[Economic Report of the President (2003)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]


 
CHAPTER 4

Regulation in a Dynamic Economy

Competition is essential to the vitality of the American economy.
Both government and the private sector play important parts in
creating markets that are competitive, and thus efficient and
equitable. The private sector is the primary source of competition
and innovation, whereas the government, often through its regulatory
activities, enforces property rights and contracts, the necessary
foundations for competitive private enterprise. In addition, the
government provides those goods and services that the private
sector cannot profitably produce, such as national defense, public
safety, a more healthful environment, and social programs to benefit
the underprivileged. Together government and the private sector can
work to produce a vibrant, dynamic economy that offers its people
the greatest possible opportunity to satisfy their wants and needs.
To realize these benefits, the government must work to foster
flexibility and dynamism in the economy by promoting sound monetary,
fiscal, tax, and regulatory policies.
This chapter focuses on the role of Federal regulation in fostering
or hindering economic dynamism. By its nature, regulation can be a
double-edged sword. Although some demands for regulation reflect a
desire to improve the efficiency of intrinsically imperfect markets,
other demands for regulation seek to change market outcomes, for
reasons that range from the compassionate to the opportunistic.
Well-designed regulation can provide society with improved market
outcomes and other benefits; poorly designed regulation stifles
economic efficiency and dynamism. Regardless of their underlying
motivation, many regulations are not well designed and impose both
short-run efficiency costs and long-run dynamic costs on the economy
that far exceed their benefits to individuals or society. This
Administration supports the development of Federal regulation based
on sound science, economics, and law--all important facets of a
viable regulatory policy.
The definition of regulation encompasses both any authoritative rule
dealing with details or procedure, and any rule or order issued by
an executive authority or regulatory agency of a government and
having the force of law. Regulation can thus be promulgated by
government at all levels, or by the private sector, or by private
authorities working in conjunction with government agencies. This
chapter largely focuses on Federal regulation and the potential of
private sector regulatory efforts, but the principles discussed can
apply to regulation at all levels of government. Also important to
recognize is that regulatory efforts generally consume a large
amount of economic resources and that the demand for regulation has
been growing over time.
Two basic approaches to government regulation of economic activity
can be identified, each with very different implications for the
dynamics and efficiency of the economy: command-and-control
regulation, and performance- or incentive-based regulation.
Command-and-control regulation typically uses the coercive power
of the government to intervene in market activity by setting prices,
quantities, technological requirements, or barriers to market entry
or exit. Performance-based, market-oriented regulation, in contrast,
harnesses market forces to achieve the same social goals. Regulation
of this type includes taxes, subsidies, and cap-and-trade permit or
quota systems. Recent experience, notably in the area of
environmental regulation, has demonstrated that these market-based
methods of regulation, which regulate results and not processes,
achieve dynamic and static efficiencies that command-and-control
regulation does not. This Administration's regulatory policy
recognizes the importance of making regulation efficient by focusing
on the use of performance- and incentive-based approaches.
Regulatory review and regulatory reform, including reductions in
the amount and scope of regulation, provide a safety valve when
the costs and other burdens of regulation become excessive. Such a
safety valve is important because some regulations, even when first
introduced, may impose short-run and long-run costs that exceed
their economic and social benefits. Moreover, new scientific
knowledge, new technologies, other economic changes, demographic
changes, and changes in the social consensus can make even well-
formulated, flexible regulations obsolete. For example, society
should not abandon health and safety regulation that protects people
or the environment, but regulatory reform may achieve such protection
in ways that are more efficient. This greater efficiency may arise
from applying new science and technology, focusing on outcomes
rather than processes or technologies, or permitting regulated
parties greater flexibility to meet specific performance requirements
and providing market incentives for them to do so.
Recent changes from command-and-control to performance-based food
safety regulation by the Department of Agriculture illustrate this
potential. Until recently, meat and poultry processors were
required to adhere to strict regulations that prescribed in
detailed fashion how food safety objectives were to be achieved.
Inspectors relied heavily on human sight, smell, and touch to
determine the safety of raw meat and poultry products. Although
the traditional approach has not been totally displaced, the new
regulation has supplemented this inspection process with
scientific practices for identifying and reducing microbial
contamination. This new approach gives the industry a greater
incentive to take advantage of new technology and scientific
information to identify pathogens, and increased flexibility to
take appropriate measures to improve food safety.
Similarly, in some potentially competitive industries, government
controls on prices or profits effectively shield certain
government-favored companies from competition. Here reductions
in regulation can yield benefits for consumers, potential market
entrants, and the economy as a whole. Regulatory reform in the
airline, railroad, and trucking industries and the lifting of
geographical restrictions on bank expansion are all cases in
point. The resulting increase in competition in these industries
has caused prices to fall, innovation to increase, and resources
to be more efficiently allocated.
These issues are of particular importance now, a time of increased
demand for regulation to restore the Nation's sense of security
and economic well-being. The national effort to enhance homeland
security has resulted in the rapid development and implementation
of new regulations for a variety of industries and activities.
The expected payoff to enhanced homeland security is reductions in
the risk of future terrorist events and their consequences. The
response to the need for greater security in economic activity--
whether, for example, in the form of Federal air marshals on
commercial flights or in the form of backup computer systems--
raises the overall cost of transacting business. It is in the
Nation's economic interest to balance the benefits of new
regulations with their costs.
Regulatory review and regulatory reform offer mechanisms to reduce
these costs, particularly as more is learned about the effectiveness
and efficiency of various types of regulation. Unfortunately, some
of the most costly recent episodes of market instability, such as
the California energy crisis of 2000-01 and the crisis in the
savings and loan industry in the 1980s, have been associated with
poorly designed efforts at reduced regulation. The consequent
fear of further instability generates resistance to regulatory
reform, even when it holds the promise of significant economic
benefit.
This chapter continues with a discussion of what causes demand for
regulation and how such demand can lead to regulations that may or
may not be economically beneficial. The chapter then considers
several principles that produce smarter regulation and illustrates
those principles with a number of recent case studies. Of course,
no matter how beneficial a regulation is when first introduced,
some regulations may outlive their usefulness. Thus the discussion
also addresses issues of regulatory reform. Because reform can be
a complex process, the discussion specifically focuses on some of
the potential pitfalls of regulatory reform. The chapter concludes
by showcasing how the Administration's regulatory policies regarding
the environment embody the principles of sound regulation.

The Demand for Regulation

As already mentioned, some regulations arise from the recognition of
market imperfections that hinder economic efficiency or harm public
health or safety. Other regulations stem from the desire of
individuals, interest groups, or society at large to modify market
outcomes because of dissatisfaction with the distributions of
production, income, and wealth that can result even when markets
function well. Unfortunately, these sources of demand for
regulation can come into conflict.
Regulation to correct market imperfections and market failures can
enhance the productivity of an economy and the wealth and
satisfaction of its people. This motivation also addresses the
lack of markets for certain important goods, such as environmental
quality. In contrast, the second motivation, whether the result
of altruism or economic ``rent seeking,'' inherently involves a
net economic cost. This cost arises because resources will be
allocated to or captured in less productive uses than would have
been the case absent the regulation. It is often difficult to
distinguish between these motivations, because the effects of
a given regulatory proposal usually have aspects of both.
Market-improving regulations do create winners and losers, and
although the winners should be able to compensate the losers,
in practice this is rarely required. Similarly, regulations
whose effects are primarily redistributive may often have
aspects consistent with the public good.
Distinguishing between these two types of demand for regulation is
an important function of economic analysis and a motivation for
requiring such analysis of major Federal regulations. However,
even regulations that primarily seek to enhance economic
efficiency and whose benefits exceed the associated costs in a
static world can unduly harm economic dynamism in the real world
and may have unforeseen consequences. This happens because
unintended consequences may at times prove important, and in the
long run regulation may lead to an inferior, less efficient outcome.


Regulation to Address Market Imperfections

Imperfections in the market cause resources to be misallocated or
allocated inefficiently. Unless these imperfect markets are
regulated or overseen in some manner, the result can be the
inefficient use of resources, waste, and lost economic value.
Generally, this occurs for any of four primary reasons. First,
external costs and benefits (often called spillovers) may not be
taken into consideration when private production or consumption
decisions are made. Second, the private sector may either
underproduce or fail to produce public goods. Third, firms or
consumers may lack information required to allocate their resources
efficiently. Fourth, if existing firms have market power, they
may underproduce and overprice their goods.


Ensuring Public Health and Safety

Public health and safety issues can arise because of economic
spillover effects. (Spillover effects, or externalities, occur when
one person's actions unintentionally affect another person for good
or ill, and no compensation is made to the person providing the
good or suffering the ill.) Depending, among other things, on who
holds the relevant legal rights, on the costs of enforcing those
rights, or on the costs of negotiating other arrangements, producers
or consumers may have little or no incentive to consider the costs
borne by, or benefits enjoyed by, other people as a result of their
actions. Markets provide an incentive for producers to maximize the
profits they earn and to minimize the costs they must bear directly,
but not to consider the profits or costs of others. In the absence
of regulation, for example, profit-maximizing producers may choose
cheaper, more polluting production processes, dispose of hazardous
waste with less care for health and environmental consequences, or
take greater risks of inadvertently harming the environment than
is socially optimal. Although private negotiations may lead to
full consideration of these external costs when few parties are
involved, this approach quickly becomes unworkable as the number
of parties increases. Thus, without government or private regulation,
public health and safety may not be adequately protected.
Specific examples of spillover effects on health and safety and of
the associated regulatory responses abound. For example, in the
past, chlorofluorocarbons (CFCs) were used as propellants in aerosol
cans and as coolants in air conditioners. CFCs have been identified
as a major cause of atmospheric ozone depletion, which in turn is
associated with adverse human health and environmental outcomes.
These outcomes are external to private decisions to use CFCs as
coolants or propellants. Ultimately, the Environmental Protection
Agency (EPA) banned certain specific uses of CFCs as propellants in
1978, and an agreement in early 1990, the Montreal Protocol, banned
their use internationally.
The choices of consumers, too, can produce spillover effects that
influence health and safety. Cigarette smokers may not fully take
into account the displeasure of or the health risks to others who
breathe their secondhand smoke. Drivers of automobiles that emit
pollutants such as hydrocarbons and nitrogen oxides may choose not
to curtail their use on days when tropo-spheric ozone is above
healthful levels, especially if the unhealthful air is blown to
another area. In such cases a role may exist for public policy or
private collective action to improve or protect the public welfare.


