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{\sf \titlepage
       
{\large {\bf \ Extending the economic theory of regulation to the form of
policy$^*$} } }

{\sf \bigskip }

{\sf \noindent ERIC RASMUSEN \newline
{\it Center for the Study of the Economy and the State, University of
Chicago and John E. Anderson Graduate School of Management, UCLA, Los
Angeles, Cal. 90024}\newline
and\newline
MARK ZUPAN\newline
{\it School of Business, University of Southern California, Los Angeles,
Cal. 90089-1421.}\newline
}

{\sf Published:{\it Public Choice} (1991), 72: 167-191.\newline
}

{\sf {\small \noindent \hspace*{20pt} 2000: Eric Rasmusen, Professor of
Business Economics and Public Policy and Sanjay Subhedar Faculty Fellow,
Indiana University, Kelley School of Business, BU 456, 1309 E 10th Street,
Bloomington, Indiana, 47405-1701. Office: (812) 855-9219. Fax: 812-855-3354.
Erasmuse@indiana.edu. Php.indiana.edu/$\sim$erasmuse. } }

{\sf {\small \vskip .2in {\bf Abstract.} The mutually beneficial connection
between industries and the governments that regulate them is the subject of
a large literature led by Stigler (1971). What has not been studied is how
firms choose their desired policies from the set including entry barriers,
price floors, subsidies, and demand stimulation. We take as given that
government and incumbents form the supply and demand for regulation and
explore the choice of political product. }}

{\sf {\small \bigskip }}

{\sf {\small *We would like to thank James Buchanan, Ami Glazer, William
Kaempfer, William Morris, Gordon Tullock, and seminar participants at the
University of Colorado, the University of Chicago, the Department of
Justice, the University of Southern California, the Public Choice Society
Meetings, and the Western Economic Association Meetings for helpful
discussion. }}

{\sf {\small \pagebreak }}

{\sf {\small 
%---------------------------------------------------------------
}}

{\sf {\small \noindent {\bf 1. Introduction} }}

{\sf {\small In his seminal 1971 article, George Stigler argued that there
is a market for regulation, in which government policymakers provide the
supply and industrial producers comprise the demand: }}

\begin{quotation}
{\sf {\small \noindent The state has one basic resource which in pure
principle is not shared with even the mightiest of its citizens: the power
to coerce. The state can seize money by the only method which is permitted
by the laws of a civilized society, by taxation. The state can ordain the
physical movements of resources and the economic decisions of households and
firms without their consent. These powers provide the possibilities for the
utilization of the state by an industry to increase its profitability.
(Stigler, 1971: 4) }}
\end{quotation}

{\sf {\small Stigler points out that among the ways the powers of the state
can be used to assist producers are provision of direct subsidies, control
over the entry of rivals, price-fixing, and regulation of substitutes and
complements. He does not investigate why particular policies would be chosen
from this set. We will address that question here: which policies would one
expect producers to demand and the government to supply? }}

{\sf {\small Most of the theoretical literature following Stigler has sought
to elaborate the economic model of politics---to show why, for example, one
might find pro-consumer as well as pro-producer regulation (Becker, 1983;
Peltzman, 1976). The empirical literature has largely sought to test
versions of Stigler's theory (see Romer and Rosenthal, 1987, for a survey).
Precious little attention has been devoted to the issue of which policy
instrument is chosen. Consequently, although the literature affords a wealth
of insight as to why regulation occurs, it provides only an indirect and
partial understanding of why regulation takes particular forms. }}

{\sf {\small Outside the literature that followed Stigler's article, two
research veins have touched at least obliquely on the question of how to
regulate. In international economics, there is a well-known debate over
whether tariffs and quotas have identical distributional and allocative
effects (see, e.g., Bhagwati and Srinivasan, 1983). In environmental
economics, the question arises as to whether standards or fees best promote
efficiency (Weitzman, 1974). Neither of these research veins, however,
addresses the broader issue of policy choice. The debate over the
equivalence of tariffs and quotas, for example, does not ask how else the
policymakers might help domestic producers who might prefer subsidies to
either tariffs or quotas. }}

{\sf {\small Our analysis proceeds in four steps. First, we provide a
regulatory typology, a convenient classification scheme for the pro-producer
policies in political markets. Second, we posit a simple theoretical model
that outlines a central regulatory problem: given the potential for
competitive entry into a monopolized industry, how do the various possible
regulatory policies affect the incumbent producer, consumers, potential
entrants, and taxpayers? Third, we explore the robustness of the conclusions
to changes in assumptions on industry demand, technology, and structure.
Fourth, we summarize the results and discuss their application. }}

{\sf {\small 
%---------------------------------------------------------------
}}

{\sf {\small \pagebreak }}

{\sf {\small \noindent {\bf 2. A regulatory typology}\newline
The government policies that an industry's producers might seek when
threatened by entry can be classified into four general types: subsidies,
demand stimulation, price/quality controls, and entry barriers. These four
types correspond to four features of any market: costs, demand, the terms of
the transaction, and industry structure. Although state assistance may
involve a combination of two or more policy types, we will break it down
into these four basic building blocks. }}

{\sf {\small \bigskip \noindent {\bf 2.1. Subsidies} (supply)\newline
Subsidies are direct payments by the government to the supplier. Perhaps the
most obvious form of government assistance is: }}

\begin{quotation}
{\sf {\small \noindent ... a direct subsidy of money. The domestic airlines
received `air mail' subsidies (even if they did not carry mail) of \$1.5
billion through 1968. The merchant marine has received construction and
operation subsidies reaching almost \$3 billion since World War II. The
education industry has long shown a masterful skill in obtaining public
funds: for example, universities and colleges have received federal funds
exceeding \$3 billion annually in recent years, as well as subsidized loans
for dormitories and other construction. (Stigler, 1971: 4) }}
\end{quotation}

{\sf {\small Other examples of subsidies include the investment tax credit
and the Price-Anderson Act limiting the liability of nuclear power producers
(Tietenberg, 1984). Subsidies can consist of lump-sum transfers to firms or
they can depend on the firms' outputs. In either case, the method works by
reducing producer costs, and it is costly to the government. }}

{\sf {\small \bigskip \noindent {\bf 2.2. Demand stimulation} (demand)%
\newline
A second type of regulatory assistance is government promotion of market
demand, either directly, by government purchases, or indirectly, by
subsidies to consumer purchases and stimulation of demand for complements.
Government purchases of farm products is an example of direct demand
stimulation, and tuition assistance, which raises demand for college
education, is an example of indirect demand stimulation. This regulatory
method works to help suppliers by changing demand, and, like subsidies, it
is costly to the government. }}

{\sf {\small 
%---------------------------------------------------------------
}}

{\sf {\small \bigskip \noindent {\bf 2.3. Price/quality controls} (the terms
of the transaction)\newline
Price/quality controls, which directly affect the terms of the transaction
without discrimination between entrant and incumbent, are a third policy.
The essence of this kind of regulation is to prevent competition along one
margin or another between firms already in the market. In contrast to
subsidies and demand stimulation, its only cost to the goverment is
administrative. Among the well-known cases of price/quantity controls are
the fixed commissions and quality ceilings mandated for brokerage service by
the Securities and Exchange Commission prior to 1975 (Stoll, 1981), rate
regulation in the property-liability industry (Joskow, 1973), and the Civil
Aeronautics Board formulas that controlled domestic interstate air fares
before 1977 (Keeler, 1981). }}

{\sf {\small 
%---------------------------------------------------------------
}}

