Price-Cap Regulation and the Incentive to Cooperate in Research

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This paper considers the impact of price-cap regulation on R&D and the incentive of firms to form research joint ventures. Using a symmetric two-stage duopoly model of cost-reducing R&D with multiple forms of research cooperation, we find that R&D is greatest when firms fully cooperate in research and share all research knowledge. Price-cap regulation, however, appears to have a small but negative effect on R&D, leading to lower total welfare.


During the 1990s the telecommunications industry, along with other traditionally regulated industries, replaced rate-of-return forms of regulation with price-cap and other incentive-based types of regulation. (1) Before the divestiture of AT&T in 1984, for example, all 50 states employed rate-of-return regulation to regulate intrastate telecommunication operations. Following the divestiture, however, several states began experimenting with alternative forms of incentive-based regulations (e.g. earnings sharing regulation, rate case moratoria, and price-cap regulation). (2) By 1996, price-cap regulation had emerged as the most common form of these new regulations. By the time of the new millennium, only twelve states retained the use of rate-of-return regulation, while thirty-five utilized price-cap regulation (see Ai and Sappington, 2002).

The rise of price-cap regulation can be attributed to its potential of providing stronger incentives for innovation than traditional rate-of-return regulation (see Vogelsang, 2002; Clemenz, 1991; Cabral and Riordan, 1989). (3) Empirical support for this view has gained considerable ground in recent years. Studies by Ai and Sappington (2002), Prieger (2002; 2001), and Resende (2000) have all found price-caps to be associated with greater innovation and greater productive efficiency, while Uri (2001a) and Lehman and Weisman (2000) have found qualified support.

The potential of price-cap regulation to encourage greater innovation has special importance in industries such as telecommunications, where innovations play a critical role in the industry's growth. Uri (2001b), for example, finds that productivity in telecommunications increased nearly 5% per year in the 1990s, with much of this growth primarily due to the development of new production technologies. The practice of developing these innovations, however, has increasingly involved firms cooperating with other firms. Duysters and Hagedoorn (2000) find that joint research partnerships in telecommunications during the 1989 to 1996 period were up 317% over the 1980 to 1988 period. (4) This emerging practice of regulated firms increasing R&D through R&D cooperation with other firms, however, remains largely ignored in the theoretical and empirical literatures.

The purpose of this paper is to explore the impact of price-cap regulation in an environment where firms may choose to cooperate in the development of research. Our analysis relies on a symmetric two-stage duopoly model to compare R&D and output levels both with and without price-cap regulation. In the initial stage, firms must choose to either compete in the production of R&D, form a research joint venture by cooperating in the production of R&D, or cooperate in the production of R&D and fully share all cost-reducing research information. Table 1 presents a summary description of these three research scenarios. In the second stage of our model, firms compete in the output market. (5) The results are then compared based on the substitutability of the firm's products, the presence and efficacy of price-cap regulation and the degree to which new knowledge can spillover to rival firms. A spillover occurs, for example, when a firm's privately created knowledge becomes publicly available and the firm lacks any legal mechanism to enforce excludability. (6)

Our findings indicate that the intersection between regulatory policies and research cooperation matters. …