles competition with an array of regulations such as those preventing many carriers who haul freight in one direction to obtain backhauls in the other direction. These regulations increase the demand for both trucks and teamsters but, of course, raise rates and lead to inefficient use of labor, fuel and rolling stock. Accordingly, the ICC has come under intense Congressional scrutiny and President Carter has recently initiated legislation for deregulation. However, lobbying pressure of the trucking industry, truck manufacturing industry, and Teamster's Union make the outcome of this struggle less than certain. It remains an open question whether deregulation in this industry will succeed as it has in securities brokerage and air transportation. However, significant gains in consumer efficiency would clearly attend passage of pending deregulation proposals since the prices of virtually all consumer goods include the costs of truck transportation.

Regulatory Reform: The Case of Fair Trade

Fair trade retailing represents another public policy that in the past has reduced consumer efficiency. Under this policy, manufacturers were permitted to fix the prices that retailers charged for their products, eliminating the possibility of price competition at the retail level. As in the case of airline and brokerage rate fixing, high fixed prices motivated retailers to compete through nonprice means including extra sales staff, "free" services, and advertising. Fair trade also encouraged the proliferation of a larger number of small stores than a competitive market would have sustained. Consumer efficiency was reduced because consumers were forced to pay boutique prices even when they desired cash and carry service.

In 1976, passage of S.408 and H.R. 3411 eliminated the antitrust exemptions that made fair trade legal. This was achieved over the intense objections of retailers and manufacturers. As a result, consumer prices on many fair trade products fell. Discernable reductions in nonprice competition also emerged including changes in advertising patterns, sales staffs, and numbers of retailers. Consumer efficiency has been enhanced by this policy because many goods that were previously fair traded are available at lower prices and because consumers who choose to purchase products with fewer services at lower prices now possess that alternative.

Regulatory Reform: The Case of the Professions

On a state level one of the most conspicuous regulatory functions pertains to the licensing of professionals. Like firms in the securities brokerage, airlines, trucking, and retailing industries, the professions are composed of a large number of individual enterprises.

The professions are so atomistic in structure that, like the other industries cited, it would be nearly impossible to cartelize them without the force of government. Not coincidentally, then, the professions have in many cases used state licensing boards to restrict market entry, thereby increasing prices. A favored method to this end is to write state licensing examinations so that only the graduates of that state's schools can pass such examinations. For example, California barbers are required to have extensive knowledge of the human circulatory system to pass the licensing exam in what is recognized as a method of constricting the supply of barbers. By the same token, California dentists are required to perform a complicated clinical procedure that is seldom if ever used in regular practice. It is taught in California dental schools solely to enable graduates to pass the California clinical exam but graduates from other states receive no such training. Where such supply restraints exist, dental fees are systematically found to be between 10 and 20 percent higher.

A more conspicuous form of professional restrictions involves information controls or advertising bans enforced by state licensing boards. In a well-known cross sectional study, for example, one analyst discovered that eyeglasses prices were 25-100 percent higher in states where optometry boards enforce advertising prohibitions (Benham 1972). Similar results have been reported for states that prohibit the advertising of drug prices (Cady 1976). Clearly consumers who are deprived of information about comparative prices are in an inferior position to make optimal market choices.

Two recent judicial decisions have eliminated this source of consumer inefficiency. In Virginia Citizens Consumer Council Inc. vs. State Board of Pharmacy (P. D. Ba. 1974 373 F. Supp. 683), the Supreme Court held that restrictions on the advertising of goods enforced by state licensing boards violate First Amendment guarantees. The court extended this interpretation to restrictions on the advertising of services in Bates vs. State Bar of Arizona (97 S. Cp 2691). As a result, all regulated professions can now advertise the prices of such products as eyeglasses, dentures, funerals, and related services. The gains in consumer efficiency associated with this example of deregulation are still being measured. However, it is clear a priori that where professionals have the option of advertising low prices they are more apt to engage in price-competitive marketing. Price advertising will mean that consumers will be more aware of the variability in prices among professionals and will tend to shop among the alternatives available to them. Given the expanding role of the professional services sector of the economy, significant gains in consumer efficiency should attend this example of policy reform.

Conclusion

This paper has argued that one major impediment to market efficiency has been public policy itself. In many instances regulatory mechanisms have been used by producer groups to stifle competition, leading to non-price competition, higher costs, and inefficiency in the involved industries. Regulation has also been used at a state level to impose information controls on the market, depriving consumers of the information necessary to fully assess market alternatives available to them. Recently, however, the price fixing power of certain federal regulatory agencies has been eliminated. By the same token the antitrust exemptions that fostered fair trade retailing have also been overturned nationwide. Finally, information controls imposed by state professional licensing boards have been held unconstitutional. These new measures, by supplanting previous policies dating from the 1930's, promise to enhance consumer efficiency markedly. Indeed, given our legacy of producer-initiated anticompetitive policy, deregulation and reregulation may offer greater gains in efficiency than other types of consumer policy.

REFERENCES

Benham, Lee K. (1972), "The Effect of Advertising on the Price of Eyeglasses," Journal of Law and Economics, 15, 337-352.

Cady, John (1976), Restricted Advertising and Competition: The Case of Retail Drugs, Washington, D.C.: American Enterprise Institute.

Kahn, Alfred E. (1970), The Economics of Regulation, New York: John Wiley and Sons.

Keeler, Theodore E. (1972), "Airline Regulation and Market Performance," Bell Journal, 3, 399-424.

Phillips, Almarin, Ed. (1975), Promoting Competition in Regulated Markets, Washington, D.C.: Brookings Institution.

Shepard, Lawrence (1975), The Securities Brokerage Industry, Lexington, Mass: D.C. Heath.

Shepard, Lawrence (1977), "The Potential Impact of Airline Deregulation on Feeder Routes in the Far West," Western Journal of Agricultural Economics, 2, 1-9.

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