{\sf {\small \bigskip \noindent {\bf 2.4. Entry barriers} (industry
structure)\newline
An entry barrier is any policy that affects the cost of entry. Stigler puts
forth the general hypothesis that: }}

\begin{quotation}
{\sf {\small \ ... every industry or occupation that has enough political
power to utilize the state will seek to control entry. In addition, the
regulatory policy will often be so fashioned as to retard the rate of growth
of new firms. (Stigler, 1971: 5) }}
\end{quotation}

{\sf {\small Entry barriers can be a fixed amount per entrant or
proportional to the entrant's output. At the extreme, policies that raise
entrants' costs exclude them from the industry entirely. The Civil
Aeronautics Board did not allow a single new firm into interstate airline
markets from 1938 to 1977 (Keeler, 1981). Local regulation of cable
television distribution generally involves the award of an exclusive
franchise to the firm that wins a franchise bidding competition (Williamson,
1976). Prior to deregulation, the Interstate Commerce Commission ensured
that the immense growth in trucking was accompanied by a steady decline in
the number of federally licensed carriers (Moore, 1978). }}

{\sf {\small Entry barriers need not imply the absolute exclusion of
potential entrants. The policy might encumber entrants and assist the
incumbent without entirely eliminating entry. Quotas and tariffs often
hinder rivals---the foreign firms---without eliminating them. Although
tariffs and quotas do have differences, the principal effect of both
restrictions is identical: foreign rivals are penalized relative to domestic
suppliers.$^1$ }}

{\sf {\small Anti-margarine regulation sponsored by the ``butter bloc''
provides examples of both partial and complete entry barriers. The federal
Oleomargarine Act of 1886 levied a heavy tax on colored margarine that
continued until 1950. Some states completely prohibited margarine sales. A
less drastic form of regulation was to require restaurants using margarine
to display signs with letters at least two inches high saying
``Oleomargarine used here'' or ``Imitation butter used'' (Stigler, 1988:
171-2). }}

{\sf {\small Various forms of partial entry barriers drive a wedge between
the costs of potential entrants and the incumbent in a less apparent manner.
Economies of scale in compliance with pollution abatements impose higher
costs on small firms than large (Pittman, 1981; Pashigian, 1984). The
stringent New-Source Performance Standards in the 1977 Clean Air Act
Amendments helped high-sulfur coal mines in the Midwest and East by
hampering development of new low-sulfur coal mines in the West (Crandall,
1983). The Brady Report issued in the wake of the October 1987 stock market
crash has been interpreted as an attempt by the New York Stock Exchange to
hamstring innovation (e.g., program trading) by rival exchanges in Chicago.$%
^2$ }}

{\sf {\small If the regulatory cost prevents entry altogether, it has no
expense to the government except that of administration. Or, the regulatory
cost might be a monetary transfer that would raise revenue for the
government if it did not block entry completely; a tariff can exist for
revenue and for protection. }}

{\sf {\small 
%---------------------------------------------------------------
}}

{\sf {\small \bigskip \noindent {\bf 2.5 Combinations of Policies}\newline
Government help does not necessarily consist of one of the four policies in
isolation. It may involve a package of policy types, as in the regulation of
agriculture. In addition, pro-producer policies that seem to lie outside our
typology can often be interpreted as combinations of the four types.
State-supported division of markets among incumbents is often a combination
of price/quality controls and entry barriers, as in the case of
international air travel. Controlling 73 percent of international traffic,
the International Air Transport Association helps 135 airlines to bar entry,
fix prices, and share profits.$^3$ American quotas on imported sugar are
another example. The 1985 Farm Bill requires that the protection of domestic
producers be accomplished ``at no direct cost'' to the government. To attain
this goal, the government has mandated a support price of 18 cents a pound
for raw sugar. Whenever the world-market price falls below that level (as of
1988, approximately seven cents), import quotas are tightened until the
domestic price rises to 18 cents a pound.$^4$ }}

{\sf {\small Selective subsidies to the incumbent firm may be decomposed
into entry barriers and an industrywide subsidy. Customized tax loopholes
and the Lockheed and Chrysler bailouts are examples. Another example is the
entitlements program used by the federal government to assist domestic
refiners after the Arab oil embargo of 1973. The entitlement program helped
small refiners more than large refiners by granting them easier access to
domestic crude oil, whose price was controlled (Kalt, 1981). }}

{\sf {\small Restraint of advertising, formerly common in law, medicine, and
optometry, is a combination of price/quality control and entry barriers. It
acts as price/quality control by restraining price competition and as an
entry barrier by disadvantaging new firms, which have difficulty making
their price and quality known to consumers without advertising. The ban on
radio and television advertising of cigarettes similarly discourages entry
and perhaps price competition (Calfee, 1986). }}

{\sf {\small How to classify government purchases from incumbents (and not
from entrants) depends on the price paid. If the government pays the same
price as the private market, the policy is similar to nondiscriminatory
demand stimulation. The private market price is bid down to cost because of
competition from entrants, so the incumbents can make no profits from the
government purchases. If, on the other hand, the government pays whatever
price results from competition among the incumbents, the policy is a
combination of demand stimulation and entry barriers. A third possibility is
that the government sets the price without reference to any market. This is
a combination of three policies: entry barriers, demand stimulation, and
price/quality controls. }}

{\sf {\small 
%---------------------------------------------------------------
}}

{\sf {\small \bigskip \noindent {\bf 3. The basic model} }}

{\sf {\small To analyze the different effects of the various types of
regulation we will use a two-period model with constant costs and linear
demand. Consumers of the industry's product are represented by the inverse
demand curve $P = \alpha - \beta Q$, where $Q$ is industry output. In the
first period, the incumbent producers determine a price and sell what they
can to consumers. The incumbents then offer the government a payment for a
particular second-period policy. The government decides whether to impose
that policy or a different one, accepting the payment if appropriate. If the
policy allows entry, potential entrants decide whether to enter. The firms
in the market, incumbents and newly-arrived entrants, then determine
second-period prices. Finally, the government is re-elected or not,
depending on how the policy has affected influential groups. }}

{\sf {\small The model implicitly assumes that the incumbents are
concentrated enough to overcome the free-rider problem of paying for
regulation and form the only group so concentrated (as we discuss further in
Section 3.2). For markets where consumers control regulation, pro-consumer
analogs of our four policies could be constructed, but we will exclude that
possibility here. In some markets, perhaps most, no interest group is
organized enough to demand rent-seeking regulation of the kind we analyze
(see Pittman, 1977). The question of the form of regulation is moot for such
markets. }}

{\sf {\small We will focus special attention on the following five
assumptions: }}

\begin{quotation}
{\sf {\small \ \noindent (A1) In period 1 the industry is monopolized by a
single incumbent firm.\newline
(A2) A large number $n$ of potential entrants appear in period 2.\newline
(A3) Each firm faces a constant average cost of $c$.\newline
(A4) The incumbent has the same cost curve as the entrants.\newline
(A5) Consumers divide equally among firms with the same price. }}
\end{quotation}

{\sf {\small The central question is: What regulatory policy maximizes the
gains from trade between the incumbent and the government? Specifying the
policies more precisely, the possibilities are: }}

\begin{enumerate}
\item  {\sf {\small {\bf Laissez faire}. The government does nothing. }}

\item  {\sf {\small {\bf Subsidy}. The government offers a subsidy to firm $%
i $ of $S+sQ_i$. }}

\item  {\sf {\small {\bf Demand stimulation}. The government purchases and
destroys $Q_g$ units of the product. }}

\item  {\sf {\small {\bf Price/quality controls}. The government establishes
a price floor of $\underline{P}$. }}

\item  {\sf {\small {\bf Barriers to entry}. The government imposes a
regulatory cost, possibly infinite, of $R + rQ_i$ on each entrant $i$ but
not on the incumbent. }}
\end{enumerate}

