Regulation, Competition, and Liberalization · Regulation, Competition, and Liberalization ... (CTC), while long distance telecommunications services ... This pattern of entry

Journal of Economic LiteratureVol. XLIV (June 2006), pp. 325–366

Jun06_Article1 5/2/06 4:50 PM Page 325

Regulation, Competition, andLiberalization

MARK ARMSTRONG AND DAVID E. M. SAPPINGTON∗

In many countries throughout the world, regulators are struggling to determinewhether and how to introduce competition into regulated industries. This essay exam-ines the complexities involved in the liberalization process. While stressing the impor-tance of case-specific analyses, this essay distinguishes liberalization policies thatgenerally are procompetitive from corresponding anticompetitive liberalization policies.

∗ Armstrong: University College London. Sappington:University of Florida. We are grateful to Sanford Berg,Severin Borenstein, Cory Davidson, Roger Gordon, AntonioEstache, Jerry Hausman, Mark Jamison, Paul Joskow,Mircea Marcu, John McMillan, Paul Sotkiewicz, JohnVickers, Catherine Waddams, Helen Weeds, and anonymousreferees for helpful comments and observations.

1. Introduction

Economists have developed an extensiveset of principles for regulating a monop-

oly supplier. The benefits of unfettered,pervasive competition are also well docu-mented and well understood. However, ourunderstanding of the precise conditionsunder which regulated monopoly supply ispreferable to unregulated competition islimited. Furthermore, we know relativelylittle about optimal liberalization policies—the policies that govern the transition tocompetitive market conditions—in caseswhere competition is deemed superior tomonopoly.

The purpose of this essay is to explorethese two issues, both of which are of sub-stantial practical importance throughout the

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world. These issues are particularly relevantin key network industries (such as thetelecommunications, natural gas, electricity,transport, and water industries) where scaleeconomies can render production by manyfirms uneconomic, but where some compe-tition may be useful to help disciplineincumbent suppliers of key services. Ouranalysis of the choice between regulatedmonopoly and unregulated competition, likeour analysis of the design of liberalizationpolicies, emphasizes the problems thatimperfect information and imperfect institu-tions pose for the design of industry policy.

This essay has three main parts: (1) sec-tion 2 reviews some recent experience withliberalization policy; (2) sections 3 through 5consider the choice between unregulatedcompetition and regulated monopoly; and(3) sections 6 and 7 consider the design ofliberalization policies in settings where com-petition is preferred to monopoly.

Section 2 summarizes selected experi-ences with liberalization in three networkindustries where liberalization has garneredsignificant attention in recent years:

326 Journal of Economic Literature, Vol. XLIV (June 2006)


telecommunications, natural gas, and elec-tricity. The experiences in Chile’s telecom-munications industry, the United Kingdom’snatural gas industry, and the state ofCalifornia’s electricity industry have variedgreatly, ranging from substantial success inChile to substantial failure in California.

Section 3 begins the discussion of thechoice between unregulated competitionand regulated monopoly by analyzing simpleformal models of these two forms of indus-trial organization. The models emphasizethe role of imperfect information. Section 4considers additional factors that affect thechoice between regulation and competition,including the resources available to the reg-ulator, the regulator’s independence andautonomy, the need to ensure ubiquitousservice at affordable prices, and the impor-tance of investment and innovation. Section5 notes that, even when monopoly supply isthe preferred mode of industry operation,some of the benefits of competition may besecured by allowing potential operators tobid for the right to serve as a regulatedmonopoly supplier.

Section 6 begins the discussion of liberal-ization policies in settings where the benefitsof competition outweigh its costs. The poten-tial merits and risks of direct entry assistanceare considered first. Liberalization policiesthat are likely to reduce the intensity of long-term industry competition (and thereforegenerally are not recommended) arereviewed next. These policies include pro-viding temporary monopolies or oligopolies,excluding foreign investors, specifying mar-ket share targets for industry participants,restricting incumbent suppliers asymmetri-cally, and affording competitors undulyfavorable long-term access to the incum-bent’s infrastructure. Section 7 discusses lib-eralization policies that typically willenhance the intensity of long-term industrycompetition (and therefore are recommend-ed). These policies include reducing thecosts that customers incur when they switchsuppliers; rebalancing the prices charged by

the incumbent supplier to better reflect itsoperating costs and otherwise redesigningthe regulations imposed on the incumbentsupplier to account explicitly for emergingcompetition; privatizing state-owned enter-prises; establishing appropriate accessprices; and increasing monitoring, datareporting, and antitrust scrutiny, at least dur-ing the early stages of liberalization.

Two central themes emerge in this essay.First, even the comparatively simple choicebetween regulated monopoly and unregulat-ed competition can be intricate and complexin practice. Second, the decision to intro-duce competition into an industry is only thebeginning of a journey down a long andwinding road that can present many obsta-cles and detours. Furthermore, the bestroute from monopoly to competition can dif-fer substantially in different settings.Therefore, there is no single set of directionsthat can guide the challenging journey frommonopoly to competition in all settings.

