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Regulation Magazine

The Cato Review of Business & Government


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

Paying for Power


In anticipation of the U.S. Supreme Court's hearing of Duquesne Light Company v. Barasch, Michael McConnell argues for a return to "Fair value" rate making for public utilities. ("Public Utilites' Private Rights," Regulation, 1988 Number 2.)

While I agree with McConnell that the "prudent investment" rule encourages overinvestment and that an aggressive application of the "used and useful" rule will encourage underinvestment, the "fair value" rule is not a real alternative. Indeed, traditional cost-based ratemaking must be overhauled radically, if not dispensed with completely.

The fair value rule first articulated in Smyth v. Ames (1998) was skewered by Justice Brandeis 65 years ago because it was too speculative. In Federal Power Commission v. Hope Natural Gas (1944), the Court developed the balancing test referred to by McConnell and thereby, quite properly, took itself out of the state ratemaking business.

The Dunquesne case, like Wolf Creek before it, is simply the wrong case to restructure either the process or the substance of public utility ratemaking and it should be either affirmed or dismissed-the damages are de minimis and there is no unconstitutional taking. No argument can be mustered to say that courts should now, on an item-by-item basis, decide which costs must be included in a utility's rate base.

In Nuclear Power Transformation (Indiana University Press, 1987), I considered the specific question of who pays for canceled nuclear power plants. A review of scores of cases, mostly at the state level, indicates that all public utility commissions split the costs for canceled plants between ratepayers and shareholders-although in different measures. There is no real economic formula for splitting these costs. Instead, this is a pure policy judgment regarding cost and risk allocation. Most states amortize cancellation costs, as McConnell describes. A few states, like New York, subscribe to the prudent-investment rule but will disallow imprudent investments, as in Shoreham. And a few other states, like Ohio, exclude a canceled plant from the rate base altogether. Even states that completely disallow a particular item, however, will permit an increase in the rate of return because of the increased risk faced by a financially weak utility, thus effecting some return to investors.

The electric power industry is entering a new era in which traditional public utilities must compete against other producers of electricity. The Federal Energy Regulatory Commission has issued a series of proposed rules that attempt to ease the transition into a more competitive environment. These proposed rules are being met with antagonism by every sector of the industry, and the new system will take some time to work itself out. Nevertheless, a return to the nineteenth century practice of having courts determine fair value will not ease the transition because that formula perpetuates an unnecessary and inefficient dependency on cost-based ratemaking. FERC proposes to create markets br trading hulk electricity so that electric rates are set by a competitive bidding process rather than in the hearing room of administrative agencies. FERCs proposals should be applauded because they move in the competitive direction with which, I believe, McConnell would agree.

Joseph P. Tomain
Professor of Law
University of Cincinnati
Cincinnati, Ohio

McCONNELL responds:

I agree with Professor Tomain that the emergence of competition in electricity generation should be applauded and that traditional cost-based raternaking should be allowed to wither. What he fails to appreciate is that the fair-value test, under modern conditions, can be a step in that direction. Unlike the fair-value rule skewered by Justice Brandeis," which was based primarily on reproduction cost, the fair-value approach I advocate is based on avoided cost, as measured by the market value of electricity produced. It therefore allows the regulator to forgo reliance on historical cost data in favor of price information from competitive markets.

I will readily concede that my preference for this methodology is a policy judgment. I will even concede that the Supreme Court need not reach this question, that it is a judgment properly made by states, and that states may legitimately differ about it. The one thing I would insist on is that the policy judgment be made and revealed in advance of investments, and not revised in retrospect. If the Court finds this one constraint in the Constitution, states will he free to search for the best ratemaking methodology. Absent a constitutional constraint, however, the threat of ex post facto state politics will needlessly raise the cost of capital for regulated utilities and their ratepayers.

Michael W McConnell
Profrssor of Law
University of Chicago
Chicago, Illinois

The Price as Right


Michael E. Deflow's thoughtful criticism of my views on price cooperation ("What's Wrong With Price Fixing," Regulation, 1988 Number 2) warrants comment.

DeBow acknowledges that cartels maybe inherently unstable in theory but argues that, in practice, they can be both long-lived and effective, lie cites the electrical equipment conspiracy of the l950s as an example. This conspiracy was certainly long-lived, but that does not mean it was stable. Indeed, it was the instability of the cartel that made it long-lived; the price agreements often lasted no longer than the meetings themselves, and new meetings had to be called. To note that there was a 10-year conspiracy in this industry does not make DeBows point. It was the conspirators' inability to fix prices successfully that perpetuated the conspiracy.