{\sf {\small \ Our analytic approach will be different from that of the
typical economics article. The question of policy choice does not require
very technical analysis, but with five policies, and five assumptions that
affect each policy, it is easy to lose the forest for the trees. Therefore,
rather than trying to fully characterize a model with general parameters, we
will use a running numerical example to illustrate first the basic model and
then its variants as assumptions (A1) to (A5) are relaxed. We will trust to
the model's simplicity to convey the degree to which its conclusions are
robust. Readers should realize that the variants are as important as the
benchmark; a large part of our message is the robustness of the conclusions. 
}}

{\sf {\small Let us round calculations to one decimal place and use the
parameters $\alpha=10$, $\beta=2$, $c=2$, and $n=10$ for the running
example, so that $P = 10 - 2Q$. For the regulatory policies we will use the
parameters $s=1,S=0,\underline{P}=6, Q_g=1$, and $r=R=\infty$. We will
assume that if the ten potential entrants do enter, they behave as
price-takers. }}

{\sf {\small 
%---------------------------------------------------------------
}}

{\sf {\small \bigskip \noindent {\bf 3.1. The demand for regulation by
business} }}

{\sf {\small In the first period, the incumbent monopolist maximizes $Q
(\alpha-\beta Q - c)$, which yields an output of $Q= \frac{\alpha - c}{2\beta%
}=2$ and a price of $P_1 = \frac{\alpha+c}{2}=6$. Monopoly profits equal $%
\frac{ (\alpha-c)^2}{4 \beta}=8$, area $A_1$ on Figure 1, and consumer
surplus equals $\frac{(\alpha-c)^2}{8\beta}=4$, area $A_3$. In the second
period, the incumbent's profits depend on the policy chosen by the
government: }}

\bigskip

\bigskip

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{\sf {\small \bigskip \noindent {\bf 3.1.1. Laissez faire.} Under laissez
faire, entry drives down price to cost. The market price is $P^* = c=2$, the
total quantity sold is $Q^* = \frac{\alpha - c}{\beta}=4$, and sales for
each firm equal $\frac{Q^*}{n+1} = 4/11.$ Profits of the incumbent and
entrants are zero, consumer surplus equals $\frac{(\alpha-c)^2}{2\beta}=16$%
---the sum of areas $A_1$, $A_3$, and $A_4$ in Figure 1---and taxes are
zero. }}

{\sf {\small \bigskip \noindent {\bf 3.1.2. Subsidy}. If there is a variable
subsidy per unit of $s$, the market price is $c-s$ because of competition
between the incumbent and the entrants. If the subsidy takes the value $s=1$%
, then $P=1$ and $Q=4.5$. The incumbent's profit equals the entrants'
profit, which is zero. Consumer surplus equals $\frac{(\alpha-c+s)^2}{2\beta}%
=20.3$, which is the sum of areas $A_1$, $A_2$, $A_3$, $A_4$, and $A_5$ in
Figure 1. This is greater than the laissez-faire level. The taxes to pay for
the variable subsidy equal $s \left( \frac{\alpha-c+s}{\beta} \right)=4.5$. }%
}

{\sf {\small A fixed subsidy of $S$ per firm would have a similar effect,
provided that the government required an entrant to produce at least some
amount $Q_s$ to be eligible for the subsidy. Entry in the second period
drives that price far enough below average cost to exhaust the subsidy. The
number of actual entrants would be Min($n, n_s)$ (ignoring the integer
problem), where $n_s$ is an integer such that 
\begin{equation}  \label{e7}
[c-(\alpha - \beta (n_s+1) Q_s)] Q_s = S.
\end{equation}
If $n_s < n$, the profits of both the incumbent and the entrants equal zero,
taxes equal $(n_s+1)S$, and consumer surplus equals 
\begin{equation}  \label{e9}
\frac{\beta[(n_s+1)Q_s]^2 }{2}.
\end{equation}
Suppose, for example, that $S=0.5$ and $Q_s=0.5$. Then $n_s=8$, because the
nine firms in the market would produce a total output of $Q=4.5$, resulting
in $P=1$ and zero profits. This is the same level of price, output, profits,
and taxation as in our earlier example of a variable subsidy with $s=1$.$^5$ 
}}

{\sf {\small \bigskip \noindent {\bf 3.1.3. Demand stimulation}. We have
assumed that under the policy of demand stimulation the government is
committed to buying one unit of output at the market price: $Q_g = 1$. This
government-induced shift of the demand curve, illustrated in Figure 2, does
not prevent elimination of the incumbent's profits in the second period.
Despite the increase in industry demand, entry drives the price down to $c$.
Industry output at price $c$ equals 5, an increase of one unit from the
laissez-faire level of 4. Profits of entrants and the incumbent equal zero.
Consumer surplus equals the laissez-faire value of $\frac{(\alpha-c)^2}{%
2\beta}=16$ (area $A_6$ in Figure 2). Taxes equal $%
(Q_{stimulation}-Q_{laissez\;faire})c=2$, which is the sum of areas $A_7$
and $A_8$ in Figure 2. }}

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{\sf {\small Under our assumption that the government destroys what it buys,
area $A_9$ does not contribute to anyone's welfare (it is, in fact, an
infinite area, representing the government's determination to buy $Q_g$ even
if the price rises to infinity). If the government transfers its purchases
to individuals who would not buy at the equilibrium price (as when it
distributes cheese to the poor), then consumer surplus rises by the amount
those individuals would have been willing to pay---somewhere between zero
and the sum of $A_7$ and $A_8$. The rise in consumer surplus can be
significant, but the rise in government expenditure is always greater. }}

{\sf {\small We have chosen to model direct demand stimulation through
government purchases. Another form of demand stimulation is
indirect---somehow making it more attractive for consumers to buy more. A
demand subsidy is an example. The shift out of the demand curve in Figure 2
(except for the vertical portion at the top) could also be produced by a
subsidy of 2 per unit to consumers. The cost to the government would be 10,
which is much greater than the 4 that direct purchases cost, despite the
identical allocative effect, because even inframarginal consumer purchases
would be subsidized. The deadweight loss is not correspondingly greater,
however, because the extra cost to the government is an extra benefit to
consumers. }}

{\sf {\small \bigskip \noindent {\bf 3.1.4. Price/quality controls}. With a
price floor of $\underline{P}$, entrants are attracted until the incumbent's
sales equal $\frac{Q(\underline{P})}{n+1}$. His profits are $1/(n+1)$ of
industry profits. Suppose that the floor price equals the monopoly price, so 
$\underline{P}= 6$. The incumbent's second-period profits equal 
\begin{equation}  \label{e4}
\pi= \left(\frac{1}{n+1}\right) \left( \underline{P}-c \right)\left( \frac{%
\alpha -\underline{P}}{\beta} \right)=0.7.
\end{equation}
The sum of the entrants' profits equals 
\begin{equation}  \label{e4a}
\sum_{i=2}^{n+1}\pi_i = \left(\frac{n}{n+1} \right) \left( \underline{P}-c
\right) \left( \frac{\alpha -\underline{P}}{\beta} \right)=7.3.
\end{equation}
Taxes equal zero, and consumer surplus is 
\begin{equation}  \label{e6}
CS= \frac{(\alpha -\underline{P})^2}{2\beta}=4.
\end{equation}
}}

{\sf {\small \bigskip \noindent {\bf 3.1.5. Barriers to entry}. We have
specified barriers to entry to be a cost of $R+rQ_i$ imposed on entrants, a
cost with fixed component $R$ and variable component $rQ_i$. Since the price
is bid down to marginal cost after entry, a fixed regulatory cost of any
size $R >0$ deters entry, and the incumbent can continue to charge the
monopoly price in the second period (this is special to the present case of
constant marginal cost). A variable regulatory cost of size $r >4$ has the
same effect: if $r$ is greater than $\frac{\alpha-c}{2}$, entry is
completely deterred. If entry is thus blocked, the incumbent's profits
remain $\frac{ (\alpha-c)^2}{4 \beta}=8$ (area $A_1$ in Figure 1), the
entrants' profits equal zero, and consumer surplus remains at the monopoly
level $\frac{(\alpha-c)^2}{8\beta}=4$ (area $A_3$ in Figure 1). }}