Even though detailed, comprehensivedirections typically are not available, somebroad conclusions (summarized in section 8)that can serve as useful guide posts can bedrawn. These broad conclusions include thefollowing five. First, the greatest potentialgains from competition tend to arise when(1) industry scale economies are limited rel-ative to consumer demand; (2) the industryregulator has limited information, limitedresources, and limited instruments withwhich to craft policy; (3) the regulator’s com-mitment powers are limited; and (4) subsi-dization of the consumption of some of thedominant supplier’s services either is notcritical or can be achieved by means otherthan through distortions in the supplier’sprice structure. Second, there are a widevariety of liberalization policies, and themerits of the different policies vary consid-erably. Therefore, it generally is more appro-priate to inquire about the benefits and costsof specific liberalization policies than to askwhether liberalization per se is desirable orundesirable. Third, liberalization policies

Armstrong and Sappington: Regulation, Competition, and Liberalization 327


1 The following discussion is drawn primarily fromAhmed Galal (1996), Pablo T. Spiller and Carlo G. Cardilli(1997), David M. Newbery (1999, pp. 123–25), CecileAubert and Jean-Jacques Laffont (2002, pp. 39–41),Laffont (2005, pp. 214–16), and Ricardo D. Paredes(2005).

that primarily aid some competitors andhandicap others on an ongoing basis can hin-der the development of vigorous long-termcompetition. Fourth, liberalization policiesthat remove entry barriers and empowerconsumers to discipline industry supplierstypically are the best means by which to fos-ter vigorous long-term competition. Fifth,well-designed liberalization policies canfacilitate a transition from stringent, detailedregulatory control to less intrusive antitrustoversight. However, during the transitionprocess, heightened regulatory and antitrustscrutiny may be required.

2. Recent Experience with Liberalization

To help ground the ensuing discussion ofthe principles of liberalization policy, we beginby reviewing briefly the recent experiencewith liberalization in Chile’s telecommunica-tions industry, the United Kingdom’s naturalgas industry, and California’s electricityindustry.

2.1 Liberalization in Chile’sTelecommunications Industry1

The General Law of Telecommunicationsopened Chile’s telecommunications industryto competition in 1982. This law generallydid not restrict the number of licenses thatwould be granted to deliver telecommunica-tions services in Chile. Importantly, thelicenses were for nonexclusive provision ofwireline and wireless services, both local andlong distance. The primary obligationimposed on all telecommunications opera-tors in Chile was to connect their networks incompliance with specified technical require-ments. Other terms and conditions of inter-connection typically were left to negotiationamong the operators.

In 1982, local telecommunications servic-es were supplied almost exclusively byCompenía de Teléfonos Chile (CTC), whilelong distance telecommunications serviceswere supplied almost exclusively by Entel.Not surprisingly, these two state-ownedenterprises were not anxious to connecttheir networks with the networks of emerg-ing rivals. Few interconnection agreementswere signed and competition was limiteduntil Chile implemented a dispute resolu-tion process that ensured the timely execu-tion of interconnection agreements. Longdistance competition also was limited untilan equal access requirement was imposed in1994. The requirement stipulated that everytime a customer placed a long distance call,she had to explicitly designate (via dialing aspecial code) a long distance company tocarry the call. The special code for each longdistance carrier—incumbent and entrantalike—had the same number of digits. Mostimportantly, a call was not automatically car-ried by Entel if the caller did not specify analternative carrier.

Once new suppliers were afforded sub-stantial opportunity to provide telecommu-nications services on terms comparable tothose faced by incumbent suppliers, compe-tition began to flourish in Chile. The num-ber of fixed lines more than tripled (fromroughly one million to more than three mil-lion) between 1992 and 2000, and the exten-sive waiting list for (fixed) wirelinetelephone service that had inconveniencedChile’s citizens for so many years quickly dis-appeared. The number of mobile telephonesubscribers in Chile increased nearly ten-fold (from roughly 36,000 to more than 3.4million) during the 1991–2000 period andnearly doubled again (to more than 6.7 mil-lion) between 2000 and 2003. Prices formost telecommunications services in Chilealso have declined substantially since 1990.

By 2003, nearly one-fourth of the fixedtelecommunications lines in Chile were sup-plied by CTC’s competitors rather than bythe incumbent supplier. Competitors



2 See Paredes (2005), for example.3 The material is drawn from Mark Armstrong, Simon

Cowan, and John Vickers (1994, chapter 8) and Newbery(1999, chapter 8).

secured especially large market shares inChile’s urban regions. This pattern of entrylikely reflects in part the lower unit costs ofserving urban areas given their relativelyhigh population densities. This entry patternalso may reflect regulated prices of basictelephone service that are further abovecosts in urban regions than in rural regions.The regulated prices of local telephone serv-ices in rural regions often do not reflect fullythe relatively high unit costs of serving theseregions. Instead, prices in rural regions tendto be set closer to (and sometimes below)cost while prices in urban regions often areset substantially in excess of cost. Such pric-ing patterns are designed to ensure thatbasic telephone service is affordable to allcitizens. These patterns may be less pro-nounced in Chile than in some countriesbecause a separate fund has been estab-lished to subsidize the purchase of basictelephone service in rural regions and low-income urban regions. Nevertheless, injurisdictions where CTC is deemed to be adominant supplier of local telephone servic-es, it is required to set the same price forbasic services across substantial geographicregions. Some suggest that this restriction onCTC’s ability to target price reductions tothose regions in which competition is mostintense may be one cause of the substantialmarket share that competitive suppliers oflocal telecommunications services have beenable to secure in Chile.2

2.2 Liberalization in the United Kingdom’sNatural Gas Industry3

Natural gas was one of the principal net-work industries in the United Kingdom tar-geted for privatization under MargaretThatcher’s program of industrial reform.Natural gas was first extracted from the U.K.Continental Shelf in 1965 and British Gas(BG) was formed as a state-owned company

4 Alternatively, BG could have been separated into anational pipeline business and several regional suppliersbefore privatization, an approach subsequently pursued inthe U.K. electricity industry.

5 This Y factor enabled BG to pass through its costs ofpurchasing gas to consumers, and thereby limited BG’sincentive to secure low gas prices. Subsequent regulationpermitted BG to pass through only a more exogenousindex of gas costs.

