Knowledge that Transforms

Regulatory lag is generally credited with providing monetary incentives for the adoption of cost-saving technological changes by regulated firms. Because regulators can not instantaneously adjust price ceilings in response to cost changes, these incentives are inherent to the process of price regulation in a dynamic world. A firm which decreases production costs through technological innovation will enjoy excess profits until the regulators lower price to a level consistent with the new conditions.' The longer the delay before regulatory response to a decrease in cost, the greater are the profits which can be derived from a cost reduction, and, therefore, the greater is the incentive for adoption of technological change.2 The passive nature of this incentive mechanism is an important characteristic. Although regulatory agencies typically have authority to force price decreases upon firms which do not take advantage of potential cost savings, this power is limited by the difficulty of proving that a firm is laggard, rather than the victim of unfortunate circumstances. Thus, the regulated firm which foregoes potential profit from adopting a costsaving innovation today may generally reap that profit at some convenient time tomorrow. Indeed, it is the main contention of this paper that, in many circumstances, a regulated monopolist can maximize the present value of profits only by delaying adoption of an innovation. That is, rather than completely adopting a cost-saving innovation when it becomes available, a profit-maximizing regulated firm will choose to adopt the innovation only gradually through time. The profitability of such delaying procedure may be illustrated by a simple example. Consider a situation in which the price of a firm's product is fixed by a regulatory authority, but periodically adjusted according to the following cost-plus-markup scheme. At each review, price for the following period is set equal to average cost of the previous period plus an allowed markup. That is, price in period i + 1 is set equal to m times average cost in period i (m ) 1). This situation is illustrated in Figure 1. A firm is initially producing output QO at cost CO(QO), with price set by the regulators at mCO(QO)/QO. Suppose a cost-saving innovation is discovered, which, if employed, would decrease average production cost to C1(Q)/Q. If the firm were to adopt this innovation immediately, it would earn a profit equal to the area of the rectangle ABCD in Figure IA. At the next regulatory review, price would be lowered to the level m times the new average cost (i.e., to P1), and profit would fall to that amount represented by the area AEFG. This amount of profit would be earned each period thereafter. However, suppose that the firm were to adopt this innovation in two steps rather than completely adopting the innovation when it first becomes available. This option is sketched in Figure lB. In the initial period, the firm adopts the innovation throughout approximately half its operations, thereby lowering average cost only to OH. In the next period, the firm completes the adoption process, lowering average cost to the final level OA. Although this procedure would yield profit equal only to HICD in the initial period, it would result in a price in the next period equal to P1 (i.e., equal to m times OH). Since average cost in that period would fall to OA, profit would equal AJKL. In the next period, price would be at the new equilibrium level OG, and profit would equal AEFG. This amount of profit would be earned each period thereafter. Given the demand and cost functions illustrated in Figure 1, the second alternative *Assistant professor of economics, Vanderbilt University. 'See William Baumol, and Alfred Kahn, ch. 2. 2See Elizabeth Bailey.

Consumer protection regulation has come under increasing fire from the Congress, courts, and the business community. In response, regulators have begun to innovate with market interventions that are more compatible with economic incentives. These incentive-compatible techniques include establishing property rights, mandating performance standards (instead of design standards), increasing competition, and encouraging and mandating information disclosure. Information disclosure allows consumer self-protection, compatible with individual preferences. Information is also compatible with sellers' incentives, inducing them to compete on the basis of information disclosed. In addition, this competition increases the incentive to generate and disseminate additional product information, thereby repeating the cycle. In this way, information remedies rely on private economic incentives to achieve regulatory goals, rather than on expensive direct enforcement by the regulator. Diagnosis of an information problem and evaluation of alternative remedies requires a number of steps: analysis of information production and distribution, identification of market failures and their implications for resource allocation in the information and product markets, and analysis of alternative remedies in light of these market failures.

