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Antiterrorist Measures Address Illusory Fears

Robert W. Hahn’s article "The Cost of Antiterrorist Rhetoric" (last issue) provides a timely critique of the antiterrorist regulations put in place after the crash of TWA flight 800. Whereas bomb and missile theories played a prominent role in speculation immediately after the crash, the possibility of mechanical failure has now come to the fore. If that hypothesis turns out to be true, antiterrorist protections are likely to be even less cost-effective than Hahn estimated.

Nevertheless, as a frequent flyer I have a vested interest in sound antiterrorist measures. Hahn suggests, however, that the entire package enacted by the Clinton administration may not be worthwhile. He estimates that the cost per life saved is in excess of $200 million. That estimate would be much less if there were a flurry of terrorist attacks and would be much greater if the TWA flight 800 crash was not due to terrorist activity. Such an expenditure level is clearly counterproductive, since it diverts resources from the standard market basket of consumer expenditures, many of which are safety enhancing. My estimates suggest that there is a loss of one statistical life every time the government spends $50 million on a regulation, and estimates by Office of Management and Budget economists John Morrall and Randall Lutter suggest the threshold may be much lower. Wasteful regulatory expenditures, thus, are counterproductive in terms of their effect on societal mortality, even when made on behalf of a good cause.

While the total set of terrorist protections may not be worthwhile, some specific precautions certainly are. Rather than considering those measures as a package, ideally it would be useful to isolate the different measures, identify their costs and benefits, and pursue the efforts that are most worthwhile. In practice, the costs may turn out to be less than estimated, as airport delays associated with checking driver’s licenses are much less than the half-hour buffer initially estimated by the Federal Aviation Administration.

Hahn shares the American Civil Liberties Union’s concern with using passenger profiles to identify likely terrorists. If, however, profiling effectively targets terrorists, I would not be as averse as Dr. Hahn to employing it. Although some of my more unkempt fellow passengers may be needlessly detained, if profiling successfully prevents a terrorist act, the benefits could be substantial. The economic value of preventing the loss of life associated with TWA flight 800 is more than $1 billion, so even a small effect on the probability of a major disaster yields a substantial reward.

The danger of the current indiscriminate set of antiterrorist measures is that they were not selected using a process whereby each component was screened on the basis of cost-effectiveness. The result is that billions of dollars of costs will be incurred, yielding expected benefits that may not be commensurate with projected costs.

The ultimate defense of these expenditures and the driving rationale for these policies is that they quell public fears. Even though airline travel may be quite safe, these measures provide an added reassurance of safety. An alternative to spending billions to accomplish this reassurance objective would be to undertake a public information campaign. More fundamentally, with limited resources, is it more important to spend billions saving real lives at risk or quelling unfounded fears?

A final aspect of this regulatory effort is that it was launched immediately after a major catastrophe, when the public’s reaction to the risk is likely to be greatest and the political pressure for action is likely to be strongest. These are the types of circumstances that necessitate a careful economic assessment of policy alternatives in order to identify which efforts will truly be effective in eliminating the real risks that we face.


W. Kip Viscusi
Cogan Professor of Law and Economics, Harvard Law School


Shortsighted Approach to Terrorism

Robert W. Hahn has done a great service by bringing a more objective analysis to the discussion of reducing terrorist threats to air travel ("The Cost of Antiterrorist Rhetoric," last issue). As he points out, the formation of the Gore Commission probably was a premature reaction to the tragedy of TWA flight 800. He might have also pointed out that this is only the latest step in an unfortunate trend toward an increasing politicization of aviation safety. For example, it is hard to see the need for a secretary of transportation to visit accident sites and to give impromptu press conferences, as happened after the American Eagle ATR crash in northern Indiana and the Valujet DC-9 crash in the Everglades. It is perhaps not a coincidence that the aftermath of those crashes was characterized by the quick adoption of regulatory steps unrelated to the apparent causes of those accidents. Hahn should also be commended for raising the important, if politically incorrect, question of how safe is safe enough. As a society, we are not willing to increase aviation security at any cost, nor should we be. As he points out, aviation security presents policymakers with difficult tradeoffs in terms of security, costs, inconveniences, and even civil liberties. It is also critical to realize, as he makes clear, that increasing the cost of air travel can cause some travelers to switch to travel modes that are less safe, such as the private auto. Thus, a costly precaution that has only a minimal effect on aviation safety could actually increase the number of lives lost.

