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Review of Network Economics

Editor-in-Chief: Grzybowski, Lukasz

Ed. by Briglauer, Wolfgang / Goetz, Georg / Pereira, Pedro

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Volume 12, Issue 2


The Optimal Institutional Design of Vertically Related Markets with Unknown Upstream Costs

Raffaele Fiocco
  • Corresponding author
  • Humboldt-Universität zu Berlin, Institute for Economic Theory I, Spandauer Str. 1, D-10178 Berlin, Germany
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Published Online: 2013-05-01 | DOI: https://doi.org/10.1515/rne-2012-0014


This paper examines the design of vertically related industries with a regulated monopolistic upstream input and competitive downstream activities. Two institutional patterns are investigated. Ownership separation entails full unbundling between upstream and downstream activities. Legal separation allows a downstream firm to own the upstream monopolist but requires the two entities to be legally unbundled so that each service is stand-alone profitable and only upstream profits are regulated. Under regulatory limited information about upstream costs, the legally separated monopolist exhibits countervailing incentives to manipulate costs. This alleviates the regulator’s control problem and yields higher welfare than ownership separation.

Keywords: access price; legal separation; ownership separation; regulation; vertical integration; JEL Classification: D82, L11, L51


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About the article

Corresponding author: Raffaele Fiocco, Humboldt-Universität zu Berlin, Institute for Economic Theory I, Spandauer Str. 1, D-10178 Berlin, Germany

Published Online: 2013-05-01

Published in Print: 2013-06-01

See the Order 636 of 1992 for natural gas and the Order 2000 of 1999 for electricity. We refer to Newbery (1999) and Viscusi et al. (2005) for an overview of the most important regulatory reforms in the UK and US network utilities.

We refer to Cave (2006) for an overview of different degrees of separation.

In the presence of unregulated downstream prices and complete information, Armstrong and Vickers (1998) show that the optimal access price can be above or below marginal costs.

Armstrong et al. (1994) provide extensions of the ECPR. We also refer to Armstrong and Sappington (2006) for a review of this topic.

Fixed costs that make the activity naturally monopolistic are irrelevant for the welfare analysis and can be ignored.

The Telecommunications Act of 1996 explicitly excludes earnings from unregulated activities for the computation of a reasonable profit accruing to US incumbent local exchange carriers (Sidak and Spulber 1998, chapter 9). In Japan, the regulated local affiliates of Nippon Telegraph and Telephone Corporation, NTT East and NTT West, must be viable per se and cannot be cross-subsidized. The European Directives 2009/72/EC and 2009/73/EC provide a similar prohibition in electricity and gas markets.

We abstract from income effects, which provides a rationale for a partial equilibrium analysis.

If firms exhibit different costs, the question of efficient entry may be raised, which is beyond the scope of this paper. Since firms sell a homogeneous good, the cost difference should be small, and therefore only the allocation of total output among firms will change while the welfare analysis remains unaffected.

See, e.g., Baron (1988) for theoretical foundations. Using (1), social welfare in (3) can be rewritten as

Hence, the regulator’s distributional concerns imply that the monopolist’s rents are socially costly. In Section 6 we consider a consumer surplus objective (γ=0).

This assumption is fulfilled, for instance, by the setting in Section 6 (see the proofs of Propositions 7 and 8 in the Appendix).

In line with some relevant literature (e.g., Vickers 1995; Iossa 1999), we restrict attention to the case where regulator must choose the institutional pattern before the firm learns its costs.

With Tu–(acu)Q, firm 1 maximizes π1+πu=p(Q)q1C(q1)–aq1+πu, where πu is a fixed payment decided by the regulator. This clearly entails the same second-stage outcome as ownership separation. Standard conditions for existence and stability of an equilibrium outcome are supposed to hold (e.g., Vives 1999, chapter 2).

Even though the regulator may have many instruments at hand to collect data on the industry, its information usually remains imperfect. This problem is particularly severe in the bottleneck part. Conversely, in the downstream market the firms sell a homogeneous good whose costs are likely to be correlated. Hence, the regulator can extract all relevant information at low cost.

See, e.g., the European Directives 2009/72/EC and 2009/73/EC for the electricity and natural gas markets. Section 7.1 extends our results to the case where firm 1 is informed.

Regulated upstream profits are typically concave in declared costs. This is because cost exaggeration increases upstream profits via a higher access price but induces downstream firms to reduce their output, which makes this strategy less appealing for high-cost declarations.

Notice from Figure 1 that the legally separated monopolist does not have any incentive to understate its costs, namely, to declare

since the loss in upstream activities more than compensates the gain in downstream activities.

We refer to the proof of Proposition 3 for technical details.

This transfer scheme seems to be in line with some practical regulatory policies, which endow the regulated firm with transfers that take into account the revenues from the marketplace. For instance, with rate-of-return regulation, the firm is subsidized whenever the revenues from the marketplace do not allow it to achieve the authorized return.

While the choice of a transfer scheme T=πu–(acu)Q does not affect the outcome under ownership separation, the regulator might find different transfer payments which generate higher welfare under legal separation. In this case, the result of welfare superiority of this regime stated in Proposition 3 would be strengthened. Significantly, if the regulator chooses a payment which is not contingent on the revenues from the marketplace, such as a fixed component of a two-part tariff, our qualitative conclusions carry over (see Proposition 10 in Section 7.3).

In Section 7.1 we show that, if the downstream parent company is informed about the real upstream costs, legal separation still generates countervailing incentives, even though they are weaker.

A positive profit weight leaves our qualitative results unaffected. Analogously, a formulation that includes the shadow cost of public funds which captures distortionary taxation (e.g., Laffont and Tirole 1986) provides the same qualitative conclusions (Armstrong and Sappington 2007).

The transfer is indeed negative, namely, the monopolist pays taxes to the regulator.

The hazard rate H(cu) is increasing in cu. This standard assumption ensures the implementability of the regulatory policy.

Notice that

in (12) is typically decreasing in cu. This is true for any ϕ∈[0,1] if H′<2, which is satisfied by commonly used distribution functions (e.g., the uniform and power distributions).

The inequality follows since positive output and increasing hazard rate respectively ensure that two bracketed expressions in the integrand are positive.

Since the downstream output also reflects real costs and, in case of cost manipulation, diverges from what the regulator anticipates

this case is relevant when the monopolist cannot be punished for its misreport.

See Section 272 of the Telecommunications Act of 1996.

For instance, this is the case of price competition with asymmetric costs or differentiated good competition. Room for positive profits is a natural feature of recently liberalized markets.

Dixon and Easaw (2001) show that British Gas has retained the first mover and pre-entry advantage following the liberalization process.

The second condition requires the price to increase with upstream costs less than the access charge, which is ensured by downstream competition (see also the proof of Proposition 2).

Without loss of generality, firm 1 is the downstream division of the vertically integrated company.

Notice that

entails αca(cu)>0.

Citation Information: Review of Network Economics, Volume 12, Issue 2, Pages 183–210, ISSN (Online) 1446-9022, ISSN (Print) 2194-5993, DOI: https://doi.org/10.1515/rne-2012-0014.

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