[Economic Report of the President (1997)]
[Administration of William J. Clinton]
[Online through the Government Printing Office, www.gpo.gov]

[DOCID: f:erp_c6._]
Economic Report of the President - - - - - - - - - - - - H. Doc. 105-002
[From the online service of the U.S. Government Printing Office]
[wais.access.gpo.gov]


CHAPTER 6--Refining the Role of Government in the U.S. Market Economy

WHAT IS THE APPROPRIATE ROLE, IF ANY, of government in regulating
the manufacture, distribution, prices, and quality of products in the
U.S. economy? Much of the 20th century has seen an expansion of the role
of government as regulator. But since the late 1970s the regulatory tide
has ebbed in many important respects.
The first major deregulatory efforts were in industries such as
airlines, railroads, trucking, banking, and natural gas. (Box 6-1
illustrates some of the benefits of deregulation.) Deregulating the
traditional utilities, particularly telephones and electricity, has
taken a slower course. However, both of those industries have been the
object of significant procompetitive policy initiatives in the past
year. On February 8, 1996, the President signed into law the long-
awaited Telecommunications Act of 1996. Two and a half months later the
Federal Energy Regulatory Commission (FERC) issued its Orders No. 888
and No. 889, which set rules for opening up interstate transmission
networks to all generators and resellers of electricity.
These two enormous steps toward bringing competition into the
utilities sector represent a sea change in the traditional relationship
between public policy and private enterprise. During most of the 20th
century, government and markets were typically viewed as substitutes.
Citizens and policymakers had to choose between government mandate and
market forces. As the 21st century approaches, we see that market forces
and public policy are less often substitutes than complements. The
Telecommunications Act, the FERC's Order No. 888, and the ongoing
Federal and State efforts to implement their principles and mandates
show how judiciously crafted public policy can increase rather than
decrease the role and effectiveness of market forces in the economy, and
thereby improve the economic and social prospects for the American
people.
Complementarity between markets and government extends in the other
direction as well. Just as well-crafted government policy can make
markets work better, so the introduction of market mechanisms into the
regulatory process can help government achieve society's goals. For
example, to ensure that wireless technologies best meet the public's
demand for communication services, the Federal Communications Commission
(FCC) has turned to auctioning off portions of the electromagnetic
spectrum. These auctions not only have been enormously successful in
getting licenses quickly into the hands of those who can use them most
efficiently, but have raised over $20 billion for the U.S. Treasury in
the process. A second success story has been the use of market forces to
provide greater flexibility in meeting environmental goals (e.g.,
tradable permits for sulfur dioxide emissions). Last but not least,
market forces can help improve the management, use, and disposal of
public lands.

Box 6-1.--The Benefits of Deregulation

That deregulation produces economic benefits when it leads to
effective competition is not merely a theoretical proposition. Data from
the field bear this assertion out as well. An assessment by a Brookings
Institution scholar finds that deregulation not only has brought
considerable short-run benefits, by making markets work better, but also
has led to technical and operating innovations that promise even greater
benefits in the long run. The table below gives some examples of this
study's findings.


------------------------------------------------------------------------
Industry                Cost Reductions
------------------------------------------------------------------------

Airlines........................  24 percent decline  Hub-and-spoke
in costs per unit   systems
of output          Computer
reservations

Trucking........................  30-35 percent       Computer
decline in          networking
operating costs    Coordinating with
per mile            logistics firms

Railroads.......................  50 percent decline  Better contracts
in costs per ton-  Double stack cars
mile; 141 percent  Intermodal
increase in         operations
productivity

Natural gas.....................  35 percent decline  Computer planning
in                 Contracting
operating and      through market
maintenance         centers
expense

------------------------------------------------------------------------
Source: Clifford Winston, Brookings Institution.

MARKETS, GOVERNMENTS, AND COMPLEMENTARITY

As a prelude to discussing the potential for complementarity between
private markets and the public sector, we review the purposes each
serves in a primarily market-driven economy.

THE ADVANTAGES OF MARKETS

The argument in favor of deferring to markets typically relies on
the efficiency of their outcomes. If markets are competitive and
function smoothly, they will lead to prices at which the amount sellers
want to supply equals the amount buyers demand. Moreover, the price in
any market will simultaneously equal the benefit that buyers get from
the last unit consumed (the marginal benefit) and the cost of producing
the last unit supplied (the marginal cost). These two conditions ensure
efficiency: when they hold in all markets, the Nation's labor and
resources are allocated to producing a particular good or service if and
only if consumers would not be willing to pay more to have those
resources employed elsewhere.
This familiar story is profound and important, yet it understates
the role of private markets in making economies work. Since at least the
1930s, economists have noted that in theory the government could reach
efficient outcomes without relying on markets, if government officials
had sufficient information and the right incentives. But it is markets'
superior information-processing ability and preservation of individual
incentives that explain their general superiority to government
management of the economy. Markets allow transactions to be
decentralized to the level where decisions are made by those most
affected by them, in direct response to budget constraints and
tradeoffs. Market participants themselves then have powerful incentives
to generate and gather information and make the deals that best serve
their interests.

Information

An insufficiently appreciated property of markets is their ability
to collect and distribute information on costs and benefits in a way
that enables buyers and sellers to make effective, responsive decisions.
Because market prices measure the marginal benefits of goods and
services to consumers, firms that maximize their profits simultaneously
maximize the difference between benefits and costs. Similarly, consumers
look to market prices to decide which goods and services to purchase,
and how to use their labor, resources, and financial wealth to generate
the income to pay for them. As tastes, technology, and resource
availability change, market prices will change in corresponding ways, to
direct resources to the newly valued ends and away from obsolete means.
It is simply impossible for governments to duplicate and utilize the
massive amount of information exchanged and acted upon daily by the
millions of participants in the marketplace.
That markets normally process all of this information so well and so
rapidly tends to be taken for granted. In light of all the investments,
hires, plans, purchases, marketing efforts, sales, contracts, and
exchanges necessary to bring goods to market, the fact that the price
system normally works as well as it does--for instance, that the
products consumers want are usually on the shelves--ought to be regarded
as astounding. Instead, it's literally business as usual.

Incentives

Even if the public sector could gather and quickly respond to all
available information on changing consumer tastes and production
technologies, private markets would still have the advantage of
preserving the incentive to produce efficient outcomes. In private
markets, buyers and sellers directly reap the benefits and bear the
costs of their demand and supply decisions. Each makes decisions aimed
at achieving the greatest benefit, or economic return, net of cost.
These incentives not only affect how resources are used today, but also
lead to innovations that will increase the efficiency with which
resources are deployed in the future and result in new products that
raise living standards.
In contrast, the links between the government and the individuals
who reap the benefits and who bear the costs of its decisions are
frequently weak. The nature of day-to-day legislative, executive,
judicial, and regulatory proceedings runs a risk of favoring organized,
established interests rather than the public at large. Accordingly,
government's role in the operation of the private economy must be
limited and judicious. Initiatives to increase our economy's reliance on
markets, and to improve the efficiency of regulation through market
mechanisms, reflect an awareness of the tremendous benefits that market
forces can bring to bear by employing private incentives to achieve
social goals.

WHY HAVE GOVERNMENT AT ALL?

If markets generally outperform government, why not leave everything
to the market? To begin with, it is useful to remember that markets and
governments can and do work together. For markets to function
effectively, deals must be enforced and fraud discouraged. Without a
governmental legal system to guarantee property rights and enforce
contracts, corporate organization and market exchange would be virtually
impossible. Anarchy and the free market are not synonymous. (Box 6-2
discusses the role of government in protecting property rights in
information in an era of electronic, global markets.)
But government has other roles beyond refereeing private
transactions. Markets left to themselves sometimes produce inefficient
outcomes. For example, markets efficiently transmit information and
provide proper incentives only when sellers compete with enough
intensity to drive prices down to cost. But in some circumstances, firms
can impede the forces of competition by agreeing among themselves to
maintain high prices, or by merging to the point where individual
production decisions substantially affect prices. The antitrust laws are
the public policy instrument for pre-

Box 6-2.--The Role of Copyright in an Electronic Global Economy

The growth of telecommunications, computing power, and their joint
progeny, the Internet, is revolutionizing the way in which information
is created and shared. Whether by satellite or by fiber-optic cable,
electronic telecommunications networks today transmit vast amounts of
scientific and commercial information, and entertainment, around the
globe in a heartbeat.
Since the 18th century, markets for the products of creative
expression and technical innovation have been supported through
copyright and patent laws, which extend private property rights to
intellectual property. These laws have historically attempted to strike
a balance between enhancing economic incentives to create and promoting
widespread use of the thing created. By preventing unauthorized copying,
intellectual property laws allow creators and innovators to profit from
their original works and inventions.
Strong copyright and patent protection can help provide the
appropriate incentives to create, by allowing creators to capture a
greater share of the marginal benefit of their efforts. The cost of
strong protection, however, is that prices to use copyrighted works or
patents may remain high for some period of time. Ironically, because
patents and copyrights build on the work of others, overly strong
intellectual property protection today could discourage innovation and
creativity in the future.
An increasingly important policy question is whether these
traditional legal means for striking the balance between incentives to
create and incentives to use will continue to apply in a global
information-based economy. Difficult issues to resolve include:
 rights to display copyrighted information on computer
screens
 the applicability of copyright to electronic data bases
 ``fair use'' rights and other traditional exceptions for
the educational and research community, and
 competition within broad-based collective copyright
licensing organizations.
The need to coordinate our efforts with other nations makes the
resolution of these crucial questions even more complex.
venting such anticompetitive collusion and mergers. Public antitrust
enforcement complements market forces by supporting conditions conducive
to competition. A second important means of promoting competition in
U.S. markets is the reduction of trade barriers and other distortions
that deter entry by foreign providers of goods and services. There may
also be a role for government when large firms have cost advantages that
discourage entry by other firms and thus make sustained competition
impossible. For instance, the government may directly regulate prices as
a substitute for market forces in such circumstances.
Markets also produce inefficient outcomes when the prices that
buyers and sellers agree on do not take account of benefits and costs
falling on third parties. The result is called an externality, a
textbook example of which is air pollution. It would be prohibitively
costly to define and enforce property rights to the use of clean air.
Therefore, unless polluters can be made to pay a compensatory tax,
purchase emission permits, comply with regulations, or face liabilities
imposed by environmental or tort law, they do not take the cost of their
pollution into account. This leads to excessive levels of undesirable
emissions--a negative externality. Externalities can be positive as well
as negative, conferring benefits rather than imposing costs on third
parties. For example, inoculations not only protect those who receive
them from contagious disease, but may prevent its spread through the
rest of the population.
An important example of a public good with positive spillovers is
basic scientific research, whose benefits can far exceed those realized
by the firm or institution undertaking the research. In such cases,
targeted Federal support can more than pay for itself through the
technological innovations and product improvements bestowed upon the
economy overall. Investments in transportation and communications
infrastructure are another example. Numerous recent initiatives, such as
the Department of Transportation's programs to provide and leverage
financing for public highways and private toll roads, can generate
widespread benefits by promoting regional economic development.
Information asymmetries, where one party to a transaction knows more
than the others, can also undercut market efficiency. Health insurance
offers an instructive example. If consumers of health insurance know
better than providers the chances of their falling ill in a given year,
only those who know they are more likely to get sick might purchase
insurance. As premiums rise to reflect the higher risk of the those
buying insurance, the healthier among them--for whom the insurance costs
now exceed their expected care needs--drop out of the market. This
process of adverse selection can repeat itself to the point where the
market collapses. One reason why the government, rather than private
insurers, provides health insurance for the elderly through Medicare is
that the elderly may have more knowledge regarding their health status
than any private insurer, giving rise to an adverse selection problem
(see Box 3-1 in Chapter 3). Maintaining a population-wide risk pool
eliminates the problem.
Finally, the efficiency standard is not the only basis for judging
the performance of an economy. Probably the most frequent indictment
laid against markets is that they can be consistent with significant
inequality of opportunities and outcomes. Progressive income taxation,
free public education, and numerous transfer programs--all acts of
government--moderate some of the inequality in our market-based economy.
Civil rights laws prohibit discrimination that market forces may fail to
eliminate. In addition, because markets are driven by the pursuit of
personal, not collective, interests, market transactions may not fully
support our shared social values. Prohibitions on child labor, laws to
preserve habitats for endangered species, and public support for the
arts exemplify ways in which government seeks to give our important
social values their due.
This list of potential limitations to the market is not meant to be
exhaustive. And markets, of course, often can and do respond to these
and other imperfections on their own. If a market is not competitive,
firms may enter that market or buyers may begin production in-house
rather than continue to deal with a monopolist. Markets may internalize
externalities in cases where it is possible to define property rights or
to bring within the same organization all those who reap the benefits
and bear the costs. In some cases, warranties and independent testing
agencies can mitigate adverse selection and other problems resulting
from imperfect information.
The pursuit of goals other than efficiency, such as alleviating
inequitable distributions of wealth, is of paramount importance. Chapter
5 of this Report discusses an array of policies for addressing
inequality, from transfer payments to progressive taxation to the earned
income tax credit. Because reducing inequality is so vital a concern, we
need to recognize that few strictly regulatory decisions will have much
of an effect on the distribution of wealth or income. The controlled
pricing of telephone service, electricity, or other products of
regulated firms may promote other social objectives, but it is unlikely
to have much effect on the prevalence and intensity of poverty. Efforts
to reduce inequality will be more effective if directed at wages, taxes,
and other determinants of disposable income, rather than at prices for
particular products, especially those that make up only a small fraction
of household budgets. However, firm and even-handed enforcement of broad
public health, environmental, and other regulatory protections can help
to ensure that low-income and minority communities are not
disproportionately affected by pollution and other activities that
generate harmful spillovers.

