Regulation: State Management of the Economic Environment

While organizational survival is enhanced by legitimacy, it is also enyj hanced by economic viability, especially in the case of private organi-zations. Classical economics suggests that economic viability is bouncka up with conditions such as low-cost production and meeting market demand better than the competition. This is not invariably the case. In large segments of United States industry, the market mechanisms that form the basis for economic theory are simply not permitted to work, as regulatory procedures and agencies are substituted.

Historically, regulation and government intervention in the marketplace have been the dominant forms of economic systems. Both the state and those who benefited from its decrees favored the admin istered and predictable controlled economy which regulation permits over the unpredictable, uncertain outcome of unrestrained competition. Adam Smith’s The Wealth of Nations made the argument in 1776 that welfare would be better served through competition. That book has so much significance because its position was so unusual for thatp time. Some have suggested that the free market economy is an unusual form, and that the regulated, govemmentally controlled economics system is not only the customary form of economic system but also the one that is likely to emerge in all countries as interdependence increases and resource scarcity becomes a greater problem. Certainly, there is evidence that in times of national crisis such as wars or rampant inflation, government intervention in the market increases.

The regulation evident in the United States often began from the . intention to overcome the evils of unrestrained competition. Competition is a form of natural selection in which only firms suited to the environment survive. However, the disappearance of competitors is troublesome, particularly for those competitors that are disappearing or failing, and consequently, a variety of market interventions were designed to overcome the harsh effects of competition. Such things as loans to small businesses, the Fair Trade laws that forbade price cutting, and governmental attempts to give procurement contracts to smaller firms all helped soften the blow of competition.

When organizations are regulated by the state, the economic environment diminishes in importance as the importance of the political and administrative environment increases. Both attention and behavior shift accordingly. The decisions of consumers become less important than the decisions of lawmakers and government agents.

Two views have developed to explain why governments regulate or intervene in markets. “The first is that regulation is instituted pri-marily for the protection and benefit of the public at large or some jlarge subclass of the public” (Stigler, 1971:3). While the regulatory process may be occasionally perverted, this line of reasoning holds that, over all, the goal of serving the public interest is met by government regulation. The second view concerning regulation is that, “as a rule, regulation is acquired by the industry and is designed and operated primarily for its benefit” (Stigler, 1971:3). Posner (1974) has extended this second view, noting that regulation may be equivalent to other product or service, supplied at some price and facing some emand distribution. Like any other commodity, more regulation is uxchased when its price is lower and the demand is higher.

The two views of regulation are not necessarily contradictory, as regulation may differ in its effects over time. It is possible that the mitial impetus for regulation comes from outside the industry, moti-vated by general public welfare concerns, but that in time the industry captures the regulatory agency and then comes to demand the con-tnuation of the regulation. A regulated industry is, of course, equivalent in many respects to a cartel, except that control is exercised by some governmental administrative apparatus rather than by a-council of the producers. We would suspect that organizational sup-port for regulation rises and falls with the effects of regulation on problematic interdependence. Regulation is likely to be viewed most vorably where it provides more benefits to the industry and when competitive uncertainty is greatest and cannot be managed by tacit interfirm arrangements.

1. Benefits of Regulation

Stigler has noted that the government can potentially provide four types of benefits to an industry. First, the government can furnish a direct cash subsidy. “The domestic airlines received ‘air mail’ subsidies (even if they did not carry mail) of $1.5 billion through 1968. The merchant marine has received construction and operation subsidies reaching almost $3 billions since World War II (1971:4). But if the government is handing out money to firms in an industry, there is a . temptation for other firms to enter the industry and share in the largesse. This dilutes the benefits to original industry members. Beneficiaries must then limit entry into the industry to avoid a situation where the government subsidy is divided among growing numbers of industry participants. Without restriction of entry, an industry is not likely to consider cash subsidies a preferred benefit from the government.