{\sf {\small If $R=0$ and $r \in [0,4]$, the incumbent can still block
entry, but he cannot maintain monopoly profits. He follows a policy of limit
pricing, with $P=c+r$ and second-period profits of 
\begin{equation}  \label{e3}
\pi \left( r \right)= \frac{\alpha -c - r}{\beta}.
\end{equation}
If the regulatory cost is $r=1$, then $P=3$, $Q=7$, and $\pi=3.5$. The
entrants' profits are zero, as are the extra taxes needed by the government.
Consumer surplus equals 
\begin{equation}  \label{e5}
CS= \frac{(\alpha - r-c)^2}{2\beta}.
\end{equation}
}}

{\sf {\small 
%---------------------------------------------------------------
}}

{\sf {\small \bigskip \noindent {\bf 3.1.6. Summary}. Table 1 summarizes the
payoffs to different groups associated with the various types of policies:
the incumbent's surplus, the sum of the entrants' surplus, consumer surplus,
and the taxpayers' burden. The most interesting numbers in this and other
tables are boldfaced. Entry barriers are clearly the incumbent's preferred
policy. Laissez faire, demand stimulation, and subsidy all reduce the
incumbent's profits to zero in period 2. Price/quality controls are somewhat
better, but they still drastically reduce his profits. Moreover, as the
number of entrants rises to infinity, the price floor leaves the incumbent
with zero profits. Only entry barriers, which keep rival firms out of the
industry, prevent significant erosion in the incumbent's profits from period
1 to period 2. }}

{\sf {\small 
\marginpar{{\sf {\small Table 1 here}}} }}

{\sf {\small 
%---------------------------------------------------------------
}}

{\sf {\small \bigskip \noindent {\bf 3.2. The supply of regulation by the
government} }}

{\sf {\small The demand for regulation by the industry is half of the
Marshallian scissors. The other half is the supply of regulation by the
government. If all the interest groups---incumbent, entrants, consumers, and
taxpayers---were identically informed and organized, and if policymakers had
no leeway to pursue their own objectives, the government would choose to
maximize total welfare rather than incumbent profits. Entry barriers would
not be imposed, since laissez faire, subsidy, and demand stimulation all
generate greater total surplus. As can be seen from Table 1, laissez faire
generates the greatest total surplus---16 in our example. Moreover, this
understates the advantage of laissez faire relative to the policies of
demand stimulation and subsidy, since those policies require taxes that add
distortions outside of our model. }}

{\sf {\small Since laissez faire is efficient, why do we observe government
intervention? Very likely, because the government's objective is not total
surplus. The previous section implies that if the objective is simply to
maximize incumbent surplus, entry barriers are best. But let us go slightly
deeper and ask whether entry barriers remain attractive when the
government's objective, while not ideology-based, is still not identical to
the incumbent's. We will not investigate ideology and preferences, though we
are the last to suppose that political competition is so strong that
policymakers care only about support from interest groups (Kalt and Zupan,
1984, suggest they do not). We will examine four questions the government
might ask about a policy. First, are the benefits concentrated and the costs
diffused? Second, are the effects obvious even to unsophisticated market
participants? Third, does the policy further government objectives in other,
related markets? Fourth, does anyone's welfare decline over time? }}

{\sf {\small \bigskip \noindent {\bf 3.2.1. Concentration of benefits and
diffusion of costs}\newline
Economic stakes do not translate one-for-one into political clout. In
particular, because entry barriers concentrate benefits and diffuse costs,
government decisionmakers may prefer them to laissez faire. The total cost
to consumers can be substantial, but the per capita cost, spread across all
consumers, is relatively small, so each consumer's incentive to lobby for
laissez faire is insignificant. By contrast, the benefits of entry barriers
are tightly concentrated, and the incumbent has a strong incentive to lobby.
No other policy concentrates benefits as much as entry barriers.$^6$ Even
under price/quality controls, each firm's surplus is much smaller than the
incumbent's surplus from entry barriers (8/11 versus 8), despite the total
surplus being as great. And as the number of potential entrants increases to
infinity, the benefit per firm shrinks to zero. }}

{\sf {\small Table 2 outlines the relevant payoffs to government
decisionmakers if they are unconcerned about the welfare of consumers and
entrants. The government's ranking clearly favors entry barriers over
laissez faire, subsidies, and demand stimulation; with subsidies and demand
stimulation ranked below laissez faire because they require taxes. Entry
barriers also rank above price/quality controls, because the benefits of
price/quality controls are shared between all the firms, not just the
incumbent. }}

{\sf {\small 
\marginpar{{\sf {\small Table 2 here.}}} }}

{\sf {\small \bigskip \noindent {\bf 3.2.2. Information problems}\newline
A second element in the government's ranking of policies consists of which
groups are best informed and which policies are easiest to become informed
about. This is related to the concentration of benefits, since informedness
is to some extent endogenous. In particular, the incumbent is most likely to
be informed, because the concentrated effects of policies on him provide a
strong incentive to acquire information. }}

{\sf {\small The individual consumer, with little at stake, is less likely
to understand how much a policy helps or hurts him. Do consumers of medical
services really understand the effects on their future welfare of licensing
requirements for medical doctors? The very fact that producers expend
lobbying dollars for the pro-consumer rhetoric that so often accompanies
pro-producer regulation suggests that some consumers can be confused about
its effects. }}

{\sf {\small The number of logical steps that consumers must take to
understand the effect of entry barriers or subsidies is greater than for
price floors, a difficulty that helps entry barriers politically and hurts
subsidies. The harmful effect of entry barriers on prices is identical to
the effect of price/quality controls, but it is indirect; and because the
causal link is less visible, consumers may not protest as much. Subsidies
have a beneficial effect on prices, but the effect is also indirect, so
consumers may not appreciate the benefit. }}

{\sf {\small The cost of information acquisition distinguishes taxpayers
from consumers where mere concentration of benefits would not. Although the
low per-capita stakes weaken the incentives of taxpayers to become
well-informed about complicated policies, the link between higher government
expenditure and higher taxes is simple and direct. Moreover, once taxpayer
unhappiness becomes a constraint on total spending, infighting among the
more concentrated beneficiaries of general government spending makes
expensive regulatory policies unattractive. }}

{\sf {\small 
%---------------------------------------------------------------
}}

{\sf {\small \bigskip \noindent {\bf 3.2.3. Linkage to other government
objectives}\newline
Different regulatory policies vary in how easily they can be made to serve
multiple government objectives. We have been concentrating on the
government's desire to please taxpayers and the regulated industry, but
regulation might also serve other interest groups. If, for example, the
government wishes to promote local programming in a cable television market,
politically the easiest way to do so might be by making such programming
part of the price paid for barriers to entry. This avoids the alternative of
direct government expenditure on air time for local programming. Such
practices are common; Schmalensee (1979) notes examples such as airline and
mail service to small communities. More generally, the policy of entry
barriers allows the protected industry to serve as a government proxy,
taking on the unpopular task of redistributing wealth, as Posner (1971)
notes in the context of cross-subsidization. This advantage of entry
barriers is intrinsically related to its ability to raise industry profits
above zero. Only entry barriers and price controls do this, so only those
policies provide the funds for cross-subsidization. }}

