A. H. Barnett
Keith A. Reutter
Abstract. The electric industry lobbied for its first step in restructuring, from local franchises to regulated state monopolies during the early 1900s. The present paper examines this restructuring with an empirical model that includes the introduction of natural gas and steam turbine generators. The restructuring resulted in fewer firms, higher costs, and higher prices, consistent with increased monopoly power and captured regulators.
restructuring is underway, if with halts and sputters. There is interstate wholesale competition and
tentative steps toward retail competition.
Congress has introduced national bills and the
There is perspective
gained by looking back at the first restructuring of the industry, a move from
its early days of local competition to regulated state monopolies. In its infancy, the
began in 1882 with plants opening in
During the late 1800s,
alternating current (AC) was widely used in
In the early 1900s,
there was loose regulation and electric firms paid local governments a typical
franchise fee of 5% of revenue.
Franchises were generally nonexclusive and many cities had multiple
providers. As an example,
Since each city had an independent franchising authority, electric firms trying to expand their areas found multiple negotiations and differing fees both costly and burdensome. As relief, the industry led by Samuel Insull of Chicago Commonwealth Edison advocated state regulation. McDonald (1962) points out that Insull led members of the National Electric Light Association, later Edison Electric Institute, in a call for state regulation.
The first state to
implement a public service commission (PSC) was
1907 NY WI
1911 CA CT KS NH NJ NV OH OR WA
1912 AZ RI
1913 CO HI ID IL IN MO MT NC OK WV
1914 ME PA
1915 AL SC WY
1919 ND TN
1956 AK MS
1975 SD MN TX
Source: NARUC Yearbook of Regulatory Agencies 1991-1992
PSCs regulated prices
within state boundaries but Clemens (1950) points to the interstate pricing
issue made clear by the
Table 2 presents some historical data, including the real price of electricity Pe calculated as average revenue per kilowatt hour (kWh) in 1932 dollars. The raw data from the Census of the Electric Power and Light Industry includes industry total revenue TR, quantity of output Q, the number of firms F, and the horsepower of different types of generation. The price dropped dramatically between 1907 and 1917. By 1927, however, 34 states had regulated monopolies and the price of electricity began to rise. Similarly, the number of firms peaked in 1917 but with the increased prevalence of state regulation declined 48% by 1932. Output increased during this period, more than doubling from 1912 to 1917 and again from 1922 to 1927, as the number of customers grew exponentially.
1907 1912 1917 1922 1927 1932
number of firms, N 4714 5221 6542 6355 4335 3429
millions mWh, Q 6 10 22 33 68 80
% generation steam, G 20% 38% 48% 58% 59% 68%
Source: Census of the Electric Power and Light Industry
With improved technology and new steam turbines, electricity output per worker rose. The four main sources of power were combustion engines, steam engines, steam turbines, and hydroelectric generation. The new technology utilizing steam turbines supplied 20% of horsepower in 1907 but by 1932 that percentage had more than tripled. The share of hydroelectric power remained stable over the period.
Between 1911 and 1920, most states replaced local franchises with state regulated monopolies, a shift from locally governed competition to state regulated monopoly. After 1920, industry output continued to grow but the number of firms decreased, and after 1927 the real price of electricity rose.
Stigler and Friedland (S&F, 1962) study the period before the Federal Power Act of 1935 and examine the effect of regulation on electricity prices, differential pricing across customer classes, and prices of electricity stocks. They conclude that regulation had no effect on electricity prices in 1922. Comanor (1970) and DeAlessi (1974) point out that under the appropriate one tailed test the S&F regulation coefficient is significant at the 10% level, suggesting the opposite conclusion.
S&F examine the ratio of residential to industrial prices and predict that regulators would cater to the popularity of cross-subsidized or relatively low rates for residential consumers. They uncover evidence of the opposite for both 1917 and 1937. The ratio of residential to industrial prices was higher in the regulated states. They conclude that regulation had no effect but might have concluded that industrial lobbies had more influence on the PSCs than residential groups.
Jarrell (1978) modifies the S&F analysis by separating “early” states that established commissions between 1912 and 1917. Jarrell finds early states had lower prices and highest outputs, and concludes that the competition induced by local franchises induced producers to lobby for state monopoly regulation.