Ensuring Economic Efficiency

Spillover effects are not limited to costs, such as the damage to
public health and safety in the examples just given. At other times,
markets may not suffice to allow producers to capture the spillover
benefits of their activities. For example, when an attractive real
estate development increases surrounding property values, or a
successful tourist attraction lures customers to nearby businesses,
other property owners and these businesses may benefit without
having to compensate their benefactor. It is easy to imagine
circumstances that can lead to the underproduction of goods or
services that provide these external benefits.
Private producers may also underproduce or fail to produce public
goods. These are defined as goods that are both nonrival in
consumption and nonexcludable. Goods that are nonrival in
consumption are those that can be enjoyed by many people without
reducing their availability to others. A simple example is a
piece of music: once written, a song or a symphony can be performed
and enjoyed over and over without ever being exhausted. For a
nonrival good to be a public good, however, it must also be
nonexcludable; that is, its use cannot be limited to only those
who pay for it. Examples of nonrival, nonexcludable public goods
include national defense, police protection, public health, a
clean environment, wilderness preservation, and public parks.
Public goods merit the name because although they are desirable to
produce, their nonexcludability makes it unprofitable for private
businesses to produce them, or at least to produce them in
sufficient quantity to maximize economic efficiency.
``Free riders'' can enjoy these goods without having to pay.
Similarly, nonrival goods tend to be underproduced because,
individually, consumers may be unwilling to pay a sufficiently
high price to warrant their production even though, collectively,
their willingness to pay exceeds the cost of their production.
This poses the immediate question of who, then, will provide
public goods. In certain cases it makes sense for the Federal
Government to step in and provide the good or service at an
efficient level, because private provision will be insufficient.
Information is also essential to the efficient allocation of
resources. Consumers and producers must have sufficient knowledge
of the characteristics and quality of products, their prices, and
other information to make good economic decisions. The absence of
sufficient information can dampen market activity because of
distrust between potential buyers and sellers. Alternatively,
too many transactions may occur if buyers are too trusting and
make purchases they would have avoided given full information.
In either case the result is a misallocation of resources and
lower economic well-being. Markets as diverse as those for used
cars and financial services are subject to informational
imperfections, and regulation has often stepped in to address
these imperfections. For example, the Food and Drug Administration
requires nutrition content labels on many foods so that potential
consumers have the information they need to protect their health.
The exercise of market power is a fourth reason why market outcomes
may be less than optimal. Market power arises when there are too
few producers in a market to ensure adequate competition and
significant barriers to entry exist. Firms with market power may
choose to underproduce, overprice, or limit consumer choices in
terms of quality and service. The exercise of market power hurts
consumers while allowing firms to use resources inefficiently or
to make extraordinary profits. These issues are the subject of
antitrust policy and regulation, which last year's Report
discussed in detail.


Regulation to Address Specific Interests

A second set of demands for regulation arises from the desire of
individuals, interest groups, or society at large to modify the
distributions of output, income, and wealth that markets produce,
whether or not those markets function well. In contrast to the
first set of demands for regulation, which focus on improving
economic efficiency, this set focuses directly on distributional
issues. For moral or altruistic reasons, members of society might
conclude that the distributions determined by the market are not
entirely fair. Market economies are efficient at producing wealth,
but they distribute income in a way that creates a gap between
the well off and the poor. For example, those with rare skills that
are highly sought after will, by the laws of supply and demand,
receive high incomes, while those with more common skills that
are not widely demanded will receive lower incomes.
Through its democratic processes, American society has often
demanded regulatory actions that alter these distributions of
income and wealth. Many of these actions seek to expand the
availability of education, training opportunities, medical care,
welfare, nutrition, housing, or other goods and services,
especially for lower and middle-income individuals. An example is
regulation under the Americans with Disabilities Act, which
requires that persons with disabilities be accommodated in public,
work, and educational facilities. Another example is the requirement
of equality in support for men's and women's athletics under Title
IX of the Education Amendments of 1972, which prohibits
discrimination based on sex in education programs or activities
that receive Federal financial support. Unfortunately, fulfilling
these demands often entails a tradeoff between maximizing production
and achieving a more equal distribution of that production.
Accepting something less than the maximum possible output may be
economically desirable if members of society care about each
other's well-being.
Sometimes, however, the desire to circumvent market outcomes has
motivations that are far from altruistic. ``Rent seeking'' is the
process by which interest groups spend resources to influence
legislative and regulatory processes to receive favorable treatment
for themselves. This, of course, is a normal and legitimate exercise
of political rights in a democratic society. However, the results
have economic consequences that are important to understand.
Regulation can foster industry interests in many ways. Many
regulations set prices, allocate marketing quotas, or control the
entry and exit of firms in an industry. Such regulations bestow
market power on firms in the target industry, raising their profits
much as in a private cartel, but with the advantage of government
sanctions and enforcement. For example, for years the New York
State Department of Agriculture and Markets, which issues licenses
to sell milk in New York, blocked the entry of out-of-state
producers into New York City's milk market, thus allowing New York
milk producers to control the milk supply to the whole city. As a
result, New Yorkers paid more for their milk than did consumers in
adjacent areas. For example, when milk was imported from New Jersey
to Staten Island, declines in the price of milk were experienced
as expected. In 1987 a Federal district court ended the regime by
ruling that the denial of licenses amounted to economic protectionism
and was unconstitutional.
Rent seeking can also result in product quality standards that
restrict supply or promote the interests of a dominant, established,
or technically advanced firm at the expense of new entrants or firms
with less advanced capabilities. For example, a dominant airline
promoted the use of uniform size templates for carry-on luggage at
airport security checkpoints. Because at least one competing airline
had invested in larger overhead cargo bins to attract customers,
the dominant airline may have viewed the uniform, restrictive
templates as a means of negating this competitive threat.


Principles of Regulation

Although the two basic motivations for regulating described above
may be inherently at odds, during periods of political and market
volatility both types of demand for regulation increase. For
example, since September 2001, the terrorist attacks of that month,
the ongoing threat of further terrorism, and the war on terrorism
as well as turmoil in financial and energy markets have eroded
Americans' sense of security and well-being. As a result, the
Federal Government has received myriad proposals for new
regulations or regulatory authorities, and it has generated many
proposals of its own. Areas of proposed regulation related to
homeland security include animal and plant health, trade and
immigration, airport security, airline security, port security,
chemical facility security, nuclear security, cybersecurity,
the maintenance of backup facilities for critical components of
the financial system, terrorism risk insurance, airline war risk
insurance, and money laundering, among others. Recent corporate
misbehavior and the resulting volatility in financial markets
and certain energy markets have also led to a host of new
regulatory proposals on issues connected to corporate governance
and accounting (see Chapter 2 of this Report), trading of energy
derivatives, safeguards for workers' retirement savings, the
conduct of investment research by investment banking firms, and
various issues related to information disclosure and transparency
in financial markets, among others.
No matter how pure and public-spirited the motivations for these
proposals, each has the potential to impose considerable costs on
the economy. Especially during a period of accelerating demand for
regulation, understanding and applying basic principles of good
regulation will improve the chances of achieving laudable regulatory
goals without paying too dearly for the benefits. The following
questions can serve as guides when contemplating and designing
regulatory intervention to maximize public welfare:

 Can the market achieve the desired outcome without
regulation?
 Can private sector regulation achieve the desired outcome
instead of government regulation?
 Will government regulation impede or distort market dynamics?
 Is there a less restrictive alternative to the proposed
regulation?
 Are the costs justified by the prospective benefits, and
how are both distributed?

Imposing new regulation without careful consideration of each of
these questions risks inflicting an unnecessary burden on the
economy, slowing economic growth, and reducing the well-being of
Americans. The significance of each of these questions will next
be examined in turn.


Can the Market Achieve the Desired Outcome?

