Abstract
In this paper, we study optimal regulation of a dominant firm facing an unregulated competitive fringe. First, assuming the size of the fringe is fixed, we demonstrate that the usual Ramsey Rule for second-best efficient pricing remains applicable in this context. We also examine the suitability of the Laspeyres price cap and show that it retains its desirable properties. This implies that regulators should continue to apply Laspeyres price cap regulation to the dominant firm after competition has materialized. Then, assuming that price and entry control are regulatory instruments, we characterize the efficient pricing and entry rules. We demonstrate that the free entry equilibrium number of firms will be excessive relative to the efficient number of firms, thereby providing a new Excess Entry Theorem. Finally, we suggest a modification of the Laspeyres price cap that can incentivize the regulated dominant firm to support efficient entry into the fringe.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
Notes
It should be noted that liberalization alone may not lead to effective competition, particularly in the presence of strategic entry deterrence by a dominant incumbent. Hence, prices are typically controlled in emerging competitive markets as well as captive markets. Moreover, with the pricing flexibility inherent in an average price cap, anticompetitive strategies by a regulated dominant incumbent remain a possibility (Sarmento and Brandao 2007). One way regulators can protect competitors is with price floors.
Monopolies in basic services still exist in approximately 35 % of the countries for which data is available, although full or partial competition in services such as mobile and Internet services is the norm (Infodev/ITU 2010).
Services provided in fully competitive markets typically are not included in a price cap regime. However, a market cannot be considered fully competitive if a dominant firm possesses substantial market power stemming from vertical economies, economies of scale or scope, or control over essential facilities. Our assumption of a dominant firm facing a competitive fringe is meant to be representative of a transitional state between pure regulated monopoly and fully deregulated competition with no firm dominant.
The applicability of the monopoly analysis to the regulated dominant firm with the dominant firm’s residual demand replacing the market demand has been noted by Armstrong and Vickers (1993).
Strictly speaking, L t+1 is a chained Laspeyres price index since the weights on the prices are the previous period’s quantities. With a simple Laspeyres price index, the weights are quantities taken from a fixed base period.
As is customary in most of the previous literature, we ignore the integer constraint on the number of fringe firms for expositional convenience.
This results directly from Proposition Two. If p 2 could increase because of entry, then πf = k will not in general be the equilibrium condition. Indeed, if πf = k and the potential entrant correctly forecasted that upon entry p 2 would increase, then this would imply that after entry πf > k, in which case the firm would enter.
A function f is quasiconvex if f(y) ≤ f(x) implies \( \nabla f(x)\; \bullet \;(y - x)\; \leqslant \;0 \).
References
Armstrong, M., Cowan, S., & Vickers, J. (1999). Regulatory reform - economic analysis and British experience (5th ed.). Cambridge: MIT.
Armstrong, M., & Sappington, D. E. M. (2007). Recent developments in the theory of regulation. In M. Armstrong & R. Porter (Eds.), Handbook of Industrial Organization (Vol. 3). Amsterdam: Elsevier.
Armstrong, M., & Vickers, J. (1993). Price discrimination, competition and regulation. Journal of Industrial Economics, XLI, 335–359.
Bernstein, J. I., & Sappington, D. E. (1999). Setting the X factor in price cap regulation. Journal of Regulatory Economics, 16, 5–25.
Brennan, T. J. (1989). Regulating by capping prices. Journal of Regulatory Economics, 1, 133–148.
Cabral, L. M. B., & Riordan, M. H. (1989). Incentives for cost reduction under price cap regulation. Journal of Regulatory Economics, 1, 93–102.
Crew, M. A., & Kleindorfer, P. R. (1996). Price caps and revenue caps: Incentives and disincentives for efficiency. In M. A. Crew (Ed.), Pricing and regulatory innovations under increasing competition. Boston/Dordrecht/London: Kluwer.
Currier, K. (2007a). A practical approach to quality-adjusted price cap regulation. Telecommunications Policy, 31, 493–501.
Currier, K. (2007b). Quality-corrected price caps. Bulletin of Economic Research, 59, 255–268.
de Villemeur, E., Cremer, E. H., Roy, B., & Toledano, J. (2003). Optimal pricing and price cap regulation in the postal sector. Journal of Regulatory Economics, 24(1), 49–62.
Gallet, C. (1999). Authorization procedures in the postal sector: Possible lessons from other sectors for entry regulation. In M. A. Crew & P. R. Kleindorfer (Eds.), Emerging competition in postal and delivery services. Norwell: Kluwer Academic Publishers.
Infodev/ITU. (2010). ICT Regulation Toolkit. http://www.ictregulationtoolkit.org/en/index.html (accessed December 2010).
Intven, H. (2010). Telecommunications regulation handbook. Module 4 - Price Regulation, 10th Edition. www.infodev.org/projects/314regulationhandbook (accessed December 2010).
Itoh, M., Kiyono, K., Okuno-Fujiwara, M., & Suzumura, K. (1991). Economic analysis of industrial policy. New York: Academic.
Laffont, J. J., & Tirole, J. (1996). Creating competition through interconnection: Theory and practice. Journal of Regulatory Economics, 10(3), 227–256.
Littlechild, S. C. (1983). Regulation of British telecommunications, profitability. Report to the Secretary of State, Department of Industry. London: Her Majesty’s Stationery Office.
Mankiw, N. G., & Whinston, M. D. (1986). Free entry and social inefficiency. Rand Journal of Economics, 17, 48–58.
Sarmento, P., & Brandao, A. (2007). Entry deterrence and entry accommodation strategies of a multiproduct firm regulated with dynamic price cap. International Advances in Economics Research, 13, 19–34.
Vogelsang, I. (2002). Incentive regulation and competition in public utility markets: A 20-year perspective. Journal of Regulatory Economics, 22, 5–27.
Vogelsang, I., & Finsinger, J. (1979). A regulatory adjustment process for optimal pricing by multiproduct monopoly firms. Bell Journal of Economics, 10, 157–171.
WIK Consulting. (2009). The role of regulators in a more competitive postal market. Final report, study for the European Commission, Directorate General for Internal Markets and Services. http://ec.europa.eu/internal_markets/post/doc/studies/2009-wik_regulators.pdf (accessed December 2010).
Author information
Authors and Affiliations
Corresponding author
Additional information
I would like to thank an anonymous referee for several suggestions leading to a clearer focus for the applicability of the model.
Rights and permissions
About this article
Cite this article
Currier, K.M. Optimal Pricing and Entry Rules When a Regulated Dominant Firm Faces a Competitive Fringe. Int Adv Econ Res 17, 465–475 (2011). https://doi.org/10.1007/s11294-011-9317-0
Published:
Issue Date:
DOI: https://doi.org/10.1007/s11294-011-9317-0