Academic journal article Contemporary Economic Policy

Trigger-Point Mechanism and Conditional Commitment: Implications for Entry, Collusion, and Welfare

Academic journal article Contemporary Economic Policy

Trigger-Point Mechanism and Conditional Commitment: Implications for Entry, Collusion, and Welfare

Article excerpt

I. INTRODUCTION

In regulated industries, a key issue faced by the regulator is how to induce investment to increase social welfare. For example, a regulated firm (monopoly) can make a research and development investment to reduce its production costs. After the investment has taken place, it is socially optimal for the regulator to reduce the regulated firm's supply price, thus reducing the firm's profit from such an investment. But anticipating the regulator's opportunistic behavior, the firm may not make the investment in the first place. (1) This type of ex ante inefficiency, however, can be mitigated or completely avoided by using some properly designed mechanisms. (2) One of those mechanisms is to write a long-term contract between the regulator and the regulated firm, under which the regulator fully commits to no change of policy. But as the environment (other than the firm's investment) changes, the policy may turn out to be bad and the regulator will have no means to correct it under the long-term contract. This represents the danger of overcommitment. As pointed out by Laffont and Tirole (1993, p. 620), "The benefit of commitment is that the regulated firm's investment is not expropriated. The cost of commitment is that the government may identify with the firm and bind the nation to a bad outcome over the long run."

The trade-off between full commitment and noncommitment naturally suggests that a mechanism of conditional commitment may be preferable. Although this type of mechanism has not been studied in the regulation literature, it has already been put to use in the real world. (3) One such example is the so-called trigger-point mechanism (TPM) used to regulate entry into container terminal service in the world's busiest container port, Hong Kong. To protect the financial interests of the private investors who developed the terminals, the Hong Kong Port Development Board (PDB) adopted the TPM, under which "new berths were not triggered until forecast throughput equalled working capacity of existing and planned berths" (PDB 1992, p. 23). The PDB makes a conditional commitment under the TPM with regard to entry: Entry will be allowed if future demand is sufficiently strong but not allowed otherwise. (4)

Another example is the second-sourcing of defense systems adopted by the U.S. Department of Defense. As described and modelled by Anton and Yao (1987), the mechanism specifies that if the developer (the primary contractor) produces x units in the first stage, then the remaining quantity, z - x units (where z is the prespecified quantity) will be reprocured and the contract will be awarded to the winner in a bid between the developer and a second contractor. Hence, reprocurement occurs if and only if x < z. If no reprocurement is interpreted as full commitment and reprocurement as noncommitment, then the mechanism of second-sourcing represents a conditional commitment.

The book edited by Levy and Spiller (1996) contains many other examples of conditional commitment regulations of the telecommunications industry in Chile, Jamaica, the Philippines, and the United Kingdom.

This article constructs a multiperiod model to investigate the effects of the regulator's conditional commitment, in the form of the TPM, on entry, collusion, and social welfare. In the first period, two firms contemplate entering the market in which future entry by a third firm is regulated. Because entry in the first period incurs a large sunk cost, the government's entry regulation affects first period entry as well as future entry. To see commitment value as clearly as possible, we suppose that there will be entry in the second period in the absence of regulation. Because future entry heightens competition and lowers the incumbent firms' future profits, their discounted profits may not be large enough to recover the sunk cost of entry in the first period if the government does not prohibit future entry. …

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