Diversification and Regulated Monopoly
Although the merits of diversification by regulated utilities into competitive markets have been widely debated by economists, regulators, and public interest advocates, the efficiency consequences of relaxing line-of-business restrictions remains unclear.1 One argument, most recently advanced by Baumol and Willig  and McAvoy and Robinson , contends that diversification restrictions are both unnecessar’ and result in significant inefficiencies through the loss of economies of scope. The alternative position, which was enunciated most cogently by Posner , is that “… regulation… creates an incentive… to diversify, regardless of efficiency considerations… for diversification may enable the [regulated firm] to evade the constraint of regulation” (p. 605). This paper reconciles these two conflicting positions by examining the incentives facing the regulated firm to diversify into competitive markets. We conclude that, under rate of return regulation, the existence of economies of scope is a necessary, but not a sufficient, condition for efficiency because any benefits are sensitive to the precise regulatory form and cost attribution rules adopted by regulators.
KeywordsCogeneration Monopoly Baumol
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