DeBow's discussion of the effectiveness of conspiracy is naive. He cites a Federal Trade Commission study of the electrical conspiracy and an estimate by the U.S. Department of Transportation on the overcharge from hid-rigging in highway construction. Unfortunately, all such studies have serious methodological difficulties. There is simply no definitive way to determine what market prices would have been in the absence of collusion arid, therefore, no definitive way to estimate "overcharges In the electrical equipment cases, for instance, the court made unwarranted assumptions concerning the pre-conspiracy period, the level of demand and order backlog, the state of technology, and many other variables in order to arrive at its overcharge estimate and its multimillion dollar fines. More reasonable assumptions would have produced no overcharge and a conclusion that the conspiracy was as ineffectual as it appeared to the businessman involved.

The alleged 2 to S percent overcharge to the states in highway construction cannot be cited as proof of anything in this debate. State governments-unlike private firms-have few incentives to "discover' collusive agreements or rigged bids. (Most of the alleged overcharges of the electrical conspiracy fell on the federal government.) With or without antitrust laws, state governments are free to change the manner by which they let contracts for construction and to boycott firms that participate in cartels.

The OPEC example is similarly unpersuasive. OPEC is a conspiracy of foreign governments, not private firms, that owed its "success" to U.S. price controls on crude oil and natural gas in the l970s.

Even if private cartels were effective in raising prices, the issue of social desirability still would not be resolved. Disequilibrium prices often must rise as they move toward an equilibrium level. How can price fluctuations as cartels form and dissolve be distinguished from other adjustments in a dynamic economy? More important, if cartels can tower costs by more than they raise prices- or simply by more than they impose in deadweight losses-then they are a social bargain. DeBow does not directly refute the argument that cartels could lower costs, hut cites criticism of Donald Dewey's analysis and dictums from Robert Bork. Unfortunately neither Dewey nor Bork in the writings cited examined actual cartel behavior to see whether there were cost savings. Those of us who have examined such agreements are not convinced that they are "naked" and devoid of social advantage.

DeBow is silent on the question of whether prohibiting price agreements violates rights. If town my goods and you own yours, how do we violate anyone's rights by agreeing to fix our terms of exchange? If I have the full right not to produce at all (to compel production would be illegal servitude), why do I have no right to engage in "restricted" production? Most economists and attorneys are wilting to limit an individual's liberty to agree on price with another, and they should be prepared to admit the trade-off and debate the question of rights.

Finally, my own view on the legal enforceability of cartel agreements is that mere promises ought not to be enforceable. Simple price agreements do not transfer title to real property; thus, a breach of the agreement does not amount to theft and does not violate rights. Firms that are "injured" by breach have simply exercised bad entrepreneurship and are not entitled to any legal remedy.

D.T Armentano
Professor of Economics
University of Hartford
West Hartford, Connecticut

DeBOW responds:

Professor Armentano's restatement of the arguments concerning the effectiveness of past U.S. cartels misses my main point: that U.S. historical evidence does not tell us how effective cartels would be under his preferred legal regime of tolerance toward price fixing. lie stresses that successful cartels tend to include governments in the role of organizer, abettor, or easy mark. This is fully consistent with the hypothesis that antitrust laws r& duce the effectiveness of price fixing among private firms.

Armentano asserts that cartels reduce costs more than they increase prices. While this might be true of some cartels, the current rule of per se illegality would appear to he the more economical one until someone can demonstrate that the net benefits from cartel behavior exceed the social costs of requiring courts to apply a rule of reason benefit-cost test in price-fixing cases.

Finally, Armentano's 'rights' argument continues to puzzle me. It seems to me that Armentano s conclusion that property owners have a natural right to enter into price-fixing agreements necessarily implies a right to agree that such agreements will be legally binding and enforceable, Why does Armentano not wish to grant this contract right, which would enable price fixers more effectively to exercise their property rights in the way they desire? Since he does not tell us, I am left with the impression that he is unwilling to follow his "rights" argument to its logical conclusion.

Professor Michael DeBow Cumberland School of Law
Samford University
Birmingham, Alabama

The Golden Door


Professor Chiswick's suggested revisions in U.S. immigration policy ("Legal Aliens," Regulation, 1988 Number 1) seem unnecessarily harsh for two reasons: First, separation of families should require extraordinary justification. Restrictions on immigration are necessarily limits on the exercise of individual freedom of choice and the general freedom of peoples to emigrate- restrictions that we, as a nation, have deplored when applied by totalitarian states. Congress's choice of kinship ties as significant in granting permission to immigrate here recognizes a strong and legitimate constituent interest-the desire of families to live together. whether or not they conform to the Western, suburban, nuclear family model.

