The Cato Review of Business & Government

Letters

We welcome letters from readers, particularly commentaries that reflect upon or take issue with material we have published. Tee writers' name, affiliation, address, and telephone number should be included. Because of space limitations, letters are subject to abridgment.

User Fees

TO THE EDITOR:

"Environmental User Fees" (Regulation, 1988 Number 1) continues economist's hoary tradition of advocating effluent fees. How many thousands of articles have been written over the last decades advancing this idea?
Perhaps it is not simple wrong-headedness by regulators of every party and ideological persuasion that explains why this perennial proposal has not been implemented.

The advocates' general point is of course persuasive and attractive. If only one could charge people reliably and practically for the environmental damage they do, we would have an extremely valuable supplementary pricing mechanism.

However, it is not practical. Reliable continuous monitoring equipment does not exist for any but a very tiny number of sources. Even where monitoring equipment might exist, there are other formidable barriers to translating emissions or discharges into environmental damage charges: a discharge into a stream at a time of low flow will produce concentrations many times that of the same discharge during spring run-off. If the wind is blowing toward a population center, the consequences to public health are greater than if it is blowing into the desert.

Environmental managers told to administer such a tax would confront the most difficult problems of equity, revenue predictability, and administrability. How can one practically calculate a charge based on damage that varies over time and that cannot be measured?

By contrast, one of the several charms of the delayed compliance penalty we developed is that it is extremely simple to apply regardless of the case. A typically underpaid and overworked young state air engineer can, in a matter of one to two minutes, while sitting across the table from a representative of a regulated firm, calculate the penalty appropriate to that firm. All he need do is take a few bits of information about the firm unavoidably central to any regulatory consideration, tables of current interest rates and industry average costs of capital, and a few relatively simple abatement compliance cost curves. The business man will understand as quickly because the engineer's calculations are the same he uses. They are the calculations of simple capital budgeting.

Here I should correct one point in your piece: the delayed compliance penalty, at least as initially conceived, has no punitive component. Simply charging a firm what it saves by not complying, using that firm's average cost of capital as the discount rate, insures that the full economic benefits from noncompliance are recouped. There is no need for a further punitive element.

Another administrative charm of the delayed compliance penalty is that, by making the calculation of penalties objective and ministerial, this task can be delegated to executive agencies without fear of abuse. This fact allows the penalty to begin running without the extraordinary delays inherent in referring a case to the Department of Justice or a state attorney general's office and then, later still, waiting for the judicial process to grind its way to a conclusion.

Even an economist should admire an incentive that can be applied immediately, certainly, and equally to everyone, and at very low cost.

Such qualities arc far more than elegant. They make the penalty credible and therefore enormously reduce the frequency with which it will have to be applied. It is an incentive in the service of voluntary compliance, the heart of any regulatory system. By contrast, an effluent fee system that could not be measured or administered equitably or practically would erode compliance not only with such a fee system but with the underlying laws.

The job of a penalty is efficiently and surely to induce voluntary compliance with society's laws. By trying to reform the laws at the same time, the effluent fee accomplishes neither purpose.

William Drayton
Chair
Environmental Safety
Washington, DC

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THE EDITORS respond:

Speaking of hoary traditions, how many thousands of times have central planners the world around dismissed market prices as impractical substitutes for bureaucratic judgment? Yet even in China and the Soviet Union some appreciation for the power of prices is beginning to emerge, as people realize that setting the price of a loaf of bread, an analytically intractable and politically explosive decision for the planner, is a trivial task for the baker. Enlightenment may yet come to American environmentalists. Putting prices on environmental pollution is a bit more difficult than putting a price on bread, but it is still not nearly as difficult as managing the environment without the aid of any prices at all.