{\sf {\small 
%---------------------------------------------------------------
}}

{\sf {\small \bigskip \noindent {\bf 3.2.4. Intertemporal welfare changes}%
\newline
A final reason that government decisionmakers might favor entry barriers is
that such a policy, unlike the others, does not make anybody's utility lower
after regulation than before. Table 3 shows this. While laissez faire makes
consumers better off in the second period, it also harms the incumbent.
Subsidies and demand stimulation are even less desirable in terms of ``not
hurting anybody.'' Not only do they strip the incumbent of his pre-entry
profits, they also require higher taxes. Entry barriers, on the other hand,
lower nobody's utility: they only prevent consumer surplus from rising. Only
entry barriers do not violate the intuition behind the Pareto criterion:
they lower nobody's utility relative to the initial state. }}

{\sf {\small 
\marginpar{{\sf {\small Table 3 here.}}} }}

{\sf {\small Intertemporal changes could be important for two reasons:
losses might be felt more than gains, and actual changes might be felt more
than potential changes. Louis XIV of France said that whenever he named
someone to a position, he created ninety-nine malcontents and one ingrate.$%
^7 $ Tullock (1975) discusses this from an economic point of view in the
context of regulation. The folk wisdom that losers are more likely than
gainers to notice losses and feel aggrieved has also been noted by political
scientists (Weaver, 1986) and psychologists (Kahneman and Tversky, 1984),
and Kahneman, Knetsch, and Thaler (1986) have found that the status quo is
often considered ``fair.'' To the extent that the regulated payoffs acquire
normative standing, policymakers may be wary of permitting entry that hurts
incumbents. Such entry seems particularly unfair if the incumbents' profits
have been capitalized and sold by the original incumbents. A taxidriver may
charge outrageous prices but still barely break even after paying for the
cost of his medallion. }}

{\sf {\small Even if gains and losses are felt symmetrically, the actual
change from period 1 to period 2 might be more important than the potential
change from one second-period policy to another. One reason is that vested
interests who gain experience in period 1 might be more skilled in
influencing policy than opposing groups new to the policymaking arena (Noll
and Owen, 1983). Hazlett (1990) suggests that this is why the Radio Act of
1927 gave away the spectrum to established radio stations rather than
auctioning it off. Another reason is that market participants can detect and
measure actual changes more easily than potential changes. In 1980 and 1984
candidate Ronald Reagan successfully bypassed the usual political appeals to
potential changes by simply asking voters whether they were better off than
four years ago. The history of public utility regulation also illustrates
the point. Prior to the 1970s there was very little regulatory effort to
ensure that electricity prices tracked costs, as noted by Stigler and
Friedland (1962), although costs were generally falling and a good case
could have been made for lowering prices. So long as prices were constant,
consumers were happy. But when input costs rose dramatically in the 1970s,
attempts to raise rates in parallel with costs brought howls of protest and
strict regulation.$^8$ }}

{\sf {\small 
%---------------------------------------------------------------
}}

{\sf {\small \bigskip \noindent {\bf 3.2.5. The gains from trade between the
government and the incumbent}\newline
We have seen that the entry barrier is the most attractive of the five
policies to the incumbent producer and that there are reasons why it might
also be the government's preferred policy. The market for regulation is
often a bilateral monopoly. One incumbent or association of incumbents faces
one government, and the two sides play a bargaining game over the gains from
trade. In keeping with our emphasis on the type of policy instead of the
mechanisms by which government is influenced, we have confined ourselves to
determining the size of the gains from trade rather than the bargaining over
its division. Many bargaining theories take it as axiomatic that the outcome
will be Pareto-optimal from the point of view of the bargaining players. If
this is true, the policy chosen will be that which provides the greatest
gain from trade, a policy that often turns out to be entry barriers. }}

{\sf {\small 
%---------------------------------------------------------------
}}

{\sf {\small \bigskip \noindent {\bf 4. Relaxing the assumptions} }}

{\sf {\small The conclusion emerging from our basic model is that entry
barriers are the policy of choice for the incumbent and perhaps also for
policymakers. To what extent is this conclusion robust? This section tries
to answer the question by relaxing the five key assumptions of the basic
model. We will continue to use the illustrative parameters $\alpha= 10,
\beta = 2, c= 2, Q_g=1, r=R=\infty, s=1,S=0$, and $n = 10$ unless otherwise
noted. When we must calculate duopoly profits, we will assume Cournot
competition---in effect, a price somewhere between the monopoly and
competitive levels. }}

{\sf {\small \bigskip \noindent {\bf 4.1. More than one incumbent}\newline
Suppose that there are still ten potential entrants, but there are two
incumbents, not just one. A free-rider problem naturally arises as to which
incumbent pays the government for the policy that benefits both of them, but
let us assume that they can make a binding agreement that both will pay via
a trade association. In period 1, if the two incumbents compete for
consumers, Cournot behavior leads to a price of 4.7 and profits of 3.6 for
each firm. The total duopoly profit of 7.2 is lower than the monopoly level
of 8. Under Cournot, firm 1 maximizes $Q_1(\alpha - \beta(Q_1+Q_2) - c)$,
which leads to the first-order condition $\alpha - \beta(2Q_1+Q_2) - c=0$.
Since $Q_1=Q_2$, each firm produces 1.3 under the assumed parameter values.
With more than two incumbents, the industry profit and the profit per firm
would be smaller. }}

{\sf {\small As shown in Table 4, laissez faire, demand stimulation, and
subsidy all eliminate the incumbents' profits in period 2. A price floor at
the single-firm monopoly level succeeds in leaving the incumbents with
positive profits, but these profits are relatively small because the
producer surplus generated by price/quality controls (8) must be shared with
all 12 firms operating in period 2. If the number of entrants were infinite,
the total incumbent surplus from price/quality controls would be zero in the
second period. }}

{\sf {\small 
\marginpar{{\sf {\small Table 4 here.}}} }}

{\sf {\small Only entry barriers prevent a significant erosion in incumbent
profits in period 2. The only noteworthy differences from the benchmark
model are that (a) the profits whose erosion entry barriers prevent are
smaller when there are two incumbents rather than one, and (b) price/quality
controls are desirable policy complements to entry barriers, a point
stressed by Stigler (1971). The combination of entry barriers and
price/quality controls would generate a total profit of 8 to be shared
between the incumbents instead of the 7.2 from entry barriers alone. As the
number of incumbents becomes larger, the advantage of the combination over
either single policy grows. At the extreme, price/quality controls raise the
surplus of the incumbents from the 0 of perfect competition to the monopoly
level of 8. A similar case results when all of a large number of potential
entrants have already entered in period 1. }}

{\sf {\small The foregoing may explain the popularity of price controls in
agriculture. A large number of producers initially exist in the market,
ensuring a competitive outcome in the absence of government intervention.
Price floors therefore increase in attractiveness as a means of raising
producer surplus, but, even so, agriculture has not proved an unusually
profitable industry. }}

{\sf {\small \bigskip \noindent {\bf 4.2. Only one potential entrant}\newline
Reducing the number of potential entrants to one does not significantly
alter the results of the benchmark model. As shown in Table 5, entry
barriers remain the policy of choice for the incumbent since they prevent
loss of profits in period 2.$^9$ Demand stimulation, price/quality controls,
subsidy, and laissez faire all leave the incumbent with positive profits in
period 2, but profits under all four policies are lower than under entry
barriers.$^{10}$ }}

{\sf {\small 
\marginpar{{\sf {\small Table 5 here.}}} }}

{\sf {\small \bigskip \noindent {\bf 4.3. Increasing or decreasing marginal
cost} }}