MARKETS AND PUBLIC POLICY AS COMPLEMENTS

The conventional emphasis on markets and governments as substitutes,
rather than complements, has often led well-meaning, thoughtful people
to take extreme positions on the role of the public sector in the
economy. Proponents of a strong government role frequently compare real
market failures with an idealized vision of a government possessing
unlimited information and purely beneficent objectives. Opponents of
government often fall prey to the opposite fallacy, contrasting the
qualities of an ideal market with the behavior of real governments,
which must act upon limited information and often with distorted
incentives. Both institutions have limitations; neither measures up to
the ideal.
A more useful approach is to compare real markets with real policy
effects, to understand when and where lines between the public and the
private sectors should be drawn. Finding this boundary is difficult;
reasonable people can and do differ on its location. Comparing the
actual performance of markets and governments also helps us see how
public policies can make private markets work better, and how using
market incentives can improve the performance of the government.
Nineteen ninety-six saw the realization of major initiatives to
establish and extend competition in two markets where it had long been
absent: local telephone service and electricity generation. Last year's
Economic Report of the President examined the future of deregulation of
those two industries in detail. When that Report was written, these
initiatives were optimistic prospects. Now the complex task of
implementing the visions behind them has begun. Policymakers are working
to devise ways to bring about competition while protecting against the
undue exercise of market power. Much of the responsibility for
maximizing competition in electricity sales and telephone service falls
to State government. As we report below, the States have not shied from
the task.
Markets also help the government do its job. A profound innovation
of the last few years has been the use of market mechanisms to help the
government achieve its goals at least cost to consumers and taxpayers.
Even where the case for government intervention is persuasive,
policymakers have been able to exploit the advantages of the market so
that public policies generate greater benefits at lower cost.
Three examples of that success are especially noteworthy. The first
is the use of tradable emission permit programs, in which the government
distributes rights to emit some pollutant and then allows firms to
allocate those rights across their plants and to buy and sell them among
themselves. Programs such as these encourage abatement of pollution at
least cost. The second example is spectrum auctions. Here the policy
goals are twofold: get spectrum into the hands of communications service
providers who can generate the greatest economic benefit from it, and
raise funds to reduce the need for taxes to cover government expenses.
The third example is the use of market-based prices to lead to more
efficient use of public lands for mining, grazing, timber, and water
supply, while protecting their environmental value. The remainder of
this chapter discusses all three examples and concludes by looking at
the limits to transferring public responsibilities to the private
sector.

USING PUBLIC POLICY TO BRING COMPETITION TO REGULATED INDUSTRIES

In light of the Federal Government's success in introducing
competition into airlines, banking, trucking, and natural gas, its delay
in deregulating the telephone and electricity industries may be
puzzling. The reasons for the delay explain why government is likely to
be a complement to the development of competitive markets in these
industries for some time to come.

REASONS FOR THE DELAY IN DEREGULATING ELECTRICITY AND TELEPHONE SERVICE

Jurisdictional issues have made it legally and politically more
difficult for the Federal Government to deregulate electric and
telephone utilities than other industries. Much of the regulation of
these industries takes place at the State level, through public utility
commissions. The Federal Government generally regulates only those
portions that involve interstate commerce. (Box 6-3 discusses some of
the economic issues involved in assessing whether regulation should take
place at the State or the Federal level.) In the telephone industry the
FCC has traditionally asserted authority over long-distance calling
between States, wireless services, and interstate access services that
local telephone companies provide to long-distance carriers. In
electricity, the FERC's jurisdiction covers wholesale power sales, the
transmission of electricity for resale to final customers, and (it
asserts) transmission service to retail buyers where such transmission
service is unbundled from the power itself.
A more fundamental difficulty is the widespread presence of
substantial economies of scale, which create natural monopolies. A
natural monopoly occurs when a good or service can be provided at lower
cost by one firm than by two or more. With a few exceptions, the
industries first deregulated in the 1970s (e.g., trucking and the
airlines) were not natural monopolies. This choice was by design.

Box 6-3.--The Economics of Federalism in Regulation

Historically, responsibility for regulating electricity and
telephone service has been divided between the States and the Federal
Government. As a legal matter, the scope of Federal authority depends
upon interpretations of the commerce clause of the Constitution, which
says (Article I, Section 8), ``The Congress shall have Power . . . [t]o
regulate Commerce . . . among the several States . . . .'' Economics,
however, can inform these interpretations by examining a variety of
factors, including:
 Economic effects that cross State lines. When problems are
local, solutions in general should be local. The case for
leaving matters of economic regulation or policy to the States
is stronger if a State's policy choices do not impose costs on
residents of other States. For example, if a State chooses to
regulate in ways that raise prices, the strength of the Federal
interest should depend on whether consumers in other States are
affected by those high prices as well. A second important
example involves environmental effects that cross State borders,
such as airborne pollutants. A State may fail to impose
sufficient pollution controls on plants within its borders if
those in other States incur the damages.
 Economies of scale in regulation. Just as the economy gains
by having firms compete in the marketplace, it may also gain by
having government jurisdictions compete in the form and content
of their regulations. In some cases, however, effective
regulation may require the devotion of considerable resources
and specialized expertise to gathering and providing
information, assessing costs, evaluating the state of
competition, estimating environmental effects, and overseeing
compliance. It may be more efficient for one entity--the Federal
Government--to undertake these responsibilities than to have
them divided among the 50 States, the District of Columbia, and
other jurisdictions. The case for Federal regulation is stronger
if considerations determining the best way to regulate vary
little from State to State.
 Comparative performance of government institutions. Public
institutions may have incentives to act in accord with special
interests rather than those of the public at large. When this
problem is more prevalent at the State level, the Federal level
is likely to be the better venue in which to vest regulatory
authority.
In both electricity and telephones the most important natural monopoly
was the local distribution network. It was believed wasteful to lay a
parallel set of electric cables or telephone lines through cities and
towns to enable different sellers to compete for customers. The value of
having everyone on the same network further argued at the time for a
local telephone monopoly.
Accordingly, electricity and telephone service used to be provided
by companies that managed virtually every important aspect of the
industry from top to bottom. Telephone service was largely the province
of the American Telephone and Telegraph Co. (AT&T), which provided most
local networks, long-distance service, and telephone equipment. The
electricity industry was more complex, but the dominant form of
organization was the vertically integrated investor-owned utility. These
utilities generated power and transmitted it over high-voltage lines to
their local distribution networks, which in turn delivered it to homes,
offices, and factories.
Technological change and new forms of organization in the last two
decades have eroded the natural monopoly characteristics of both these
industries. Combined-cycle gas turbine generators reduced the scale
necessary to produce electricity at low cost, increasing the potential
for competition in power production. The telephone industry has seen the
development of wireless technologies, along with reductions in the cost
of fiber-optic transmission lines and of the computers and software that
may someday route telephone calls over alternative pathways such as
cable television systems. These innovations have encouraged some to
believe that entry into local telephone service, the last
telecommunications monopoly, may soon take place on a massive scale, but
such entry has not yet occurred to a substantial degree outside of
specialized mobile and business services.
Elimination of natural monopoly in the physical distribution and
transmission of electricity may take longer. It remains generally
uneconomical to build overlapping sets of power lines for the local
delivery of electricity. Long-distance power transmission also has
monopoly characteristics. Because directing electricity along a
particular transmission path is prohibitively costly, current supplied
into a grid will take all available paths between two points and
therefore affect power loads and congestion on many lines. Consequently,
the interconnection of independently owned transmission lines--a
practice to promote reliability of the system as a whole--tends to
convert the separate grids into a single entity.
Experience with structural change in these industries has
complemented these technological developments in opening utility markets
to competition. In electricity, public policies that have created an
independent power producing industry, mostly to promote cogeneration
(production of electricity by factories as a by-product of
manufacturing) and renewable technology, had the side effect of
demonstrating the feasibility of relying on nonutility generators for
power supply. The analogues in telephones were the ``equal access''
rules, imposed on the local telephone companies created in 1984 by the
AT&T divestiture, to give all long-distance carriers equivalent
technical interconnection, telephone numbering, customer subscription,
and billing arrangements. The divestiture created distinct local and
long-distance companies, and compliance with the equal access rules
provided valuable experience in how to interconnect separately owned and
managed facilities. Interconnection is, as we discuss below, a crucial
prerequisite for competition in local telephone service and in electric
power generation.