Markets are powerful institutions. They allow an economy to adapt
quickly to changes in technology, availability of resources,
consumer preferences, external threats, or other aspects of the
environment in a way that best meets the needs and desires of
consumers and producers. The American economy relies heavily on
private initiative, mediated through the marketplace, to respond
to change. Through the voluntary interactions of many buyers and
many sellers, markets create and reveal information about the
scarcity and value of goods and services and reward efficiency.
By promoting competition, markets induce producers to reveal the
cost of producing additional goods and services, and consumers to
reveal their willingness and ability to pay for those goods and
services. As consumers and producers respond to market prices,
resources are shifted among firms so as to meet consumer demands
at the lowest possible prices. By rewarding with profits those
firms that meet the desires of customers, and imposing losses
on those firms that do not, the market encourages and enables
the migration of resources to their most valuable uses.
When markets alone cannot achieve these societal goals,
performance-based, market-oriented regulation can be used to
harness some of the positive qualities of markets such as efficiency
and flexibility. Such an approach is desirable because the
contrasting characteristics of markets and government regulation
imply that society can achieve greater flexibility and productivity
with greater reliance on markets and less on government regulation.
In contrast to the voluntary interactions of markets, government
regulation relies on the potentially coercive authority of the
state to achieve desired ends. Since government regulation is
largely motivated by displeasure with market performance or outcomes,
it may ignore market information and may risk directing resources
away from their most productive uses. For the same reasons,
regulation may obstruct market signals and reduce flexibility in
the economy. Interference with market dynamics can reduce the rate
of technological innovation and the efficient allocation or
reallocation of resources across firms or industries. Ultimately,
such interference can reduce the rate of economic growth. (This line
of argument as it applies to developing countries is further explored
in Chapter 6 of this Report.)
Historical evidence on the conduct of commercial and investment
banking serves as an example of how markets can respond to challenges
that might otherwise be addressed by regulation. The Glass-Steagall
Act of 1933 separated commercial and investment banking in order to
avoid conflicts of interest. Researchers have shown, however, that
market participants react in ways that discourage such conflicts on
their own. Thus regulation under Glass-Steagall may have provided
little additional benefit while preventing banks from achieving
economies of scale and scope.
During the 1920s, commercial banks circumvented existing rules
segregating investment and commercial banking services by
establishing State-chartered affiliate banks that could underwrite
securities. The Glass-Steagall Act was passed in part as a response
to the potential conflicts of interest that arise when bankers have
superior information relative to both investors and depositors.
The primary danger is that when risky investment banking activities
are combined with commercial banking, bankers will be tempted to
use their superior information to take advantage of less well
informed investors or depositors. In the absence of deposit
insurance, depositors could be harmed if commercial banks, through
their investment banking affiliates, held risky or poorly performing
assets without appropriately increasing their equity capital to
protect depositors from losses. With deposit insurance, this
conflict of interest arises with respect to insurers. It is
generally mitigated through the imposition and enforcement of
minimum capital requirements, among other measures. Interestingly,
historical evidence indicates that banks in the 1920s actually held
higher capital-to-asset ratios before safety net regulations were
imposed. Recent international experience suggests that banks
substitute government deposit insurance or public capital for private
capital. Thus the safety net may induce bankers to exchange one
form of prudent behavior for another.
Researchers have also found that investors in that era penalized
the ``universal banks'' that offered both investment and commercial
banking services: the securities underwritten by universal banks
commanded lower prices and had to pay higher yields when investors
perceived a conflict of interest. To avoid being thus penalized in
the markets, universal banks tended to create distinct investment
banking affiliates, with their own capitalization and boards of
directors. Evidence shows that firms that organized investment
banking services as a department rather than as a separate affiliate
obtained lower prices for securities before Glass-Steagall's
enactment. Analysis of the quality of securities sold by integrated
banks shows that quality did not suffer from the joining of
investment and commercial banking services, and at the same time
banks benefited from economies of scale and scope through the use
of common resources, assets, and knowledge. Perhaps in recognition
of this evidence, the Congress passed the Financial Services
Modernization Act (also known as the Gramm-Leach-Bliley Act) in 1999,
which repealed many of the provisions of Glass-Steagall relating to
the separation of commercial and investment banking services.
Chapter 2 of this Report further examines the importance of market
forces in providing appropriate incentives for socially responsible
behavior by corporate managers.


Can Private Regulation Suffice?

A common misconception is that government is the only source of
regulation. In fact, trade associations and other private
organizations also administer regulation. Private regulation may
arise in response to the threat of government regulation or as a
spontaneous private solution to a market imperfection. For example,
private organizations are often effective at providing regulation
to overcome informational problems through standard setting,
certification, monitoring, brand approval, warranties, product
evaluations, and arbitration. They often act in cooperation
with government regulators, certifying or guaranteeing compliance
with government-set or government-sanctioned standards, or acting
as self-regulating organizations under the purview of a
government regulator. Such private regulations may be effective
because private regulators have their own independent,
reputational capital at risk and can enforce their regulations.
Just as markets and government regulators are imperfect, however,
so, too, are private regulators. And just as government regulators
may face conflicts of interest, so, too, may private regulators.
For example, one form of private regulation is the regulation of
professional ethics by professional associations, such as those
in the medical and legal professions. Members of such boards may
face a conflict between the interests of consumers and the income
potential of their fellow professionals. They may also be reluctant
to reveal professional misconduct for fear of reducing public
regard for their profession. Private regulators, like government
regulators, may also face incentives or pressure to provide
incumbent or dominant firms with competitive advantages or barriers
to competition.
Despite such imperfections, private regulation offers a variety of
benefits over government regulation in some circumstances. Because
private regulatory mechanisms cannot be backed up with the use of
coercive force, they tend to be more flexible and have lower
compliance costs. Private regulators are less able to dictate
command-and-control regulations, and therefore the regulated
businesses and individuals typically spend less time and other
resources complying. To be effective, private regulators need to
be open to suggestions from industry members, consumers and
consumer groups, universities and other scientific organizations,
and government agencies. As a result of these dynamic relationships,
private regulators have a market incentive to closely follow changes
and technological advances so as to preserve their expert status and
protect their reputation.
Private regulators face market pressures to control the burdens they
impose on businesses and consumers. These pressures can provide an
incentive to minimize their costs and facilitate flexibility. By
increasing their own cost-effectiveness, private regulators also
lower compliance costs for businesses if they operate in competitive
markets. In contrast, although many government regulatory agencies
also rely on fees for their services, their budgets are set in the
political arena and may rely on general government revenue. Private
regulators have an incentive to provide firms with well-formulated
guidelines and firm-specific recommendations, helping firms reduce
compliance costs while meeting necessary standards. Private
regulation may also require less paperwork, which significantly
reduces the time cost of regulation.
Although private regulators lack certain powers that governments
have, their regulation can nonetheless be effectively enforced
through legally enforceable contracts, sanctions (including revoking
approvals, assessing fines, and pulling products off the market), and
public announcements. Both private regulators and the companies that
use their services also put their reputations--often one of their
most valuable assets--on the line. Firms choose to comply with
voluntary private regulation because they perceive it as an
important marketing tool, and the associated compliance costs as
a necessary cost of doing business rather than as a burden.
One example of successful and longstanding private regulation
involves the establishment by the insurance industry of an
independent, not-for-profit organization to test and certify product
safety. This organization, founded in 1894, provides voluntary
certification for a variety of industries and products including
electrical appliances, automotive products, medical appliances,
alarm systems, and chemicals. In 2001 alone, 64,482 manufacturers
produced certified products, and 108,296 product evaluations were
conducted. Beyond testing and certification, this organization
takes an active role in developing industry standards. To protect
their reputation for quality, many retailers are reluctant to
purchase goods unless they have received the organization's
approval, even though Federal law does not mandate certification.
Furthermore, the market for safety certification and testing is
competitive, with at least 11 other private organizations
providing similar services. In a competitive market, all of
these organizations face incentives to minimize the cost of their
services. Similar organizations exist to certify the environmental
soundness of products and services, showing that they meet
established standards for reducing pollution and waste, conserving
resources and habitats, and minimizing global warming and ozone
depletion.
These examples illustrate how independent private regulators can
provide a market-based solution to a market failure, namely,
imperfect information. In all these cases consumers cannot on
their own readily verify production processes or quality
characteristics that are important to them. Imperfect information
is also important in financial markets, and there, too, the answer
has often been third-party verification. For example, several
firms specialize in providing risk ratings for firms seeking to
issue stocks and bonds or enter into customized derivatives
contracts. This service helps firms market their securities at more
attractive prices, because third-party certification from the credit
rating agencies enhances the transparency of the risks associated
with these securities and the credibility of those offering them.
Some of the benefits of private regulation can most efficiently be
captured when private regulatory activity operates under government
sanction. The United States has a number of self-regulating financial
organizations, including stock exchanges and futures markets. These
organizations operate as private entities that establish rules,
policies, and standards of conduct for their members and member
organizations. However, these regulatory activities are overseen
and approved by a government agency: the Securities and Exchange
Commission in the case of stock markets, the Commodity Futures
Trading Commission in the case of futures markets. Government
regulators may also choose to work in cooperation with private,
third-party certifiers. For example, the Department of Agriculture
recently completed the implementation of regulations governing the
production and labeling of foods as organic. These new standards
rely primarily on independent, private sector firms to certify that
producers of foods claiming to be organic meet the government-set
standards. The market incentives faced by both the producing firms
and the certifying firms should help reduce the cost of meeting and
enforcing these standards from what it would be under pure government
enforcement.
Private regulation or government-sanctioned self-regulation may also
be an option for some aspects of homeland security. The chemical
industry faces the risk of terrorist attack due to the potential to
turn common, useful chemicals into weapons of mass destruction. About
15,000 facilities in the United States handle large quantities of
dangerous chemicals already regulated under the EPA's Risk Management
Program (RMP). These are chemicals that, if released, would pose a
significant threat to public health and safety.
Both private and public regulatory approaches could be used to
improve chemical site security. As an example of the former, one
industry trade association imposed regulation on its members, requiring
them to assess and reduce their vulnerability to terrorist attack.
However, only about 1,500 facilities, or 10 percent of those
handling chemicals covered under the RMP, are owned by members of
this association. At least two public sector approaches have been
suggested to extend this regulation more broadly. A command-and-
control approach would require certain designated actions or
technologies to reduce the threat. This approach focuses on reducing
the use and storage of chemicals, changing methods and processes,
employing safer technology, and generally improving security, all
of which might reduce the threat but fail to consider marginal (that
is, incremental) risks or costs. An alternative approach is a
market-based mechanism, in which a chemical facility would be
required to obtain insurance coverage against liability arising
from an unanticipated release of chemicals, subject to review by
the appropriate government agency. The level of required coverage
would depend on an assessment of the facility's vulnerability and
the hazard to security, undertaken by the facility itself or its
agent, which would include an estimate of the probable range of
losses resulting from a terrorist attack. This insurance-based
approach to chemical facility security would rely on market
flexibility to attain the socially desired level of security at the
least cost.
This market-based approach has several advantages over
government-mandated standards. First, insurance prices that are
adjusted for risk can provide incentives for the owners and operators
of chemical facilities to invest in safety and security measures to
the extent this is socially optimal. In contrast, government-mandated
standards may over- or underspecify investments relative to that
optimum. Second, reliance on the insurance market rather than the
government to provide regulation gives owners and operators the
flexibility to implement the most efficient and cost-effective
precautionary measures given their facility's existing technology
and situation. Third, under a government-mandated standards regime,
chemical facility operators would likely slow or halt the deployment
of new security measures until any uncertainty about security
requirements was resolved. In contrast, an insurance-based
mechanism, with its inherent flexibility, can build on existing
security measures, encouraging quicker deployment. However, the
insurance-based approach will work only if private insurers are
willing and able to provide coverage at an affordable price and if
the insurance industry itself is sufficiently competitive. If
these conditions are not met, the appropriate government agency
could promulgate regulations mandating compliance with certain
safety standards but waive those standards for facilities that
obtain a sufficient level of insurance.


Will Government Regulation Impede or Distort Market Dynamics?