6 The 2 percent value for X was widely believed tounderestimate the realistic potential for productivity gains.Of course, lenient price regulations enhance revenuesfrom privatization.

in 1972. BG held a legal monopoly over thesale of gas to consumers and a legal monop-sony over the purchase of gas from produc-ers in the U.K. fields. Since gas explorationand production involve substantial sunkcosts, BG’s monopsony power necessitatedthe use of long-term (e.g., twenty-five year)purchase contracts to limit expropriation ofthe substantial investments made by gasproducers.

An initial attempt to liberalize the gas sec-tor occurred in 1982 when entrants wereauthorized to employ BG’s pipelines (atterms negotiated with BG) to supply gas tofinal customers. In addition, BG’s legalmonopsony was removed. Although thesesteps were intended to facilitate competitionin the gas industry, competition did notemerge immediately.

BG was privatized as a vertically integrat-ed monopoly in 1986.4 At this time, con-sumers were divided into two categories forregulatory purposes: (1) the tariff market,consisting of those consumers who pur-chased less than 25,000 therms of gas peryear, and (2) the contract market, consistingof the remaining higher-volume consumers.BG continued to enjoy a legal monopoly inthe tariff market after privatization. BG’sprices in this sector were regulated: theannual increase in the average price pertherm was limited to RPI + Y − X, whereRPI is the inflation rate, Y is a measure ofthe increase in the price BG pays for gas,and X is a productivity improvement factor.5

X was set at 2 percent in 1986, but raised to5 percent in 1992.6



7 These access charges were distance related. BecauseBG’s retail prices did not vary across geographic regions,this pricing policy enabled entrants to secure a higherprofit margin when serving customers located close to thegas landing point.

Competition in the contract marketwas potentially open to competition andBG’s prices in this market were not regu-lated. Although it was legal, competitiondid not emerge in this market until 1990.The delay reflected in part limited regu-lation of the prices BG charged retailcompetitors for access to its pipelines.BG also practiced price discrimination inthe contract market, charging higherprices for gas to those industrial userswho had no reasonable alternative energysource (e.g., electricity).

To combat these perceived problems,new regulations were imposed in 1988.The regulations required BG to (1) pub-lish a tariff on which any customer in thecontract market could purchase gas (inan attempt to limit price discrimination);(2) publish a corresponding tariff of net-work access charges (although thesecharges remained otherwise unregulat-ed); and (3) purchase no more than 90percent of the gas in any newly discov-ered gas field. This final requirementessentially forced some limited entry intothe contract market. By 1990, though,BG supplied 93 percent of the gas sold inthis market.

Limited competition in the contractmarket promoted three further regulato-ry reforms in the early 1990s. First, themonopoly threshold in the tariff sectorwas reduced from 25,000 therms to 2,500therms, thereby permitting smaller cus-tomers to purchase gas from competitors.Second, the prices charged for access toBG’s pipelines came under regulatorycontrol.7 Third, BG was required toreduce to 40 percent (by volume) itsshare of sales to the contract market by1995. At the same time, new gas fieldswere being opened, and entrants were

8 As a result, BG was left with long-term obligations topurchase gas that it no longer needed to serve its own con-sumers. When BG was privatized, investors were promisedthat BG would be able to supply approximately two-thirdsof the demand for natural gas by volume until 2009. Asregulation and liberalization developed, this promise wasnot honored.

9 The following discussion is based primarily on SeverinBorenstein (2002).

able to buy supplies from these newfields.8

Although regulation did not force BG toseparate its pipeline and gas supply opera-tions, intense regulatory scrutiny and oner-ous separate accounting requirements ledBG to undertake such vertical divestiturevoluntarily. Furthermore, the monopolyfranchise threshold of 2,500 therms wasremoved entirely in 1998, so all consumerswere permitted to purchase gas from suppli-ers other than BG. Competition intensified,and all retail price controls were removed in2002. Only access charges continue to beregulated. Many consumers continue to pur-chase natural gas from BG even though BGcharges more than some competitors forwhat is largely a homogeneous product. Thisfact may suggest that customer switchingcosts or other causes of customer inertia areimportant in this industry.

2.3 Liberalization in California’s ElectricityIndustry9

Although the state of California’s experi-ence with liberalization in its electricityindustry is quite recent, the experience isalready legendary. In 1996, California enact-ed legislation that introduced five primarychanges in the state’s electricity sector. First,electricity generation and wholesale pricesfor electricity were deregulated. Second, asthey were required to do, the three incum-bent (vertically integrated) suppliers of elec-tricity sold a sizable portion of theirgeneration capacity, focusing instead on thetransmission and delivery of electricity. By1999, the incumbent suppliers had sold tofive independent suppliers generationcapacity that produced roughly one-third of



10 It has also been suggested that some of the few largesuppliers of electricity may have exacerbated the problemby intentionally reducing their supply of electricity, there-by raising the market-clearing price of electricity and,hence, the profits of electricity suppliers. (See Paul L.Joskow and Edward Kahn 2002, for example.)

the state’s electricity consumption. Third,retail competition was introduced as retailcustomers were permitted to purchase elec-tricity from firms other than the incumbentsuppliers. Fourth, a ceiling was imposed onthe retail price that incumbent supplierscharged for electricity. Fifth, the threeincumbent suppliers were afforded strongfinancial incentives to buy and sell electrici-ty through the California Power Exchange(Cal PX) during its first four years of opera-tion. Cal PX was established in 1998 to runthe day-ahead market for electricity in thestate of California. Although the incumbentsuppliers’ participation in Cal PX helped toensure substantial short-term supply of anddemand for electricity, the incumbents’ cor-responding limited use of long-term con-tracts for the purchase or sale of electricityultimately proved to be detrimental.