THE TELECOMMUNICATIONS ACT OF 1996

The Telecommunications Act of 1996 outlines the route that
competition and deregulation in the telecommunications industry will
follow. It first takes on the challenge of facilitating competition in
local telephone service. New competitors may fall into any of three
categories: providers with facilities offering all aspects of local
telephone service; partial facilities-based carriers that would purchase
unbundled network elements, such as switching capacity, from the
incumbent local carrier; and resellers that would purchase local service
at wholesale and resell it at retail, often as part of a ``one-stop
shopping'' package of local and long-distance telephone service. (Box 6-
4 discusses some other aspects of the Telecommunications Act.)
The Telecommunications Act requires each incumbent local telephone
company to allow facilities-based competitors to interconnect with its
networks so that customers on both networks can call each other.
Responsibility for interconnection rests initially with the carriers
themselves, who can negotiate nondiscriminatory terms and conditions,
subject to State Government mediation and arbitration. Incumbent local
telephone companies must make network elements and wholesale local
service available to competitors. To eliminate unnecessary entry
barriers, they must also adopt technology to permit customers to keep
their phone numbers when switching carriers, and must provide
information necessary for network interoperability. The
Telecommunications Act also charges the States and the FCC with devising
competitively neutral policies to promote universal service, that is, to
ensure that telephone service is reasonably available to all income
groups and geographic areas in the United States.
The Telecommunications Act also eliminates court-imposed rules
keeping the regional Bell operating companies (RBOCs, the regional
telephone companies created by AT&T's breakup) out of other
communications businesses, most notably long-distance tele-

Box 6-4.--Telecommunications Policy Is Not Just for Telephone Companies

The Telecommunications Act covers much more than the current set
of firms in the telephone industry. It also expands the number of radio
and television stations a single firm may own, simplifies license
procedures, and sets policies applicable if the FCC grants existing
broadcasters rights to additional spectrum for tomorrow's advanced
digital television services (while giving the FCC the power to reclaim
those additional rights or even those that broadcasters currently have).
But because the act also loosens FCC rules on concentration of radio and
television station ownership, such concentration may raise antitrust
concerns. Increasingly, radio and broadcasting mergers are now being
scrutinized by the Antitrust Division of the U.S. Department of Justice.
The Telecommunications Act also reduces price regulation of some
cable television systems, while maintaining for 3 years regulations on
cable systems that do not face effective competition. Cable television
shares the wire-based network characteristics that have made local
telephone and electricity service natural monopolies, but it arguably
faces greater competition from other video media such as broadcast
television, videocassettes, and direct broadcast satellite service. To
encourage telephone companies to compete with cable operators, the
Telecommunications Act establishes a common-carrier ``open video
systems'' framework that local telephone companies can use to provide
cable television service with substantially less regulation. In
addition, the act amends the Public Utility Holding Company Act of 1935
to permit public utility holding companies to acquire or maintain an
interest in ``exempt telecommunications companies'' (ETCs), which could
provide telecommunications or information services in competition with
incumbent providers. Since the act was passed, the FCC has approved a
number of petitions for determination of ETC status.
Other major provisions of the act seek to control the availability
of obscene and indecent material to minors via the Internet and require
that televisions with screen sizes exceeding 13 inches include a so-
called V-chip, which when activated blocks programs with ratings
designed to inform parents of sexual, violent, or indecent content that
their children might see. As of this writing, several Federal courts
have ruled that the content provisions regarding indecency on the
Internet violate freedom of speech.
phone service (Box 6-5). The act replaced these rules with a long-
distance entry approval procedure administered by the FCC. For an RBOC
to receive FCC authorization to provide long-distance service to its
local service customers, it must have an approved interconnection
agreement with a facilities-based competitor, or, if no competitor has
made a good-faith request for interconnection or network elements within
a specified time, it must have an approved statement of terms and
conditions under which it will provide interconnection. In either case
the RBOC must offer interconnection under terms and conditions that meet
a 14-point statutory checklist. The FCC then must determine whether
granting the RBOC's application to provide long-distance service ``is
consistent with the public interest.'' In making its determinations, the
FCC is required to consult the regulatory commissions of the relevant
States to verify compliance with the checklist, and to solicit and grant
substantial weight to the Department of Justice's evaluation of the
application. The Antitrust Division of the Department of Justice has
long experience in competition analysis, and thus has the expertise to
judge the effects of an RBOC's provision of long-distance service.
Similar prohibitions against manufacturing of telecommunications
equipment by the RBOCs are repealed, effective when the company obtains
approval to provide long-distance service. The Telecommunications Act
prohibits RBOCs from discriminating against competitors in areas such as
procurement and access to technical network information. To protect
against anticompetitive discrimination and the possibility that local
telephone customers will end up paying for the RBOCs' ventures into
long-distance service, manufacturing, and other new enterprises, these
offerings must be provided by separate subsidiaries for a minimum of 3
years.
Yet creating competition is not simply a matter of legislative
declaration; controversies regarding market power and dominance will
persist for some time. Exemplifying both the complexity of the issues
and the case for regulatory oversight is the FCC's First Report and
Order implementing the local competition provisions of the
Telecommunications Act. Table 6-1 summarizes some of the controversy and
the FCC's decisions.
As of this writing, the 8th Circuit Court of Appeals has stayed
implementation of parts of the order, holding that the FCC went beyond
its jurisdiction in prescribing prices and pricing methods for network
elements and wholesale telephone service. While the courts consider
these issues, State regulators continue to mediate, arbitrate, and
approve interconnection negotiations between incumbent local telephone
companies and new entrants. The FCC will still have to make decisions
regarding whether the RBOCs have met the prescribed conditions for being
allowed to offer long-dis-

Box 6-5.--Why Were the Regional Bell Operating Companies Kept Out of
Other Markets?

The RBOCs are the local service companies spun off by AT&T in 1984
as part of the settlement of the antitrust case brought against it by
the Department of Justice. The divestiture was premised on the economic
harm created when a regulated monopoly can evade controls on prices and
profits by operating businesses in other unregulated (or less tightly
regulated) markets. In U.S. v. AT&T, the regulated monopolies in
question were AT&T's local service companies, and the relatively
unregulated businesses were its long-distance service and its
telecommunications equipment manufacturing subsidiary. The leading
concerns were:
 Anticompetitive discrimination. A regulated local telephone
monopolist that also provides long-distance service might, for
example, provide delayed or inferior connections to other long-
distance competitors. If long-distance companies can only
complete calls through the local network, those competitors
cannot turn elsewhere for adequate connections. This boosts
demand for the monopolist's own long-distance service, allowing
it to raise long-distance prices.
 Cross-subsidization. A regulated local telephone company
might purchase equipment and labor to provide long-distance
service and record these purchases as costs of providing local
service. It could then cite these added costs to justify to its
regulator an increase in its local telephone rates. Because it
has a local service monopoly, customers cannot turn elsewhere
and must pay the higher rates. The profits show up on the books
of the unregulated long-distance service.
In the 1970s and early 1980s the local telephone monopoly appeared
permanent and regulatory approaches ineffective. The Department of
Justice's Antitrust Division therefore pressed AT&T to divest its local
operations, creating the RBOCs. To prevent anticompetitive
discrimination and cross-subsidization from recurring, the RBOCs were
kept out of long-distance service and other markets. Enacted 12 years
after that divestiture, the Telecommunications Act of 1996 reflects
technical change that has made the prospect of local competition more
realistic, and gives the RBOCs a reasonable opportunity to meet
conditions under which their provision of long-distance service would
promote rather than inhibit competition.

Table 6-1.--The Interconnection Debate
----------------------------------------------------------------------------------------------------------------
FCC policy  (absent a
Entry method                    Entrant side            Incumbent side        negotiated agreement
between the parties)
----------------------------------------------------------------------------------------------------------------

Facility-based total                   Incumbent would          Act left                 Set basic rules for
service providers                       preserve monopoly by     interconnection to       interconnection
refusing to              bilateral negotiation;   between
interconnect.            FCC intervention will     existing local
give too little weight   telephone companies
to local market          and new end-to-end
considerations.           providers.

Purchase of ``network                  Incumbent would offer    Entrants demand          Determine the ``network
elements''                              too few elements at      inefficient slicing of   elements'' (loops,
too high a price.        network; rates based     switches, other
on forward-looking       components) incumbent
costs will not provide    carriers should make
enough revenue to pay    available; specify
for past investments.    cost-based methods for
setting their prices.

Resell incumbent's                     Wholesale discounts      Resellers should not     Set a default wholesale
service at retail; own no               below retail rates are   get service at prices    discount of 17-25
facilities                              necessary for               discounted from        percent below retail,
profitable retail        retail rates that,       based on estimates of
competition.             because of regulation,   incumbents' costs
are below the cost of     related to retailing
providing service.       that incumbents would
avoid.
----------------------------------------------------------------------------------------------------------------
Source: Council of Economic Advisers, based on Federal Communications Commission interconnection order.

tance service, in accord with the checklist and the ``public interest''
standard in the Telecommunications Act.
While the interconnection issue is pending, the Joint Board of FCC
and State Public Utility Commissioners has adopted recommendations for
funding universal service subsidies for telephone service to low-income
or high-cost (generally rural) areas through competitively neutral
contributions from interstate telecommunications service providers. The
proposal defines universal service as including basic voice telephone
service and ancillary services. The current practice of subsidizing
universal service through ``access charges'' (fees that long-distance
companies pay the local incumbent to originate and terminate calls) is
neither transparent nor likely to be sustainable in a competitive
environment, as the entry of new telephone companies fosters bypass of
the payment system. In December 1996 the FCC initiated proceedings to
reform access charges. It is proposing to prescribe specific changes in
access charges and/or to grant a local telephone company different
degrees of pricing flexibility depending upon whether it faces potential
entry, actual competition, or substantial competition.
One question in addressing universal service and access charges is
whether, after deregulation, the earnings of incumbent telephone
companies will suffice to cover the infrastructure costs mandated under
prior regulatory regimes. As last year's Economic Report of the
President argued in the context of ``stranded costs'' of electric
utilities (which are discussed further below), recovery of costs
legitimately incurred pursuant to regulatory obligations would be
warranted. Such recovery should be limited, however, to investment
expenses not already recovered through past earnings. It is also crucial
that any such recovery be accomplished in a manner that is competitively
neutral--for example, creating neither artificial price nor cost
advantages for the incumbent carrier.
The years of debate that preceded passage of the Telecommunications
Act are likely to presage additional years of regulation and litigation
to realize its goals. These complex issues will require active policy
oversight to ensure a proper outcome.

