The Skeptical Regulator*
Modest Observations on Regulatory Policy
Release 1.4 n December 2003

Austrian physicist Erwin Schroedinger proposed the following thought experiment. Place a cat in a box with a tiny amount of radioactive matter, a Geiger counter, a hammer and a vial of poison. Rig the box so that if the atom decays, it would set off the Geiger counter and in turn the hammer would strike the vial of poison and kill the cat. The probability that the atom will decay in an hour is 50 percent. Leave the cat in the box for an hour.(1) Is the cat dead or alive?

Schroedinger's observer in a quantum world says the cat is both dead and alive until observed, whereupon the 'state' of the cat is fixed. Thus, in the quantum world, the observer's act is determinant of the feline's fate. Before then, the cat's life is dependent on the probabilistic waveform of the atom being decayed or not.

Upon understanding this thought experiment, the proper reaction is: "Whoa, freaky!"

Besides misofelia, what does Schroedinger's experiment have to teach about regulation and markets? Schroedinger's purpose was to lay plain the fundamental paradox of quantum physics - the wave function of the atom, which is a probabilistic notion, collides with the classical notion, which is steady state.

The Skeptical Regulator thinks regulatory management toward a competitive market is something like this. Markets are dynamic and probabilistic. Regulation is a steady-state operation. Markets adjust price, quality, product mix and promotion in a myriad of ways to attract consumer attention. Regulation adds up costs, prescribes a return, and catches up with the dynamism in a subsequent rate proceeding.

Presently, at various stages across the country, regulators are asked to transform formerly-protected monopoly industries into a competitive marketplace. Yet, the very persistence of the regulators in the space affects that transformation and determines its vitality or its failure. The regulator, therefore, confronts a paradox where continuing the legacy role prevents the desired competitive end, but likewise exiting entirely is not an option because of legal mandates and reliance interests.

Tied up in logical knots yet? Just like the quantum world, the observer affects the outcome of the experiment.(2) Here, the regulator - to accomplish the very job he is tasked to do - must apprehend the market in a steady state. The regulator must , as it were, open the box to see if the cat is alive. At the same time, that observer's action of fixing the steady state fails to apprehend the dynamic, changing nature of the market; that the market is behaving in a quantum fashion that the regulator's observation cannot capture.

Let's take two present examples. In the telecommunications world, since 1996, the policy command has been to open markets and bring competition to the communications sphere. Among the regulators' tools to do this are wholesale unbundling and pricing powers. In using these tools, the regulators fix the network, fix its parts and, by fiat, set its price. But, the regulator's gaze cannot apprehend the effect these decisions have on the market's forward-looking incentives. The regulator cannot apprehend whether unbundling this component, at these prices, is helping short-term market share apportionment at the expense of long-term sustainable competition. And, finally, the rationale justifying this intrusion will be eroded by alternative technologies and platforms - unless of course the initial price and unbundling mandate never makes those alternative platforms attractive in the first place. A paradox.

Likewise, electricity markets have been opened to different degrees around the country. Two regulatory tools used to make this happen have been the 'standard offer' shopping package prescribed by regulators to induce switching away from incumbent providers or, alternatively, fixing retail prices while letting wholesale prices fluctuate freely. The perils here are familiar. A too bountiful shopping credit creates subsidy dependence by competitors that must be paid by customers of the incumbent or the incumbent itself. In turn, this increases the incentives for gaming and rentseeking. Retail rate freezes, meanwhile, wreak upstream havoc in wholesale markets, making them more volatile and scarcity-prone. In these cases, the 'political' deal made so that competition will be attractive, obviates the benefits desired from competition in the first place.

The point is not that regulators do nothing. That is not an option. Regulators are there, and inevitably active participants, for good or ill, in the transition from monopoly to competition. Rather, regulators need to at all times be conscious of their intractable role in defining the progress, regress or distortions toward a competitive marketplace. The regulator is not so much the disinterested observer to the possibly gruesome cat experiment. Instead, the regulator is an active participant in the experiment, his presence forcing the dynamic market into his steady-state understanding.

The question, then, becomes one of prudence. Prudence is never tidy and, perilously, the muse can invite short-term political or aesthetic judgments. Want competitors? Subsidize them into the market with a generous shopping credit. This will induce changes in the supply chain, but also breed dependence on cross-subsidies. Want to protect nascent competitors? Make the incumbent hold a price umbrella over new entrants for a decade or more like the FCC forced AT&T to do in the long distance market. (In the meantime, consumers paid those inflated prices.) In addition to the immediate social costs, these short-term inducements have long-term affects on the development of a real, non-regulatory managed market.

Schumpeter's gales of creative destruction do not wash over industries where capital is not welcome. The pool is too shallow for much of a wave to get started. By contrast, in an industry where Schumpeterian dynamism is working, the regulator had best get out of its way and let it work its magic on legacy pockets of market power. Schroedinger's cat illustrates the paradoxical job the regulator is asked to do.

Thus, the prudent and well-intentioned regulator must look in Mr. Schroedinger's box and assess how to unleash the captured dynamism of the marketplace. A breakthrough - a quantum change, as it were - in regulation would permit regulators to view the market dynamically and without the effects of a dulled, steady state. Having further explored the problem, we will next continue with a description of the various analytic schools that might help resolve the paradox.

- The Skeptical Regulator

Next for The Skeptical Regulator: The Chicago Turnaround: Antitrust Meets Regulation

Footnotes

* The Progress & Freedom Foundation debuted The Skeptical Regulator in July 2003. The periodic essays are authored by president Raymond Gifford and other fellows at the Foundation. Send comments to regulator@pff.org.

1. E. Schrodinger, "Die gegenwartige Situation in der Quantenmechanik", Naturwissenschaften 23: pp.807-812; 823-828; 844-849 (1935). Translation on the web available at: www.emr.hibu.no/lars/eng/cat/Default.htm. A poetic version of the tale is available at: www.straightdope.com/classics/a1_122.html .

2. No doubt, some readers and felinophiles alike would prefer an emphasis on the Heisenberg or Uncertainty Principle. A founder of quantum mechanics, German physicist Werner Heisenberg demonstrated that an observer could affect the outcome of an experiment simply through observation. The Skeptical Regulator does not pick favorites among the luminaries of physics nor meddle in the rivalries of the German and Austrian people. However, the Austrian Schroedinger opens the door to a deeper look at the contributions to economic science made by his countrymen in a future epistle.