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Saturday, September 9 • 11:38am - 12:12pm
Price-Cap Regulation of Firms that Supply Their Rivals

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Motivated by the Federal Communications Commission’s Business Data Services proceeding, we study the effects of price-cap regulation in a market in which a vertically integrated upstream monopolist sells a requisite input to a downstream competitor. Business data services lines are dedicated high-capacity connections used by businesses and institutions to transmit voice and data traffic. Markets for business data services are often dominated by an incumbent local exchange carrier that sells wholesale service to a downstream rival. Because competition in the provision of business data services is limited in the United States, these services have a history of regulation by the FCC.

Using a theoretical model of firms that supply their rivals, we find that, in the absence of regulation, entry benefits both firms but may be detrimental to (downstream) consumers because the upstream monopolist can set a high input price that pushes downstream prices above the monopoly level. However, if a regulator imposes price caps that constrain the incumbent's upstream and downstream prices, consumers—as well as both firms—benefit from entry. Moreover, price cap regulation does not encourage the incumbent to attempt to foreclose potential entry because to the contrary: entry serves as the primary means by which the regulated incumbent earns above zero profit.

Using dynamic extensions of the model, we also explore the concerns that price caps may induce incumbents to forgo cost-reducing investments or dampen entrants' incentives to self-provision the essential input. In particular, a regulated incumbent that relies on entry for its main source of profit may be less interested in marginal cost reductions for its own services than if the incumbent remained unregulated. As we show, this intuition turns out to be incomplete: under regulation, less of the gain from increased efficiency is passed on to consumers than without regulation, motivating a regulated incumbent to invest more.

In contrast, we find that, under most parameter values in our model, entrants are more likely to self-provision the essential input without regulation. On the one hand, entrants seeking to self-provision face a lower priced rival incumbent under regulation than without, and hence less of a rival response when they lower their own price. On the other hand, when the input price is not regulated, self-provision can dramatically reduce entrant costs. This latter effect usually dominates.

Thus, regulators considering the impact of price cap regulation in markets where firms supply their rivals must weigh both static and dynamic considerations. Specifically, regulators like the FCC must consider whether cost-reducing investment by incumbents or upstream market entry are more important for long term competition when determining whether or not to rely on price caps in new markets.

Presenter
AY

Aleksandr Yankelevich

Michigan State University

Author

Saturday September 9, 2017 11:38am - 12:12pm
ASLS Hazel Hall - Room 225

Attendees (6)