EXPANDING COMPETITION IN ELECTRICITY:
FEDERAL ORDERS AND STATE INITIATIVES

Telecommunications was not the only industry during the past year to
be the object of procompetitive policy initiatives. Major regulatory
decisions by the Federal Energy Regulatory Commission, along with
ambitious State initiatives, are already opening markets in electric
power generation to competition. Legislation to increase competition in
electric power markets is under active consideration by the Congress and
the Administration. (Box 6-6 discusses the important role of merger
enforcement during the transition to competition in the electricity and
telephone industries.)
The 1992 Energy Policy Act authorized the FERC to order a
transmission-owning utility to provide wholesale transmission service.
This enabled generators owned by the transmission utility, by other
utilities, or by independent power producers to compete to sell power to
local distribution companies or anyone else engaged in the resale of
electricity. Opening up wholesale markets and interstate transmission
networks to the panoply of generating companies should lower prices and
will be necessary for effective retail competition. State regulators are
now determining the extent to which competition in electricity may
extend to retail markets.
The key provisions of the FERC's Order No. 888, issued April 24,
1996, require public utilities to file nondiscriminatory ``open access''
tariffs for the interstate transmission of electricity sold at
wholesale. Order No. 888 also requires ``functional unbundling'' by
utilities of generation from transmission, with separate rates for
wholesale power, transmission service, and other ancillary services.
These tariffs are intended to ensure that the utility treats
nonaffiliated power companies the same way it treats its own generators
in terms of prices and service options. To implement these procedures,
Order No. 889 mandates the creation of Open Access Same-Time Information
Systems (OASIS) to provide all generators with up-to-the-minute data
regarding power flows and congestion in the transmission network. The
thrust behind these two orders is the

Box 6-6.--Mergers During the Transition to Competition

At the same time that the FERC, the FCC, and State governments are
engaged in designing regulations to facilitate competition in telephone
and electricity markets, these industries are seeing considerable merger
activity. Mergers may enable firms to exploit economies of scale, but
they can also engender concerns that competition will be reduced. The
Horizontal Merger Guidelines promulgated by the Department of Justice
and the Federal Trade Commission point out that mergers can lessen
competition by making it easier for firms to collude and, in some cases,
by giving monopoly-like power to the merging parties.
A crucial consideration in evaluating mergers is what antitrust
experts call market definition: identifying who is in the market and who
is not. All else being equal, the more sellers that remain in the market
after a merger, the less likely it is that the merger will reduce
competition. As the industries have been structured up to now, mergers
between local telephone companies, or between electric utilities, might
have little anticompetitive effect, because the two would by law and
economics be in separate markets. Following the Telecommunications Act
of 1996 and Order No. 888, however, the concern is that these mergers
might reduce potential competition in the future. The effects of a
merger in these industries depend on how those initiatives are
implemented and how the industries respond. We do not yet know how the
markets will turn out--whether two, three, or ten companies will compete
to provide electricity or local telephone service to customers in any
particular area. Moreover, the mergers themselves may reflect the firms'
belief that they should merge now before authorities can prove that the
mergers would reduce competition.
In principle, mergers can be a way for firms to reduce costs and
improve their ability to compete. However, efforts to block
anticompetitive mergers are crucial if legislative and regulatory
efforts at all levels of government to promote competition are to
realize their full potential.
creation of institutional arrangements that will support greater
competition in the industry.
Among the many complex issues to be resolved in managing the
transition from regulation to competition in electric power generation,
two stand out. One is the degree to which more stringent forms of
separation between generation and transmission will be necessary to
prevent discrimination. Order No. 888 did not require strict corporate
separation between transmission companies and generators. A widely
discussed alternative is to create so-called independent system
operators (ISOs). An ISO would operate (but not own) a transmission
grid, keep power supply equal to use, and manage responses to
emergencies and blackouts. The FERC recognizes the need to prohibit
conflicts of interest between ISOs and power providers and has set forth
principles that ISOs must satisfy. However, the agency has left the
development and implementation of ISOs to the utilities and the States.
A second major issue involves what are known in the electricity
industry as stranded costs. As discussed in last year's Economic Report
of the President, electric utilities facing competition from new, low-
cost power suppliers may be unlikely to recover substantial amounts of
their undepreciated investments in high-cost power plants. A second
source of stranded costs is long-term contracts with high-cost renewable
power suppliers. Such contracts were mandated by Federal laws intended
to promote purchases of such power by utilities at their avoided costs
of new plant construction. Over time, however, those contract prices
have probably turned out to be higher than the projected cost of power
under deregulation.
Allowing utilities to recover prudently incurred investment and
contract costs is important. Investors in regulated enterprises need to
be reasonably confident that the government will not renege on its
commitments by arbitrarily denying the investors any opportunity to
recover their upfront costs. At the same time, however, regulated firms
may engage in wasteful investments if recovery is guaranteed
unconditionally. To avoid creating this incentive, a presumption in
favor of cost recovery should apply only for costs incurred to comply
with specific regulatory mandates or before competition became a
significant prospect.
In its recent Order No. 888, the FERC granted utilities the right to
seek recovery of costs stranded when a former wholesale customer
purchases power from new suppliers. The FERC's rule only covers
contracts established prior to July 11, 1994, the day the agency
published its stranded cost rulemaking in the Federal Register. It
served notice that it would not consider a request for wholesale
stranded cost recovery for contracts entered into after that date. Much
of the potentially stranded costs, perhaps over 90 percent, fall under
State jurisdiction, however, and are being resolved by the various
States in different ways.
States across the country are also expanding competition in
electricity. New Hampshire has already undertaken a pilot program in
which 16,000 randomly selected customers were allowed to choose their
electric company. In response, over 30 power companies have offered a
variety of flat rates and usage discounts, rebates and other
inducements, and promises of environmental sensitivity. In February 1996
the Wisconsin Public Service Commission submitted a proposal to the
State legislature describing a 32-step plan to bring retail competition
to consumers there by 2001. In September 1996 California enacted a plan
that would offer consumers a choice of power providers as early as
January 1998, with deregulation of retail power prices by 2002. These
initiatives illustrate how complementarity between public policy and
private markets holds at the State level as well as for Federal
regulation.
The existing statutory and regulatory framework may make it
difficult to resolve the complex issues, such as ensuring system
reliability, that are sure to arise as competition in electricity
evolves. Accordingly, the Administration is considering a variety of
legislative proposals to modify existing regulatory frameworks. Such
legislation could promote competition and efficiency in the electricity
industry by permitting more flexible industry structures and clarifying
the jurisdictional boundaries between State and Federal Governments.

MARKETS COMPLEMENTING GOVERNMENTS

The Telecommunications Act, the FERC's open access orders, and State
and Federal actions to implement them illustrate how government policy
can facilitate the development of responsive, competitive markets. The
street goes both ways, however. Recent policy developments regarding
pollution control, spectrum management, and land use show how government
can use market forces to help achieve important social objectives. (Box
6-7 indicates how advances in telecommunications are making the
government more accessible to the public.)

EMISSIONS TRADING: APPLICATIONS TO AIR POLLUTION

Concerns about environmental degradation and resource depletion have
led to an intensified search for innovative, cost-effective solutions.
One fairly new approach is emissions permit trading. Proposed at least
as long ago as the 1971 Economic Report of the President, emissions
trading is now often regarded as the preferred policy approach to a
range of environmental problems. By giving polluters a financial
incentive to reduce emissions in the least expensive possible way,
emissions trading reduces the costs of environmental protection. Firms
with high abatement costs can purchase permits from firms with low
abatement costs, which thus find it profitable to reduce their emissions
and sell their surplus permits. As a result, greater responsibility for
reducing emissions is allocated to those firms that can do so at least
expense.

Box 6-7.--Bringing the Government to the People via the Internet

An important advance in the use of telecommunications technology
to promote democracy is the expanding availability of government
information via the World Wide Web on the Internet. Any citizen with
access to a computer and a telephone line at home, work, or the public
library can now search this vast hoard of information.
To get to these sources of information, one enters a website
address (formally called a uniform resource locator, or URL) in a World
Wide Web browser program. The URL usually takes the form:

http://www.name.gov/

where in place of ``name'' the user specifies the site. Some of the
leading government websites are:


Library of Congress                                                           loc
White House                                                                   whitehouse
Department of Agriculture                                                     usda
Department of Commerce                                                        doc
Department of Education                                                       ed
Department of Energy                                                          doe
Department of Health and Human Services                                       dhhs
Department of the Interior                                                    doi
Department of Justice                                                         usdoj
Department of Labor                                                           dol
Department of State                                                           state
Department of Transportation                                                  dot
Department of the Treasury                                                    ustreas
Department of Veterans Affairs                                                va
Environmental Protection Agency                                               epa
Federal Communications Commission                                             fcc
Federal Trade Commission                                                      ftc
Government Printing Office                                                    gpo
National Aeronautics and Space Administration                                 nasa
National Science Foundation                                                   nsf


Within the Library of Congress website, a useful source of
information on the Congress and on Federal legislation is the Thomas
data base. From the White House website, one can use the ``Interactive
Citizens' Handbook'' to find websites for other Executive Office
agencies, including that of the Council of Economic Advisers, which
includes an electronic edition of this
Report.

Emissions Trading in Practice

Much of the enthusiasm for emissions trading is due to its success
in attaining mandated reductions in sulfur dioxide (SO2) emissions
from electric utilities, at lower-than-expected costs. The Environmental
Protection Agency (EPA) implemented emissions trading as part of its
Acid Rain Program. That program, instituted under the 1990 Clean Air Act
Amendments, called for major reductions of atmospheric SO2 and
nitrogen oxides (NOx), the pollutants that cause acid rain. To hold
SO2 emissions to a targeted maximum total level, the EPA issued
each polluter a number of permits based on fossil-fuel usage in the mid-
1980s. (Box 6-8 discusses the relative merits of giving away emissions
permits, auctioning them to the highest bidder, and charging emissions
fees.) After the initial distribution, permitholders were allowed to buy
or sell permits or use them to offset excess pollution in other parts of
their own operations.
During the debate over the Clean Air Act in the 1980s, utilities
warned that annual compliance costs could exceed $4 billion by the year
2000, and SO2 pollution allowances were predicted to trade at
prices ranging from $170 to almost $1,000 per ton of emissions. By the
end of 1995, however, the price of SO2 permits was around $80 per
ton. Some preliminary analyses suggest that several factors--
deregulation that reduced the cost of shipping Western low-sulfur coal
by rail, improvements in fuel blending technology, and subsidies for the
installation of equipment (called ``scrubbers') to filter out emissions
from smokestacks--reduced demand for and thus the price of SO2
permits. The flexibility provided by the emissions trading system,
however, is credited with promoting competition in coal markets and
encouraging innovation that led, at least in part, to these cost
reductions. Whatever the linkage, as market-based methods reduce the
costs of abatement, more stringent environmental standards become easier
to justify.
The first phase of SO2 emissions trading, affecting 110 plants,
began January 1, 1995. Phase II of the Acid Rain Program is slated to
begin in 2000, when an additional 700 fossil fuel-burning plants will be
subject to emissions caps. Moreover, analysts expect that permit trading
will play a greater role in other ways as the market expands. The EPA is
examining ways to respond to increased competition following the FERC's
Order No. 888, which according to the EPA's analysis will increase the
market share of relatively high emission coal-fired plants. A trading
system for NOx is a strong contender.