The move to state regulation reduced regulatory negotiations, increased information asymmetries with regulators, and dispersed the effects of regulation. State monopolies ended franchise fees for local governments, and the public paid costs of the PSCs. Of the 40 states with PSCs in 1941, only 23 had a provision for the utilities to pay regulatory commission expenses (State Commission Jurisdiction, 1941).
The principal-agent problem underlies another motive for the industry to advocate state regulation as developed by Barnett and Sophocles (1997). A regulated industry has incentive to distance itself from its regulator. Local nonexclusive franchises would seem likely to keep price closer to the competitive level. Kaserman and Mayo (1995) point out that state regulation involves an elected official, a legislative committee, and a regulatory commission staff. With this increase in the number of principal-agent relationships, there is more opportunity for agents to substitute their own agendas for those of customers. In contrast, local franchises would make customer wishes more prominent.
By expanding the scope of regulation from the local to the state level, the industry dispersed the effects of regulation over more customers. This larger and more diverse customer base made it more difficult for customers to organize politically in opposition to regulatory rulings. This, in turn, gave both regulators and regulated firms more discretion. Similarly, Peltzman (1976) makes the point that the electric industry would now prefer federal to state regulation.
At the turn of the century, natural gas was a final product, providing lighting and a general substitute for electricity. Natural gas was also an input in electricity generation. The input of gas in electricity generation increased dramatically during this transition: 1.3 billion cubic feet in 1907, 20 billion in 1922, and 96 billion in 1932. Further, by 1932 steam turbines generated over 60% of all electricity.
The following multi-market system of stochastic equations captures these market interdependencies. Two stage least squares estimates on the pooled data yield consistent unbiased estimators:
lnD = a0 + a1lnPe + a2lnY + a2lnPg + a4lnM + a5lnN + a6T + e1 (1)
lnS = b0 + b1lnPe + b2lnPg + b3lnPc + b4lnPo + b5lnF + b6G + b7lnH + e2 (2)
lnF = c0 + c1lnE + c2R + e3 (3)
lnDg = d0 + d1lnPe + d2lnPg + d3lnY + d4lnM + d5lnN + d6T+ e4 (4)
lnSg = e0 + e1lnPg + e5. (5)
Symbols in the model are:
D quantity of electricity demanded
S quantity of electricity supplied
Pe price of electricity
Y manufacturing wage bill (proxy for aggregate income)
Pg price of natural gas
V manufacturing value added
N state population
Pc price of coal
F number of electric firms
G % steam generation
H % hydro generation
E electric industry revenue
R state PSC regulation dummy variable
Dg quantity of gas demanded
Sg quantity of gas supplied
The quantities of electricity demanded and supplied equal the quantity of output in market equilibrium, De = Se = Qe. Price Pe is average revenue per kWh, reported in the data for 1927 and 1932 and calculated consistently for previous years. To the extent that electricity was a substitute for gas in consumption, the relationship between its price Pg and the quantity of electricity demanded D would be positive in (1). Aggregate income Y, the manufacturing wage bill by proxy, should increase demand if electricity is a normal good. Industrial demand for electricity, represented by manufacturing value added V, would also raise demand. Population N should increase demand, as should time T with the introduction of electric appliances during the period.
On the supply side, a
higher price for the inputs of gas Pg, coal Pc, and oil
The number of firms F is the endogenous variable in (3). Electric industry profit should lead to entry, and industry revenue E is a proxy for profit. State PSC regulation R is an exogenous political variable in the model that imposes entry barriers and should reduce the number of firms F.
Data for natural gas
are from Mineral Resources of the United
States. A system of pipelines
developed during the period from the major producing states:
The manufacturing wage bill Y is from Earnings of Factory Workers and the Statistical Abstract after 1929. Manufacturing value added V and total state population N are also from the Statistical Abstract.
Dates of state PSC
regulation from the NARUC Yearbook differ
in a few cases from Stigler-Friedland (1962) and
Jarrell (1978). Both S&F and Jarrell
assume regulation was effective three years following a PSC but they typically
began after years of judicial debate.
