Academic journal article
By Sarmento, Paula; Brandao, Antonio
International Advances in Economic Research , Vol. 13, No. 1
Abstract In this paper we study the way a multiproduct firm, regulated through a dynamic price cap, can develop a price strategy that uses the regulatory policy to deter entry. We consider a firm that initially operates as a monopolist in two markets but faces potential entry in one of the markets. We conclude that the regulated firm can have the incentive to block the entry. This strategy leads to the reduction of the price in both markets. However, the final effect of the entry deterrence strategy on total consumer surplus is not always positive.
Keywords price cap regulation * entry
JEL Classification L11 * L51
Price cap regulation was an important innovation in regulatory policy in the 1980s. Since then it has been extensively applied in many economic sectors and countries around the world, namely in network industries as telecommunications and electricity. (1) Typically, in network industries firms are multiproduct and price cap regulation is applied to the prices of a basket of products from markets with different levels of entry attractiveness. There are innumerable examples of price cap regulation applied to multiproduct firms. For instance, the British Airport Authority, the British regulator for the largest airports in United Kingdom, applies price cap regulation to a basket of airport charges. Also, in telecommunications sector in United States, price cap regulation is applied to the long distance access charges defined by the Local Exchange Carriers. (2)
In this paper we study the way a multiproduct firm, regulated through a dynamic price cap, can develop a price strategy that uses the regulatory mechanism to deter entry. We consider a regulated firm that initially operates as monopolist in two markets but, in a second period, entry is possible in one of those markets. As, accordingly to the regulatory policy considered, the price cap of the second period depends on the prices defined in the first period, the incumbent firm might strategically reduce the first period prices in both markets. Then, with the resulting price cap of the second period, entry is not attractive. From this analysis we conclude that the regulated firm has the incentive to follow an anticompetitive strategy to prevent the entry of a new firm in the market where entry is possible, as long as the fixed entry cost is above a critical level.
Our conclusion is in the same line of Armstrong and Vickers (1993). Armstrong and Vickers compare two types of price regulation, average cap and separate cap, applied to a firm that operates simultaneously in a potentially competitive market and in a captive market. The authors conclude that under average cap the firm has an incentive to choose a lower price in the competitive market and a higher price in the captive market than it would have in the case of separate caps. However, the comparison of the two types of price regulation is developed in a static framework which does not allow the study of strategic manipulation of the prices by the regulated firm. Differently, we consider two decision periods to study the effects of the first period prices' definition on the second period's decisions about entry. We conclude that the entry deterrence strategy leads to the reduction of the price not only in the market where entry is possible but also in the captive market.
Bos and Nett (1990) have also studied the entry in markets where there is an incumbent firm regulated by price caps. Considering only one market and the existence of capacity constraints, they showed that the incumbent firm is able to deter entry for high capacity costs of the entrant. However, in Bos and Nett's model there is also only one decision about the price which does not allow the study of strategic price definition.
Foreman (1995) and Law (1997) studied the intertemporal manipulation of price's weights by a regulated monopolist. In spite of considering different models, both authors conclude that the strategic manipulation of price weights by the monopolist regulated firm can have negative consequences on aggregate welfare. …