In the summer of 2000, unusually hightemperatures and very dry conditions pro-duced both a substantial increase in thedemand for electricity and a significantreduction in the available supply of electric-ity from hydroelectric generating units in thestate. When less efficient generating unitswere dispatched to meet the high demandfor electricity, the wholesale price of elec-tricity soared well above the ceiling that hadbeen imposed on retail electricity prices.Consequently, incumbent suppliers incurredsevere financial losses. The higher wholesaleprices were not sufficient to augment thesupply of electricity greatly due to the longlead time necessary to construct new gener-ating capacity and due to the particularlyhigh costs faced by established producers ofpeak load capacity. These high costs reflect-ed less efficient operating technologies, par-ticularly high wholesale prices for naturalgas, and expensive pollution permits.10

In 2001, the state of California adopteddrastic measures to quell the crisis that haddeveloped in its electricity industry. Thestate established itself as the wholesalebuyer of power for the incumbent suppliersin response to the reluctance of other parties (including wholesale suppliers ofelectricity) to deal with the financially dis-tressed incumbents. The state also raisedsubstantially the prices incumbent suppli-ers could charge for electricity, especially tolarge retail customers. In addition, to pre-vent these customers from securing elec-tricity from alternative suppliers at lowerprices, the state terminated retail competi-tion. In essence, California’s experimentwith deregulation and liberalization hadended.

3. Regulated Monopoly and UnregulatedCompetition

In an economic paradise, where a regula-tor is omniscient, benevolent, and able tofulfill any promise he makes, competitioncannot improve upon regulated monopoly.In such a paradise, the regulator will ensurethe firm produces the ideal range of servicesat the lowest possible cost and will set wel-fare-maximizing prices for these services.Consequently, industry performance wouldnot improve if an additional firm operated inthis setting.

Of course, the real world differs markedlyfrom this paradise. In practice, regulatorsinvariably lack important information aboutthe markets they oversee and so will not beable to direct and control perfectly the activ-ities of a monopoly producer. Because of itsdaily operation in the industry and its directcontact with consumers, the regulated firmwill be better informed than the regulatorabout the demand for the regulated servicesit supplies, the minimum possible currentcost of delivering the services, and thepotential for less costly future provision.This information asymmetry generally givesrise to an unavoidable trade-off between



11 Martin Loeb and Wesley A. Magat (1979) provide aformal statement and proof of this conclusion. William W.Sharkey (1979) critiques Loeb and Magat’s analysis. JorgFinsinger and Ingo Vogelsang (1981, 1982) and David E.M. Sappington and David S. Sibley (1988) suggest dynam-ic modifications of the Loeb and Magat policy that affordless rent to the regulated firm and/or can be implementedwith less precise information about the surplus generatedby the firm’s activities.

12 This model is drawn from the large literature thatexamines the design of regulatory policy when the regulat-ed firm is better informed about its environment than theregulator. Reviews of this literature include BernardCaillaud, Roger Guesnerie, Patrick Rey, and Jean Tirole(1988), David P. Baron (1989), Laffont and Tirole (1993),Laffont (1994), and Armstrong and Sappington (forthcom-ing). Joskow and Richard Schmalensee (1986), Armstrong,Cowan, and Vickers (1994), Glenn Blackmon (1994),Sappington (1994), Robert Mansell and Jeffrey Church(1995), Sappington and Dennis L. Weisman (1996), andJoskow (2005), among others, provide less technical dis-cussions of incentive regulation. Michael A. Crew and PaulR. Kleindorfer (2002) and Vogelsang (2002), for example,provide critiques of this literature.

rent and efficiency: the firm can be motivat-ed to operate efficiently but only if it isawarded substantial rent for doing so. Inparticular, the firm will operate at minimumcost and attempt to satisfy the needs anddesires of customers only if it is awarded thefull surplus that its activities generate.11

However, such a generous award to the reg-ulated firm typically will provide it with sig-nificant rent and thereby reduce the netbenefits enjoyed by consumers. To limit therent that accrues to the regulated firm, someinefficiency typically is tolerated.

To examine the optimal resolution of thistrade-off and to examine the impact of lim-ited information on the choice betweenregulated monopoly and unregulated com-petition, consider the following simplemodel.12

3.1 A Simple Model of Regulated Monopoly

Suppose that when regulated monopoly isimplemented the regulator faithfully pur-sues the social goal of maximizing theexpected value of V + �U, where V denotesthe surplus enjoyed by consumers, U is thefirm’s rent, and � ∈ [0,1] is a parameter.Because � ≤ 1, society values consumer wel-fare at least as highly as the welfare of share-

13 Laffont (2005, pp. 1–2) reports that for each dollar oftax revenue the government collects, citizens in a devel-oped country bear a cost of approximately $1.30 (so λ =0.3). The corresponding cost typically is substantiallygreater in developing countries.

holders, perhaps because consumers are lesswealthy than shareholders or because manyshareholders reside in other jurisdictions.

A transfer payment T from consumers tothe firm entails a reduction of [1 + λ]T in thesurplus enjoyed by consumers. The parame-ter λ ≥ 0 represents the social cost of publicfunds. This cost arises from the distortionscreated by the taxes imposed on con-sumers/taxpayers to raise the funds.13 Noticethat because public funds entail unit cost1 + λ, each dollar of public funds secured bytaxing the profit of the regulated firm can beemployed to increase consumer/taxpayerwelfare by 1 + λ dollars.