Regulating economic behavior in a dynamic economy, especially
through traditional command-and-control regulation, is a laborious
undertaking, with the potential for unintended and unwanted results.
Government regulation can lead to the expenditure of effort and
resources inconsistent with the initial regulatory intent. This
happens because regulation does not suspend or eliminate market
forces but rather suppresses or redirects them. When government
promulgates and enforces regulations, it alters the incentives of
economic decisionmakers (consumers, managers, and investors) by
changing costs, prices, information, or risks. Decisionmakers
respond by changing their behavior, often in ways that are unintended
or even contrary to the aims of the regulation. If regulation is
static in design, failing to anticipate these reactions, the ratio
of intended to unintended consequences tends to diminish over time,
which in turn may increase the demand for regulatory reform. Dynamic
regulation, in contrast, seeks to anticipate the reactions of
consumers and firms to regulatory changes, to ensure that the
regulation achieves the intended results.
Firms may respond to the regulatory constraints imposed on them by
increasing or decreasing production, entering or exiting industries,
changing lines of business, or developing new technologies. Consumers
may look to unregulated sources to obtain products or services that
regulation has made more expensive or rendered unavailable. Investors
may shift capital from regulated to unregulated industries or among
research and development projects to technologies that are more likely
to be profitable under the regulatory regime. For example, when
airfares were regulated and airlines competed on the quality of their
service, the airlines demanded that manufacturers develop faster,
longer range aircraft. After regulatory reform led airlines to adopt
the hub-and-spoke system, allowing them to serve many locations at
less cost, they largely switched their new purchases to shorter
haul aircraft.
Performance-based regulation, too, can impede or distort market
dynamics. For example, corporate average fuel efficiency (CAFE)
standards distinguish between cars and light trucks, imposing
less strict standards on the latter. This provided automobile
manufacturers with an incentive to shift production away from
cars to light trucks, to meet consumer preferences for larger
vehicles as real fuel prices dropped. This regulation has also
affected the relative profitability of production locations for
vehicles sold in the United States.
CAFE standards were established under the Energy Policy and
Conservation Act of 1975 in an effort to reduce oil consumption
after the 1973 Arab oil embargo. At the time, high gasoline prices
and long lines at the pump induced a shift in consumer demand to
more efficient vehicles. The least expensive way to attain better
fuel economy was to downsize passenger cars, but this downsizing
had two safety-related consequences: the smaller vehicles were
less stable when a driver lost control, and they offered less
protection in a collision. The result was an increase in traffic
fatalities. Because light trucks were used mostly as commercial
and agricultural work vehicles and made up a relatively small
part of the market, lower fuel economy standards were instituted
for them than for passenger cars.
The effects of the 1970s oil crisis dissipated when gasoline prices
declined in the 1980s, and American consumers again demanded larger
vehicles. Because the CAFE standard was substantially lower for
light trucks than for passenger cars, manufacturers designed their
new larger vehicles as minivans and sport utility vehicles (SUVs)
to qualify as light trucks rather than passenger cars. Consumer
acceptance of these vehicles has sharply increased U.S. sales of
light trucks (including minivans and SUVs), raising their share of
the vehicle fleet from approximately 20 percent in 1976 to 28
percent in 1985 and nearly 50 percent in 2001 (Chart 4-1).  When
the CAFE standards are binding, manufacturers must sell smaller,
more fuel-efficient vehicles for less but can sell larger, less
fuel-efficient vehicles for more than they would in the absence of
these standards. The shift in vehicle production from passenger
cars to light trucks has thus offset the intended effect of the
regulation.
Another market-distorting characteristic of the CAFE standards is the
``two-fleet rule,'' which applies to passenger cars but not light
trucks. Under this provision, automobile production is divided into
two fleets: vehicles made in North America and those made elsewhere.
This encourages the manufacture of small cars in North America, to
bring the domestic fleet's average fuel economy up to the CAFE
standard, but encourages the manufacture of large vehicles abroad,
because overseas manufacturers tend to produce more fuel efficient
fleets than CAFE requires. Thus foreign manufacturers can produce
higher profit, less fuel efficient cars without facing CAFE
penalties. Moreover, there is some evidence that because CAFE
standards induce manufacturers to raise the price of less fuel
efficient vehicles and lower the price of more fuel efficient
vehicles, they tend to shift market shares toward imports at the
expense of domestic automakers.
Alternative, market-oriented solutions are available to boost fuel
economy while reducing market distortions and regulatory burdens.
One option would be to allow manufacturers to trade fuel economy
credits. Such a policy would allow manufacturers to concentrate
production in their area of comparative advantage, whether it be
small, fuel-efficient vehicles or large, less fuel efficient ones.
Trading CAFE credits would also equalize the cost of attaining the
standards across manufacturers, a precondition for economic
efficiency. Thus, if combined with an overall cap on credits, this
approach would reduce the total cost of attaining any particular
level of fuel economy that policymakers choose to target. Other
options would focus on policies that more directly address fuel
consumption rather than vehicle design, because the key to reducing
fuel consumption efficiently is to focus on the desired outcome
rather than specific technologies or processes.


Is There a Less Restrictive Alternative?

When public regulation is necessary, government agencies should
respond to the demand by promulgating regulations that are both
statically and dynamically efficient. Measures aimed at static
efficiency are those that are the most cost-effective that can be
taken today to address the problem at hand. Dynamically efficient
regulation, in contrast, gives firms an incentive in the long run
to innovate and discover technologies that lower costs and avoid
negative spillover effects in the future.
Command-and-control regulation relies on dictating prices or
quantities, restrictions on technologies or processes, or who may
enter or exit a market. Agriculture in the United States, for
example, has long been characterized by




price and quantity restrictions. Government programs effectively
guarantee minimum prices to growers of major crops such as cotton,
rice, wheat, corn, and soybeans. Sugar and tobacco are marketed
subject to government quotas, and many fruits and vegetables are
subject to marketing orders that limit the quantity and quality that
may be offered for sale. Entry and exit restrictions often apply
to government-regulated monopolies such as cable, telephone,
electricity, and transportation services. Many early environmental
regulations, including the landmark clean water and clean air
legislation of the 1970s, include provisions that require polluters
to adopt certain pollution-reducing technologies. For example, the
Clean Water Act effectively requires pollution sources to adopt the
``best practicable technology,'' and the Clean Air Act Amendments of
1977 require such sources to adopt the ``best available control
technology'' in certain regions of the country.
Performance-based regulations, in contrast, stipulate a performance
goal but allow firms flexibility in determining how best to meet that
goal. Vehicle emissions standards are one example. An advantage of
this kind of regulation is that it uses market forces to encourage
firms to find low-cost solutions to meet a given standard.
Market-based approaches, which include tradable permit systems,
emissions taxes, and compliance subsidies, are similar to
performance-based approaches but are even more efficient. The gain
in efficiency arises from the equalization of marginal compliance
costs across firms. If the regulatory goal is to reduce pollution,
for example, the polluter is afforded the flexibility to discover
the most efficient techniques to decrease its emission levels.
Simultaneously, the market ensures that innovation and creativity
are rewarded.
Command-and-control regulations, such as technology standards, may
induce polluters to lower their emissions and in some cases may
involve lower enforcement costs for the regulator, but they fail to
provide the long-term dynamic incentive that induces innovative
behavior. Indeed, command-and-control regulation often does not even
meet the criterion of static efficiency--achieving the regulatory
goal at lowest cost given current technology--because it may fail
to provide the greatest benefits per dollar spent on solving problems
today. This point is highlighted in Chart 4-2, which compares costs
under a command-and-control regime with those under a least-cost
program, such as a market-based mechanism, across studies of a
variety of regulatory initiatives. For example, one study of
sulfur dioxide abatement found that command-and-control regulation
imposed costs that were approximately 1.8 times what they would
have been under an efficiently designed market-based mechanism;
another sulfur dioxide study found that those costs were 4.3 times
higher. Other comparisons across a variety of antipollution programs
all paint a similar picture: much the same environmental improvement
could have been achieved with far fewer resources if market-based
policies had been adopted.



Command-and-control regulation typically provides few incentives for
producers or consumers to search for more cost-effective ways to
reduce pollution in the future. This happens because regulators
have directed attention to the wrong target. Rather than focusing
efforts on developing cheaper ways to use mandated technologies,
as command-and-control regulations typically do, regulators should
target the real problem: finding or developing  the most
cost-effective way to reduce emissions.
This fact is highlighted when one considers the incentives created
under the 1977 and 1990 Clean Air Act Amendments. Before 1990,
electric utilities faced command-and-control regulation centered on
the adoption of certain specified pollution control technologies.
Although the 1970 Clean Air Act had already established national
ambient air quality standards for a number of pollutants, including
sulfur dioxide, it was the 1977 Clean Air Act Amendments that
clarified national standards for sulfur dioxide and added a
specific technology requirement for electric utilities. The
amendments required that most new coal-burning plants use flue
gas desulfurization units, or ``scrubbers,'' to achieve the required
maximum emissions rates. To achieve the air quality standards, plants
were required to demonstrate the use of ``best available control
technology'' for each pollutant emitted, including sulfur dioxide.
Because the legislation mandated the specific means by which the
utilities were to control their pollution, it created no incentive
for them to innovate to increase the ability of the scrubbers to
reduce pollution. Rather, the utilities faced only an incentive
to develop methods to lower the operating costs of scrubbers, to
reduce the costs of complying with the regulation.
The 1990 Clean Air Act Amendments, by enacting a market-based trading
regime, radically shifted the utilities' approach to complying with
the emissions reductions mandate. Utilities were required to hold
permits for each ton of sulfur dioxide emitted. These permits were
made tradable: a plant that found itself unable to cover its total
emissions with the initial allocation of permits could purchase
permits from another plant that had more permits than it needed.
Plants were no longer required to install scrubbers; instead they
could choose the method of reducing emissions that they found to be
most cost-effective and thus were given an incentive to engage in
research and development that would reduce emissions further.
Indeed, research into patents granted before 1990 in the electric
utilities industry shows that innovation in that industry had no
effect on how much pollution the scrubbers were removing, but
instead sought to lower their operating cost. After the 1990 Clean
Air Act Amendments, innovations, again as measured by patents
granted, continued to lower operating costs but also increased the
removal efficiency of scrubbers. By using a market mechanism,
regulators were able to meet the goal of reduced emissions in a much
more efficient and environmentally conscious manner: the dynamic
market-based approach not only spurred environmentally friendly
innovation, but also encouraged firms to control emissions in a
more efficient and cost-effective way.
Creating a regulatory environment that enhances economic efficiency
is a difficult task. Just as markets are not always perfect, so,
too, government agencies are not inherently benevolent, omniscient,
or omnipotent (Box 4-1). Unlike market participants, who are
motivated primarily by the self-interested goal of maximizing their
profits, government regulators often are motivated by several,
sometimes conflicting, mandates. Regulators can also make mistakes.
They may make assumptions or estimates that result in unintended
consequences and increase the burden of regulation by imposing
inappropriate standards, penalties, production restrictions, or
prices. Further, the government may suffer from persistent problems
in retaining sufficient knowledge and staffing expertise in the
activity being regulated. Finally, individuals motivated by rent
seeking or economically inefficient social goals may unduly
influence regulatory decisions. All of these factors may lead
regulators to make decisions that impair economic efficiency.
The President's Management Agenda for fiscal year 2002 provides a
strategy for addressing inefficiencies in government and government
regulation. This strategy aims to refocus government activities in
ways that are citizen-centered, results-oriented, and market-based
and that actively promote