The second outcome the government can provide is restriction of entry by rivals. The theory of economics states that when firms are earning unusually large profits, these profits should act as a signal to attract new entry into the industry. New competition then eliminates any excess profits. Organizations, not wishing to experience these consequences, spend a great deal of time attempting to prevent such new entry. Advertising is one type of barrier; others are vertical integration arrangements and the practice of setting price below attractive levels. These actions themselves reduce profits, and an even better control is the requirement for governmental certification. The centralized decision structure of regulation makes entry restriction easier to implement. The Civil Aeronautics Board, for example, has not allowed a single new trunk line to be launched since it was created in 1938 (Stigler, 1971). The Interstate Commerce Commission has been equally vigilant. Volotta (1967) found that the number of truck carriers has persistently declined, despite more than 5000 applications per year for new certificates. The total number of carriers declined, from18,036 in 1957 to 15,426 in 1966. Such a decline at a time when the- volume of motor freight was rising leads to fewer but larger carriers; and an increasingly concentrated industry. Volotta (1967:123) noted) that of the general commodities carriers, in 1957, 2.32 percent had over $5 million in revenues and accounted for 49.94 percent of total” revenues of this class. Just seven years later, 3.47 percent of the large carriers accounted for 66.42 percent of the revenues of general commodities carriers. A similar result holds for special commodities carriers.

In reviewing the history of transportation regulation, Volotta uncovered some rather substantial gaps in governmental logic. “Justification, then, for governmental control over competition was established for modes of transport with diametrically opposite economic and operating characteristics: i.e., railroads tended toward monopoly, so public interest was best served by fostering competition; and motor carriers had highly competitive characteristics, therefore competition should be restrained” (1967:3).

The third set of benefits government can provide are actions that will affect substitutes and complements. The truckers have waged intense advertising campaigns pointing out the utility and social value of the highway trust fund. Airlines are interested in improving airports. And America s railroads would like to obtain the public funding of rights of way-through government support for AMTRAK—that both airlines and trucks enjoy through governmental maintenance of roads and airport facilities. Another example of government action, this time taken to diminish the attractiveness of substitute products, is the early restriction on artificially coloring oleomargarine. When margarine was first introduced, the dairy industry perceived it as direct competition for butter. Regulations were implemented that resulted in margarine being sold with a packet of food coloring that the individual purchasers could mix in. Buying a tub of some white substance and then mixing in yellow food coloring, of course, is not nearly as attractive to consumers as purchasing a product which is, in appearance at least, indistinguishable from butter. Many states had restrictions on coloring oleomargarine until the late 1950s, and Wisconsin, a dairy state, dropped the regulation only relatively recently.

The final benefit the government can provide is the ability to fix price legally to coordinate and manage competition. When one considers the enormous antitrust damage suits that have been won, it is clear that the ability to fix price legally is quite an important benefit. Regulation to fix price is likely to be most important when industries face the maximum competitive uncertainty and interdependence, at some level of moderate or intermediate concentration at which tacit or semiformal interorganizational coordination mechanisms are less likely to be effective. Without the ability to fix prices, competition might depress the profits of firms in the industry. The classic study of price regulation and its relationship to cartels is that done by Macavoy (1965). Analyzing the price behavior of railroads in the late 1800s, Macavoy concluded that there was a railroad cartel operating out of Chicago to the east coast, but that it had some difficulty in maintaining the cartel price. With the advent of the Interstate Commerce Commis-sion, however, railroad rates were legally enforced at a rate slightly higher than the previously highest cartel price, and since enforcement was in the hands of the government, the price was maintained without any variation or price wars.

That organizations attempt to control their economic environments politically through regulation has been documented by Stigler (1971). Regulated truck weight allowances suggest that economic interests, in part, determine regulatory policy. By the early 1930s, nearly all states regulated the weight and dimensions of trucks, regulations which are subject to controversy and lobbying to the present day. , Weight and dimension limitations constrain the amount of freight hauled per trip. Trucking and railroad interests both attempted to adjust weight requirements to their own benefit. Railroads wanted low weight limits to restrict trucks to smaller hauls and limit competition for rail traffic; truckers wanted the more profitable larger dimensions , and weight allowances. The public interest was presumably related to the problem of road maintenance and weight limitations were justified on the basis of road conditions. However, railroads were frequently the more powerful interest and were able to obtain policies they , favored. “Sometimes the participation of railroads in the regulatory process was incontrovertible: Texas and Louisiana placed a 7000- pound payload limit on trucks serving (and hence competing with) two or more railroad stations, and a 14,000-pound limit jon trucks serving only one station (hence, not competing with it) (Stigler,. 1971:8).

