Partial Regulation in Vertically Differentiated Industries

Abstract

This paper offers theoretical foundations to price-and-quality cap regulation of recently liberalized utilities in which vertically differentiated services are provided by a regulated incumbent and an unregulated entrant competing in price and quality. The model may equally well represent competition across asymmetrically regulated industries. We establish that, in a variety of strategic settings, optimal weights in the cap targeted to the incumbent depend also on the market served by the entrant, despite the latter is not directly concerned by regulation. This calls for the possibility that regulators use information about the whole industries, rather than on the sole incumbents. We also evidence that the proposed regulatory scheme is robust to small errors in the estimation of the social value of quality.Keywords: Price-and-quality cap; Partial regulation; Vertical differentiation J.E.L. Classification numbers: D43, L13, L51 * The paper was completed while the second author was visiting the University of Montréal, whose hospitality is gratefully acknowledged. We are indebted with Carlo Fiorio, David Martimort, Jérôme Pouyet, Bertrand Villeneuve, Ingo Vogelsang, an Associate Editor and two anonymous referees for helpful suggestions. We further acknowledge useful comments from participants at the XVIII SIEP Meeting (Pavia), the 5th Infraday (Berlin), the 4th Conference on Railroad Industry Structure, Competition and Investment (Madrid), the 47th SIE Meeting (Verona) and the 22nd EEA Meeting (Budapest) as well as from seminar participants at the University of Florence. All remaining errors are our own.

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