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Box 4-1.  The Government Is Not Perfect, Either
There are many ways in which markets may fail, or at least fall
short of the ``perfect'' market described in any elementary economics
textbook. A common result of such imperfections is that more or less
of a good or service is produced than is optimal from the perspective
of society as a whole. Nonetheless, when market failure is diagnosed,
it is important to avoid a reflexive leap to the conclusion that
the government can necessarily bring about a better outcome. Just
as the actual operation of a market may deviate from the idealized
model, so, too, government intervention may not always achieve the
ideal outcome envisaged by lawmakers or regulators.
Whenever markets are alleged to have failed, policymakers need to
consider the following question: Can the government bring about a
particular outcome more efficiently than the market? Actual government
regulators, unlike their omnipotent theoretical counterparts, face
an array of potential complications that may make the answer to that
question negative. The following are some examples:

 Inability to respond effectively to market dynamics. The
bureaucratic environment in which regulators typically operate may
impede their ability to act quickly in response to changing
technology or market conditions. The result can be a significant drag
on the economy.
 Imperfect information about particular industries.
Government regulators may lack the necessary information or foresight
to devise or implement effective regulation for an industry.
Regulation that is uninformed can result in unforeseen consequences.
 Lack of competitive pressure. Regulators and other
government officials do not face the same competitive pressures that
firm owners and managers and other private sector actors do. It is
precisely this competitive pressure that induces private firms to
innovate and enhance their productivity, and its absence may prevent
government regulation from being equally innovative and efficient.

Complications such as these may mean that even an imperfect market
might achieve a more efficient outcome than government regulation,
even if theory suggests that government intervention would improve on
the market outcome. Policymakers, therefore, should consider not only
market failure but also government failure, and should ask themselves
tough questions about the likely efficacy of government intervention
in the circumstances at hand.
---------------------------------------------------------------------



innovation. By mandating more strenuous review of government costs
and performance, the President's agenda seeks to balance the
imperfections of government activity against those of the market. As
part of this agenda, citizen-oriented government activities are
intended to limit rent seeking by bureaucrats and private
interests; results-oriented activities will be regularly reviewed
and their impacts on overall economic efficiency assessed, to allow
a better understanding of program costs and benefits; and
market-based activities will be used to reduce informational and
incentive discrepancies between the public and the private sectors,
to help improve the quality of information available to regulators
and the quality of their decisions.


Do the Benefits Justify the Costs, and How Are Both Distributed?

On the one hand, one reason that regulation sometimes has an adverse
impact on the general public may be that proponents of the regulation
focus on its benefits and disregard its costs. On the other hand,
proposed regulations whose benefits would justify the associated
costs may be blocked because opponents focus on the costs and
downplay the benefits. Whether or not a regulation is adopted may
depend on how hard interest groups work to influence the legislative
process and the regulatory agencies. As a result, some regulations
may be adopted that benefit a particular group to the detriment of
overall societal goals, whereas others that could be socially
justified are blocked because they would impose significant net
costs on particular groups. Appropriate regulation is based on the
balancing of marginal costs and marginal benefits to society in
general. When both costs and benefits are considered simultaneously,
regulations that are particularly beneficial or detrimental can more
easily be identified. In this process it is important to consider
the regulatory cost to the whole economy, not just the direct
budgetary cost to the government. Regulatory costs also include the
private sector's direct and indirect compliance costs as well as
incentive effects such as reductions in the incentive to innovate.
To improve information about the benefits and costs of major Federal
regulations (those with annual impacts in excess of $100 million),
the Administration is currently reviewing and revising its guidelines
on regulatory analysis (Box 4-2).
From an economic perspective, the standard rule of thumb to ensure
efficiency is that resources should be allocated across activities
in such a way that the marginal benefit is equal to the marginal
cost. For example, in the context of homeland security, it may be
the case that additional resources devoted to international
counterterrorism efforts would reduce the risk of terrorist attack
much more than would additional resources spent on border
enforcement. If so, resources should be shifted toward
counterterrorism up

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Box 4-2. Assessing the Economic Impact of Major Regulatory Initiatives
Federal regulatory agencies issue approximately 4,500 new rulemaking
notices each year. About 600 of these are projected to have effects
of such magnitude as to warrant review by the Office of Management
and Budget (OMB). Of those 600, between 50 and 100 each year meet
the necessary criteria to be designated ``economically significant,''
that is, creating annual benefits or costs worth more than $100
million. Every ``economically significant'' proposal must undergo a
formal analysis by the agency initiating the proposal of its
benefits and its costs. The OMB establishes guidelines for the
regulatory agencies on how to perform these economic analyses. In
an effort to promote their transparency and maximize the net benefits
to society, the OMB and the Council of Economic Advisers are
currently revising these guidelines.
Consistent with the principles of good regulation outlined in this
chapter, one proposed revision would have agencies complement their
benefit-cost analysis of proposed economically significant
regulations with a cost-effectiveness analysis. The two types of
analysis are conceptually very different: a cost-effectiveness
analysis identifies those options for achieving the regulation's
objectives that make the most effective use of the resources
available, but it does not require quantification in dollar terms
of the relevant costs and benefits. This exercise provides the
analyst with a transparent means of comparing regulatory outcomes
across an array of policy choices while maintaining scientific
rigor. Yet it is important to note that although all efficient
policies are cost-effective, not all cost-effective policies are
efficient. This fact highlights the advantages of properly
recognizing the total benefits and the total costs of promulgating
new regulations, reviewing existing ones, and developing
legislative proposals concerning regulation.
In this spirit, the guidelines highlight several state-of-the-art
techniques by which to estimate the benefits of a regulation, and
they outline appropriate methods for estimating its costs. On the
benefits side, the guidelines endorse the use of stated and
revealed behavior in actual markets as signaling economic values.
On the costs side, the guidelines urge that all of the costs
associated with the regulation--including monitoring and enforcement
costs, direct compliance expenditures, and other direct costs such
as legal and transactions costs, product substitution, and
discouraged investment--be recognized.
This major revision of the conduct of regulatory analysis is
consistent with the Administration's goal to establish a greater
focus on accomplishment by producing performance-based budgets.
Under this new approach, high-performing programs will be reinforced
and poorly performing activities reformed or terminated. This
paradigm change increases accountability and provides the necessary
structure to more completely integrate information about costs and
program performance in a single oversight process. This is a
necessary first step in shifting budgetary resources among programs
to ensure that the greatest possible benefits are achieved with the
available funds.
---------------------------------------------------------------------


to the point where the marginal impact on overall homeland security
is unaffected by further resource shifting--that is, when risk
mitigation per dollar is equalized across activities.
This kind of economic analysis of major regulations generates
information that can be used to distribute limited regulatory
resources to those areas where they will do the most good.
Because even socially efficient regulation creates winners and
losers, firms and other interest groups have an incentive to
spend considerable resources trying to capture the benefits of
regulation for themselves. Even when the benefits far exceed the
costs, regulation rarely affects all participants equally. For
example, regulation can create barriers to competition by raising
the cost of market entry, or by imposing fixed compliance costs,
which put smaller firms at a disadvantage relative to larger ones
that can spread those fixed costs over their larger revenue base.
Sometimes existing firms may successfully lobby for exemptions
from new rules.  For these reasons, the Regulatory Flexibility Act,
as amended by the Small Business Regulatory Enforcement Fairness
Act of 1996, specifically requires a separate analysis of the impact
of new regulation on small businesses. Such analyses can limit, or
at least shed light on, the rent-seeking activities of dominant
firms and other interest groups.
Recent experience with regulation governing the introduction of
generic pharmaceuticals illustrates these points. In this case,
manufacturers of brand-name pharmaceuticals took advantage of
government regulation to shelter their products from competition
from lower priced generic substitutes. The brand-name manufacturers
circumvented the spirit of the law, but not necessarily its letter,
by listing minor variations on their patents in order to extend
their protection from competition. Generic drugs represent a
cost-effective means of providing Americans low-cost access to
important medical technology. The market entrance of generic drugs,
typically priced far below their branded counterparts, logically
leads to their rapid substitution in place of name-brand drugs.
The Hatch-Waxman Amendments to the Federal Food, Drug, and Cosmetic
Act, enacted by the Congress in 1984, amounted to a major reform of
the approval process for generic drugs and has led to a large
increase in the number of such drugs available to consumers. This
profusion of generic drugs, whose use is also encouraged by health
insurers, has saved consumers vast sums of money.
However, it has recently come to light that certain provisions of
the Hatch-Waxman amendments are subject to potential abuse. Under
the amendments, a generic drug maker may seek permission from the
Food and Drug Administration to produce a generic equivalent of a
brand-name drug whose manufacturer claims patent protection. However,
the brand-name manufacturer is given the opportunity to obtain a
stay on the marketing of the competing generic, during which time
it can defend its patent in court. In recent years brand-name drug
manufacturers have increasingly adopted a strategy of listing new
patents--often for characteristics such as product packaging--following
a generic manufacturer's application to market an equivalent generic.
Such a move forces the generic manufacturer to resubmit its
application and effectively extends the government-enforced stay on
generic competition. The Administration has proposed a new rule
that seeks to counter this strategy and balance the need for
property rights protection and innovation against the need for
competition and greater access to lower cost generics. The new
rule does this in two ways. First, it would limit a brand-name
manufacturer's ability to forestall generic competition by limiting
the government-enforced stay on generic competition. Second, it
would tighten the patent listing process to ensure that only
appropriate patents are filed. The potential savings to consumers
from these changes are estimated at $3 billion annually.