Stigler (1971) analyzed weight allowances as a function of the, potency of three interest groups. On the truckers side were fanners, who favored the allowance of heavy trucks. Trucks clashed with railroads, particularly on short hauls, since economies of operation made railroads favored on long hauls. The longer the average railroad haul) the less the railroads would need protection from truck competition. And finally, the surface of the road, which was ostensibly the reason, for limiting weight at all, might be of interest to the public, which would not want its roads damaged by heavy trucks. Stigler combined these three variables in a regression equation and examined how they t affected the weight limits set for four- wheel and six-wheel trucks. His results are reproduced in Table 8.1 and show how the three interests» affected the weight allowances for trucks that were set in the 1930s.

Other evidence similarly concluded that regulation is an effective means of altering the economic environment of an industry to its benefit. Peltzman (1965) examined the entry restriction imposed on commercial banking in 1935 after the bank failures of the Great De- pression. He estimated that the entry rate into commercial banking was cut by 25 to 50 percent. There are about half as many banks as there might be had entry not been restricted. Demsetz (1968) contrasted early competition in the utility industry with the protection Companies gained from regulation and legally protected market areas.

Stigler and Friedland (1962) attempted to assess whether regulation made a difference in the performance of utilities. They dated the start of regulation in a state from the creation of a special state commission empowered to regulate rates for electricity. Two-thirds of the states had commissions by 1915, and three- quarters by 1922. For the most part, the utilities themselves “provided most of the force behind the regulatory movement” (Demsetz, 1968:65). Stigler and Friedland attempted to assess the effect of regulation on rates. A simple com- parison between rates in regulated and unregulated states may be misleading, as other economic factors may be involved, such as the size and density of the market, the price of fuel, and the incomes of consumers. Stigler and Friedland (1962), after adjusting for these variables, found no effect of regulation on rates. These authors also examined rate structure, particularly whether household users paid relatively lower rates compared to industrial users. Comparisons of the average ratio of charges per kilowatt hour to domestic users over charges to industrial users showed no effect for regulation. Finally, Stigler and Friedland examined the effect of regulation on investors in electric utility equities. There was a slight, insignificant effect of regulation tending to decrease share price, but again the essential conclu-sion was that there was no effect of regulation. The results suggest that there were no observable benefits to customers, investors, or the public coming from regulated rather than unregulated utilities.

2. Occupational Licensing

Yet another example of regulation to the benefit of the regulated is that achieved through occupational licensing of professions like medicine, law, and dentistry. Holen found that:

(1) There is less movement between states among dentists and lawyers than among physicians; (2) there is a significant relationship between licensing- examination failure rates and average state professional incomes for dentistry and law (but not for medicine), indicating that mobility is impeded by exclusionary practices even apart from the structure of licensing arrangements; (3) dispersions of state average professional incomes for dentistry and law are consistent with the hy- pothesis that mobility restriction results in professional misallocation on a geographic basis; (4) barriers to interstate mobility prevent the benefits of geographical specialization in education from being fully realized in the field of law (1965:492).

The dilemma in occupational licensing has been recognized for some time (e.g., Council of State Governments, 1952). On the one hand, it is necessary to protect the public from harm and from frauds. On the other hand, licensing arranged by practitioners leads to state- sanctioned monopolies and a consequent increase in professional incomes. There are no easy solutions to the problem, and Holen s study does show that some monopoly profits accrue to professionals because of their licensed or regulated status.

Pfeifer (1974b) reviewed the literature on occupational licensing and attempted to examine four hypotheses derived from that literature concerning the relationship between licensing practices and occupational incomes. First, he investigated the effect of regulation on occupational incomes. To perform such an analysis, it is, of course, necessary to find occupations that are regulated in some states but unregulated in others and for which data on income by occupation by state are available. The stronger professions such as medicine and law are regulated in every state and have been for some time. The only’ three occupations that could be examined were plumber, real estate broker and salesman, and insurance broker and salesman. For these, three occupations, controlling for state median income, there was no.- evidence that regulation had a statistically significant effect on occupational incomes.

