Commentary: Deregulation: Innovation vs. Stability

By Peter Coy

The year 2001 was awful for three important American industries. Electric utilities suffered capacity shortages that led to price spikes and scattered blackouts. Airlines, even before September 11, had to cancel flights and put planes into desert storage. And the overbuilt telecom-services sector cut investment so dramatically that it helped drag the entire U.S. economy into recession.

What 2001 demonstrated is what many economists have long argued--that certain industries are inherently unstable. Utilities, airlines, and phone companies all have the same Achilles' heel: Nearly all their costs are up front. Once they build capacity, they can increase their output at little cost. This may sound like a recipe for making money, but it's really a recipe for a big mess. Industries whose costs keep falling as production rises tend to turn into monopolies or oligopolies. Their pricing is byzantine. Captive customers (like business flyers) pay far more than noncaptives (like tourists). And investment tends to swing wildly between boom and bust.

Regulation can tame these instabilities, but it also suppresses innovation and takes away incentives for companies to be efficient. So for the past two decades, government has been deregulating so-called increasing-returns industries--to the delight of some and the horror of others.

What have we learned in recent years? In a nutshell, deregulation of increasing-returns industries has been less than a complete success. On the positive side, deregulation has increased efficiency and innovation. Airlines have reduced costs by concentrating operations in hubs. Upstart independent power generators have built gas-fired "peaker" plants that start up when prices rise. In telecom, cell phones have shrunk to palm-size and let their owners cruise the wireless Web for weather, traffic, and market updates.

But deregulation has also brought about concentration of ownership, enormous pricing disparities, and violent gyrations of investment. What's more, these problems are not easily avoidable. They may, in fact, be the price society pays for efficiency and innovation. The Brookings Institution's Robert W. Crandall, a leading advocate of deregulation, acknowledges that booms and busts of investment, in particular, are "just endemic in capitalist markets."

Think about why increasing-returns businesses are unstable. It costs a lot of money for them to gear up, but once they do, each incremental unit of output is extremely cheap to produce. Take airlines. Once they fill their planes enough to cover their fixed costs, each additional passenger is enormously profitable. Trouble is, those profits invariably entice new entrants. Capacity increases. Fare wars begin. In desperation, airlines cut fares until some passengers are paying barely more than the cost of their meals. No longer earning enough to cover their fixed costs, airlines must merge or go bankrupt. Capacity falls, fares rise, profits increase, and the cycle begins again.

The turmoil can be considerable. Barely more than a third of the 292 U.S. airlines with scheduled passenger service that were operating when deregulation began in 1978 or began service afterward were still operating independently by 2000. Deregulation advocates like Brookings' Clifford Winston argue that the turbulence is justified by savings on air fares, which he calculates are substantial in comparison with what fares would have been if regulation had remained in place. It's hard to know what fares would have been under regulation. But the fact is that air fares have not fallen, despite the availability of some highly publicized bargains. According to the Bureau of Labor Statistics, in fact, overall prices have risen. The airfare component of the consumer price index has risen 130% from its 1982-84 base, vs. an increase of 77% for the CPI as a whole.

Electric utilities are another case in point. In the past several years, many states have deregulated the business of electricity generation (though not electricity delivery, which remains a monopoly service), hoping that competition will lead to greater efficiency and lower prices. That may eventually be true. But the transition is ugly. In areas with capacity shortages, spot prices have occasionally spiked to hundreds of times the average rate. California has had rolling blackouts two summers in a row. Lured by the high spot rates, independent power producers have gone on a crash building program in the Golden State. As a result, a glut is developing. It's a classic case example of the booms and busts that increasing-returns industries experience. Eugene Coyle, a consulting economist in Vallejo, Calif., argues that the answer is public ownership of the electricity business--something that's already a fact of life for customers of the Tennessee Valley Authority and sundry municipal utilities across the country. The increased receptivity to that extreme solution is a measure of just how bad things have gotten.

Perhaps no deregulated industry exhibits more signs of increasing returns than telecommunications--in particular, long-haul transmission over fiber-optic networks. The cables are expensive to string on poles and lay in trenches, but once they're in place, it costs hardly anything to carry traffic over them. As with airlines, fiber carriers are tempted to slash prices to capture customers--to the point that revenues fall below what's needed to pay the interest on their debts. Last year, 28 publicly traded telecom companies, each with more than $100 million of liabilities, sought protection from creditors in bankruptcy court, reports

This is an old problem, to be sure. Hal R. Varian, dean of the School of Information Management & Systems at the University of California at Berkeley, notes that more miles of railroad track were laid in the 1880s than in any decade before or since. And more miles of track were in the hands of companies in bankruptcy in the 1890s than at any other time.

Why do companies persistently overbuild in increasing-returns industries? Often, they are hoping to emerge as winners after the shakeout. The surviving few competitors in an increasing-returns industry can make cozy profits. Knowing that, dozens of companies will spend heavily to be among those survivors. Companies are competing not so much in a market as for a market. Some inevitably bomb out. Even the winners, by spending so much up front to grab the prize, effectively lower their long-term returns to ones that are no higher than average.

Meanwhile, if technology or consumer taste changes, the profits these surviving companies are vying for may never materialize. That's how perfectly rational managers can overinvest. "It's worse if you add to that the fact that businesses are not rational organisms but bureaucratic cultures where people come before the managing committee and ask for stuff," says J.Bradford DeLong, a Berkeley economist.

There are ways to quell the turmoil, at least a bit. Even in businesses with increasing returns to scale, small rivals can carve out a niche that protects them from a price-slashing giant. That's happening even in the selling of electricity--the ultimate generic commodity--where some companies are marketing their power as green. The passage of time should help somewhat, too. Telecom and electricity were deregulated recently enough that companies are still thrashing around for a strategy. Many overexpanded by misjudging the demand for new services. Brookings' Winston argues that even airlines are at last figuring out how to get capacity right. He says they would have come through the recession all right if it hadn't been for September 11.

Still, increasing-returns businesses will never be quiet and well-behaved--their cost structures simply won't allow it. And the race for technological supremacy keeps things roiling as well. Crandall, the dereg advocate, acknowledges that regulation would smooth out booms and busts, but at the cost of slowing advances in the state of the art. "One thing that regulation is very good at doing is suppressing technological progress," he says. Take your pick: stability or speed. In increasing-returns businesses, you can't have it both ways.

Coy is Economics Editor.

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