The Demand for Regulatory Reform

The more regulation limits the choices of producers, consumers, or
investors, the greater is the possible harm to economic activity, and
the greater the demand for regulatory reform. Moreover, the impact
and efficacy of regulations can change over time. With time,
regulations are more likely to become constraining, or simply
irrelevant, because of changes in technology or in the products
and services available in the marketplace. Such changes are often
a prerequisite for successful regulatory reform, because they
weaken resistance to reform from those interest groups that benefit
from the status quo.
When government regulation controls prices, profits, or entry into
a potentially competitive industry, effectively shielding certain
incumbent firms from competition, regulatory reform can yield
benefits for consumers, potential market entrants, and the industry
as a whole. Reform of regulation in the airline, railroad, and
trucking industries and the lifting of geographical restrictions on
bank expansion are all cases in point. As a result of the competition
that followed regulatory reform of these industries, prices fell,
innovation increased, and resources were more efficiently
allocated. Gains may also be available from reform of government
regulations that address persistent market imperfections, for
example with regard to health, safety, or environmental quality.
In these cases, reforming regulation to more closely comply with
the principles of regulation outlined earlier in this chapter can
reduce the costs of meeting regulatory goals.
Like the demand for regulation itself, the demand for regulatory
reform arises for two distinct and conflicting reasons. Sometimes
such regulatory harm comes to light when producers or investors
perceive potential profit opportunities if the regulation is removed.
Some calls for reform arise from the recognition that a regulation
is imposing more costs than it is creating benefits, or providing
unfair advantages to some at the expense of others. For example, when
the restrictions on entry in the New York City dairy market,
discussed above, raised milk prices there, New Jersey dairies saw
the chance for profit if those restrictions could be jettisoned. The
courts agreed, finding that if the New Jersey dairies were allowed
to sell milk in New York City, the price of milk there would drop
to that in other nearby locales where ample competition existed.
In other cases, consumers themselves may discover that regulation
is preventing them from finding desired products and services. For
example, the regulatory requirement that certain prescription drugs
be supplied in child-resistant containers made opening the container
difficult for the elderly and the handicapped. Subsequently, the
Consumer Product Safety Commission launched an educational awareness
program to inform the public and pharmacists about appropriate
exemptions from and requirements of safety cap regulations.
Other calls for reform, however, may arise because a firm perceives
an opportunity to gain or take advantage of market power. This
demand for regulatory reform is a type of rent seeking, as the
firm is attempting to influence regulatory outcomes in order to
receive favorable treatment for itself.


Regulatory Review and Regulatory Reform

The President recently declared that, ``There comes a time when
every program must be judged either a success or a failure. Where we
find success, we should repeat it, share it, and make it the
standard. And, where we find failure, we must call it by its name.
Government action that fails in its purpose must be reformed or
ended.''
Regulation often has unintended consequences or causes changes in
economic behavior that make it less desirable or effective than
anticipated. This makes it important to revisit from time to time
the question of whether the results of a regulatory initiative solve
real problems that the American people care about. In this sense,
regulatory review represents an important backstop against policies
that are misguided, ineffective, or outdated.
This principle can be illustrated by a simple anecdote in which a
specific command-and-control regulation that appeared to offer a
straightforward solution to an apparently uncomplicated situation in
fact provoked a dynamic reaction that few if any had anticipated.
This story shows how, even in the seemingly most innocuous cases,
government regulatory failure can greatly complicate matters,
reducing consumer choice and economic efficiency.
In 1972, in an effort to reduce the incidence of burns among children,
the Federal Government implemented a regulation requiring newly
manufactured pajamas for small children to be made flame-resistant.
Amended in 1974 to include larger children's sleepwear, this
standard required that fabrics used for children's sleepwear
self-extinguish when exposed to a small open flame such as from
a cigarette lighter, candle, or match. Although the regulation
neither prescribed specific fabrics nor required flame-retardant
treatments, in order to comply, manufacturers either switched to
synthetic materials (mostly polyester) that were inherently
flame-resistant or treated fabrics such as cotton with
flame-retardant chemicals.
One such chemical, called TRIS, was widely used by industry as a
flame retardant to treat acetate, triacetate, and some polyester
garments. However, TRIS was subsequently found to be carcinogenic
and was therefore banned from use in cotton sleepwear. Polyester
then became the fabric of choice for manufacturers, since it did
not require the use of a flame-retardant chemical. Parents,
however, began to express a demand for natural fibers such as
cotton for their children's sleepwear. In response to this demand,
retailers began increasing their stocks of cotton and cotton-blend
long underwear sets that did not meet the Consumer Product Safety
Commission's flammability standard for children's sleepwear, in
some cases intermingling them with flame-resistant sleepwear on
children's sleepwear racks. Responding to this change in consumer
preferences, in 1996 the commission voted to exempt snug-fitting
sleepwear (and all infants' clothing up to size 9 months), after
concluding that snug-fitting pajamas exhibited a lesser propensity
to burn.
Once again, consumers responded to this restriction by altering
their choices. They continued to purchase children's long underwear
in large quantities, as well as traditional flame-resistant
polyester sleepwear that had improved in style and comfort. They did
not show a preference for snug-fitting pajamas, which tended to be
less comfortable, and comfort was likely the primary concern of
parents who preferred cotton sleepwear to synthetic garments in
the first place. Unit sales of children's underwear increased from
1993 to 1996 by about 22 percent (98 million pieces). According
to a well-known clothing trade publication, this gain in underwear
sales was attributable to underwear being used as sleepwear. Unit
sales of children's sleepwear (excluding underwear) increased over
the same period by about 28 percent (36 million pieces), reflecting
an increase in sales of traditional fire-resistant sleepwear
garments. In 2000 the Consumer Product Safety Commission launched
an educational program for parents by requiring manufacturers to
place hangtags and permanent labels on garments reminding parents
to choose either snug-fitting or flame-resistant sleepwear.
This example highlights how even well-intended regulations can have
a high cost and unexpected consequences. It also demonstrates that
market forces continue to function after regulation is imposed:
although the regulation sought to limit the options of producers
and consumers, consumers' preferences ultimately determined what
was actually manufactured and sold.


Effects of Reform on Prices

When reformed regulation opens an industry to new entrants and frees
prices to respond to market forces rather than regulatory fiat,
prices typically fall. Deregulation of the airline industry is a
prime example. Almost from its inception and through the late 1970s,
the airline industry was subject to strict Federal regulation. The
Civil Aeronautics Board (CAB), established by the Congress in 1938,
exercised nearly complete control over the industry, with authority
to establish maximum and minimum fares, control market entry and
exit, and govern airlines' route structures. By the mid-1970s,
however, pressure for reform of airline regulation was building,
motivated in part by research arguing that regulation suppressed
competition and resulted in welfare losses to society. The CAB
responded to this pressure in the late 1970s by reducing entry
restrictions and control over fares. Major cuts in fares soon
followed, accompanied by higher industry profits. These initial
positive results spurred the Congress to pass the Airline Deregulation
Act (ADA) in 1978. From 1977 to 1996, airfares fell approximately
40 percent in inflation-adjusted terms. According to a recent
estimate of the welfare gains from this regulatory reform, before
September 2001 consumers were saving about $14.8 billion (in 2000
dollars) annually in lower fares compared with what they would be
paying if the previous system were still in place. One may reasonably
assume that this downward pressure on prices resulted, at least in
part, from increased industry competition: as of late 2002, 32
domestic carriers flew scheduled service in the United States,
compared with only 15 in 1978.
Regulatory reforms in other industries have had a similarly salutary
effect on consumer prices. Until 1980 the Interstate Commerce
Commission (ICC) regulated shipping rates for railroads and
prevented railroads from abandoning unprofitable lines. After
partial regulatory reform in 1980, rates on rail freight fell
steadily: by 1999 real rates were roughly half their 1984 level.
Regulatory reform in the trucking industry, which took place
primarily between the late 1970s and the early 1980s, resulted in
similar rate declines. From the mid-1930s to the beginning of
reform in 1980, regulation had effectively controlled shipping
rates and given incumbent truckers veto power over the extension
of new or expanded authority to transport goods. This stifled
competition from potential entrants. Declines in shipping rates
by truck and rail, combined with improved flexibility and on-time
dependability, also made possible by regulatory reform, are
estimated to have saved U.S. industry between $38 billion and
$56 billion annually.