{\sf {\small \noindent {\bf 4.3.1. Increasing marginal cost}\newline
Under increasing marginal costs, there are rents to being a firm so long as
the number of producers is less than infinity. Suppose we assume that
marginal cost equals $c = 2 + .5Q_i$ in our running example. With 10
entrants and 1 incumbent, each firm earns positive profits in period 2 under
a policy of laissez faire. Positive profits also accrue to all period 2
producers under the price floor, demand stimulation, and subsidy, as shown
in Table 6. Demand stimulation ranks unusually poorly in terms of efficiency
because the extra output is especially costly, but under no policy are
incumbent profits as high as under entry barriers. }}

{\sf {\small 
\marginpar{{\sf {\small Table 6 here.}}} }}

{\sf {\small \bigskip \noindent {\bf 4.3.2 Decreasing average cost.}\newline
The effect of decreasing average cost depends on whether or not the market
is contestable. If there is a large sunk cost, or if marginal costs are
falling, then the market is a natural monopoly and the incumbent need not
fear entry. Subsidy or demand stimulation would be his preferred policies.
If there is a large fixed cost, but entry and exit are easy, then the threat
of entry would keep the incumbent's profits equal to zero under laissez
faire, and entry barriers would be the preferred policy. A price floor might
or might not allow entry, depending on whether two firms could both
profitably operate in the market, but it could never be superior to an entry
barrier. }}

{\sf {\small 
%---------------------------------------------------------------
}}

{\sf {\small \bigskip \noindent {\bf 4.4. Cost differences between the
incumbent and potential entrants} }}

{\sf {\small The cost curve of a potential entrant is not always the same as
that of the incumbent. The incumbent might have either lower costs or higher
costs. If the incumbent has lower costs, the results are not much different
from the benchmark model. Suppose that the cost is 2 for incumbents and 3
for entrants. As shown in Table 7, entry barriers still leave the incumbent
as well off as possible in the second period. Demand stimulation, subsidy,
and laissez faire still work to erode the incumbent's profits---although not
as completely as in the benchmark model, because of the incumbent's cost
advantage and limit pricing. Only the price floor falls in relative ranking.
A price floor allows entry (the incumbent cannot limit-price) and thereby
leaves the incumbent with lower profits than either demand stimulation,
subsidy, or laissez faire.$^{11}$ }}

{\sf {\small 
\marginpar{{\sf {\small Table 7 here.}}} }}

{\sf {\small If the entrant possesses a cost advantage over the incumbent,
nothing of substance changes compared to the benchmark model. Table 8,
calculated under the assumption that the cost is 2 for the incumbent and 1
for entrants, is very similar to Table 1. Entry barriers again allow the
incumbent to retain his entire profit. Demand stimulation, laissez faire,
and subsidy eliminate the profit, and, in fact, chase the incumbent out of
the market altogether due to the entrants' cost advantage. A price floor of
6, the incumbent monopoly price, results in the incumbent retaining $1/(n+1)
=1/11$ of his monopoly profits.$^{12}$ }}

{\sf {\small 
\marginpar{{\sf {\small Table 8 here.}}} }}

{\sf {\small 
%---------------------------------------------------------------
}}

{\sf {\small \bigskip \noindent {\bf 4.5. Switching costs}\newline
Assumption (A5) says that firms with equal prices have equal market shares.
This rules out switching costs, which would give the incumbent an advantage
over entrants. Let us consider what happens with lexicographic brand
loyalty: if prices are equal, consumers stick with the incumbent. Table 9
summarizes the relevant payoffs if the benchmark model is thus amended. }}

{\sf {\small 
\marginpar{{\sf {\small Table 9 here.}}} }}

{\sf {\small Under laissez faire and demand stimulation, the incumbent's
profits are eliminated in period 2 as the price falls to cost, but brand
loyalty prevents entry. With a subsidy of 1 per unit of output, the
incumbent's profits are also eliminated as the price falls to $c - s = 1$,
and brand loyalty still prevents entry. But entry barriers allow the
incumbent to retain his monopoly profits, as do price/quality controls,
since an entrant who tries to sell at the floor price would attract no
customers. }}

{\sf {\small \bigskip \noindent {\bf 4.6. Summary of the Effects of Relaxing
Assumptions}\newline
The conclusions of the benchmark model are reasonably robust. Under a
variety of relaxations of its assumptions, entry barriers remain the
incumbent's policy of choice. The three differences that emerge are minor.
First, as the number of incumbents increases or the number of entrants
decreases, a price floor becomes relatively more attractive---particularly
if imposed in conjunction with entry barriers. Second, with increasing
costs, certain kinds of decreasing costs, or a cost advantage for incumbents
(all of which allow rents to the incumbents), there is an increase in the
attractiveness of demand stimulation and subsidies, because the rents grow
when demand stimulation and subsidy expand the industry's size. Third, if
there are switching costs for consumers, a price floor and entry barriers
prove equally beneficial to the incumbent, because the price floor prevents
entrants from giving the price discount necessary to attract customers. }}

{\sf {\small 
%---------------------------------------------------------------
}}

{\sf {\small \bigskip \noindent {\bf 5. Concluding discussion} }}

{\sf {\small In outlining his theory of regulation, Stigler's primary
objective was to debunk the views of politics as either an irrational
process or as reflecting the naive public-interest theories of high school
civics texts. In the pursuit of this objective, he met with enormous
success: the article spurred the development of models of political behavior
consistent with the rest of microeconomics while leaving room for altruistic
goals of rational individuals to affect legislative and regulatory outcomes.
As the economic theory of regulation developed, researchers typically
focussed on specific cases of policymaking and identified the interest
groups that shaped the observed regulatory outcome. In the case of
occupational licensing for physicians, for example, the imposition of
licensing requirements (i.e., entry barriers) is predicted to be a positive
function of the political clout of doctors and a negative function of the
political strength of consumers of medical services. Where econometric
analysis provides causal support for these predicted relationships, the
economic theory of politics is taken to be confirmed. }}

{\sf {\small Missing from previous attempts to flesh out the economic theory
of politics has been an explanation of which policies are preferred by
participants in regulatory markets. We have explored this question.
Employing a simple model in which a monopolist seeks to use state action to
protect his position, we have shown why he generally favors entry barriers,
and why policymakers also may prefer that policy. }}

{\sf {\small From the incumbent's perspective, nothing works as well to
maintain profits as entry barriers. Price/quality controls, demand
stimulation, and subsidies all allow entry and require the political boon to
be shared between the incumbent and entrants. From the policymaker's
perspective, the concentration of benefits and distribution of costs combine
with information problems and the timing of welfare changes to favor entry
barriers also. }}

{\sf {\small We have not used formal statistical analysis in this
paper---and, in fact, we doubt that such analysis could be usefully
performed. If, for example, we selected some particular industry and checked
which policies the incumbent firms had sought using a cross section of
states or countries, we would leave ourselves open to the justifiable
criticism that the industry was not randomly selected. We might mention,
however, three pieces of empirical evidence that corroborate the predictions
of the theoretical model. First, when incumbent domestic producers are
threatened by foreign rivals and a spirit of laissez faire does not prevail,
the most common regulatory response is the entry barrier. Whether this takes
the form of tariffs, quotas, exchange controls, administrative barriers, or
government preferences in purchasing, the entry barrier is clearly the
policy of choice when it comes to aiding domestic producers. Price/quality
controls, when they are employed, are used as a complement to entry barriers
constructed against foreign producers. As in the case of the federal
government's sugar program, price controls ensure that competition among
protected incumbent domestic producers will not dissipate the monopoly rents
generated by entry barriers. }}