Emissions Trading and Climate Change Policy

In July 1996 the Administration announced that the United States
would support an international effort to set reasonable and attainable,
binding emissions-reduction targets for greenhouse

Box 6-8.--Taxing Pollution Versus Giving Away Emissions Trading Permits
Versus Auctioning

The first emission permits under the EPA's Acid Rain Program were
issued to utilities without charge. But handing out tradable emissions
permits for free is not the only way to introduce markets into
environmental protection. Other policy options include placing fees on
emissions, and auctioning rather than giving away permits. By changing
relative prices, and therefore incentives, all of these policies seek to
improve upon traditional command-and-control methods that specify
pollution limits for each plant and, in some cases, even the
technologies to be used to achieve those limits. Market-based incentive
policies tend to increase efficiency by imposing a marginal cost on
firms for polluting, through either paying more fees, purchasing more
permits, or forgoing the opportunity to sell permits to someone else.
Facing these costs gives firms the incentive to reduce pollution most at
plants where it costs the least to do so, and by developing and using
less expensive abatement technologies.
Economically, the choice between fees and marketable permits is of
secondary importance. If it is crucial to set some absolute limit on the
quantity of pollution introduced into the environment, permits together
with stringent enforcement can ensure that that limit is not exceeded.
If the incremental social cost from adding pollutants is known to be
relatively constant, the theoretically better approach would be to set
fees equal to that cost. Collecting emissions fees, and auctioning
rather than giving away permits, also raise revenue that can be used for
deficit reduction or to cut other, more distortionary taxes.
Whether regulators give away permits, auction them off, or impose
pollution fees, anything that forces firms to abate pollution or cut
back output is sure to raise the cost of supplying the goods and
services those firms produce. These higher costs translate into higher
product prices. Higher prices, however, lead consumers to take pollution
costs into account when making their own purchasing decisions.
gases--the gases whose emission is believed to cause global warming. The
possible effects of global warming include risks to coastal areas from
rises in sea level; changes in rainfall and agricultural productivity;
and increased incidence of diseases such as malaria, yellow fever, and
cholera. Combustion of fossil fuels, primarily coal and oil, is the main
source of elevated levels of carbon dioxide, the most prevalent of the
greenhouse gases.
The United States has called for flexible and market-based
approaches for reducing these emissions, one of which may be domestic
and international greenhouse gas emissions trading systems. Extending
trading internationally is especially intriguing. An international
trading system would be able to take advantage of greenhouse gas
reductions in those participating nations where the marginal cost of
reducing emissions is relatively low.

Other Implementation Issues

Determining the initial distribution of emission permits can be
contentious. The alternative to allocating permits through the market by
auctioning them is to rely on a formula, which may be based on past and
current pollution. Such formulas can be controversial because recipients
of permits are given a scarce and valuable resource. Moreover, companies
anticipating an allocation based on current practices have an incentive
to delay actions to limit pollution or other environmentally harmful
activities, in order to qualify for more permits. This incentive can be
partially neutralized by linking reductions to some prior historical
baseline. However, this approach can make the choice of allocation
formula more difficult, since participants will realize that a
distribution of permits based on historical practices penalizes those
who were the first to undertake actions to improve the environment.
In cases where the incremental harm from emissions is relatively
constant over time, the efficiency of emissions trading can be enhanced,
at least in the short run, by allowing polluters to bank and borrow
permits. Under such a system, polluters could defer their use of a
permit, or borrow against future allowances, as their costs dictate.
Where workable, this can allow the emissions trading market to allocate
reductions over time in a more efficient manner. Timing flexibility can
reduce compliance costs through better coordination of emissions
reductions when replacing old facilities with less polluting technology.
In the first year of the EPA's SO2 trading program, emissions
reductions were about 40 percent greater than the target level, as
utilities ``banked'' allowances for future years.
A problem can arise when the damages from emissions are not
distributed evenly over the geographic area in which firms can trade
permits. If polluters with high abatement costs--the ones most likely to
buy permits--are geographically concentrated, a ``hot spot'' area that
is persistently in serious noncompliance may result. Hot spots are a
potential problem with SO2, but they may be more serious with
regard to NOx. Better market mechanisms for dealing with hot spots
should be developed.
Despite these and other complications, interest in emissions trading
remains strong, primarily because of the potential cost savings and
efficiency gains. The EPA estimates that meeting possible SO2,
NOx, and mercury targets through an emissions trading program with
banking would reduce abatement costs in 2005 by almost two-thirds
compared with a traditional command-and-control approach. Researchers at
the Stanford Energy Modelling Forum have predicted that international
emissions trading for carbon dioxide could reduce costs as much as 50
percent below the minimum achievable using purely domestic programs--and
as much as 80 percent if flexibility in the timing of emissions
reductions is allowed. These cost savings do not conflict with
considerations of intergenerational equity, because they take place
within a program designed to ensure that concentrations of carbon
dioxide never exceed critical target levels in any year.

SPECTRUM AUCTIONS

Auctions of rights to use publicly owned resources can allocate
those resources efficiently, as well as generate revenues to help cover
the costs of government programs. The chief example in 1996 was the
FCC's auctions of rights to use parts of the radio spectrum for personal
communications systems (PCS). By virtually all accounts, this was an
enormously successful example of using market forces to complement the
public sector.
Auctions can be designed in numerous ways. Some feature one-time
sealed bids, whereas others feature repeated open bids. Rights or
permits to be auctioned can be offered together or one at a time.
Winning bidders may pay the bid they offer or, to limit strategic
incentives to underbid, they may pay the second-highest bid offered. The
winner can be determined either as the last to make an offer higher than
all preceding offers, or as the first to speak up as an auctioneer
offers a succession of declining sales prices. Regardless of the method,
the goals are the same: to get assets into the hands of those who will
derive the greatest economic value from them, and to do so rapidly and
efficiently. How best to design the auction depends on a variety of
strategic considerations. A primary factor in the PCS auctions (Box 6-9)
was to enable bidders to pursue collections of licenses and preserve
their options when strategies needed revision. This added flexibility is
likely to have increased firms' willingness to bid, allowing the
government to capture some of the economic benefits created by making it
easier for firms to place bids for one license based on their beliefs
about whether they will win others.
Spectrum auctions have particular advantages over earlier methods of
issuing spectrum licenses. Comparative hearings, in which the FCC
attempted to distinguish among prospective licensees on noneconomic
grounds, generated enormous delay and expensive litigation with little
if any public benefit. Using lotteries to distribute licenses randomly
to applicants eliminated the need for the

Box 6-9.--Spectrum Auctions: A $22 Billion Economic Idea

As a mechanism for capturing the value of the electromagnetic
spectrum for the public, and for getting spectrum quickly into the hands
of service providers, auctioning has been spectacularly successful. The
most dramatic examples have been the auctions of spectrum for broadband
personal communications systems (PCS). Broadband PCS might be thought of
an advanced form of wireless mobile telephone, fax, and data service,
akin to cellular radio.
To understand the success of PCS auctions, it is important to
understand how they work. The FCC first defines spectrum blocks, each
consisting of a range of frequencies and a geographic area over which a
winning bidder may use these frequencies. In the first broadband PCS
auctions, concluded in early 1995, two 30-megahertz blocks (designated A
and B) were assigned to each of 51 ``major trading areas.'' These
auctions were open to all firms, subject to ownership restrictions to
promote competition. In the second PCS auction, which took place in
1996, an additional 30-megahertz block (designated C) was offered in
each of 493 ``basic trading areas'' across the United States. Bidding in
that auction was restricted to smaller ``entrepreneur'' firms, with
discounts built in to promote participation by the smallest (those with
less than $40 million in annual revenue).
A key innovation was to allow bidding to continue for all areas
until no one wanted to place a higher bid on any particular area. This
allowed firms to bid in an effort to combine PCS licenses so as to
provide services over broad territories. These innovative auctions,
designed by the FCC with the help of experts in auction theory, achieved
the FCC's goals in outstanding fashion. Bids on the A and B blocks
fetched $7.7 billion, and those on the C blocks over $10 billion more.
The FCC's recently completed auctions of its D, E, and F blocks for PCS
service raised more than $2.5 billion. This same method had already
raised over $1 billion in 1994, in auctions for narrowband PCS
services--useful for paging and voice message services.
When the less complicated auctions for interactive video and data
services and direct broadcast satellite licenses are included, auctions
so far have raised over $22 billion and, more important, rapidly
promoted the use of innovative, advanced telecommunications technologies
throughout the economy.
FCC to determine which firm would be a better service provider.
Unfortunately, they also created a cumbersome and expensive mechanism
for collecting and processing vast numbers of applications, many from
those with no motive other than to sell their ``winning ticket'' to an
actual service provider. Instead of the government collecting revenues
to cover the costs of public programs, a few lucky winners got
windfalls. Moreover, the cellular lotteries did nothing to eliminate
delays in the efficient aggregation of licenses, whereas the PCS
auctions incorporated such aggregations into the bidding mechanism.
Auctions eliminate the need for arbitrary comparisons and the cost
of filing and processing speculative applications. The winner is
presumably the firm that believes it can make the greatest profit in
markets for telecommunications services for which the license can be
used. If it fails, it can generally sell its license, just as firms
throughout the economy that overestimate the profits they expected can
sell their plant and equipment to other entrepreneurs.
Auctions need not be inconsistent with achieving important
noneconomic objectives associated with spectrum use. Providers can bid
for licenses that include, for example, designated public service
obligations. But auctions are no panacea:
 If spectrum uses are specified in advance, auctions may not
lead to efficient outcomes. The economic value of spectrum, and
thus the revenue to the government, are greater when bidders
have more flexibility in how they can use the spectrum. To
promote these goals and implement recent legislation, the FCC is
proposing a new wireless communication service, with licenses to
be auctioned during 1997. Licensees would have considerable
flexibility to lease portions of either their spectrum or their
geographic coverage to other providers.
 If auctions are regarded primarily as a revenue-raising
device, the government may have an incentive to restrict the
spectrum available for any particular service. We need to
recognize, however, that a tax on any good or service has the
effect of reducing its supply. In that regard, the potential
output effect of using spectrum auctions specifically as a means
for raising revenue for the government would not be unique.
 A dominant firm might outbid potential entrants simply to
preserve its market power. Antitrust oversight and restrictions
on bidders may be necessary to preserve competition in spectrum-
related services.
 The incentive to develop new spectrum uses might be
diminished if auctions take place only after developers of those
uses disclose their innovations. If disclosure of the new idea
is what leads to the auction, innovators will have to bid for
spectrum made valuable only because of that idea. This could
reduce the incentive to innovate in the first place. An approach
sometimes used to deal with this problem is to grant ``pioneer
preferences'' in spectrum auctions to innovators. A better long-
run policy might be to commit to auction useful portions of the
spectrum up front, rather than make auctions contingent on
public disclosure by innovators of their ideas.

NATURAL RESOURCE POLICY REFORM

America's natural environment is an important part of our national
heritage and has contributed to the development of our economy. Federal
agencies, including the Bureau of Land Management (BLM) and the National
Park Service of the Department of the Interior and the U.S. Forest
Service (USFS) of the Department of Agriculture, manage large tracts of
land, particularly in the Western United States. Indeed, the majority of
land in several Western States is regulated by these agencies. The
Bureau of Reclamation of the Department of the Interior and the U.S.
Army Corps of Engineers also influence the quality of many of the
Nation's aquatic ecosystems through their construction and operation of
numerous diversion, flood control, hydropower, and navigation projects.
Federal public lands are used for a number of purposes, including
recreational use and resource extraction. Historically, three industries
have dominated the extractive use of public lands: livestock grazing,
mining, and timber harvesting. All these activities continue today:
grazing, for example is permitted on over 240 million acres of Federal
rangeland. Policies for management of the Nation's public lands and
aquatic resources have evolved over time as the result of legislation
and its interpretation by other branches of government. The
Administration is committed to ensuring that natural resource policies
reflect today's realities and balance the diverse and sometimes
competing objectives of all who derive benefits from the natural
environment.