Effects of Reform on Innovation and Consumer Satisfaction

Another common effect of the competition fostered by regulatory
reform is increased innovation, resulting in greater variety and
higher quality for consumers. Before deregulation of the trucking
industry, both permitted routes and goods carried were narrowly
specified, creating costly inefficiencies. Reform allowed truckers
to offer on-time delivery and more flexible service, so that
manufacturers could order components to arrive ``just in time''
at the assembly line, and retailers could have the finished goods
``just in time'' to be sold. This streamlining resulted in greatly
reduced costs of holding and maintaining inventories.
The case of the airline industry is particularly revealing of the
potential for innovation unleashed by regulatory reform, and the
resulting benefits to consumers. Before reform, airlines competed
primarily by attempting to provide better service to customers,
since they were essentially prohibited from competing on the basis
of price. In the spirit of such nonprice competition, airlines
attempted to offer more flights while decreasing the number of
passengers on each flight and emphasizing the quality of food and
other in-flight services. Following reform, it was expected that
fares would fall but that service quality would decline as well,
in accord with consumer preferences. In reality, however, the
unanticipated development of an entirely new route structure--the
hub-and-spoke system--allowed airlines to increase flight
frequency, giving customers a wider variety of departure times from
which to choose. Under the regulated regime, with its restrictions
on entry of existing carriers into currently served markets, such
massive route restructuring would have been impossible. Research
has shown that consumers valued this innovation, an unexpected
benefit of unregulated competition, far more than enough to
compensate for other declines in service quality such as longer
average travel times. Research has also shown that the benefit to
consumers is about $10.3 billion each year from increases in
flight frequency, thanks to the hub-and-spoke system, in addition
to the billions in gains from lower fares.
The same competition that produced the efficiencies of the
hub-and-spoke system continues to inspire innovation and reshape
the structure of the airline industry in efficiency-enhancing ways.
Following the hub-and-spoke revolution, another wave of innovation
resulted in the emergence of carriers offering low-fare, no-frills,
point-to-point service as an alternative to the major airlines that
dominated the major hubs. This, too, was a direct response to
consumer preferences. More recently, the introduction of the
``regional jet,'' a new type of small jetliner, is again changing
the face of air travel. The low operating costs of regional jets
make it more economical to serve medium-length routes capable of
supporting only a modest number of passengers. This innovation opens
up the prospect of adding smaller cities, more frequent service to
the spokes of hubs, and possibly even a new market for point-to-point
service. Without the stimulus of competition associated with
regulatory reform in the airline industry, these efficiency-enhancing,
cost-saving innovations in air travel would likely not have been
conceived, much less brought to fruition.


Effects of Regulatory Reform on Resource Allocation

In general, regulation that stifles entry and competition presents
an attractive opportunity for reform to improve the efficiency of
resource allocation. A corollary, however, is that, in some
instances, reform can result in transitional losses to parties that
were protected under the regulatory scheme. For example, truckers
who had benefited from entry barriers that kept shipping rates
artificially high saw a 10 percent drop in their wages relative to
workers in the rest of the economy; before reform, however,
ICC-licensed truckers paid their workers about 50 percent more
than comparable workers in other industries. Another
efficiency-enhancing reallocation of resources can be seen in the
airline industry, where some carriers succumbed to competition
following reform but were replaced by new, more competitive
entrants. By 2001 the total market valuation of the major airlines
alone, adjusted for inflation, was more than double that of all
carriers in 1976, before regulatory reform.
The lifting of restrictions on the geographic expansion of banks
provides yet another example of the efficiency gains and economy-wide
benefits that result when regulatory reform induces a reallocation
of resources. These reforms involved both State and Federal
actions, including the passage of the Riegle-Neal Interstate Banking
and Branching Efficiency Act of 1994. Beginning in the 19th century
and continuing through much of the 1970s, States imposed geographic
restrictions on the ability of banks to open branches. Such
restrictions were motivated in part by a desire to protect bank
profitability, since taxes on banking activity were an important
source of revenue in some States, as well as by fears that
unfettered bank expansion would lead to a concentration of financial
power. The development of large corporations with interstate banking
needs ultimately created pressure for a less fragmented banking
system, but that need was not fully met until a major episode of
reform occurred at the State level, which began in 1978 and was
essentially complete by the end of 1992.
Although little evidence is available on the effects of the
Federal-level reforms, studies of State-level reforms indicate
impressive net benefits. Bank efficiency, and thus the efficiency
of economy-wide resource allocation, increased following the
introduction of statewide banking, as loan losses, noninterest
expenses, and loan rates all fell significantly. With these
improvements came more rapid growth of both personal income and
State government revenue in States that had embarked on branching
reform. These increases in bank efficiency reveal the implicit
cost of the old branching regulations and are attributable to a
number of factors. First, restrictions on branching and interstate
banking may have limited opportunities for the most efficient
banks to expand. When those restrictions were lifted, the weaker
banks lost some of the protection from competition they had enjoyed
and gave up market share to the stronger banks, improving efficiency
in the allocation of resources. Second, the lifting of geographic
restrictions may have increased pressure on managers concerned
about takeovers, resulting in increased managerial discipline;
evidence of this is a higher turnover rate for banks' chief
executive officers and a tighter relationship between pay and
performance. This increased discipline may also have improved
banks' performance. Finally, the geographic restrictions had
limited banks' ability to expand to their most efficient size;
removing these restrictions thus allowed small banks to grow and
to take advantage of economies of scale by reducing their average
costs and increasing their opportunities to diversify the risks
associated with lending.


Pitfalls of Regulatory Reform

The potential benefits from regulatory reform for firms, consumers,
and the broader economy are great. Yet reform holds several
potential pitfalls if not undertaken with considerable care. Efforts
to reform the regulation of thrifts in the 1980s and of electricity
markets in California in the 1990s led in both cases to costly
debacles, increasing public skepticism about reform. But
regulators, advocates of reform, and the general public can learn
much from these experiences, and applying those lessons will help
ensure the success of future efforts. Although reform in these
markets held great promise for efficiency gains, with corresponding
benefits to consumers, the precise form that reform took in these
instances illustrates the complexity of the issues with which
reform must typically contend. The two cases explored here
underline the dangers of partial or incomplete reform. They also
show the dangers of not considering potential deviations from
competitive conditions or the creation of perverse incentives.


Failure to Coordinate Reforms

California's recent attempt to deregulate its electricity markets
demonstrates the potentially expensive consequences of regulatory
reform that lifts restrictions in one part of an industry without
addressing restrictions elsewhere in the same industry. For most of
its history, the electricity industry in California was heavily
regulated and heavily concentrated: a few privately owned,
vertically integrated monopolies owned and operated electricity
generation, transmission, and distribution facilities throughout
most of the State. Under pressure from consumers, who paid some of
the highest electricity prices in the Nation, the California
legislature in 1996 passed a restructuring law. Among other things,
this law required the traditional monopolies to open their
transmission and distribution lines to competing generators and
wholesale marketers, and it encouraged utilities to divest their
existing generating capacity. Independent power producers were
allowed to apply for environmental and siting permits and to sell
power to eligible wholesale and retail customers. Retail customers
were permitted to choose between purchasing electricity directly
on the wholesale electricity market and continuing to pay regulated
rates to obtain the ``default'' service from their local utility
distribution company. Utilities serving retail customers were
required to obtain electricity at unregulated rates through newly
established wholesale market institutions and to charge customers
a regulated rate for that electricity.
The restructured wholesale and retail markets for electricity
functioned reasonably well as long as demand remained low or moderate
and generation remained high. Regulators did not sufficiently
anticipate, however, that the excess capacity that prevailed in the
industry before restructuring would dissipate as rapidly as it did.
Many interdependent factors, including an increase in electricity
demand, rising natural gas prices, rising prices for pollution
emissions permits, and other problems on the supply side, combined
to drive wholesale energy prices higher than regulators had
expected. This proved financially disastrous for the utilities,
because the fixed price at which they were compelled to sell
electricity to retail customers was now far below the wholesale
price at which they could purchase electricity. In December 2000
utilities were paying almost $400 a megawatt-hour for electricity
in the wholesale market and reselling it to retail customers at
$65 a megawatt-hour (Chart 4-3). Their burden was compounded by
the fact that regulators refused to allow the utilities to enter
into long-term forward contracts to hedge their short positions.
Ultimately, the failure to coordinate the reform of wholesale and
retail electricity markets in California proved a leading factor
in



the effective bankruptcy of California's two largest utilities
and the collapse of the wholesale markets, which precipitated an
expensive effort to guarantee continued electricity availability.


Deviation from Competitive Conditions

Other factors also contributed to the failure of California's
experiment in electricity deregulation. Although spot markets
worked reasonably well at low and moderate levels of demand relative
to supply, the fact that consumers were sheltered from price
fluctuations meant that, in situations where demand was high
relative to supply, even small producers had considerable market
power. Generators quickly found that, under these circumstances,
withholding electricity supply led to higher prices that increased
their profitability, further roiling markets. From November 2000
until May 2001, about 35 percent of total generating capacity was
not in service--roughly double the typical historical outage
rate. California government officials have argued that, in some
cases, plants were withdrawn from service for strategic reasons,
a claim that generators dispute. In any case, regulators had not
planned for this extreme situation and had not built adequate
flexibility into the regulatory structure to respond effectively.
Moreover, by keeping retail prices fixed, regulators short-circuited
the pricing mechanism and precluded the possibility that consumers
would respond to higher electricity prices by curtailing
consumption. Furthermore, by failing to address problems in the
licensing process for new power plants and by creating an atmosphere
of uncertainty over their potential profitability, regulators may
have diminished the ability and the incentives of market participants
to respond to high prices in the longer term by developing new
generating capacity.
To prevent widespread blackouts, the State of California itself
eventually had to enter into the sort of long-term contracts for
electricity production that regulators had previously prevented
utilities from entering. However, because these contracts were
signed in the spring of 2001 at the height of a spot market crisis,
California committed itself to purchase power at prices at least
three times those prevailing in futures markets by the end of that
summer. Had all of the factors complicating electricity deregulation
been carefully considered, had the possibility of deviations from
competitive conditions been entertained, or had lessons from
successful reform efforts in other jurisdictions been learned,
California might have avoided this costly experience.