Pfeffer next examined the effects of regulatory board composition) investigating the proportion of the board comprised of public repre- sentatives and the  proportion comprised of occupational practitioners. While there was some support for the idea that public members on licensing boards tended to reduce occupational incomes, the support was quite weak. Of 17 correlations computed, only 6 reached a magnitude of .20 or higher in the expected direction, while 11 of the 17 were in the predicted direction. Again, however, there was no variance in many of the more powerful professions such as law and medicine- licensing boards were comprised solely of occupational practitioners in every state.

Pfeifer (1974b: 108) also replicated Holen’s analysis examining the correlation between the failure rate for applicants applying for licenses and occupational income. However, Pfeifer did control for state median income and examined some additional occupations not considered by Holen. This analysis was consistent with the argument that licensing restricting entry related to increased incomes. Five of the six correlations were in the expected direction, indicating the higher the proportion of applicants who actually received licenses, the lower the average income for the occupation in that state. Finally, Pfeffer (1974b: 110) was able to show that the more professionalized the occupation, the less occupational income was affected by state median income, or in other words,^general state economic conditions. While Pfeffer s study is, at times, consistent with the argument that regulation increases incomes, it does show that such a proposition is far too simplistic. The mere presence of regulation in the case of lower power occupations does not necessarily provide any benefits.

An analysis of the history of licensing of various occupations will reveal that over time, the requirements for licensure become more and more stringent and the effect is to reduce the total number of persons who can practice the occupation. This effect seems to appear regardless of whether the demand for licensing comes from the public or the occupation. The case of marriage counselors is an interesting illustration of the attempt to use state licensing to enhance occupational status and incomes. Marriage counselors have recently moved to achieve licensing in many major states. California was one of the first to license marriage counselors, taking that action in 1963. The achievement of licensing requirements for this occupation was difficult. First, marriage counseling is practiced by many different groups, including the clergy, doctors, lawyers, social workers, teachers, as well as marriage counselors. With so many diverse interests in the occupation, it is difficult to put together a coalition. Second, the states frequently hire social workers with only bachelor’s degrees, and thus to have a law passed, it is necessary to explicitly exclude the state from the regulation. Licensing is introduced by first writing a bill that excludes prac- tically no currently powerful group practicing the occupation. Over time, requirements are tightened to restrict the entry of new practitioners. Such is the history of the California law. While there is no evidence on whether the quality of service has increased with the requirements, it is clear that marriage counselors incomes have increased while the divorce rate has increased as well.

3. Relationship Between the Regulated and the Regulator

Surprisingly enough, there have been very few studies which have attempted to examine the relationship between the regulator and the. regulated industry, or to ask the question: Why does regulation typically favor, or at least not harm, the industry being regulated? Stigler and Friedland concluded that there was no effect of regulation on electric utilities because: (1) the individual utility system did not possess any large amount of long-run monopoly power because oi competition from other power sources; and (2) the regulatory body, because it does not control operating decisions, cannot force the utility to operate at a specified combination of output, price, and cost (1962:11). Jordan (1972) has suggested that under conditions of producer monopoly, regulation will have no effect as the producer is already obtaining monopoly returns, while when there is oligopoly or competition, regulation will increase producer returns by effectively transforming the industry into a cartel.

There may be a third reason why regulation does not operate to benefit consumers or the general public. The regulatory commissions become captives of the regulated companies. The commissions must face the task of doing day-to-day business with the companies they are regulating. Accommodation would be the rule, rather than the exception, particularly when commissions are so poorly funded they must rely on the regulated companies for the data to make their decisions. Leiserson (1942) noted that in the regulatory process, the client groups typically give social and technical support to the agency by providing information and participating in some administrative functions. Such client involvement comes from resource constraints on the regulatory agency. The Federal Power Commission must generally , obtain its information on the amount of gas reserves from the gas companies themselves. Few of these agencies, with staffs numbering in the several hundreds at most, are able to develop data about an industry of many multibillion dollar organizations. The regulated organizations find themselves in the position of supplying the data the; regulators use to regulate them. In the midst of the energy crisis, it emerged that government estimates of proven gas reserves and industry estimates were vastly different, with the industry estimates being much lower, implying higher prices for the gas.