The monopoly supplies a single product atregulated unit price p ≥ 0. The demandcurve for this product, q(p), is commonknowledge. The regulator sets both the unitprice, p, for the regulated product and atransfer payment, T, from consumers to theregulated firm. The firm is obligated to serveall customer demand at the establishedprice.

The firm incurs a fixed cost of operation,F, and a constant marginal cost of produc-tion, c. For simplicity, the firm’s marginalcost can take on one of two values, cL or cH.Let ∆ ≡ cH − cL > 0 denote the differencebetween the high and the low marginal cost.The firm knows from the outset of its inter-action with the regulator whether its mar-ginal cost is high or low. The regulator doesnot share this information and neverobserves the firm’s marginal cost directly.The regulator perceives the two possiblecost realizations to be equally likely. For sim-plicity, the firm’s fixed cost of operation, F, isassumed to be common knowledge. Thefirm seeks to maximize its rent, U, which isthe sum of its profit, π ≡ q(p)[p − c] − F, andthe transfer payment, T, it receives from theregulator.



14 See Roger B. Myerson (1979), for example.

Suppose the regulator announces that hewill set unit price pi and deliver transfer pay-ment Ti to the firm when the firm reports itsmarginal cost to be ci, for i ≡ L,H. When thefirm with cost ci chooses the (pi,Ti) option, itsrent will be Ui ≡ q(pi)[pi − ci] − F + Ti. Therevelation principle ensures there is no lossof generality in examining regulatory policiesthat induce the firm to report its marginalcost truthfully.14 Therefore, social welfarewhen the firm’s marginal cost is ci is:v(pi) − [1 + λ]Ti + �[q(pi)[pi − ci] − F + Ti]

= wi(pi) − [1 + λ − �]Ui,

where wi(pi) ≡ v(pi) + [1 + λ][q(pi)[pi − ci] −F], and where v(p) denotes consumer sur-plus when price p is established. (v(.) is aconvex function of p.)

If the firm’s realized marginal cost wereobserved publicly, the regulator wouldimplement the (Ramsey) price that maxi-mizes wi(.) when cost ci is realized, fori ≡ L,H. These full-information prices will bemarginal-cost prices (pi = ci) when λ is zerobecause transfers from consumers to thefirm entail no direct social costs in this case.In contrast, when λ is large, payments toconsumers financed by the firm’s profit arehighly valued and the full-information priceswill approximate the prices chosen by anunregulated profit-maximizing monopolist.

When the firm’s marginal cost is notobserved publicly, it must be the case thatq(pL)[pL − cL] − F + TL ≥ q(pH)[pH − cL] −F + TH or, equivalently,

(1) UL ≥ UH + ∆q(pH),

to ensure the firm truthfully reports its lowmarginal cost of production. To ensure thefirm finds it profitable to operate when itsmarginal cost is high, it must be the case thatUH ≥ 0. Because social welfare declines asthe firm’s equilibrium rent increases (when� < 1 or λ > 0), UH is optimally held to zero.To limit the firm’s equilibrium rent, con-straint (1) also will hold as an equality under

15 G might also include the surplus lost when regulationretards industry innovation. Charles Jackson, Tracey Kelly,and Jeffrey Rohlfs (1991) and Jerry A. Hausman (1997)estimate that delays in licensing wireless telecommunica-tions providers in the United States reduced consumersurplus by billions of dollars.

16 This fact is evident from expression (2).

the optimal regulatory policy, soUL = ∆q(pH). Therefore, total expected wel-fare if price pi is set when marginal cost ci isrealized (for i ≡ L,H) will be:

(2) 1−2[wL(pL) − [1 + λ − �]∆q(pH)]

+ 1−2 wH(pH) − [1 + λ]G,

where G is a (fixed) cost of regulation thatis financed with public funds. This costmight include the salary of the regulatorand his staff, for example, and all othercosts associated with acquiring essentialinformation about the regulated industry.15

Differentiating expression (2) with respectto pH reveals that, when the regulator can-not observe the firm’s marginal cost, he isable to achieve the level of expected wel-fare that he could achieve if the firm’s costswere observable, but the high marginal costwas cH, where:

(3) cH ≡ cH + [1 − 1−−�−+−−λ]∆ > cH.

Therefore, the optimal price when the highmarginal cost is realized is the full-informa-tion (Ramsey) price corresponding to theinflated cost cH. The inflated price when cH

is realized reduces the number of units ofoutput on which the firm can exercise itscost advantage when cL is realized.Therefore, the increase in pH and the associ-ated reduction in TH limit the rent thataccrues to the firm when its marginal cost iscL. Because the firm has no incentive tounderstate its production cost, there is novalue to distorting the firm’s activities whenit reports its marginal cost to be cL.Consequently, the optimal price when thelow marginal cost is realized will be the full-information price corresponding to thefirm’s actual cost (cL).16



17 Section 6 considers the possibility that both firmsmay not find it profitable to operate in the industry. SeeEmmanuelle Auriol and Laffont (1992) and Michael H.Riordan (1996), for example, for related models in whichthe duopoly is regulated.

Three features of the optimal regulatorypolicy in this simple setting characterizeoptimal regulatory policy in more generalsettings where the monopoly supplier is bet-ter informed than the regulator about keyfeatures of the regulated industry. First, thefirm generally commands rent from its supe-rior information. Second, to limit this rentand thereby generate greater surplus forconsumers, the regulator will design a menuof options from which the firm can make abinding choice. A well-structured menu ofoptions can induce the firm to employ itssuperior knowledge to secure outcomes thatare better for both the firm and consumersin more favorable environments (e.g., whenthe firm has lower operating costs). Third,the optimal regulatory policy generallyinduces inefficient performance to limit thefirm’s rent.

