Capacity Choice and Government Regulation in a Vertical Industry

Abstract

This paper sets up an industry competition model consisting of two upstream enterprises and two downstream enterprises. Then we rely on the model to explore how non-regulation and different regulatory policies (maximizing the total profits of the upstream enterprises, the social welfare of the upstream industry or the overall social welfare) affect the following factors: the excess capacity, enterprise profits, consumer surpluses, social welfare in the upstream and downstream enterprises and the overall social welfare. The following conclusions are drawn from our research. First, whether and how the government regulates the capacity choice greatly affect the equilibrium outcomes, as well as the welfare distribution among the upstream enterprises, downstream enterprises, and consumers. The specific effects are dependent on market demand and enterprise cost. Second, the government should formulate its regulatory policies on capacity choice based on the overall social welfare of the entire supply chain. If the government aims to maximize the profits of the upstream enterprises, the social welfare of the downstream industry will be negatively affected. Third, excess capacity does not necessarily suppress social welfare. Under certain conditions, the worst scenario of excess capacity may occur under the pursuit of the maximal overall social welfare. Excess capacity may arise from various causes, rather than market competition or government regulation alone. Excess capacity cannot be attributed solely to government failure. These conclusions have some significance for optimizing capacity regulation policies.