Is Regulation a Roadblock on the Information Highway?

Introduction

For much of the 20^th century, regulatory policy directed toward the telecommunications market was concerned with “getting the prices right”. Regulators took the set of existing firms and products as given and sought prices that maximized consumer surplus, subject to the constraint that the regulated firm cover its costs of providing the current set of services. Although other regulatory objectives such as universal service played a role, regulation was framed within an essentially static view of the market. In the latter part of the century, however, as the pace of technological change increased in the telecommunications industry, it became clear that regulation could hinder innovation. In this chapter, we consider the evidence that regulation dampens firms’ incentive to innovate. We begin by laying out the theoretical reasons underpinning this notion. In the main section of the chapter, we review the empirical studies in the literature, focusing on the U.S. market. In so doing, we find remarkably consistent evidence from numerous institutional and geographic settings that lighter forms of regulation encourage innovation.

Before proceeding, we must ask what innovation is. The term is used in the economics literature to refer to everything from basic invention to new product introduction to diffusion of existing technology. We use the term in a broad sense to refer to the making available of something new in a given market. It is useful, however, to distinguish between process and product innovation. Process innovations are advancements in the methods of creating existing products, and may not be directly apparent to consumers. Process innovation lowers the cost of producing goods or services currently available to consumers. Product innovation is the creation (or diffusion to new markets, in our expansive definition) of new goods previously unavailable to consumers.

Regulation affects firms in many ways. Regulators historically deemed regulation justifiable, to reap the economies of scale and scope created by a single service provider and to further social goals such as universal service, while avoiding the inefficiency due to monopoly pricing. Regulatory control over prices and profits was chosen instead of reliance on competition or antitrust policy, which is generally not designed to prevent market expansion by firms with legitimate cost advantages over rivals. Competition law, at least in the U.S., furthermore does not outlaw the unilateral exercise of market power in setting prices.

The economic inefficiency created by prices above their competitive level is illustrated in Figure 1, which depicts the demand and marginal cost curves for a telecommunications service. Total economic benefits from the service are the entire area between the demand and the marginal cost curves. Benefits are maximized when quantity Q* is provided (as would happen if the competitive price P* is charged). These social benefits, shared between the consumers and the firm, arise because one part of society (consumers) consumes units for which it is willing to pay more than it costs another part of society (the firm) to produce. If a carrier with some market power charges a higher price, such as P^m, then a lower quantity Q^m of the service is purchased and the market loses benefits in the amount of area DWL in Figure 1. This deadweight loss, also known as the “Harberger triangle”, represents the dollar value of the economic benefits lost to consumers and the firm from units between Q^m and Q* that are not consumed at the higher price. Deadweight loss is a static loss in welfare, because it is calculated given the service is already available.

Figure 1.

Static versus dynamic efficiency