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ATVs

TO THE EDITOR:

"For Want of a Wheel" (Regulation, 1988 Number 1) seems to maintain that three-wheel all-terrain vehicles (ATVs) are as safe as other recreational vehicles. At one time I was prepared to accept such a claim. I was the commissioner to whom the article refers as not having concurred with the CPSC's preliminary finding that there might have been an unreasonable risk associated with ATVs. That, however, was long before the evidence established the highly dangerous nature of these machines, especially to children and to untrained or inexperienced riders of any age.

Your article erroneously states that "the CPSC sought to order a mandatory recall and refund program for all three-wheeled ATVs already sold." The CPSC never sought a recall, although it could have done so. What the CPSC and the U.S. Department of Justice sought through the courts was a voluntary refund to purchasers of three-wheel ATVs or four-wheel ATVs bought for use by a child-in other words, the opportunity for these purchasers to return their ATVs if they so chose once informed of the nature of the risk involved. This remedy was intended to complement a safety-awareness campaign and training program and to correct the impression created by ATV advertising that such vehicles were safe for the entire family.

Further, the article mistakenly places significance on the conclusions of an internal ATV task force, citing the fact that it did not find an imminent hazard or recommend a ban, recall, or refund program for three-wheel ATVs. The mission of the ATV task force was only to make technical findings and to recommend specific safety measures addressing ATV hazards, which it did. A separate confidential report by the Office of the General Counsel provided legal options on which the decision to file a Section 12 imminent hazard action was based.

Finally, much of the article delves into the CPSC's use of death and injury statistics. In the course of its deliberations, the commission carefully reviewed the critiques of its data done under contract to the ATV industry, and found no serious question concerning the ATV safety statistics it utilized.

In recent months, the debate about ATVs has moved from the CPSC to the courts and to Capitol Hill. Measures far more stringent than those of the consent decree are under consideration. The battle now concerns not whether ATVs are safe, but to what extent the government needs to act. Surely the commission's action, which avoided litigation and resulted in a joint industry-government agreement approved by the court, represents a reasonable approach to what is without a doubt a serious safety problem. For the record, this commissioner cast the deciding vote in the 2 to 1 decision to accept the negotiated settlement.

Carol G. Dawson
Commissioner
US Consumer Product
Safety commission
Bethesda, MD

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THE EDITORS respond

We did not question the decision to settle the ATV case; we questioned some of the remedies sought by the CPSC that were dropped in the settlement. Undoubtedly, this is because we failed to appreciate the difference between a recall and a "voluntary" refund enforced through the courts. Voluntary in this context apparently refers to the consumer's choice to receive a refund; the payment of refunds is mandatory for affected companies. Since recalls are always voluntary for consumers, we are still having trouble appreciating the distinction.

The debate now taking place in Congress and in the courts is preoccupied with the question of who should pay how much money to whom. This is unfortunate. Resolving that question will consume many resources and produce few public benefits. The debate about the safety of ATVs ought to continue.

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Raising Rivals' Costs

TO THE EDITOR:

The ascendancy of an economic approach to antitrust analysis has never been gleefully embraced by the antitrust bar. Neither has it been welcomed by some activist antitrust scholars, who strive to develop complex new theories to circumvent the barrier the Supreme Court erected when it adopted an economic standard for evaluating vertical business arrangements. Before the Court's Sylvania decision, efficiency played virtually no role in antitrust analysis. Krattenmaker and Salop ("Exclusion and Antitrust," Regulation, 1987 Number 3/4) would return to the good old days when anticompetitive theories were given first class treatment, while evidence relating to economic efficiency was consigned to the back of the bus.

What is striking about the more recent "sophisticated" theories of anticompetitive behavior is the similarity between the premises they employ and those of the traditional theories. Ten years ago, Professor Robert Pitofsky complained that the Court's concern with free riding "creates an almost insurmountable barrier to effective enforcement, and is irreconcilable with antitrust's traditional hostility to price fixing." Pitofsky also advocated discounting evidence relating to the business purpose of an arrangement because such evidence "will often reflect what counsel advise businessmen their purpose should have been." In a similar vein, Professors Krattenmaker and Salop disparagingly equate efficiency explanations with "fairy tale" claims that one hires an "economic consultant" to fabricate.