{\sf {\small Second, the hallmark of ``old-style'' economic regulation is
control over entry by new producers; again, often coupled with price floors
to prevent competition among protected incumbents from destroying industry
profits. The regulation of industries such as airlines, trucking, rail,
electric and gas utilities, ocean shipping, telecommunications, taxi cabs,
banking, and securities exemplifies the old-style regulatory approach. Its
defense generally rests on the importance of banning entry to avoid
``ruinous competition'' and ``cream-skimming.'' Demand stimulation and
subsidies are policies much less frequently employed (the postal service,
agriculture, and the maritime industry being among the exceptions). Where
they are employed, moreover, they are concommitant with entry barriers and
price/quality controls. Price/quality controls themselves are seldom to be
found in the absence of entry barriers (see, for example, the various
policies in the surveys in Weiss and Klass, 1981). }}

{\sf {\small Third, in classic cases where changes in technology have
threatened the monopoly power of incumbent producers, the typical regulatory
response is to create entry barriers. The telecommunications industry
provides a pertinent example. The advent of cable television in the 1950s
and 1960s threatened existing broadcasters. To mitigate the threat, they
lobbied successfully for tight federal restrictions on cable growth (Owen,
1981). The federal ``freeze'' limited cable growth, especially in major
urban markets, by constraining the number and type of distant signals that
cable systems could import, establishing royalties on imported distant
signals, placing restrictions on the movies and sports programs, and
imposing local origination/public access requirements. More recently the
entry barriers in telecommunications have been different. The freeze on
cable television was thawed in the mid-1970s, mainly due to growth in the
political strength of the cable industry. As the cable industry acquired
greater clout in Washington, it in turn sought restraints on new, competing
technologies: satellite master antenna television (typically found in hotels
and multiple dwelling units) and fiber-optic integrated broadband networks
which allow telephone companies to provide both voice and video services. }}

{\sf {\small We close with two caveats. First, while there are good reasons
why policymakers might prefer entry barriers to other policies, we do not
argue that entry barriers will always be adopted. Absent the information,
timing, cross-subsidization, and free-rider problems discussed earlier, one
would expect laissez faire to be the policy supplied in the political market
because it provides the greatest total surplus. In other situations,
consumers might have enough political influence relative to taxpayers that
subsidies would be the equilibrium policy. Second, in evaluating individual
policies, we do not mean to imply that a single policy is better than a
combination. We have mentioned that a price floor may be a desirable
complement to entry barriers. Other combinations such as demand stimulation
and entry barriers also have attractive interactions, but we have not
modelled the government's objective function precisely enough to rank all
such combinations. We hope to have pointed out the importance of policy
choice and the interaction of supply and demand that determines it. We offer
a set of building blocks, and leave to future research the exploration of
policy amalgams for particular industries and political regimes. }}

{\sf {\small 
%---------------------------------------------------------------
}}

{\sf {\small \newpage }}

{\sf {\small ENDNOTES. }}

\begin{enumerate}
\item  {\sf {\small {A quota can be thought of as a nonlinear variable entry
barrier. It is equivalent to a tax of zero per unit for the first units of
output and an infinite tax per unit past some threshold. Government ``Buy
American'' policies can be thought of as taxes, possibly infinite, on sales
by foreign firms.} }}

\item  {\sf {\small {G. Jarrell, ``Brady Panel Sold Innovation Short,'' {\it %
Wall Street Journal}, 19 October 1988.} }}

\item  {\sf {\small {E. Chang and M. Zupan, ``International Fliers Could Use
Takeoff on U.S. Deregulation,'' {\it Wall Street Journal}, 8 October 1985.} }%
}

\item  {\sf {\small {``Sugar Daddy,'' {\it Wall Street Journal}, 4 June 1987.%
} }}

\item  {\sf {\small If there is no output requirement, a fixed subsidy of $S$
per firm would result in all 10 entrants entering and the same price and
quantity as under laissez faire. The fixed subsidy would merely involve a
transfer of wealth from taxpayers to producers. The size of the transfer
would increase with the number of potential entrants, and if $n$ were
endogenous an infinite number would enter, each producing an infinitesimal
amount. }}

\item  {\sf {\small {A selective subsidy to the incumbent represents a
combination of a subsidy with an entry barrier and similarly concentrates
benefits. It has the disadvantages of blatancy and harm to the taxpayer,
who, as discussed below, may be better informed than the consumer.} }}

\item  {\sf {\small ``Louis XIV disait que, quand il nommait quelqu'un \`{a}
une place, il faisait qu\^{a}tre-vingt-dix-neuf m\'{e}contents et un
ingrat,'' Michel Bracquart, {\it Le Petit Livre des Grandes Pens\'{e}es},
Paris: MA Editions, 1987, p. 212. }}

\item  {\sf {\small George Stigler has pointed out to us that entry
barriers, unlike the other policies, have the additional advantage that
their benefits are automatically indexed to rising costs, inflation and
market growth. }}

{\sf {\small %9
}}

\item  {\sf {\small {\ If the subsidy or demand stimulation were large
enough, the incumbent would prefer them to entry barriers. Since the
government finds tax-using policies unattractive, determining which policy
led to the greatest gains from trade would require more structure on the
government's objective function than we have imposed.} }}

{\sf {\small %10.
}}

\item  {\sf {\small In this case, a subsidy leads to higher total welfare
than laissez faire, because it is subsidy of duopolists, who are
underproducing under laissez faire. }}

\item  {\sf {\small {Price/quantity controls are inefficient because they
allow the high-cost entrants to operate. The higher total welfare under
subsidy than under laissez faire is another second-best result, as in the
single entrant case.} }}

\item  {\sf {\small {Entry barriers and price floors are very inefficient
because the incumbent has high costs.} }}
\end{enumerate}

{\sf {\small 
%---------------------------------------------------------------
}}

{\sf {\small \newpage }}

\begin{center}
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\end{center}

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{\sf {\small 
%---------------------------------------------------------------
}}

{\sf {\small 
%---------------------------------------------------------------
\titlepage

}}

\begin{center}
{\sf {\small {\bf Table 1. Payoffs under different policies} }}

{\sf {\small 
\begin{tabular}{llllll}
\hline\hline
{\bf Policy} & {\bf Incumbent} & {\bf Entrant} & {\bf Consumer } & {\bf %
Taxpayer } & {\bf Total } \\ 
& {\bf surplus} & {\bf surplus} & {\bf surplus} & {\bf surplus} & {\bf %
surplus} \\ 
&  &  &  &  &  \\ \hline
Laissez faire & 0 & 0 & 16 & 0 & {\bf 16} \\ \hline
Subsidy & 0 & 0 & 20.3 & -4.5 & 15.8 \\ \hline
Demand stimulation & 0 & 0 & 16 & -2 & 14 \\ \hline
Price/quality controls & 0.7 & 7.3 & 4 & 0 & 12 \\ \hline
Entry barriers & {\bf 8} & 0 & 4 & 0 & {\bf 12} \\ \hline\hline
\end{tabular}
}}
\end{center}

{\sf {\small \titlepage

}}

\begin{center}
{\sf {\small {\bf Table 2. Surplus of politically powerful groups} }}

{\sf {\small 
\begin{tabular}{lll}
\hline\hline
{\bf Policy} & {\bf Incumbent} & {\bf Taxpayer } \\ 
& {\bf surplus} & {\bf surplus} \\ 
&  &  \\ \hline\hline
Laissez faire & 0 & 0 \\ \hline
Subsidy & 0 & -4.5 \\ \hline
Demand stimulation & 0 & -2 \\ \hline
Price/quality controls & 0.7 & 0 \\ \hline
Entry barriers & 8 & 0 \\ \hline\hline
\end{tabular}
}}
\end{center}

{\sf {\small \titlepage

}}

\begin{center}
{\sf {\small {\bf Table 3. Change in surplus from periods 1 to 2} }}