Current Policies

Current policies toward natural resource use are mainly rooted in
past legislation intended to stimulate the economies of the West and
encourage settlement of the region. These policies facilitate the
development and exploitation of natural resources.
Subsidized Use of Federal Public Lands. Most uses of Federal public
land are currently subsidized in one of at least three possible ways.
First, a subsidy can exist when the price to the user is less than the
government's cost of overseeing the activity. Second, a subsidy may
exist when users of Federal lands pay the government a price below that
paid for the similar use of comparable privately owned lands. Finally,
resource users may receive a subsidy if they pay the government less
than the opportunity cost of the land's use, which is defined as the
value of the highest alternative use of the resource. The type and
amount of subsidy offered on Federal lands vary with the nature of the
activity and with the location of the land.
Public grazing fees are almost always below private fees and may not
even cover the government's cost of administering the grazing program.
The amount of the subsidy varies widely by location. The Public
Rangeland Improvement Act of 1978 dictates that grazing fees be
determined as a function of aggregate livestock market conditions,
including a forage value index, the price of beef cattle, and an index
of prices paid by farmers; because the formula disregards local factors,
public grazing fees are the same everywhere. Private grazing fees, by
contrast, differ widely and systematically throughout the West,
depending upon the quality of local forage and regional livestock market
conditions. A recent study concluded that average private grazing fees
between 1965 and 1992 were $12.75 per animal unit month (AUM) in
Montana, $7.80 per AUM in Arizona, and $11.20 per AUM across the 11
contiguous Western States. Public grazing fees, by contrast, averaged
$1.20 per AUM during this same period. Although these figures do not
account for the higher quality of forage often found on private land, or
for the value of private landlord services, they nevertheless represent
a significant subsidy for grazing domestic stock on public land.
The subsidy offered to ranchers is small, however, compared with
that given to miners taking hardrock minerals such as gold, copper,
silver, and uranium: miners do not pay the government any significant
revenue or fee for hardrock minerals extracted from Federal public
lands. This policy, established in the 1872 General Mining Law, bestows
a large subsidy on private mining companies. In 1994, for example, a
mining company patented a claim in northern Nevada with a gross mineral
value of $10 billion, for which the Department of the Interior collected
only $9,765. Although this was the largest single transfer of public
mineral assets in recent years, it is not the only such case (Table 6-
2). Between May 1994 and September 1996 the Federal Government was
forced by the General Mining Law to give away over $15.3 billion worth
of minerals, in return for which taxpayers received only $19,190.
Timber extraction from Federal public lands is also subsidized,
although the subsidy is more subtle than those for mining and grazing.
Generally, the USFS subsidizes timber extraction from public lands by
collecting less in timber sale revenues than it spends on timber program
costs. In 1995, for example, the USFS collected $616 million in timber
receipts but spent over $850 million on timber management,
reforestation, construction of logging roads, payments to States, and
other program costs. Closer analysis of this negative cash flow reveals
that the losses vary by region. In seven of the nine National Forest
System regions, annual cash

Table 6-2.--Examples of Mining Patents Issued Since 1994
----------------------------------------------------------------------------------------------------------------
Paid to
Location of patent              Date               Mineral              Mineral value    United States
----------------------------------------------------------------------------------------------------------------
Eureka and Elko Counties, Nevada.....      5/1994  Gold                          $10,000,000,000          $9,765

Clark County, Idaho..................      9/1995  Travertine limestone            1,000,000,000             275

Humboldt County, Nevada;.............
Imperial County, California..........    3-6/1995  Gold                            1,200,000,000           3,585

Pima County, Arizona.................     12/1995  Copper and silver               2,900,000,000           1,745

Eureka County, Nevada................      9/1995  Gold                               68,000,000             540

Mohave County, Arizona...............      4/1996  Gypsum                             85,000,000             100

Seward Peninsula, Alaska.............      9/1996  Gold                               38,600,000           2,680

Pinal County, Arizona................      9/1996  Copper                             56,000,000             500

Total..............................              ...........................    15,348,000,000         19,190
----------------------------------------------------------------------------------------------------------------
Source: Department of the Interior.

receipts from timber harvesting have consistently failed to cover the
USFS' annual expenditures. This problem is particularly severe in the
Rocky Mountain, Northern, and Intermountain regions, where expenditures
have exceeded receipts from timber sales by a ratio of 3 to 1 over the
past decade.
Federal water projects constructed and managed by the Bureau of
Reclamation, the Army Corps of Engineers, and the Natural Resource
Conservation Service of the U.S. Department of Agriculture are all
highly subsidized. For example, projects constructed by the Bureau of
Reclamation embody a number of different subsidies. These include
interest-free repayment for capital invested in irrigation facilities,
limitation on repayment associated with ``ability to pay'' guidelines
that do not necessarily reflect changing economic or market conditions
or individuals' income, and the repayment of costs above an irrigator's
estimated ability to pay by using hydropower revenues far in the future.
The length of the repayment period is also important in determining the
overall magnitude of the subsidy. Subsidy amounts vary by project
depending on date of construction, repayment terms, and interest rates,
but on many projects the subsidy is significant. Moreover, even when
farmers and other users pay some portion of the true cost of delivering
water, they pay nothing additional for the value of the water itself.
Recreational use of Federal public lands is also heavily subsidized:
in many areas fees paid by recreational users do not cover the costs of
maintaining the resource for recreation. The Park Service spends around
$250 million annually to provide visitor services at its 374 parks,
monuments, and historic sites. Entrance fees raise only $80 million
annually.
The National Park Service is currently implementing new fees in
accordance with the demonstration projects authorized in Public Law 104-
134. Fees for the recreational use of USFS and BLM land are charged
sporadically. The revenues are far smaller than for National Park lands
and are well below costs. These agencies are also implementing selective
fee increases.
Environmental Damage. Grazing, mining, timber harvesting, and water
project development have all placed heavy burdens on the Nation's
natural resources. Streams and rivers in the Western States are
particularly affected.
Ever since the first European settlement of the West, rangeland
vegetation there has been affected by the introduction of livestock
grazing and related changes in the occurrence of fire. Livestock grazing
has reduced native grasses and palatable shrubs in upland communities,
exposing bare ground and increasing soil erosion. More important,
however, is the damage done by grazing to the riparian (river-related)
areas upon which all fish and nearly all terrestrial species depend.
Whereas the condition of uplands has improved since rangeland management
began in the 1930s, riparian areas in the Western United States have
continued to decline under the impact of grazing and are considered to
be in their worst condition in history.
Mining operations have also caused significant environmental damage.
Although problems of acid drainage have been reduced by the Clean Water
Act, and dangerous mining of mercury and asbestos has been curtailed,
mining operations still pose serious environmental risks. Groundwater
infiltration of abandoned mine sites and cyanide contamination of
streams and aquifers from gold extraction are serious concerns (Table 6-
3). The mining industry and State and Federal regulators have taken
steps to reduce the ongoing damage, but much remains to be done.

Table 6-3.-- Miles of Streams Polluted by Hardrock Mine Wastes
------------------------------------------------------------------------
State                                Miles
------------------------------------------------------------------------

Arizona...............................................               200

California............................................               578

Colorado..............................................             1,298

Montana...............................................             1,118

New Mexico............................................                69

Utah..................................................                83

Total...............................................            3,346
------------------------------------------------------------------------
Source: Western Governors' Association.

Federally sponsored water projects inflict significant damage on our
aquatic resources. Dams can inhibit the spawning of migratory fish such
as salmon and steelhead. The vast Columbia River basin is in many
respects the most affected by water project development. The Columbia
River watershed now contains, by one count, 79 hydroelectric projects;
30 of these are Federal projects that provide subsidized power. The
basin holds 450 major dams, if those for irrigation are included, many
of which have no fish passage facilities. Diversion of water to farms
and cities for crop irrigation and drinking reduces the quantity of
water in rivers and streams; return flows are often warmer than
desirable and may contain agricultural chemicals and other pollutants
that lower water quality. Timber harvesting, mining, and ranching have
also degraded Western fisheries by inundating spawning habitat with silt
and debris.
Use Restrictions. Use restrictions are one tool by which Federal
agencies coordinate activities on public lands. The fact that the price
of resource extraction and recreation is often subsidized places more
emphasis on such nonprice policies for controlling the use of public
lands.
Those extracting resources from Federal public land often have
exclusive rights in a given area for the activity in which they are
engaged; this is one sense in which public lands have already been
partially privatized. For example, the General Mining Law of 1872
provides for exclusive possession as against other miners, even while
prospecting. Similarly, the Taylor Grazing Act of 1934 grants an
exclusive grazing right to a single permitholder in a given area of BLM-
managed land. This provision of grazing law was created largely to avoid
the ``tragedy of the commons'' that had afflicted these public
rangelands. With open access, each rancher has an incentive to introduce
additional animals to the range until the average benefit equals the
marginal cost. In this way, open access can dissipate the overall
economic benefits from grazing.
Use-it-or-lose-it provisions are another type of use restriction on
extractive activities. Under these provisions, whoever holds the right
to extract a given amount of a resource in a certain time period must
extract the resource as specified or face the possibility of losing the
right. For example, grazing permits issued by the USFS require that a
rancher graze close to the maximum permissible number of cattle or face
termination of the permit (temporary exemptions are available, however).
Similar provisions apply to timber harvesting permits and to water
diversion rights. These provisions were intended to promote the
utilization of public lands; in practice, however, they limit the
transferability of extraction rights by reducing the incentives for
conservation interests to obtain them.