Given this hostile attitude toward the concept of efficiency, it is not too surprising to discover that Kratten- maker and Salop fail to recognize efficient arrangements when they occur, as their objection to proprietary computerized airline reservation systems demonstrates.

One puzzling aspect of the Krattenmaker and Salop article is the citation of Robert Bork to support the proposition that certain distribution patterns can be used for predatory purposes by imposing costs on rivals. They ignore Bork's conclusion that such patterns often reflect a firm's search for a better-that is more efficient-way of doing business. More important, as Bork cautions, "[t]he real danger for the law is less that predation will be missed than that normal competitive behavior will be wrongly classified as predatory and suppressed."

Professor Liebeler's contribution ("Exclusion and Efficiency") is tow-fold. First, he carefully explains how efficiency fits into the calculus of competition. Second, he ties his discussion of efficiency to an analysis of how the Kratten-maker-Salop model is fundamentally hostile to property rights. This second prong of Liebeler's rebuttal is his most important contributions to the debate.

Krattenmaker and Salop are preoccupied with exclusion and raising costs, and advocate a new legal standard that embodies a strong presumption against such behavior. But Liebeler demonstrates that exclusion and raising costs are simply the side effects of the legitimate enforcement of property rights, just as higher prices to consumers are the costs of restricting or eliminating free riding. Commercial activity often entails trade-offs between price, quality, information, and service. Krattenmaker and Salop-like many antitrust activist-prefer those arrangements and practices that produce low prices for consumers and do not impose higher costs on business rivals. But consumer welfare is not served by such an arbitrary preference, since consumers also benefit from non-price and service competition. Any regime that prevents firms form competing in nonprice dimensions will distort incentives and reduce the value of goods and services more than it reduces their price.

Efforts by firms to seek more efficient means of doing business will often require them to enforce property rights. And many times these efforts will result in raising costs of rivals and prices to consumers. Krattenmaker and Salop simply assume that anytime this happens alarm bells should go off. It is left to people like Liebeler to remind us that any model that ignores efficiency and property rights considerations hardly can be said to promote consumer welfare, however much it may appeal to the plaintiff's bar.

Robert Zwirb
Commodity Futures Trading
Commission
Washington, DC

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TO THE EDITOR:

In "Exclusion and Antitrust," Professors Krattenmaker and Salop reformulate the legal rules against exclusionary behavior with a view to ensuring "that they operate solely to the benefit of consumers."

However, their proposed two-step test evidently does not distinguish between practices on the basis of "efficiency," whether this term is narrowly defined to denote the direct effects on costs or quality of product, or taken broadly to include an accounting of anticompetitive effects as well. In fact, adoption of their test would quite probably produce highly permissive treatment for all exclusionary practices, including the "inefficient." We have before us now the record of recent merger regulation under the Airline Deregulation Act, which imposes a burden of proof similar to the plaintiff's burden proposed by Krattenmaker and Salop. It has virtually prevented successful opposition to proposed mergers, even where the prospects of anticompetitive impact appeared significant, and regardless of the expected effect on costs and quality. This record suggests that the double hurdle Krattenmaker and Salop propose may be more troublesome for plaintiffs than they realize.

An antitrust policy defensible in economic terms will require not only a more realistic test for anticompetitive impact but also some provision for direct consideration of cost and quality effects. It is not easy to determine where Krattenmaker and Salop stand on the latter point. Although they seem reluctant on principle to accept any efficiency defense, they appear to feel confident that courts can deal with efficiency arguments, at least to the extent of "requiring credible evidence of real cost savings" and hence preventing " 'fairy tale' efficiency claims from justifying anticompctitive exclusion." It may be added that courts, aided by enforcement agencies, can also reasonably be expected to evaluate whether particular efficiency gains can be obtained by less exclusionary means.