While some of the proposals that may be ultimately recommended by the Gore Commission may be ill advised, we need to be careful not to overstate the case against them. For example, the Federal Aviation Administration’s recommendation that travelers arrive thirty minutes earlier than normal does not necessarily add thirty minutes to each traveler’s travel time. Many travelers already allow themselves extra time at the airport. Moreover, the value of time calculations for those sorts of delays are tricky and increasingly easy to overstate. With the advent of cellular phones, laptop computers, and airline clubs with business services, extra time at the airport may not be lost time for the business traveler. Added security measures may impose time costs on travelers, but those time costs may not be as great as it initially appears.

Explosives detection is another area where the long-term prospects are more attractive than the initial experience. Pan Am was severely criticized in some circles in the wake of the sabotage of Pan Am 103 over Lockerbie, Scotland, because a couple of suitcases had not been put through explosives screening. The sad irony is that even the state-of-the-art explosives detection systems at that time could not have reliably detected the amount of explosives that is believed to have blown up that aircraft. In other words, it did not matter whether those suitcases went through the detection equipment. Considerable progress has been made in explosives detection since then, and one can expect more technological progress in the future. Were such equipment to be widely dispersed domestically, the increase in the size of the market for that equipment could be expected to stimulate even more research and technological progress. A narrow cost-benefit analysis based on only current technology may understate the long-run value of such a policy.

Similarly, passenger-bag matching may prove much less disruptive than Hahn estimates. Matching has already been implemented on flights to Hawaii, and the evidence to date does not reveal dramatic disruptions or delays. Recent experiments by the airlines, conducted in response to a request from the Gore Commission, also suggest that it may not take as long to pull a bag that has already been loaded as some had feared.

The point is that any of these steps can be expected to be more disruptive at first than once airlines and travelers have had time to adjust. If the airlines were forced to implement passenger-bag matching on all domestic flights, they might change some of their operating procedures—perhaps the physical location where bags are checked would be relocated to the gate; perhaps new baggage tags and loading procedures would be developed to reduce the time required to pull a bag; or perhaps financial penalties would be imposed on passengers who check bags and then fail to board the aircraft. There are any number of possibilities.

In a competitive market, reducing delays and increasing convenience are dimensions along which airlines would be expected to compete. Surely an industry that has refined capacity-controlled discount fares to nearly an art form could apply that ingenuity to reducing the inconveniences and costs of whatever security procedures are proscribed. The risk would be that the regulations would be specified in terms of procedures that must be followed rather than performance standards that must be met, thereby stifling the airlines’ ability to innovate. The FAA has been supportive of performance standards in some areas in the past and, it is hoped, it would adopt that approach in the future.

As Hahn makes clear, the benefits of these measures are inherently difficult to estimate. Such is the case with aviation safety where the events policymakers try to prevent are already rare and each has some idiosyncratic features. In trying to estimate these benefits, however, we need to keep the changing nature of aviation terrorism in mind. Throughout the 1980s, for example, the number of acts of aviation sabotage was falling while the number of people killed and injured by those acts was increasing. Terrorists seemed to be selecting larger targets with more dramatic consequences. Furthermore, as the recent event in Oklahoma City suggests, the terrorist threat is not posed solely by foreign nationals.

No proposal is foolproof, but it may be instructive to look at earlier efforts to reduce hijackings. The imposition of screening provisions for passengers and their carryon baggage in the United States in 1973 and the widespread adoption of those procedures worldwide in 1974 resulted in a dramatic reduction in hijackings and attempted hijackings. Those procedures are far from 100 percent effective in detecting weapons and they do not cover all of the pathways by which a weapon may be put on an aircraft, nonetheless, they have had a dramatic effect. We should not be too quick to reject a measure just because it is not foolproof.

As Hahn points out, we need to remember that terrorists will find the weakest link in the chain. Blocking one avenue for terrorists will simply encourage them to look for others. We may not accomplish much if we simply divert terrorist bombs from one set of routes to another or from crowded aircraft to crowded airports. We need an integrated look at the entire problem rather than a preoccupation with a single dimension. Along those lines, we need to resist the tendency to "fight the last war" or, in this case, to prevent Pan Am 103. As was the case in Pan Am 103, much of the FAA’s focus has been on finding bombs in checked baggage. Yet, historically, aircraft cabins have been a far more common location for bombs than baggage compartments. We need to examine and draw systemic lessons from all of our experiences with terrorist acts, not just the most recent or most spectacular. We also need to heed the cautions Hahn offers before we rush into policies that ultimately do more harm than good.