3.2 A Simple Model of UnregulatedCompetition

Now consider the following simple modelof unregulated competition. Suppose twofirms produce a homogeneous product andengage in Bertrand price competition. Eachfirm knows its own constant marginal cost ofproduction and its rival’s marginal cost,c ∈ {cL,cH}, when it sets its price. No transferpayments to or from the firms in the indus-try are possible in this setting. In particular,the firms’ profits cannot be appropriated bythe government to reduce the general taxburden elsewhere. Therefore, the social costof public funds λ plays no role in this settingand social welfare is v(p) + �π, where π isindustry profit. Both firms find it profitableto operate in the industry.17

Each firm has the low marginal cost, cL,with probability 1/2. The firms’ costs may becorrelated. Let ρ ∈ [1/2,1] represent theprobability that the two firms have the same
18 The probability that both firms have high cost is ρ/2,
the probability that both firms have low cost is ρ/2, and theprobability that a given firm has low cost while its rival hashigh cost is [1 − ρ]/2.

19 The profit-maximizing price for a firm with the lowmarginal cost is assumed to exceed cH. Consequently, whenonly one firm has the low marginal cost, it will serve theentire market demand at price cH in equilibrium.

cost.18 The firms’ costs are perfectly corre-lated when ρ = 1. Their costs are uncorrelat-ed when ρ = 1/2. Bertrand competitionensures the equilibrium price will be cH

except when both firms have low cost, whichoccurs with probability ρ/2. A firm’s operat-ing profit is zero unless it has the low mar-ginal cost while its rival has the highmarginal cost, in which case the firm’s profitis ∆q(cH).19 A firm realizes this positive prof-it with probability [1 − ρ] /2. Consequently,expected industry profit in this duopoly set-ting is [1 − ρ]∆q(cH), which declines as thefirms’ costs become more highly correlated.Notice that the probability that the industrysupplier has low marginal cost is (1 − ρ/2).This probability decreases as ρ increases. Incontrast, the probability that the industryprice will be cL is ρ /2, which increases as ρincreases.

Ignoring the firms’ fixed costs of production(F) for now, social welfare in this unregulatedduopoly setting is:

(4) −ρ−2 v(cL) + [1 − −ρ−2 ]v(cH) + �[1 − ρ]∆q(cH).

3.3 Comparing Regulated Monopoly andUnregulated Competition

Regulated monopoly offers four potentialadvantages over unregulated competition inthis simple setting: (1) industry prices canbe controlled directly; (2) transfer pay-ments can be made to the firm to providedesired incentives; (3) the firm’s profit canbe taxed to generate public funds, therebyreducing the deadweight losses associatedwith other sources of public funds; and (4)duplicative fixed costs of production can beavoided because there is only one industrysupplier.



20 If � = 1, regulated monopoly and unregulated duop-oly provide the same level of expected social welfare.

Unregulated competition has three corre-sponding potential advantages: (1) the likeli-hood that the industry producer has the lowmarginal cost is higher than under monopolybecause even if one firm fails to secure thelow cost, its rival may do so; (2) the presenceof a rival with correlated costs reduces theinformation advantage of the industry pro-ducer; and (3) any direct, operational costs ofregulation (e.g., the salaries of regulators andtheir staff) are avoided. The first of thesepotential advantages of unregulated duopolyis referred to as the sampling benefit of com-petition. The second potential advantage willbe referred to as the rent-reducing benefit ofcompetition.

To compare the performance of regulatedmonopoly and unregulated competition inthis setting, initially suppose λ = 0, F = 0,and G = 0, so there is no social cost of pub-lic funds, no fixed cost of production, and nodirect cost of regulation. Expressions (2)and (3) reveal that the maximum expectedwelfare under monopoly regulation in thiscase is:

(5) 1−2v(cL) + 1−2 v(cH + [1 − �]∆).

A comparison of expressions (4) and (5)provides four conclusions regarding the rel-ative performance of regulated monopolyand unregulated duopoly.

First, unregulated duopoly delivers ahigher level of expected social welfare thandoes regulated monopoly when the duopo-lists’ costs are perfectly correlated (soρ = 1).20 When costs are perfectly correlat-ed, the industry producer never has a costadvantage over its rival and so commands norent in the duopoly setting. Furthermore,competition drives the industry price to thelevel of realized marginal cost. Therefore,the ideal (full-information) outcome isachieved under duopoly but not undermonopoly, where regulated prices diverge

21 When demand is perfectly inelastic (so q(p) ≡ 1, forexample), expression (4) is weakly greater than expression(5) whenever ρ /2 ≥ �[ρ − 1−2], which is always the case.

22 The convexity of v(.) implies the expression in (5) isat least [v(cL) + v(cH) − [1 − �]∆q(cH)]/2. Therefore, the dif-ference between expressions (5) and (4) is at least [1 −ρ][v(cL) − v(cH)]/2 − ∆q(cH)[(1 − �)/2 + �(1 − ρ)]. Because

this expression is nondecreasing in �, it is at least [1 −ρ][v(cL) − v(cH)]/2 − ∆q(cH)/2. This term is positive when

demand is sufficiently elastic.

from marginal cost in order to limit the rentthe monopolist commands from its privi-leged knowledge of costs. In this case, then,unregulated duopoly is preferred to regulat-ed monopoly even though the former offersno sampling benefit. The benefits of compe-tition arise entirely from rent reduction inthis case.