{\sf {\small 
\begin{tabular}{llllll}
\hline\hline
{\bf Policy} & {\bf Incumbent} & {\bf Entrant} & {\bf Consumer } & {\bf %
Taxpayer } & {\bf Total} \\ 
& {\bf change} & {\bf change} & {\bf change} & {\bf change} & {\bf Change}
\\ 
&  &  &  &  &  \\ \hline\hline
Laissez faire & -8 & 0 & 12 & 0 & 4 \\ \hline
Subsidy & -8 & 0 & 16.3 & -4.5 & 3.8 \\ \hline
Demand stimulation & -8 & 0 & 12 & -2 & 2 \\ \hline
Price/quality controls & -7.3 & 7.3 & 0 & 0 & 0 \\ \hline
Entry barriers & {\bf 0} & {\bf 0} & {\bf 0} & {\bf 0} & 0 \\ \hline\hline
\end{tabular}
}}
\end{center}

{\sf {\small \titlepage

}}

\begin{center}
{\sf {\small {\bf Table 4. Two incumbents} }}

{\sf {\small 
\begin{tabular}{llllll}
\hline\hline
{\bf Policy} & {\bf Incumbent} & {\bf Entrant} & {\bf Consumer } & {\bf %
Taxpayer } & {\bf Total} \\ 
& {\bf surplus} & {\bf surplus} & {\bf surplus} & {\bf surplus} & {\bf %
surplus} \\ 
&  &  &  &  &  \\ \hline\hline
Laissez faire & 0 & 0 & 16 & 0 & 16 \\ \hline
Subsidy & 0 & 0 & 20.3 & $-4.5$ & {\bf 15.8} \\ \hline
Demand stimulation & 0 & 0 & 16 & $-2$ & 14 \\ \hline
Price/quality controls & 1.4 & 6.6 & 4 & 0 & 12 \\ \hline
Entry barriers & {\bf 7.2} & 0 & 7.0 & 0 & 14.2 \\ \hline\hline
\end{tabular}
}}
\end{center}

{\sf {\small \titlepage

}}

\begin{center}
{\sf {\small {\bf Table 5. One entrant} }}

{\sf {\small 
\begin{tabular}{llllll}
\hline\hline
{\bf Policy} & {\bf Incumbent} & {\bf Entrant} & {\bf Consumer } & {\bf %
Taxpayer } & {\bf Total} \\ 
& {\bf surplus} & {\bf surplus} & {\bf surplus} & {\bf surplus} & {\bf %
surplus} \\ 
&  &  &  &  &  \\ \hline\hline
Laissez faire & 3.6 & 3.6 & 7.0 & 0 & {\bf 14.2} \\ \hline
Subsidy & 4.5 & 4.5 & 9 & $-3$ & {\bf 15} \\ \hline
Demand stimulation & 5.6 & 5.6 & 7.7 & $-5.3$ & 13.6 \\ \hline
Price/quality controls & 4 & 4 & 4 & 0 & 12 \\ \hline
Entry barriers & {\bf 8} & 0 & 4 & 0 & 12 \\ \hline\hline
\end{tabular}
}}
\end{center}

{\sf {\small \titlepage

}}

\begin{center}
{\sf {\small {\bf Table 6. Increasing marginal cost} }}

{\sf {\small 
\begin{tabular}{llllll}
\hline\hline
{\bf Policy} & {\bf Incumbent} & {\bf Entrant} & {\bf Consumer } & {\bf %
Taxpayer } & {\bf Total } \\ 
& {\bf surplus} & {\bf surplus} & {\bf surplus} & {\bf surplus} & {\bf %
surplus} \\ 
&  &  &  &  &  \\ \hline\hline
Laissez faire & 0.2 & 2.4 & 10.2 & 0 & 12.8 \\ \hline
Subsidy & 0.3 & 2.9 & 13.0 & $-3.6$ & 12.6 \\ \hline
Demand stimulation & 0.4 & 3.6 & 9 & $-4$ & {\bf 9} \\ \hline
Price/quality controls & 0.6 & 6.5 & 3.2 & 0 & 10.3 \\ \hline
Entry barriers & {\bf 7.1} & 0 & 3.2 & 0 & 10.3 \\ \hline\hline
\end{tabular}
}}
\end{center}

{\sf {\small \titlepage
}}

\begin{center}
{\sf {\small {\bf Table 7. Incumbent cost advantage} }}

{\sf {\small 
\begin{tabular}{llllll}
\hline\hline
{\bf Policy} & {\bf Incumbent} & {\bf Entrant} & {\bf Consumer } & {\bf %
Taxpayer } & {\bf Total } \\ 
& {\bf surplus} & {\bf surplus} & {\bf surplus} & {\bf surplus} & {\bf %
surplus} \\ 
&  &  &  &  &  \\ \hline\hline
Laissez faire & 3.5 & 0 & 12.3 & 0 & 15.8 \\ \hline
Subsidy & 4 & 0 & 16 & $-4 $ & {\bf 16 } \\ \hline
Demand stimulation & {\bf 4.5 } & 0 & 12.3 & $-3 $ & 13.8 \\ \hline
Price/quality controls & {\bf 0.7} & 5.5 & 4 & 0 & {\bf 10.2} \\ \hline
Entry barriers & {\bf 8} & 0 & 4 & 0 & 12 \\ \hline
\multicolumn{6}{l}{Assumption: $c_{incumbent}=2, c_{entrant}=3$} \\ 
\hline\hline
\end{tabular}
}}
\end{center}

{\sf {\small \titlepage

}}

\begin{center}
{\sf {\small {\bf Table 8. Entrant cost advantage} }}

{\sf {\small 
\begin{tabular}{llllll}
\hline\hline
{\bf Policy} & {\bf Incumbent} & {\bf Entrant} & {\bf Consumer } & {\bf %
Taxpayer } & {\bf Total } \\ 
& {\bf surplus} & {\bf surplus} & {\bf surplus} & {\bf surplus} & {\bf %
surplus} \\ 
&  &  &  &  &  \\ \hline\hline
Laissez faire & 0 & 0 & 20.3 & 0 & 20.3 \\ \hline
Subsidy & 0 & 0 & 25 & $-5$ & 20 \\ \hline
Demand stimulation & 0 & 0 & 20.3 & $-1$ & 19.3 \\ \hline
Price/quality controls & 0.7 & 9.1 & 4 & 0 & {\bf 13.8 } \\ \hline
Entry barriers & {\bf 8 } & 0 & 4 & 0 & {\bf 12} \\ \hline
\multicolumn{6}{l}{Assumption: $c_{incumbent}=2, c_{entrant}=1$} \\ 
\hline\hline
\end{tabular}
}}
\end{center}

{\sf {\small \titlepage

}}

\begin{center}
{\sf {\small {\bf Table 9. Switching costs} }}

{\sf {\small 
\begin{tabular}{llllll}
\hline\hline
{\bf Policy} & {\bf Incumbent} & {\bf Entrant} & {\bf Consumer } & {\bf %
Taxpayer } & {\bf Total } \\ 
& {\bf surplus} & {\bf surplus} & {\bf surplus} & {\bf surplus} & {\bf %
surplus} \\ 
&  &  &  &  &  \\ \hline\hline
Laissez faire & 0 & 0 & 16 & 0 & 16 \\ \hline
Subsidy & 0 & 0 & 20.3 & $-4.5$ & 15.8 \\ \hline
Demand stimulation & 0 & 0 & 16 & $-2$ & 14 \\ \hline
Price/quality controls & {\bf 8} & 0 & 4 & 0 & 12 \\ \hline
Entry barriers & {\bf 8} & 0 & 4 & 0 & 12 \\ \hline\hline
\end{tabular}
}}
\end{center}

\end{document}
