Allocative efficiency and diversification under price-cap regulation

Abstract

This paper shows that the effect of price-cap (PC) regulation and modified price-cap (MPC) regulation on the allocative efficiency and diversification of core and non-core goods depends crucially on (i) whether core and non-core goods are complements, substitutes, or independent, and (ii) whether the non-core market is perfectly or imperfectly competitive. Under PC regulation, efficient production of the core good is impossible unless the non-core market is perfectly competitive. Further, we show that the regulated firm may or may not supply less output in the non-core market under MPC than under PC regulation, depending upon, in part, whether the scheme of common cost allocation is based on either a monotonic method or a relative revenue method. Also, a perfectly competitive non-core market implies core-market overproduction distortion under MPC. We discuss implications for the entry of the ‘Baby Bells’ into long-distance and cellular markets.