Clinton V. Oster Jr.
Professor of public and environmental affairs, Indiana University


Random Taxes, Random Claims

In her understandable eagerness to trounce Proposition 211, California’s since-defeated ballot referendum to transform the state into a haven for plaintiffs in shareholder suits, Susan Woodward rushes headlong to the opposite extreme, suggesting that shareholders would be better-off if there were no securities class action litigation altogether ("Proposition 211: A Random Tax on Investors," Regulation, 1996 No. 3). While we quite agree that Proposition 211 was a bad idea and that "strike suits" may not be the most efficient means for achieving the optimal level of disclosure in securities markets, we believe Woodward weakens her otherwise useful discussion of the issues by exaggerations and arithmetical errors that need to be put right.

Woodward’s big picture argument rests on the dual premise that most shareholders are at least somewhat diversified and that for every purchaser buying at an inflated price, there is a seller realizing inflated proceeds. Factoring legal costs into the equation, she concludes, "Long-term, diversified investors are made worse off, not better-off, by frequent suits of this type. . . . Among the three parties—buyers, long-term stockholders, and lawyers, the game is zero sum. But among past and future shareholders, it is a losing game." Are we really to believe that the investment community as a whole would be better-off if issuers, officers, directors, auditors, and underwriters were free to make material misrepresentations and omissions with no threat of litigation? The static dead-weight loss represented by litigation costs is indeed of concern, but it seems paltry compared to the social benefits of more accurate securities pricing that enforcement brings to the capital markets.

Imprecision also impairs Woodward’s analysis of conflicts among those on whose behalf a suit is filed. The conflict issue is important because if the interests of class members are not aligned, this fact may impede plaintiffs’ ability to gain class certification. In theory, extreme conflicts might even motivate some plaintiffs to oppose the certification effort. This is a less remote possibility under the 1995 Private Securities Litigation Reform Act than previously or under Proposition 211, for the act offers a pivotal role (lead plaintiff) to large holders—the very entities most likely to be disadvantaged by a big settlement or award.

Woodward sets up her mathematical illustration of class conflict by asserting, "The legal costs [of shareholder class actions] are borne equally by all holders of the stock postcorrection." If this were more or less true, we would not quibble. However, the notion that third parties can be ignored in considering the allocation of costs is no more reasonable in the "strike suit" domain than in, say, healthcare. Yes, issuers pay dearly in legal fees, management time, and discovery expenses, but director and officer liability insurance and "deep pocket" codefendants (auditors and underwriters) fund at least 50 percent of total settlement payments in half of the cases. While some of these third-party payments may be shifted back to defendant issuers in the form of increased fees and premiums, others are borne by shareholders marketwide, making them irrelevant from the standpoint of class conflict. Only to the extent that the issuer’s finances are on the line will litigation disadvantage some class members (current shareholders) relative to others (former holders).

Building on this base, Woodward constructs a numerical example to illustrate the preconditions for the most blatant form of class conflict, wherein some class members are better-off by not litigating than by doing so. Given the 2-to-1 ratio of shareholder costs to plaintiff benefits that follows from her assumptions about the size and distribution of legal costs, however, she seriously understates the potential for class conflict in saying, "A class member’s proportionate holdings need only to exceed his proportionate claim on damages by double . . . in order for the plaintiff to wish to drop the suit entirely." We take this to mean that a potential claimant’s share of holdings must be at least double his share of damages for him to be ill served by litigation. The actual condition is much less restrictive: if a class member’s share of holdings is at least half his share of damages, he would be better-off if the suit were dropped. For example, someone representing 10 percent of damages and 15 percent of holdings would (given Woodward’s assumptions but contrary to her conclusion) want the suit dropped because it presents him with $3 in costs for each $1 in recovery.

The same arithmetical error that mars Woodward’s general conclusion about class conflict may underlie her more particular claim: "Those who hold stock bought during the damages period, but no other stock in that company, would want this suit to proceed." In fact, given Woodward’s assumptions, class members do not have to own any shares purchased outside the damages period to be made worse off by the litigation. On the contrary, a class member whose holdings exactly equal his "damaged" shares will be disadvantaged by a suit provided only that the total number of damaged shares is at least half the number of shares outstanding. For example, if 800 shares are damaged, 1,000 are outstanding, and expected recovery is $1.00 per share, a class member who both holds and can claim damages on one share can expect to recover $1.00, but the cost to him, as shareholder, will be $1.60 (i.e., 2 x $1.00 x 800/1,000). Woodward’s claim notwithstanding, there exists a real possibility that class members who still hold all their damaged shares will have interests antagonistic to those of class members who are no longer shareholders in the company.