Second, when demand is perfectly inelas-tic, unregulated duopoly produces a higherlevel of expected welfare than does regulatedmonopoly.21 When demand is perfectlyinelastic, price distortions do not affect out-put levels and, therefore, do not serve to limitrent. Consequently, only the probability ofobtaining a low-cost supplier affects expectedwelfare, and this probability is higher underduopoly than under monopoly because of thesampling benefit of competition.

Third, regulated monopoly will generatea higher level of expected welfare thanunregulated duopoly when demand is suffi-ciently elastic (and ρ < 1). When demand isvery elastic, prices that do not track costsclosely entail substantial losses in surplus.Prices track costs more closely under regu-lated monopoly than under unregulatedduopoly.22

Fourth, unregulated duopoly outperformsregulated monopoly when the differencebetween the high and the low marginal cost(∆) is sufficiently close to zero. Monopolyrent and duopoly profit are both negligiblein this case, and so the choice betweenmonopoly and duopoly depends upon whichregime produces the low marginal cost morefrequently. The sampling benefit of compe-tition ensures the duopoly regime does so



23 The benefits of unregulated competition may be lesspronounced if industry competition is less pronounced.For example, Cournot competition may better describeindustry interaction than Bertrand competition.Alternatively, industry producers might collude in settingprices. (Recall that limited industry competition may havecontributed to the substantial increase in the wholesaleprice of electricity in California in 2000.)

24 In contrast, if the fixed cost of regulation, G, is suffi-ciently large, unregulated duopoly will outperform regu-lated monopoly because the former avoids this cost, byassumption.

25 In developing countries where consumers have limit-ed income, the corresponding limited demand for keyservices can result in higher average production costswhen scale economies are present.

whenever costs are not perfectly correlated(so ρ < 1).23

More generally, if the fixed costs of opera-tion (F) are sufficiently large, regulatedmonopoly will outperform unregulatedduopoly in the simple model analyzed herebecause monopoly avoids the duplication offixed costs.24 This conclusion is a corollary ofthe more general observation that monopolysupply will minimize industry costs if pre-vailing scale economies are pronounced rel-ative to industry demand.25 Scale economiesoften are pronounced in network industries,where substantial physical infrastructure(e.g., a gas, water, or electricity distributionsystem or a telecommunications network)must be deployed in order to deliver serviceto customers.

When the social cost of funds (λ) is con-sidered, regulated monopoly offers an addi-tional advantage over unregulated duopoly.The monopolist’s rent can be taxed to funddesirable social projects, thereby reducingthe need to employ other (potentially morecostly) means to raise revenue.

4. Additional Considerations

The simple models considered in section 3abstracted from several important institu-tional factors that can affect the optimalchoice between regulated monopoly andunregulated competition. These institutionalfactors include (1) the resource constraintsthe regulator faces; (2) the potential role of

26 For further discussion of the effects of institutions onregulatory policy, see Brian Levy and Spiller (1994, 1996),Newbery (1999), Roger G. Noll (2000), J. Luis Guasch(2004), Ioannis N. Kessides (2004), Mark A. Jamison,Lynne Holt, and Sanford V. Berg (2005), and Laffont(2005), among others. We focus on the effects, rather thanthe origins, of a country’s institutions. Daron Acemoglu,Simon Johnson, and James Robinson (2005) trace a coun-try’s institutions to its colonial origins. In countries wherepoor living conditions rendered settlement unattractive,for example, little effort was devoted to developing thecountry’s institutions. Such effort was more prominent incountries where long-term settlement was more attractiveand more widespread.

27 The theory of optimal regulation when the firm isprivately informed about several aspects of its operationawaits further development. Jean-Charles Rochet and LarsStole (2003) provide a survey of the theory of multidimen-sional screening.

28 Jon Stern (2000) documents the limited regulatoryresources that are available in many countries. Stern sug-gests that resource sharing among regulatory agencies canhelp to mitigate partially the effects of severe shortages ofcritical regulatory resources in some settings. Noll (2000)also emphasizes the merits of sharing regulatory resources.

regulation in pursuing distributional objec-tives; (3) the instruments available to theregulator; (4) the prevailing degree of regu-latory independence and accountability; (5)the ownership structure of the incumbentindustry producers; and (6) the importanceof industry investment and innovation.These factors are now considered in turn.26

4.1 Resource Constraints

Although the regulator was not omniscientin the models of section 3, he had consider-able knowledge of the regulated industry. Inpractice, a regulator’s information can be farmore limited.27 A regulator’s difficult task ofoverseeing and directing the activities of amonopoly supplier can become nearlyimpossible when the regulator’s informationand expertise are severely limited and whenhe lacks the physical and financial resourcesto overcome these limitations. Consequently,allowing competition to replace regulatoryoversight as the primary means of motivatingand disciplining the incumbent supplier canbe advantageous when the efficacy of regula-tory oversight is severely compromised bylimited regulatory resources.28



29 The public finance literature (e.g., Anthony B.Atkinson and Joseph E. Stiglitz 1976) notes that when anonlinear income tax is feasible, prices of goods and serv-ices often should reflect production costs. Laffont andTirole (2000, section 6.2) consider the implications of thisconclusion for pricing policy in regulated industries. RobinBurgess and Stern (1993) review the theory and the prac-tice of tax policy in countries with limited wealth.

The resources of other oversight agenciesalso influence the relative merits of monop-oly supply and liberalization. For example,competition may be less likely to imposemeaningful discipline on a dominant incum-bent supplier if the antitrust agency thatoversees industry competition has limitedexpertise and meager physical and financialresources. Consequently, both the relativeand absolute level of resources available tooversight agencies influence the relativemerits of monopoly and liberalization.