S&F use 1914 as the first year for a state commission in
5. Empirical Results of the Multi-Market Model
Table 3 presents the model estimates. The demand for electricity D in (1) is price inelastic, suggesting regulatory constraints were binding. The price and quantity demanded rose over the estimation period but control variables should adjust for increased demand. Without binding regulation the state monopolies would have charged higher prices, but the regulated price might have been higher than it would have been with competitive local franchises.
(1) (2) (3) (4) (5)
lnD lnS lnF lnDg lnSg
lnP -0.923 -4.379 3.046
(-8.77) (-8.49) (4.39)
lnY 0.218 -1.756
lnPg -0.149 0.583 -15.37 12.36
(-0.88) (0.54) (-3.14) (-2.83)
lnV 0.321 2.135
lnN 0.223 7.185
T 0.075 0.462
Higher income Y increased demand, indicating electricity was a normal good. The price of gas Pg did not affect demand, suggesting electricity was not an effective substitute for gas in consumption. Manufacturing output V had a positive effect on demand. Population N and time T increased demand.
On the supply side in (2), the price of electricity Pe had a negative effect on quantity supplied. The trend toward regulated state monopolies during the period evidently undermined the economic relationship between price and output.
Input prices of gas Pg
and coal Pc had no effect on electricity supply in (2) but a higher
price of oil
Electric industry revenue E had a positive effect on the number of firms F in (3). Revenue E is a proxy for profit, and higher profit would attract firms to the industry. State PSC regulation R lowered the number of firms, most likely promoting consolidation or mergers as it inhibited competition.
Regarding the demand for natural gas DG in (4), the price of electricity Pe had a positive impact. Even though electricity was not a substitute for gas in consumption, gas was a substitute for electricity. Consumers were sensitive to the price of electricity, at the time newer and relatively expensive. The coefficient on the price of gas Pg in (4) indicates highly price elastic demand. Higher income Y lowers demand for gas suggesting it was an inferior good (a marginally insignificant effect). The demand for gas increased with both population N and time T. The price of gas Pg had a negative effect on the quantity of gas supplied Sg in (5) due in part to the states reporting no production and the imputed positive price.
Previous studies have reported inconclusive evidence on the effect of state regulation on the price of electricity. Price was falling during the early period but the decline stopped at about the time a substantial number of states had regulatory commissions. Increased regulation lowered the number of firms, reducing supply. Solving (1) and (2) in Table 3 for lnP, the elasticity of price with respect to the number of firms is dlnPe/dlnF = -0.002. Given dlnF/dR = -60.3 from (3), it follows that dlnPe/dR = .061. State PSC regulation led to a higher price of electricity.
It is possible to calculate the entire set of price elasticities in a similar fashion. In equilibrium, lnD = lnS in (1) and (2). Dropping insignificant coefficients and solving for lnPe,
lnPe = .173 lnPg + .045 lnY + .067 lnV - .002 lnF + .046 lnN + .015T + .730H. (6)
Every 1% increase in the price of gas Pg raised the price of electricity by only 0.173%. Elasticities of price Pe with respect to income Y, manufacturing value added V, number of firms F, and population N are very small.
The present section examines the effect of regulation on cost and profit using data from 1907 to 1922. After 1922, the Department of Census quit reporting “expenses” perhaps due to pressure from the evolving monopolies. There might have been an assumption that revenue and cost would be equal for rate-of-return regulated firms. Of the 40 states that had regulated monopolies by 1932, all but two had made the transition by 1922.
Let Ce represent the average cost (price) of producing one kWh of electricity, calculated as total expenses divided by output. Average output per firm is q. Table 4 presents an estimate of the cost function at the firm level,
lnCe = f0 + f1lnPg + f2lnPc+ f3lnPo + f4lnq + f5G + f6H + f7R + f8T + e7. (7)
lnPg 0.119 -0.049
lnPc 0.618 0.004
lnPo 0.511 0.096
lnq -0.254 1.050
G -0.087 -0.256
H -1.073 0.394
R 0.189 -0.125
T -0.027 -0.034
An increase in the
price of gas Pg raises cost Ce,
while prices of coal Pc and oil
A higher percentage of hydro production H lowers cost Ce. Its positive effect on price in (2) suggests that regulated monopolies enjoyed lower costs but charged higher prices when they moved to hydro generation. Regulation R raises cost due to the lack of competitive pressure and the incentive to overstate cost to regulators. Cost Ce declines over time T.
