Competition and Regulation in Vertically Related Markets

Abstract

In an industry where naturally monopolistic and competitive activities are vertically related, should the natural monopolist be allowed also to operate in the deregulated competitive sector? Unlike much of the literature on vertical integration, this paper assumes that monopoly pricing behaviour is regulated, and therefore the effect of vertical integration on the task of regulation is central to the analysis. In the model there is both imperfect information and imperfect competition. When vertical integration by the monopolist is allowed, the regulator's task is made harder insofar as the monopolist has anticompetitive incentives to raise rivals' costs. On the other hand, integration may lead to there being fewer firms in the deregulated sector and hence less duplication of fixed costs. The overall welfare comparison between separation and integration is ambiguous, as two simple examples illustrate. Various extensions to the analysis are also considered. One of the central questions in debates on regulatory reform is how to organize industries that contain both naturally monopolistic and potentially competitive activities. Electricity transmission and distribution are characterized by natural monopoly cost conditions, but electricity generation is not. In the gas industry, pipeline services may be naturally monopolistic, but supply to larger customers is not. In telecommunications, natural monopoly is more a feature of local network operations than of long-distance operations, and is not present in apparatus manufacture and supply or in the provision of value added services. In railways, while the infrastructure of track and stations is naturally monopolistic, the supply of train services might not be. Policy developments, notably those associated with privatization in Britain and deregulation in the United States, have sometimes led to radical structural reform in these industries.' AT&T, for decades a vertically integrated monopolist, was required under the 1982 settlement of its long-running antitrust case against the U.S. Government to divest itself of its local network operations. The Central Electricity Generating Board (CEGB) in England and Wales was restructured both vertically-transmission grid activities were separated from generation-and horizontally before privatization in 1990-1991. By contrast, British Telecom was privatized as a vertically integrated dominant firm. BT now faces competition from Mercury and others, especially in the long-distance market, but its dominance of local network operations might affect competition there and in other areas such as apparatus supply. The local network monopoly would of course have to be regulated in any event, but its link via ownership to vertically related and potentially competitive activities poses additional regulatory questions. Many of the efforts of the regulatory body Oftel-notably in relation to interconnection between BT's and rivals' 1. For a general account of the theory and British experience of regulatory reform in the utility industries,