Finally, Woodward exaggerates the effects of the 1995 act’s cap on Rule 10b-5 fraud damages—a cap that Proposition 211 would have rendered moot for California cases. In suits triggered by stock price drops, the act limits damages for purchases retained at least ninety days after the corrective disclosure to purchase price less average price during that postdisclosure period. Noting that daily stock prices are as apt to rise as to fall, Woodward declares, "For some substantial fraction [of companies], but less than half, stock prices will rise enough to make the difference between the precorrection price and the ninety-day average positive rather than negative, precluding any recovery at all." Far from being "substantial," the prospect that a defendant’s damages will be eliminated by the cap—Rule 21D(e)—is nil, if the experience of 196 class actions that settled from 1991 to 1994 is indicative. The average price during the ninety-day look-back period rebounded to the immediate precorrection level in 19 percent of the cases, but in only 5 percent did it rise to the average class period value, and in no instance did it climb to the highest class period value. Yet that last value is the purchase price pinnacle that bounce-back must scale if it is to eliminate 10b-5 damages.


Marcia Kramer Mayer
Vice President, National Economic Research Associates

Lucy Allen
Senior Consultant, National Economic Research Associates


Utility Deregulators Take Heed

Recent issues of Regulation have been full of the electricity deregulation debate. The subject has been examined from one end to the other. While it may be hard believe, the discussion may have missed a few points.

First, the usual reason that investment takes place is to reduce marginal operating costs. This is true for all kinds of investments whether regulated or not. Take, for example, Commonwealth Edison, the utility most heavily invested in nuclear power. Its nuclear power generating plants produce electricity at lower marginal operating costs than any of the alternatives. The numbers for 1995 per kWh are: .56 for nuclear (including an allowance of .14 for spent fuel disposal), 2.47 for natural gas, 2.64 for coal, and 3.99 for oil. All but the least experienced observer can recognize the striking marginal cost advantage of nuclear power, even when some allowance is made for the disposal of spent fuel. Indeed, this ordering is precisely why nuclear fuel is always considered part of the base load, with gas and oil reserved for peaking units.

Those who argue that the recovery of "stranded costs" for nuclear plants should be denied conveniently ignore the corresponding obligation to give up the electricity generated with those plants. They also ignore the substantially higher marginal costs of the alternatively fueled plants, many of which cannot be used on a continuous basis for the base load. It appears to this observer like the familiar craving for a free lunch.

Second, the purchase of electric power outside of the regulatory regime implies a huge increase in price volatility. That could be handled like natural gas through the use of futures and options contracts. However, the electricity contracts now being traded for delivery at the Palo Verde interchange and at the California-Oregon border are not very active. (See "Electricity Futures Face Static Demand," Wall Street Journal, 30 December 1996.) This is probably due to the disappointing deregulation plan enacted recently in California.

That result has a strong implication for the pricing structure under regulation. The steady prices for electricity under regulation contain an options premium. In exchange for the premium consumers are saved the detailed planning and adjustment of their consumption to fit the volatile nature of a commodity driven by peak load conditions. That, in turn, puts into serious question whether the expected lower average prices due to "an increase in competition" will actually compensate consumers for the sharply higher volatility in prices. Many consumers will view living out of the electricity spot market as being akin to driving without automobile insurance; they may not view either as much of a bargain.

To get an idea of what the options premium is, one can look at the calls for natural gas (often used to generate electricity) traded on the New York Mercantile Exchange where transaction costs are low compared to other forms of hedging. For example, the February 1997 at the money call contract settled 31 December 1996 at $0.301. That is a premium of more than 10 percent on the underlying futures price of $2.70 per 10,000 million BTUs.

Third, the modern approach to valuing investment under uncertainty is based on the options model. It is an alternative to the historic and the replacement cost ways of valuing assets. The options model has important implications for the estimation of "stranded costs" for nuclear power generating plants. When there is growth in electricity consumption and, more important, a growth in the peak load for a service area, the value of a generating plant is enhanced. When the system runs at near full capacity (when the vulnerability of the system is greatest), there is substantial value from having extra capacity. In northern Illinois both of these conditions are present. Total mWh consumption has been growing at an average annual rate of 2 percent and the peak load has been growing at nearly 3 percent per year over the same period. Thus, the use of historic costs to value nuclear generating plants may actually underestimate their economic worth.

Electricity deregulation is a difficult exercise. If deregulation is merely a rushed political exercise, then the result could be a serious mistake. Poorly designed deregulation could turn out to be worse than the regime that is displaced.