Profit pe is income less expense, and the following profit function focuses on the effect of regulation R on profit,
lnpe = g0 + g1lnP + g2lnPg + g3lnPc + g4lnPo + g5lnq + g6G + g7H + g8R + g9T + e. (8)
The estimate of (8) is also in Table 4. A higher price of electricity Pe raised profit pe, and by about the same
percentage. Input prices Pg,
Larger firms have higher profit, every 1% increase in output per firm q resulting in slightly more than 1% increased profit pe. Firm size q does not affect cost in (7) and must have stimulated revenue. The consolidation and mergers of restructuring paid dividends.
Increased percentage use of steam plants G lowered profit pe slightly even though costs in (7) are not affected. Firms were evidently not able to raise revenue with the increased use of steam. Increased percentage hydro generation H raised profit pe in (8) and lowered cost in (7). Over time T, profit pe fell.
The negative coefficient for regulation R in (8) might suggest that it was successful in controlling profit pe. Regulated monopolies, however, have the incentive to overstate costs and report low profit. Combining the results for R in Tables 4 and 5 indicates that regulation led to higher cost and lower profit. Higher costs could have been due to relatively high worker perks, overcapitalization, or inefficiency of the new state monopolies.
lnPe 0.978 lnPD 0.306
lnPg -0.012 lnPgD -0.064
lnPc -0.084 lnPcD 0.207
lnPo 0.207 lnPoD -0.088
lnq 0.980 lnqD 0.118
M -0.721 MD 0.555
H 0.279 HD 0.392
R -0.249 RD 0.168
To examine the effect of regulation on profit over time, split the 1907-1922 data into two subsets with the break at 1912 corresponding roughly to what Jarrell (1978) calls early and late regulation. Only 18 states had commissions in 1912 but there were 30 by 1917, and Jarrell uses 1917 as the break date. A dummy variable D for the profit function in (8), D = 0 in 1907 or 1912 and D = 1 otherwise, is interacted with each term in (8) and reported in Table 5.
Price had a strong effect on profit pe up to 1912. Prices of gas Pg and coal Pc had no effects on profit pe during either period, evidence electric customers paid fuel costs regardless of industry structure. Competition ensured lower fuel costs resulted in to lower electricity prices.
A higher price of oil
The negative effect of percentage steam generation G on profit pe occurred before 1912. The new technology was not profitable during the more competitive era. Competition may have encouraged the new technology but firms were not able to translate that technology into higher profits.
Increased percentage hydro generation H, however, raised profit pe during the competitive early period. Higher profit is consistent with the lower cost in (7). However, over the entire period in the multi-market model, increased hydro generation resulted in lower cost and higher electricity prices. Hydro generation was cost effective but consumers did not benefit over the entire period, perhaps due to monopoly pricing.
There is a negative relationship between regulation R and profit pe during the competitive period up to 1912, but regulation encouraged firms to report lower profit. Firms lobbying for a monopoly franchise would want to appear unprofitable. The coefficient of R for the late period is the sum of coefficients of R and RD: .249 + 0.168 = -0.081. The t-statistic is calculated by the dividing the coefficient estimate by its standard error [var(G) + var(GD) + 2cov(G, GD)]2 = 0.105. The insignificant t-statistic is -0.762. After 1917, regulation did not affect profit.
In the early years of
At present, there is an opposite move of sorts, from regulated state monopolies toward retail competition. Reversing the results of the present study, the implications are more firms, lower cost, and lower price. There are complicating issues and historical differences from the earlier restructuring, including lower energy consumption shares, higher per capita consumption, better technology, telecommunication, more local pollution, increased awareness of pollution, highly organized interest groups, increased government involvement at various levels, and federally regulated interstate wholesale competition. Still, it is safe to say that a move away from regulated state monopolies toward increased competition will increase the number of firms, lower costs, and lower prices in the electric industry.
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