Creating Perverse Incentives

In any regulatory reform, special care must be taken to ensure that
the proposed changes do not inadvertently foster incentives for
parties to engage in activities or take risks that are likely to
be harmful to the public good or counter to the purpose of the
reform. Another telling case of a reform that created perverse
incentives is that of the thrift industry, where regulatory reform
without appropriate safeguards resulted in imprudent risk taking at
the expense of the government.
Until the late 1970s, government regulation set limits on the
activities that savings and loan associations, or thrifts, could
undertake, essentially constraining them to taking in deposits and
making mortgage loans. Because the deposits they accepted were short
term and the mortgages they issued long term, the thrifts were exposed
to interest rate risk: a sharp increase in short-term interest rates
would increase their deposit interest costs while leaving their
interest income from mortgages substantially unaffected. In 1966
Regulation Q, which established an interest rate ceiling on bank
deposits, was extended to cover thrift deposits as well. This
regulation temporarily resolved the interest rate squeeze facing
the thrifts, but at the expense of depositors, for whom few
alternative instruments offered safety and liquidity comparable to
thrift or bank deposits. Other financial firms soon learned to
circumvent Regulation Q by creating money market mutual funds. With
this innovation, Regulation Q ceased to provide interest rate
protection to thrifts, which then began to run substantial losses
with the rising inflation and sharply higher interest rates of the
late 1970s and early 1980s. In response to the thrifts' pleas for
relief, the Congress passed legislation in 1980 and 1982 that
significantly expanded the thrifts' lending authority: federally
chartered thrifts were now permitted to make commercial real estate
loans, commercial loans, and consumer loans and to take direct
ownership positions in investment projects. The reform also allowed
thrifts to offer adjustable-rate mortgages and phased out interest
rate ceilings on deposits.
In industries throughout the economy, creditors protect their
interests by monitoring the management and financial health of the
firms they lend to. Owners and managers who enjoy limited liability
may face incentives to take excessive risks with the firm's assets
or to operate in other ways that conflict with the creditors'
interests. This danger is particularly acute when the firm is
running losses that put it in danger of imminent bankruptcy. In the
case of banks and thrifts, however, Federal deposit insurance
short-circuits this usual safeguard. Thus no mechanism existed to
induce potential depositors to avoid the riskier thrifts. A thrift's
principal creditors--its insured depositors--have little incentive
to monitor the institution's financial health or its risk taking,
because their deposits are insured by the Federal Government to a
maximum of $100,000 per account. Also, thrifts faced flat rates
for deposit insurance, instead of rates adjusted for the likelihood
of insolvency. Accordingly, no economic disincentive deterred thrift
managers from taking excessive risks.
The usual regulatory response to the absence of this normal,
market-based protection is ``safety and soundness'' regulation, in
which the government exercises the oversight role normally carried
out by a firm's creditors. The Achilles' heel of thrift reform was
precisely that it failed to accompany the thrifts' deregulation with
enhanced safety and soundness regulation. The effective bankruptcy
of the Federal Savings and Loan Insurance Corporation (FSLIC) in
the early 1980s constrained the regulatory response as the capital
positions of some thrifts eroded. In contrast to the airline
industry, where safety regulation was maintained as reform proceeded,
the necessary safety and soundness regulation of thrifts was
undermined. Minimum net worth requirements for thrifts were actually
lowered in both 1980 and 1982. Accounting rules were liberalized, so
that thrifts could avoid the consequences of failing to maintain
inadequate capital. Also, the number of field-force examiners
declined between 1981 and 1984, and the number of examinations per
thrift and per billion dollars of thrift assets fell significantly.
Moreover, the Congress raised the per-account limit on federally
insured deposits from $40,000 to the present $100,000, further
discouraging depositors from taking an active oversight role and
increasing the exposure of the Federal Government to the risky
behavior of thrift managers. These conditions enabled thinly
capitalized or insolvent thrifts to act on their incentive to
shift risk to the FSLIC, and ultimately the taxpayer, through
increases in asset risk and capital distributions to shareholders.
Regulatory reform of the thrift industry could have been just as
beneficial as that in other industries. The reforms provided thrifts
with new opportunities to improve their financial condition by
opening up new investment and loan markets to them and by increasing
their ability to attract new deposits. Without the check of
additional safety and soundness regulation, however, those thrifts
whose financial condition was deteriorating faced incentives, and
were given the means, to engage in excessive risk taking.
Ultimately, this combination contributed importantly to an
industry-wide crisis, which culminated in 1989 in a Federal
bailout whose ultimate cost to taxpayers was $124 billion.


Putting the Principles to Work

Of course, inventorying and showcasing sound regulatory principles is
not enough; good principles that are not acted upon represent
lost opportunities and frustrate effective public policymaking.
Whether the principles outlined in this chapter become a dead limb
on the tree of regulatory policy evolution or a vibrant branch
depends on whether policymakers act to put these ideas into practice.
This Administration has pursued the principles of sound regulatory
reform while recognizing that sound science drives good policy. It
is now undertaking a major revision of the guidelines for conducting
regulatory analysis that utilizes these principles to ensure a
greater focus on performance and efficiency. The new guidelines
emphasize transparency and increased accountability, which together
will provide the necessary structure for the sharing of information
across regulatory agencies. This will ensure that the funds available
for regulatory activity achieve the greatest possible benefits.
Examples from the environmental arena show that the Administration
is pursuing these principles in its regulatory initiatives. Efficient
policies are a hallmark of the President's strategy. The President's
Clear Skies Initiative to improve air quality in the United States
uses market-based regulation to tackle a pollution problem on which
a scientific consensus has emerged. Announced by the President on
February 14, 2002, Clear Skies will reduce emissions by power plants
of three noxious air pollutants by well over half--sulfur dioxide by
73 percent, nitrogen oxides by 67 percent, and mercury by 69
percent--over the next 16 years. The reductions will also occur in
a timely fashion, as illustrated in Chart 4-4, which compares the
near-term reductions under Clear Skies with those under the Clean
Air Act Amendments of 1990.
Clear Skies uses a dynamic approach to regulation that provides firms
with the flexibility to reduce emissions in the most efficient and
least costly manner possible. Through a market-based cap-and-trade
program, Federal emissions limits, or caps, are set for each
pollutant, and emissions permits are distributed



to electricity generators. The cap is to be reduced over time, first
in 2010 and again in 2018, and firms are required to respond by
reducing their emissions accordingly. The advantage of this
market-based approach lies in its ability to allow individual firms
to choose for themselves the most efficient methods to reduce
emissions. If they reduce emissions by more than the cap requires,
they can sell their unneeded permits on the open market or bank them
for later use; if their emissions exceed the cap, they can purchase
unused permits from other firms. Within this structure, firms can
design an efficient and cost-effective strategy tailored to both
their current budgets and their future plans. Further, this
approach creates an incentive for firms to innovate to find
economical techniques for reducing emissions. This dynamic
approach to regulation is in sharp contrast to previous methods
of command and control, which were characterized by uncertainty
over their enforcement.
The Clear Skies Initiative is modeled on the highly successful
acid rain reduction program under the Clean Air Act, which also
used a cap-and-trade system. This program accomplished dramatic
reductions in sulfur dioxide emissions at two-thirds the compliance
cost of a traditional emissions reduction program. It resulted in a
decrease in pollution greater than all other Clean Air Act programs
combined. Emissions were reduced more quickly than required: annual
sulfur dioxide emissions were cut in the first phase by 50 percent
below allowed levels. Just as remarkable, the program requires only
a handful of EPA employees to administer. By taking this successful
program as its model, the Clear Skies Initiative hopes to achieve
the same levels of efficient and cost-effective emissions reductions.
The Clear Skies Initiative is an example of a new, original program
that enjoys scientific consensus and adheres to the principles of
good regulation. The Administration has also aggressively pursued
reform of existing regulatory programs in the area of air pollution.
An example is the proposed changes to New Source Review (NSR).
Established as part of the 1977 Clean Air Act Amendments, NSR is
intended to protect public health and welfare as new sources of air
pollution are built and when existing sources are modified in a
way that significantly increases air pollutant emissions.
When the Congress established NSR, its intent was to maintain and
improve air quality while providing for economic growth. Through
the issuance of mandatory permits, regulators oversaw the construction
and modification of plants by establishing various actions that the
sources had to undertake to control emissions. Although this appeared
at the time to be a viable approach to emissions regulation, over
time NSR has become substantially more complex as industrial
practices and regulations have evolved.
In June 2002 the EPA issued a report to the President on NSR, citing
several adverse impacts of the regulation. Generally, the report
found that NSR impedes or results in the cancellation of projects that
would maintain or improve the reliability, efficiency, or safety of
existing power plants and refineries. Not only did the regulatory
uncertainty and lack of flexibility surrounding NSR hinder
investment, the report found, but the added costs and delays imposed
by the NSR process had become quite burdensome as well. The NSR
permit process can add more than a year to the time needed to
review proposed modifications to a plant and can cost over
$1 million. Such obstacles might lead firms to delay or forgo
plans to modernize their facilities in ways that would benefit
the environment.
To take just one example, a manufacturer that operates a process
that includes a drying system determined that the system's energy
efficiency could be improved if the existing drier nozzles were
replaced with Teflon-coated nozzles. The firm found, however, that
the replacement would be economical only if the expense of obtaining
an NSR permit could be avoided. NSR currently does exclude repairs
and maintenance activities that are deemed routine, but it relies
on an intricate and lengthy analysis to determine whether a given
repair meets the definition of ``routine.'' Since the firm could
not readily discern whether the installation of new nozzles would
be considered routine maintenance, a repair, or a replacement, it
decided not to proceed with the project. In this way, NSR deters
firms from conducting needed repairs and often results in unnecessary
emissions of pollutants. In this case NSR requirements actually made
the environment worse off.
The Administration recognizes that government action that fails in
its purpose must be reformed or ended. Recent EPA research points to
the conclusion that the NSR program has become outdated and is in
need of revision: although NSR was intended to be a method of reducing
pollution, it has led to actions by the private sector that were not
intended and that do not promote the goals of the regulation. After
careful consideration of the detrimental effects of the regulation,
this Administration has chosen to undertake reforms that will remove
constraints on firms that wish to make plant-level modifications
that will have beneficial impacts on the environment.


Conclusion

Administered effectively, government regulation can contribute greatly
to the Nation's economic well-being. But regulation is not a silver
bullet. Unintended consequences occur and can negate the positive
effects of regulation. Although no regulatory agenda is foolproof,
this chapter has showcased some fundamental principles of regulation
and regulatory reform that can foster competition and correct market
failures while maintaining both static and dynamic efficiency.
These principles include the encouragement of economic flexibility
and dynamism, an increase in market orientation, and a reduction
in reliance on command-and-control regimes. In addition, regulatory
review is an important safety valve for relieving the regulatory
burden.
The two policy initiatives summarized above--the adoption of Clear
Skies legislation and the reform of NSR--highlight the shortcomings
of a one-size-fits-all regulatory approach. In some cases, when the
science dictates it, regulation must be made more stringent. In
others, where regulation impedes progress, reforms must be instituted
that reduce or change the nature of the regulation. The principles
laid out in this chapter, together with the lessons learned from
past experience, can lend important insights into efficient ways
to tackle such difficult issues as homeland security and corporate
reform.