In a recent paper in this Review, Ernst Berndt and David Wood provide a useful clarification of and complementarity, pointing out that energy and capital can be substitutes in a production subfunction and yet complements in the aggregate production function. Using this theoretical proposition, they attempt to reconcile the econometric findings of energy-capital complementarity with other studies finding energy-capital substitutability. Their reconciliation rests on the finding that those studies finding energy-capital substitutability considered only capital (K), labor (L), and energy (E). By omitting materials (M) one obtains only a elasticity. The elasticity, which allows for the additional substitution between the KLE aggregate and M, can indicate energy-capital complementarity. In fact, KLEM studies generally find energy and capital complementarity. The purpose of this comment is to question whether the net and the gross elasticity distinction provides such a reconciliation among the econometric results. I agree that this explanation tends to reduce the disparity between the original Berndt-Wood elasticity estimate and Griffin-Gregory. Yet, three independent sources of evidence suggest that the omission of M is not a sufficient explanation, and probably not even a major explanation for the disparity of findings. First, the difference between the elasticity in a KLE submodel and the elasticity in a KLEM model depends critically on the elasticity of substitution between M and KLE. Let us adopt the Berndt-Wood notation and consider their mathematical example which demonstrates the possibility of capital energy substitutability as in the Griffin-Gregory study with capital-energy complementarity:

Most governments possess a monopoly franchise in the creation of money. Economists provide an analytical justification for this institutional arrangement either in terms of the use of aggregates for macro-economic stabilization or in terms of the alleged inability of competitive markets to generate tolerably efficient results. Any complete case for the government's monopoly must, however, depend on a comparison of market and political arrangements, a comparison that requires predictions about how governments are likely to behave once a monopoly franchise is assigned. Similarly, such predictions are crucial in evaluating restrictions that might be imposed on the government's exercise of its money creation power-in designing a monetary In the analysis of political arrangements, the revenue implications of the money creation power are probably more significant than considerations of either macro-economic stability or optimality in the money supply. Although those revenue implications are incidental to demonstrating the nature of market failure in arrangements, they are fundamental in understanding how the government might exploit a monopoly in money creation, once granted. Our interest in the revenue effects of money creation stems from a broader study of constitutional restrictions on the revenueraising authority of government (see our book). The power to create money is naturally encompassed in this. Restrictions on the revenue-raising power must embody restrictions on the power to create money; consequently, the fiscal constitution has important implications for the constitution. In this paper, we examine both the revenue implications of money creation, and desirable consitutional restrictions on the money creation power within the context of a specific model of political processes.

Two crucial assumptions frequently made in industrial organization are that an established firm deters entry either by a constant high output (the Sylos Postulate) or by high excess capacity (the Excess Capacity Hypothesis). These assumptions may be an accurate description of the observed conduct of firms in some industries. However, when the rules of the post-entry game are clearly specified, the optimal output and investment strategies of an established firm may depart considerably from these behavioral assumptions. Because of this possible inconsistency with rational behavior, any conclusions about the formation of industry based upon either assumption are highly suspect. What is more, these assumptions avoid the main issue of whether entry deterrence is worthwhile at all. This paper presents a dynamic model of entry in which established firms pursue a Cournot Nash (alternatively Stackelberg) strategy toward a potential entrant. The entrant behaves in Cournot-Nash fashion and chooses output on the basis of expected postentry profits at the equilibrium of the post-entry game. Within this framework, a constant output entry-deterring strategy would involve maintenance of an entry-deterring output level before and after entry is threatened. An excess capacity entry-deterring strategy would involve holding excess capacity at an entry-deterring level and increasing output to that level after entry is threatened. Special conditions are presented under which the Sylos Postulate or the Excess Capacity Hypothesis will accurately describe optimal entry-deterring strategies. In addition, special conditions are examined under which the established firm maintains a constant output or holds pre-entry excess capacity when large-scale entry does in fact take place. The analysis shows that in general, established firm reactions to entry are quite different from these special cases. The Sylos Postulate (see Joseph Bain; Paolo Sylos-Labini; Franco Modigliani, 1958) asserts not only that potential entrants expect established firms to maintain their output constant as entry occurs, but that established firms keep output constant at a level that deters entry whether or not it is profitable to do so. Hailed as a welcome major breakthrough on the oligopoly front (Modigliani, 1958) the Sylos Postulate underlies many papers in the large theoretical and empirical literature on limit pricing.' Yet the Sylos Postulate ignores both the strategic interaction between firms and the dynamic aspects of entry.2 Unless the established firm's monopoly output exceeds the entrydeterring level, the established firm with a general cost function able to choose an entry-deterring output level will instead always desire a lower output level before entry. For the special case where capacity is an upper bound on output and the established firm is a Stackelberg leader in the post-entry game,