Changing Conditions in the West

Current Federal resource policies are thus characterized by
subsidized extraction and use restrictions that limit the
transferability of extraction rights. These policies have resulted in
overextraction and significant environmental damage. Changing economic
conditions in the Western States and increasing recognition of
environmental values suggest that many of the original motivations for
these policies no longer apply. The Western regional economy is now
prosperous and diverse, and extractive activities there provide far less
income and employment in the aggregate than do recreation, tourism,
manufacturing, and finance.
Less Reliance on Resource Extraction. The economy of the Western
States has become highly diversified. Total employment in the West was
more than 22 million in 1982. This figure had increased by nearly 50
percent to over 33 million by 1990. Industries in which employment has
increased as a share of total employment include services, finance,
insurance, real estate, construction, and retail trade. The Western
regional economy produced more than $1 trillion worth of goods and
services in 1982, and $1.35 trillion in 1990 (both figures are in 1993
dollars). Industries whose income has increased as a share of total
regional product include services, manufacturing, and retail trade. In
many respects these changes in employment and income generation mirror
broader trends in the Nation's economy, with the result that the West
does not look as different from the East as it did in the 19th century.
Extractive industries now make up only a small and declining fraction of
economic activity.
Agriculture (including timber extraction) and mining together
provided only 6.3 percent of income and 5.3 percent of employment in
these States in 1990, and their importance is declining. Their share of
employment in the Western States fell by 21 percent between 1982 and
1990, during which time their share of regional income fell by 15
percent.
A declining number of Western families rely solely on income from
ranching, mining, timber extraction, or farming. For example, ranch
families in Arizona have, on average, two people employed off the ranch,
who together contribute 53 percent of household income. In part this
trend reflects the maturation of the regional economy. More jobs in the
region translate into more opportunities for outside employment. This
trend also implies that the incomes of families with a member employed
in the resource extraction sector are also affected by public policies
that strengthen the nonagricultural economy.
Nor should one overestimate the importance of extraction from
Federal public lands to the livestock and timber industries as a whole.
Permitted use on Federal lands accounts for only about 7 percent of beef
cattle forage and about 2 percent of the total feed consumed by beef
cattle in the 48 contiguous States. Similarly, less than 15 percent of
the national timber harvest is from Federal lands.
The small contribution of extractive industries to economic activity
in the Western States and the small contribution of public lands to
total national cattle and timber production should not, however, obscure
the fact that many rural communities and individual businesses in the
West currently depend on Federal public lands for their economic well-
being. Moreover, participants in the traditional Western industries
represent, in the Department of the Interior's words, ``a significant
part of the world's image of America and America's image of itself.''
The unique cultural institutions of the West are valuable, and their
preservation should factor into the debate about the nature of
economically desirable natural resource policies.
Increasing Value Placed on the Environment. The American public
places more importance on a healthy environment today than at any other
time in our history. This change in values is revealed in several ways.
Public interest groups play an increasingly prominent role in the debate
over public lands policy and have prompted various Federal agencies to
enact important changes in policy. In recent years the Congress has
enacted historic legislation designed to enhance the quality of the
Nation's environment. To the extent that legislation reflects social
preferences, these laws reveal an increasing value placed on
environmental quality and a recognition of resource scarcity.
Recreational use of public lands is also increasing rapidly. On USFS
lands, for example, such use increased by over 20 percent between 1991
and 1995, from 279 million to 345 million visitor-days. This rate of
increase far outstrips the rate of population and income growth during
this time period and may well reflect a change in preferences when
compared with changes in other determinants of recreation demand.
A recent USFS study shows that recreation on National Forest System
lands produces far more income and jobs than do traditional extractive
industries. The agency calculated that recreation on these lands
(including hunting, fishing, and wildlife viewing) contributed over $105
billion to GDP in 1993, or nearly 85 percent of the total Forest System
contribution to GDP (Chart 6-1), and resulted in over 2.7 million jobs.
Grazing, timber harvesting, and mining together contributed less than
one-seventh as much income and employment as did recreation. The USFS
projects that, by 2045, recreation will generate an even larger share of
the economic benefits from the Forest System, particularly if
environmental quality improves.
Changing National Fiscal Priorities. Finally, it is important to
consider Federal natural resource policy in the context of Federal
deficit reduction. Deficit reduction produces numerous public bene-


fits, detailed elsewhere in this Report. Reducing the Federal deficit is
a prime economic policy objective of this Administration.
With this emphasis on deficit reduction, all public spending,
including subsidies on public land use, is under closer scrutiny than in
the past. Economic principles suggest that the marginal benefits of all
government expenditures should be equal when the government is making
maximal use of its fiscal resources. This means we must compare the
value of an additional dollar spent subsidizing timber extraction or
grazing--or on environmental restoration--with the value of a dollar
spent on providing school lunches or job placement assistance or
supporting basic research. If these marginal values are not equal, then
an optimal allocation of public funds requires reducing some
expenditures that provide lower marginal benefit while increasing others
with higher marginal benefit.

New Foundations of Natural Resource Policy

These changing economic and social conditions--the maturation of
Western economies, the emphasis on deficit reduction, and the increasing
value placed by the public on environmental quality--motivate a new set
of objectives for Federal natural resource policy.
Market Incentives. Users of Federal public lands should be more
exposed to market signals, so that their decisions will help maximize
economic welfare for all. Economics teaches that subsidizing the use of
public lands affects economic behavior in ways that may prove costly. By
encouraging overinvestment and overproduction in the livestock, mining,
and timber industries, subsidies attract resources away from other, more
productive sectors of the economy and reduce overall economic well-
being. Reducing subsidies can improve economic performance by giving
producers better information about the true cost of using public land.
Increasing the transferability of extraction rights is another
market-oriented reform that may increase aggregate economic welfare.
Some rights to extract resources from public lands are currently
tradable in a limited sense. For example, Federal grazing permits are
often transferred with the sale of a ranch to other qualified ranchers.
One possibly beneficial reform would be to allow conservation interests
to compete for extraction rights on an equal basis with other interests.
For example, environmental groups could acquire grazing permits and use
the land to introduce native plant species and improve wildlife habitat,
or acquire permits for the use of timberland and permanently retire that
land from commercial harvesting. Such voluntary transactions can provide
value to the seller as well as to the buyer, and thereby maximize the
value received by all elements of society from the stock of public land.
Environmental groups already have acquired grazing permits at the State
level.
Not everyone favors the trading of extraction rights. Rural
communities sometimes assert that allowing conservation interests to
acquire permits reduces the number of extractive businesses, thereby
threatening the livelihood of their suppliers and possibly raising input
costs to those producers who remain. Although some rural communities
have indeed suffered from the loss of input supply businesses, it is
important to recall the backdrop against which changes in public land
policy are taking place: a maturing and diversifying Western economy. It
is possible that these businesses would fail in any case, as the economy
shifts away from natural resource-based industries, and jobs lost as a
consequence are increasingly likely to be replaced by others within the
community or region.
Another objection comes from resource managers who argue that
grazing and timber cutting in particular play a key role in managing
biological activity on public lands. For example, grazing of livestock
and thinning of timber can reduce the danger of destructive fire.
However, conservation interests have many of the same incentives as the
government--and perhaps even greater incentive--to preserve resources in
good condition. These groups may, for example, allow grazing, but at a
low level of intensity.
Contribution to Deficit Reduction. Reducing subsidies can contribute
to deficit reduction. For example, requiring royalty and bonus payments
for hardrock mineral extraction, as many private landowners do and as
the Federal Government itself does for oil and gas, could provide
additional revenues. The Department of the Interior has calculated that
an 8 percent net income royalty on hardrock minerals extracted from
Federal public lands would generate at least $275 million for the
Treasury over the next 5 years. Reducing subsidies for timber
extraction, grazing, water deliveries, hydropower, and recreation would
have beneficial fiscal impacts as well.
Increasing reliance on market mechanisms can also support deficit
reduction. For example, grazing permits could be allocated through
competitive auctions (much like the successful spectrum auctions
described earlier in this chapter); it is quite possible that such a
reform would raise more money for the government than the grazing fee
increases proposed in 1994. Similarly, the current patenting process for
mineral extraction could be replaced with a system of royalties and
competitive bidding on bonus payments to the government. Such a system,
already used for other minerals and by numerous other landowners, is
likely to raise more revenues than a simple royalty payment as envisaged
in current reform attempts. However, replacing the current patenting
system with a leasing-competitive bidding regime might raise difficult
policy and administrative issues.
Timber contracts are currently allocated competitively. However, the
bidding process could be fine-tuned to the benefit of taxpayers by
incorporating a larger share of road and overhead expenses in the
minimum acceptable bid. This adjustment would reduce continuing Federal
losses from many timber sales and would give logging interests more
accurate price signals about the true resource cost of timber
extraction.
Environmental Stewardship and Efficient Land Use. Reducing or
eliminating resource subsidies can improve environmental quality on
Federal public lands. To the extent that environmental damage is related
to the level of production, reducing subsidies reduces the incentives
for production and thereby reduces environmental damage.
Of course, the environmental impact of resource extraction is not
just a question of production levels; technique is also important. For
example, the environmental damage from grazing may be due both to the
number of livestock grazed and to the way in which grazing is managed:
where animals are permitted to graze and for how long. Similarly, the
impact of mining on water quality depends not only on the volume of
minerals produced; control technologies and reclamation practices also
have important effects. Direct use restrictions and reclamation
requirements can help correct for the environmental damage done. For
example, the government can exclude riparian areas from grazing. It can
also place more environmentally sensitive lands off-limits to mineral
location and production. Without environmental taxes to provide price
incentives, direct controls can be an important way to improve
environmental quality and achieve an efficient resource allocation.
Subsidizing the price of environmentally friendly extraction
technology may also be consistent with increasing efficiency. Reducing
the price of such technology increases the likelihood that it will be
adopted. Such a subsidy can be implemented in a number of ways. Public
investment in agricultural research and development is one approach that
has generally paid impressive returns. Land-grant universities and the
cooperative extension system have helped farmers increase productivity
and, more recently, cope with environmental problems. Increased funding
of land-grant research, development, and outreach directed at public
lands management is one way to encourage the adoption of more benign,
and more productive, extraction technologies.
Transferability of extraction rights can also be consistent with
environmental stewardship in at least two ways. Trading can allow
conservation interests and various levels of government to acquire the
resources they value the most at prices that compensate willing sellers.
For example, the Department of the Interior has initiated innovative
willing-seller programs to reallocate water from agriculture and enhance
instream flows in the San Francisco Bay/Delta estuary and Nevada's
Truckee River basin. As the government excludes more resources from
extraction, trading among the remaining permitholders can also help
mitigate the industry's economic losses by allocating extraction rights
to those entities that can use them most profitably. At the same time,
trading can lead to a more efficient economy-wide allocation of
resources, effectively allowing us to produce more with fewer resources.
Reconfiguring the Public Land Base. The Federal Government owns a
substantial share of the Nation's natural resources. It owns about one-
third of all the land in the United States, including 29 percent of
forestlands and 43 percent of rangeland. State and local governments and
American Indian Nations own another 8 percent of U.S. lands. Over 10
percent of the U.S. population receives water from Federal diversion
projects.
Sound economic reasons argue for the government keeping such a large
share of our natural resources in its possession. Most goods in our
economy are private property, traded in markets that appropriately
determine prices and quantities. But many natural resources possess
characteristics that make them unsuitable for private market control.
The most important of these is the fact that many natural resources are
public goods.
A public good is anything that can be used or enjoyed by one person
without detracting from the use or enjoyment of others, and to which it
is difficult to restrict access. For example, suppose that the land
comprising Yosemite Valley were subject to being bought and sold in a
market. A developer thinking of purchasing the land might consider only
how to maximize the individual returns from owning it: he or she might
weigh the potential profits earned from preserving the land for tourist
use against, say, developing a housing tract or a shopping mall on the
site. There is no guarantee that preservation would win out, even if
Americans would value that outcome more highly in the aggregate. Even if
concerned citizens established a fund to preserve the land, the money
collected might well fall short of the actual value the Nation places on
preserving this important site. Each potential contributor would have an
incentive to wait, hoping that someone else would make the necessary
donation to prevent development. In this case the public good character
of the natural resource leads to a failure of the market to reflect
collective values, and society is better off if the government manages
the asset.
This discussion suggests another principle for resource policy
reform that should receive serious attention. Federal public lands that
private owners could manage efficiently, in a manner that protects the
public interest, should be considered for privatization. Conversely,
many lands currently in private hands have certain characteristics of
public goods, and thus might be more efficiently owned and managed by
the Federal Government. Achieving the most efficient mix of public and
private lands may require reconfiguring the public land base, adding to
it in some places and divesting in others. The Administration is
currently working on several exchanges that are consistent with this
general principle: for example, the Federal Government is in the process
of acquiring the Headwaters forest in Northern California and the New
World Mine adjacent to Yellowstone National Park in exchange for surplus
properties elsewhere.
Reconfiguring could be accomplished directly through swaps of public
for desired private lands, as is most common today, or public lands
could be sold and the proceeds put into an account for land purchases
elsewhere. Economists have long recognized that the swap option is
limited by the ``double coincidence of wants'' problem. It is often hard
to find a swap partner who both owns an asset the government wishes to
acquire and places a similar value on an asset the government wishes to
sell. For this reason, a land purchase fund that decouples buying and
selling land assets is superior to direct swaps.