Second, investors and other needed workers should be able to be accommodated without undue restriction, given the current economy. Unemployment rates nationwide are the lowest in 14 years. While the current rate of job creation cannot be said to provide certainty about the future, it suggests that the U.S. economy has the capacity to accommodate more immigrants than we now let in legally, given the slower rate of workforce increase our aging population will produce over the next couple of decades. Adjustment of immigration policy to admit as many immigrants as can find work or create jobs would have beneficial effects on tax revenues, and would eliminate the many social ifls of the underground economy associated with illegal immigration.

In sum, the economy appears likely to create sufficient jobs to accommodate both relatives and those willing to invest their money or skills in the United States. If Congress is to act, it should consider opening the door-not slamming it.

William A. Price
Attorney at Law
William A. Price & Associates
Wheaton, Illinois

"Shareholders are Revolting"


Your panel discussion of corporate takeovers ('Corporate Takeovers: Who Wins; Who Loses; Who Should Regulate?' Regulation, 1988 Number 1) was timely and thoughtful. If, however, Professor John Coffee was correct in his statement that the panel agreed shareholders are not being abused, I think they were wrong. The discussion began with the assertion that the shareholders of acquiring firms lose out in takeovers. And I would argue that target shareholders lose as well, in the adoption of value-depressing anti-takeover provisions (some, like the poison pill, without shareholder approval). This is possible because an integral part of the contract between those who provide the capital (shareholders) and those who provide the labor (corporate management) has all but disappeared, due to rampant inefficiency in the most important mechanism for shareholder communication-the voting of proxies. Simply put, the mechanisms for expression of shareholder opinion, principally voting, do not work. This is documented in Conflicts of Interest in the Proxy Voting System, a study by the Investor Responsibility Research Center.

One reason is the Byzantine structure of the system itself. Roughly 70 percent of all corporate stock is now held in street name" (the name of the bank or broker), and held at a regional depository. lithe investor does not want its name released to the company whose shares it holds, as is true of many large institutions, it is kept confidential. This makes it very difficult for any shareholder to identify, much less contact, the other shareholders. Corporations gather and count proxies with no supervision and no obligation to report the totals. The beneficial owners of more than a third of all stock are not even able to find out how the stock is voted on their behalf, so they have no way to evaluate the performance of their fiduciaries. The companies, on the other hand, do know how the shares are voted, enabling them to put pressure on the trustees.

Furthermore, there is the well-documented problem of collective choice and "rational ignorance." Shareholders, even large ones, can seldom justify the expense of thorough analysis, much less activism, for only a pro rata share of any return. And even when shareholders are successful in taking action, management may not have to abide by their direction.

As SEC Commissioner Joseph Grundfest pointed out,"After many years of neglect, the shareholders are revolting against a system that has not rewarded their risk and investment as well as it could have." They really have no alternative. The large institutional investors, projected to hold half the shares of stock in this country by the year 2000, are just too big to follow the traditional "Wall Street rule-vote with management or sell the shares. Moreover, over 400 companies have adopted poison pills as antitakeover devices, despite empirical data showing that poison pills depress share value. An institutional investor cannot sell out of all of them. The adoption of state antitakeover laws and the change in the tax treatment of greenmail has pushed the battle for corporate control out of the tender offer and into the proxy fight, presenting shareholders with an Increasing number of complicated and controversial decisions. This makes it all the more important that the proxy system work fairly and efficiently.

The SEC's recent adoption of the one share, one vote rule is an important step in maintaining management s accountability to shareholders. Public disclosure of proxy votes by institutions (currently proposed in California), independent monitoring of proxies, and more efficient transmission of the ballots would also make it easier for shareholders to evaluate their options fairly and act on them correctly. As Professor Roberta Romano noted in your panel discussion, "we focus on enhancing shareholder value because when looking at a corporation, it is difficult to conceive of who else's interests would be appropriate for determining the efficient allocation of resources in the economy." I suggest that if we let shareholders focus on shareholder value, they, particularly institutional investors, can function as watchful "long-term owners' essential for the competitiveness of American industry.

Nell Minow
General Counsel, Institutional
Shareholder Services, Inc. Washington, DC

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