If this confidence is justified, it should be possible to protect efficiency-producing arrangements from legal deterrence without opening the gates wide for the undeserving and the deserving alike. This result might be obtained by the adoption of a rule which (a) imposes upon the plaintiff a relatively light burden of proof of anticompetitive effect-that is, a requirement that he show the practice in question is capable of disadvantaging present or potential competitors of the excluding party and (b) provides that, in the event the plaintiff makes the required showing, the practice will nevertheless be allowed if its proponents can show, among the methods that they have examined or that the plaintiff can suggest, it is the least exclusionary way of producing some cost saving or product improvement. Though this rule might permit some practices with net negative economic impact, it is obviously an improvement over a policy of universal approval, and may well be the best available approach, given the practical impossibility of reliably assessing the actual net effect of any given practice.

Lucile S. Keyes
Economist
Washington, DC

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Emissions Trading

TO THE EDITOR:

Robert W. Hahn and Gordon L. Hester ("EPA's Market for Bads" Regulation, 1987 Number 3/4) use the term "command-and-control system to refer to environmental regulation. Is this careful use of language, or simply polemics? I suggest that it amounts to the latter, whether intentionally or not, because if there is one thing that government regulators are not able to do it is to "command and control."

As writings in Regulation have shown time and time again, much of the complexity of regulation arises from the fact that regulators and regulates are in a constant process of negotiation and compromise-sometimes stimulated by the courts, sometimes by other intervenor groups. While some statutes, particularly in the environmental area, have the superficial appearance of "commands" as written, it is absolutely clear from the scholarly literature of the past 10 years that the implementation of these acts is light years away from anything that might reasonably be called "command and control." The correct term would be bargaining, for that is what EPA officials do in discussions with polluting factories, and it is what OSHA inspectors do in discussions about worker safety and health.

While the military may "command and control," civilian government essentially has only the power to persuade.

Michael D. Reagan
Professor of Political Science
University of California, Riverside

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TO THE EDITOR:

I agree with one conclusion offered by Hahn and Hester: economists have been correct in predicting that market-based approaches to regulation are cost-effective. This is inarguable. I disagree with them, however, regarding the conditions for further progress on market-based reforms.

The status quo is a vicious competitor against any new idea. Most regulators, regulatees, and intermedianes have a strong interest in defending the status quo, and even the potential beneficiaries of market-based reforms may be too risk averse to endorse those reforms. Incoherent messages from regulators result in apprehension among even ardent industry advocates of emissions trading. These factors make the future of emissions trading uncertain.

Emissions trading has been analyzed using traditional microeconomic models of firm behavior. It has not, however, been evaluated in terms of utility maximizing behavior of individuals within firms and in regulatory agencies. Profit maximizing models overemphasize the eagerness of plant managers to pursue cost savings and to take risks, especially in large companies and regulated utilities. There fore, advocates and analysts of regulatory reform need to look beyond simple models and examine who makes the decisions required to advance an emissions trade and what their incentives are. By looking at emissions trading in the context of what we know about risk aversion, the diffusion of new technologies or goods, and group decision-making, we are better able to predict the success of such programs.

Emissions trading reforms are threatened because those in industry who trade must undertake a considerable risk. Many accurately calculate that a 50:50 chance of saving their company millions of dollars a year is overshadowed by the possibility that the transaction might engender litigation, that it might take up to five years for the trade to be approved, or that the indifference of regulators might mean the eventual withdrawal of the permit submittal required to effect the trade. Today, potential industry emission traders avoid developing bubbles just to avoid the associated risks.

Today, as we await amendment of the Clean Air Act, it is important that interested parties separate myth from reality. Hahn and Hester, along with others, have shown that market-based approaches to air pollution regulation work better than the current system. Only the fiction of an omniscient and benevolent regulator can impede recognition that markets work and that their use as a tool in attaining regulatory goals should be endorsed.