DISPOSAL OF SURPLUS DEFENSE PROPERTIES

The closing of military bases offers a good illustration of the
principle that land no longer needed by the Federal Government can be
turned over to local authorities or to the private sector. In four
rounds of defense base reductions beginning in 1988, independent base
closure commissions performed the difficult task of determining which
bases would be closed. Nearly 100 major installations have been selected
for closure.
Disposition of these properties has not been easy. A number of
objectives have to be taken into account, including local economic
redevelopment, savings for the Federal budget, and the needs of the
homeless. Recognizing the complexity of this task, the law provides for
a 6-year period from the initial closure decision to actual closure, to
determine how best to meet these goals.
Until recently, the disposal of surplus military bases--one of the
most significant divestitures of Federal real property--reflected the
hierarchical approach embodied in the Federal Property Act. Other
Federal agencies had first call on the land, followed in order by State
and local governments, and finally the private sector. Specific national
priorities, such as the provision of shelter for the homeless, enjoyed
privileged status.
Recognizing that government downsizing represents both a major
economic dislocation and an opportunity to stimulate new economic
activity, the Administration has taken several important steps to smooth
adjustment and promote economic development in these situations. The
President's five-part Program to Revitalize Base Closure Communities,
supported in 1993 by new statutory tools, institutionalized economic
revitalization as a priority. In 1994 the Administration secured further
legislation that gave communities and providers of assistance to the
homeless increased flexibility to meet the needs of the homeless either
with specific buildings or other surplus government property, or with
the proceeds from sale of these assets, applied in ways that make the
most sense in the local setting. The base closure and redevelopment
process illustrates that increased flexibility in the disposal of
surplus Federal land enhances both the speed of disposition and the
economic value of reuse.
A remarkable set of alliances has developed to put these sites into
productive reuse, to support residual defense activities along with
those of other Federal and State agencies, and, most important, local
communities and the private sector. Throughout the Nation, economic
revitalization from all of these sources is well under way in affected
communities. New uses range from airports and manufacturing to college
campuses and affordable housing. As a result, numerous new jobs have
been created. At the 40 major closed installations, nearly half of the
civilian jobs lost have already been replaced, and more are being
created every day. Most communities affected by closure expect to regain
or exceed previous civilian employment levels.
The steps described here represent vast improvements over the
hierarchical manner in which surplus base closures have been handled in
the past. Continued flexibility and innovation will be required to
achieve the program's objectives.
Even where the Defense Department has retained installations, it is
looking for ways to maximize their economic benefit. This can include
introducing multiple uses for vast weapons and training ranges, such as
mining, recreation, and preservation of wildlife habitat. To minimize
the need for Federal land and to spread operating expenses, the Defense
Department is actively attracting compatible Federal activities, other
State and local government functions, and private business activity.
Privatization of some government functions, such as military family
housing, is another example of this trend.
As the Federal Government increasingly adopts private sector
management methods and privatizes its functions, exclusively Federal use
of its real estate is likely to diminish, and the value of that real
estate to the local and national economy is likely to increase.

CHANGES IN FARM POLICY

The Federal Agriculture Improvement and Reform (FAIR) Act of 1996
makes important changes to American farm policy. Most significantly, the
legislation increases market influence in planting decisions and reduces
the distortions in resource use caused by previous commodity programs.
Under Title I of the new law, eligible producers of grains, cotton, and
rice can enter into 7-year production flexibility contracts, receive a
series of predetermined annual payments, and have almost complete
flexibility to plant any crop on any land. Contract commodities may be
planted on any acreage, and any commodity except fruits and vegetables
may be planted on contract acreage. It is unlikely that there will be
large changes in land allocation or prices as a result of the act, at
least in the short run. Under the 1990 Farm Act, growers were given
planting flexibility on up to 25 percent of their base acres but
actually used, on average, only about one-fourth of that flexibility to
plant alternative crops.
The amounts paid to farmers during the 7 years covered by the 1996
Farm Act are large--almost as large as during the past 7 years under
previous law. Furthermore, the new payments are well above the amounts
that would have been expected if the previous law had been extended.
Under the old law, deficiency payments increased when prices were low
relative to the target price set by the law, and decreased or fell to
zero as prices rose toward the target price. Under an extension of the
previous system to 2002, deficiency payments would have provided little
cash support, because prices received by producers in 1995 and 1996 were
high relative to the old target prices, and prices are expected to
remain high for the next several years. However, once the 7-year
payments run out, they are not expected to be renewed. At that time
farmers will become subject to market forces.
The act's impact on conservation is also significant. The
Conservation Reserve Program (CRP) is reauthorized through 2002, with up
to 36.4 million acres enrolled at any time. Under the CRP the government
contracts with farmers to convert highly erodible or otherwise
environmentally sensitive cropland to approved conservation uses for 10
to 15 years. In exchange, farmers are paid an annual rent and a share of
the cost of converting and maintaining the land. The Wetlands Reserve
Program (WRP) provides payment and cost sharing to farmers who grant
permanent or long-term easements (over 30 years) that restore farmlands
to a wetland environment. The landowner is allowed certain economic uses
of the restored wetland, which may reduce the cost of the easement. The
WRP is reauthorized through 2002 for a maximum of 975,000 acres.
Finally, the Environmental Quality Incentives Program (EQIP) combines
and replaces several earlier programs. One of its objectives is to
encourage farmers and ranchers to adopt practices that reduce
environmental and resource problems through targeted 5- to 10-year
contracts providing educational, technical, and financial assistance.
More is known about the budgetary and economic costs of these
programs than about their benefits. Further, the benefits are
multidimensional, as decisions about how to use farmland affect soil
loss, water quality, wildlife habitat, and other environmental
characteristics. Thus, to maximize overall benefits, the CRP and other
programs must be managed to achieve multiple objectives, recognizing the
tradeoffs among policy goals.
The conservation programs of the 1996 Farm Act have the potential to
enhance social welfare, but they are also expensive. The CRP alone
retires up to 10 percent of the Nation's stock of cultivated cropland
and raises prices received by farmers overall. Impacts on particular
commodities will depend on the extent to which farmers vary cropping
patterns in response to price changes. Since there are few restrictions
on cropping decisions under the new law, market prices will allocate
land left out of the CRP to the highest-valued uses. Legislation and
administration have increasingly reflected concern for more careful
management of conservation programs. The 1990 act encouraged the
Department of Agriculture to improve the cost-effectiveness of the CRP.
In response, the department actively targeted subsequent CRP signups to
land that would best contribute to conservation reserve goals by using a
national ranking of applications based on costs and an environmental
benefits index. The 1996 act encouraged targeting of priority areas for
the CRP, the WRP, and the EQIP and specifically called for the EQIP to
maximize the environmental benefits per dollar expended.

LIMITS ON BRINGING MARKETS INTO THE PUBLIC SECTOR

The success of spectrum auctions and emissions permit trading
programs again raises the question of whether we might not leave all
government service provision to the market. For example, if airport
landing rights can be sold, why not sell the right to operate the air
traffic control system as well? Recently proposed legislation would lead
to the privatization of the Patent and Trademark Office. And the
National Aeronautics and Space Administration recently signed a $7
billion contract with a joint venture between two leading aerospace
companies to run the space shuttle program. In principle, more might be
done. The Federal Government might contract out or privatize virtually
every one of its operations, from law enforcement to Medicare
administration, from the Census Bureau to the Army. Where, if at all,
should we draw the line?
It is worth noting that the U.S. economy is already in private hands
to a greater degree than the economies of most other industrial
countries. In many countries, services provided privately in the United
States--including telephone service, electric power, broadcasting,
health care, and air transportation--are nationalized. In the United
States, most goods and services except for the mail, the public schools,
local mass transit, intercity passenger rail, and some local utilities,
are already provided in the private sector. Moreover, in those sectors
where the public sector is the dominant service provider, as well as in
the rest of the government, many day-to-day operations such as food
service, transportation, and cleaning are supplied by private firms
under contract. Indeed, the increasing scope of privatization in the
rest of the world is a response to its demonstrated success in the U.S.
economy.
But contracting out has important limits in the public sector, just
as it does in the private economy. Firms exist because internal
production of goods and control of services are often less expensive
than going to the market every day to procure employees, equipment, and
supplies. Outside procurement, especially under long-term contract, is
especially problematic when assets and services are specialized to a
particular enterprise, leaving one party or both vulnerable to
opportunistic threats to breach the agreement. One way the government
can avoid the costs of using the market and its exposure to such
opportunism is to undertake specialized, long-term activities in-house
rather than to contract out for them. This, too, is consistent with the
Administration's policy to imitate effective private sector activities
in providing public services. Private firms, after all, organize
themselves the way they do in large measure to realize savings from
producing goods and services in-house rather than purchasing them from
others.
A second reason for limiting the scope of privatization of public
services stems from the fact that the justification of many of these
services is on other than economic grounds. Privatization works best
when the goals of an activity are well defined, performance at meeting
those goals can be accurately assessed, and the primary objective is to
ensure that they are met at least cost. These conditions are often met,
but in many cases it is hard to define goals explicitly or to monitor
private providers to ensure that the public's goals are being met. Many
times, service providers themselves have to judge how best to meet
publicly designated objectives. In those cases it may then be more
efficient to keep those service providers within the government.
Agencies could then hire personnel who already understand and share
their objectives. Where such a professional ethic is important to
achieve the public sector's goals, delegation to private, profit-
maximizing entities may be an inefficient way to promote the public
good.

CONCLUSION

Markets have undeniably significant advantages over the public
sector in processing and transmiting enormous quantities of information
about the costs and benefits of goods and services. They also allow
millions of individuals and businesses to act in such a way that they
directly reap the benefits and bear the costs of their actions. When
insufficient competition, incomplete markets, imperfect information, or
noneconomic goals complicate the picture, however, markets may not lead
to efficient or socially desirable outcomes. On the other hand, as both
academic research and practical experience point out, the public sector
is not always the perfect alternative when markets fail to meet
theoretical ideals.
Too much of the debate about the virtues and vices of government
involvement in the economy is predicated on an artificial dichotomy
between government and markets, usually understating the deficiencies of
one and overstating those of the other. With a careful, pragmatic
balance of the costs and benefits of public intervention in the economy,
however, we have seen that markets and governments need not be regarded
as substitutes, but as highly effective complements. The passage and
implementation of the Telecommunications Act of 1996, the promotion of
electric power competition through the FERC's Orders No. 888 and No.
889, the introduction of emissions trading and spectrum auctions, and
the reform of land management policies all exemplify this principle.
Public policy can help markets perform better, and market mechanisms can
help the government better serve the public while reducing burdens on
taxpayers and the economy as a whole.