Insufficient regulatory resources, of course, are not the entire cause. The nature of the enduring relationship between the regulatory agency and the companies tends to promote cooperation. The participants come to know each other and they share common interests, as they depend on one another. Without the support of the industry, the regulatory commission may find it harder to obtain budget, and furthermore, the cooperation of the industry is necessary for the agency to do its job. Thus, a symbiotic relationship develops—less than 50 license renewals have been turned down by the Federal Communications Commission since that agency was founded in 1934.

Bernstein (1955) has noted how commissions, as they mature and public interest wanes, are left to face the regulated industry alone. The continued association between the two is almost inevitably going to lead to some accommodation being reached. “The single most important characteristic of regulation by commission is the failure to grasp the need for political support and leadership for the success of regulation in the public interest” (Bernstein, 1955:101). In the absence of external political support, the commission can either come to some accommodation with the regulated industry or attempt to fight it out with the organizations in that industry. But commissions, like any other organization, are interested in certainty and survival. In the absence of any support, they are not likely to operate long in conflict with the only group interested in their operations—the regulated in-dustry.

The missing social and political support of an active public is supplied by the industry. Various mechanisms of environmental linkage are used by regulated organizations to obtain favorable outcomes. Organizations which are regulated frequently supply their own personnel to the regulatory agencies as either advisors or as actual regulators. Overt conflict of interest is denied. Robert C. Bowen, an employee of Phillips Petroleum who worked for the Federal Energy Administration while on leave from Phillips, told a congressional subcommittee that his duties were carefully defined to avoid policy making and his superiors at the agency denied any conflict of interest. Obtaining expertise by drawing on the regulated industry’s own employees is frequently observed.

Another mechanism, already discussed, is cooptation. Although it is not legally permissible for regulators to sit on boards of organizations being regulated, it is quite possible to use the company’s board to develop a coalition of significant political support which may itself influence regulation. This would be particularly important for organizations confronted by regulatory agencies that set rates and allowable rates of return. Since rates are determined after public hearings, com- missions are likely to be responsive to important political interests in the area. A possible strategy for organizations operating in the regulated industry would be to coopt important political interests. Our earlier analyses of cooptation have already indicated that there tend to be more outside directors on the boards of firms which are regulated. It is also possible to examine cooptation in a regulated industry more directly.

Pfeffer (1974a) analyzed 96 privately owned electric utilities in 1967 and 1968, obtaining operating data on the utilities from the Federal Power Commission (1969) and on the composition of utility boards from Dun and Bradstreet (1969). Average revenues of the 96 utilities were $128.29 million in 1968, with 39.4 percent coming from residential customers, 27.6 percent from commercial customers, 23.1 percent from industrial users, and 4.6 percent from sales to other utilities. The average board had 11 members, with two-thirds of the directors coming from outside the organization’s management.

If electric utilities were following a strategy of coopting important political interests, we would expect them to select directors covering segments of the population in proportion to their dependence on these ¡, segments for political support. Thus, for a utility operating within a state dominated by agriculture, the proportion of agricultural directors on the board should be higher than for a utility operating in a manufacturing area. Some evidence consistent with this argument emerged from the analysis of the composition of the boards of the 96 utilities in the sample. There was a positive correlation between the proportion of board members with agricultural backgrounds and the proportion of, the population engaged in agriculture, and a relationship between the proportion of persons on the board from manufacturing organizational, and the proportion of the population employed in manufacturing. Moreover, members were sampled from different cities in the state as a function of the extent to which the population was dispersed or concentrated.

Of course, it might be that representatives were being selected for the board because they are important customer groups. While plausible, this is not likely to be the entire explanation. The proportion of manufacturing representatives on the board was more highly correlated with the proportion of the population in manufacturing (r = .54) than with the proportion of die utility’s revenues from industrial customers (r = .31), a statistically significant difference between the two correlations. This indicates that the utilities were coopting political interests necessary for dealing with the regulatory agency, not only with customers.

Regulation is only one specific outcome of a political process thatr involves the government in the management of economic conditions. Our examination of regulation, then, is only a part of the total ex-amination of   political   actions   taken   by   organizations   to   manage   their environments for their benefit.

Source: Pfeffer Jeffrey, Salancik Gerald (2003), The External Control of Organizations: A Resource Dependence Perspective, Stanford Business Books; 1st edition

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