REGULATORY POLICY AND THE REVERSE CELLOPHANE FALLACY

A proper economic analysis of whether a regulated firm has—or, more accurately, would, in the absence of regulation, have—market power is a significantly different exercise from a typical market power analysis of an unregulated firm. We show that applying the usual tools of market power analysis to firms in regulated industries can lead to predictably erroneous outcomes. Prices set by regulatory fiat at below-cost levels would cause what we term the “reverse cellophane fallacy.” The uneconomically low prices cause other services to appear to be weaker substitutes than they would be at compensatory prices and therefore lead to improperly narrow market definitions and erroneous inferences of market power. This in turn leads to the self-perpetuation of regulation, in which regulators insist on finding that the incumbent lacks market power before deregulating prices, whereas the artificially restricted prices lead to an erroneous inference of market power. We test this hypothesis empirically by examining a sample of geographic “markets” (incumbent exchange service areas) in a single U.S. state in 2004. Our findings indicate that the relative absence of competition in rural areas should not be interpreted as evidence that the incumbent would be able to exercise market power absent price regulation.