John Palmisano
President
AER*X Division of RMT, Inc.
Washington, DC

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TO THE EDITOR

Hahn and Hester provide a good overview of the progress and problems in creating a "Market for Bads" at EPA, but they fail to explore the roots of these problems or one of the most promising potential solutions. While they accurately identify uncertainty, rigidity, differential control requirements, and political bickering as major sources of inefficiency, these problems arise not simply out of carelessness but out of deeply conflicting interests. Consequently, the most promising solutions will be those that adapt emission reduction trading to continued uncertainty and conflict.

EPA's use of the term "emission reduction credits" rather than "property" or "pollution rights," for example, is more than just semantics. It recognizes that while there may be a "right" to choose any of several environmentally equivalent means with which to comply with an emissions limit, there is no permanent "right" to pollute at a given level. EPA regards emissions permits as a limited privilege which can be curtailed with timely notice in response to new information. Dismal as that sounds for those few of us that are truly market oriented, it is likely to persist as a major source of uncertainty.

South California, for example, already burdened with some of the world's most stringent emission standards, will soon face even tighter limits on existing as well as new sources because of its continued failure to meet the standards for ambient air quality. It is difficult to have much certainty under these circumstances. Firms live in fear of retroactive limits that confiscate valuable credits, and environmentalists fear that rights to pollute will be permanently vested. While they both try to raid the emissions reduction bank, potential reductions are hoarded under mattresses-withheld from the market in order to conceal their whereabouts. Regulators impose ever more stringent limits on new entrants to the market who have no rights to vest or to conceal.

One promising solution which can still work in the face of such endemic uncertainty and conflict combines features of both emissions trading and a pollution tax. Variously referred to as a "mitigation fee" or an "indirect offset fee," this form of emission reduction trading has already been endorsed by the National Commission on Air Quality and representatives of both the Sierra Club and the Western Oil and Gas Association. It allows the regulator to establish more stringent limits without regard to case by case feasibility, and then allows sources with higher than average marginal costs the flexibility to pay a fee in lieu of making the required reductions. Proceeds from the fee are used to purchase additional emission reductions at the lowest possible cost, and fees are set at the estimated market clearing price.

One form of a mitigation fee has already been formally proposed by the Department of Interior for use by sources on the outer continental shelf. Under this system, oil platforms off southern California will be allowed to pay fees which will then be used to obtain emission reductions in the adjacent onshore areas. Such a system continues to allow sources to comply through on-site controls or traditional offsets but provides an important additional fee option where uncertainty and high transactions costs prevent a firm from taking advantage of major savings through external trades.

J. David Foster
Senior Development Planner
Research Triangle Institute
Research Triangle Park, NC

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Hahn and Hester respond:

The comments on our analysis of the EPA's emission trading policy raise three important issues: the (perhaps) glib characterization of most EPA regulatory activity; the appropriate unit of analysis for understanding the nature and outcomes of the regulatory process; and new ways to introduce flexibility in environmental regulation.

Professor Reagan argues that "command-and-control" does not adequately capture the richness of developing and implementing technology-based standards, such as scrubbing requirements. He is right, but the term is widely understood to connote a form of regulation where firms are given relatively little flexibility in meeting regulatory targets such as emissions requirements. Unfortunately, it is still true that the bulk of environmental regulations do not encourage firms or individuals to find cheaper, better ways of achieving environmental goals.

Mr. Palmisano notes that importance of looking at the motives of individuals within firms and regulatory agencies in trying to explain the evolution of emissions trading. We agree; however, information on individual motives is very difficult to come by. Moreover, analysis of firm behavior can still provide useful insights into the workings of the regulatory process.

Finally, Mr. Foster suggests looking for new alternatives to emissions trading. We think his proposal of indirect offsets has promise, but it also has some glaring weaknesses. Most notably, when the government serves as an active middleman on transactions, the market may wither away. In any case, this and other ideas which promote flexibility deserve serious consideration.

Robert W. Hahn
Senior Economist
Council of Economic Advisers
Washington, DC

Gordon L. Hester
Carnegie-Mellon University
Pittsburgh, PA

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