Jim Johnston
Policy Adviser, Heartland Institute


Bradley Responds to O’Neill

Richard P. O’Neill asks in a letter to the editor ("Bullies in the Electric-Policy Sandbox," last issue), "Has Robert Bradley ever found evidence of a natural monopoly?" Dr. O’Neill presumably is referring to two essays that I wrote on the origins of electricity and manufactured gas regulation where my review of the secondary-source literature shows that "natural monopoly" either never existed or existed under unstable conditions. Those essays explain why competition fatigue among leading incumbent firms, not a public-spirited rebellion against "natural monopoly," led to public utility regulation of these two great industries.

I do not consider the debate closed, however. New primary-source research is still needed to provide in-depth accounts of the performance of firms prior to public utility regulation per metropolitan area as well as the political impetus for replacing open entry with legal monopoly. I do not expect that such investigation will resurrect the natural monopoly model, but it will further confirm how technological change, self-help strategies, and high-risk venture capital (and even some entrepreneurial error) prevented or dislodged single-seller dominance and made single-seller situations the antithesis of "market failure."

While the current state of research suggests that "natural monopoly" is an overrated theoretical concept and a scarce empirical phenomenon, future research could depreciate it to a point where social scientists will be forced to rethink the whole concept. Due to the work of Julian Simon and others, for example, I have abandoned in intellectual midlife the distinction between "depletable" and "nondepletable" energy and believe it should be entirely expunged from decisionmaking in business and public policy. Renewable versus nonrenewable may continue to have life as an artificial construct like "perfect competition," but it is an inoperative real world concept that can only cause trouble if used.

"Natural monopoly" may be the same—that is, a reduction ad absurdum (everything qualifies since only one thing can be in one place at one moment), or a transient feature of the competitive cycle that if treated as a permanent outcome misdirects business and public policy decisions.

So to answer Dr. O’Neill’s question, I am not sure that I have seen a "natural monopoly" any more than I have seen a "depletable resource," and it certainly is not a proven category of "market failure."

I must pose a burning question to Dr. O’Neill: Given the less-than-perfect performance of state and federal public-utility regulation of gas and electricity in the United States this century, would you have taken your chances under laissez-faire?


Robert L. Bradley Jr.
President, Institute for Energy Research


Zoning Best Regulated by States

George W. Liebmann demonstrates the difficulty of drawing a line between conservative and liberal positions on zoning issues ("Modernization of Zoning," Regulation, 1996 No. 2).

The trouble with Liebmann’s multifaceted attack is that more, not less, government centraliza tion and interference with local autonomy are needed to make his reforms work. Many problems he notes, such as exclusionary zoning, are the products of insular and unrestricted local land-use regula tions. This is why the Quiet Revolution introduced state-level controls to create a fair zoning system. Liebmann likes Oregon’s state-level system, but it is not clear whether he would endorse its adoption else where. He calls for enacting a "Developer’s Bill of Rights," but it is not clear to what extent his proposal would permit state intervention in the local zoning process. Nor is it clear if he would always recommend statutory or judicial intervention to carry out his recommenda tions, although that kind of intervention usually would be necessary.

For instance, Liebmann argues that communities should allow duplex homes and accessory apart ments in all new residential construc tion. While that kind of change is possible at the local level, it is unlikely to occur without a state mandate. California, for exam ple, has a statute mandating zoning for accessory apartments. In another recommendation, Liebmann opposes discrim ination in zoning ordinances based on the number of housing units in a residential structure. Implementing that kind of reform requires either judi cial interven tion to prevent discriminatory zoning or legis lative intervention to mandate the kind of regulation sug gested.

Some of Liebmann’s proposals are debatable. Time limits for reviewing development applications, which he recommends, are now common in many parts of the country. They are not panaceas because munici palities can find ways to evade them by claiming the applica tions are incomplete. Accessory "granny homes," which he also recommends, are not an unmixed blessing if they increase densities and traffic in residential areas. To allow them without restriction, as Liebmann suggests, may not be wise.

Last year a task force of the American Planning Association examined how planning and land-use regulation should respond to the takings issue. The association issued a working paper and the Journal of the American Planning Association (1996) published an article based on the paper’s recommendations. Our paper suggests comprehensive reforms of land-use planning and regulation that include making planning more effective, improving planning proce dures, and adopting strategies to protect the small landowner from unfair regulation. I recom mend the paper as an elaboration of the prob lems presented in Liebmann’s article.


Daniel R. Mandelker
Task Force Member, American Planning Association

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