4.2 Income Redistribution and UniversalService Goals

The analysis in section 3 abstracted fromany differences in the cost of serving differ-ent customers and did not model explicitlydifferences in the wealth levels of differentconsumers. Such differences can raise con-cerns about universal service—the ubiqui-tous delivery of essential services ataffordable rates. When a government haslimited ability to redistribute income direct-ly (perhaps because income taxes are widelyevaded, for example), the regulated prices ofessential services can constitute an impor-tant means to promote universal service.29

To illustrate, suppose a country wishes toensure that all its citizens have access toclean water or to basic communications serv-ices at low prices. Because prices tend toreflect costs under unfettered competition,individuals that are particularly costly toserve (because of their geographic location,for example) may face unduly high prices forkey services under unregulated competition.In contrast, a regulated monopolist willagree to serve high-cost (e.g., rural) cus-tomers at relatively low prices if it is permit-ted to offset the associated financial losses by

30 The difference between expressions (4) and (6) is[v(cL) − v(cH)]ρ/2 + �∆q(cH)[1−2 − ρ]. The convexity of v(.)implies this expression is at least [ρ/2 − �(ρ − 1−2)]∆q(cH).This expression is nonnegative because it is a decreasingfunction of ρ and is nonnegative at ρ = 1.

charging prices sufficiently above the costsof serving low-cost (e.g., urban) customers.Consequently, universal service (and otherdistributional) concerns can cause regulatedmonopoly to be preferred to unregulatedcompetition.

4.3 Available Instruments

The policy instruments available to over-sight agencies also influence the relative mer-its of monopoly and competition. Toillustrate, return to the simple setting consid-ered in section 3, where the regulator wasable to set prices and deliver transfer pay-ments. In practice, regulators are not alwaysable to deliver transfers to the firms they reg-ulate. If the regulator lacked this ability in thesetting analyzed in section 3.1 and wished toensure the monopolist never terminated itsoperations, the regulator could do no betterthan to set a single price equal to the highmarginal cost, p = cH (assuming fixed costs arezero). This policy would generate expectedwelfare

(6) v(cH) + 1−2�∆q(cH).

It is apparent that the level of expectedwelfare in expression (6) is less than the cor-responding level in expression (4).30

Consequently, unregulated duopoly isalways preferred to this restricted form ofmonopoly regulation in the setting consideredin section 3.1.

More generally, if a regulator has limitedability to reward a monopoly supplier forsuperior performance and penalize the firmfor inferior performance, the regulator maybe unable to motivate the firm to serve con-sumers well. This is the case regardless ofhow well the regulator understands thefirm’s capabilities and consumers’ prefer-ences. Similarly, if the regulator is not



31 See Nicolas Curien, Bruno Jullien, and Rey (1998)and Laffont and Tirole (1990a), for example.

32 Of course, a country with limited ability to collecttaxes also may have limited ability to enforce desiredprices. The relative strengths of the country’s institutionsare important to consider in such cases. A country may bebetter able to measure electricity consumption andenforce associated charges than to prevent citizens fromhiding wealth in order to evade income taxes, for example.

authorized to compel the firm to report dataon its operations, the regulator will find it dif-ficult, if not impossible, to make informed pol-icy decisions, even if the regulator has ampleresources and ability to analyze and interpretdata. Consequently, limited powers to rewardor penalize the firm or to compel data report-ing can render monopoly regulation ineffec-tive, and so can increase the relative merits ofunregulated competition.

A regulator’s powers to control the activi-ties of new suppliers also can affect the rel-ative merits of monopoly and competition.To illustrate, suppose the regulator cannotimpose any regulations on new competitors.In particular, suppose a regulator cannotlimit the range of services that competitorsoffer or tax any of these services. In thiscase, even though liberalization may help tomotivate the incumbent supplier to reduceits operating costs, it may allow competitorsto engage in cream-skimming. Cream-skim-ming is the act of serving the most profitable(e.g., urban, business telecommunications)customers and leaving the incumbent sup-plier to serve the less profitable (e.g., rural,residential telecommunications) customers.Cream-skimming can limit the ability of theincumbent supplier to finance particularlylow prices on some services with substantialprofit earned on other services and therebyundermine socially desirable pricing struc-tures.31 Therefore, even though managedcompetition (which entails the regulation ofboth incumbent suppliers and new entrants)might be preferable to monopoly, monopolymay be preferable to unfettered competi-tion when an ineffective tax system requiresthat universal service be pursued throughindustry prices.32

33 For instance, Michael I. Cragg and I. AlexanderDyck (2003) find that the financial compensation of man-agers is not as closely linked to the performance of the firmin state-owned enterprises as it is in privately owned firms.

34 See János Kornai, Eric Maskin, and Gerald Roland(2003).

35 William L. Megginson, Robert C. Nash, andMatthias van Randenburgh (1994), Juliet D’Souza andMegginson (1999), Rafael La Porta and Florencio López-de-Silanes (1999), Kathryn L. Dewenter and Paul H.Malatesta (2001), Megginson and Jeffry M. Netter (2001),Scott J. Wallsten (2001), and Simeon Djankov and PeterMurrell (2002), among others, present (sometimes mixed)evidence that the efficiency of SOEs increases after priva-tization, particularly in the presence of substantial industrycompetition and independent regulators.

36 Of course, in practice, this greater potential need notalways translate into more pronounced reductions inindustry costs. Fumitoshi Mizutani and Shuji Uranishi(2003), for example, report that liberalization in Japan’spostal industry did not substantially increase the produc-tivity of the SOE.

4.4 Private versus State Ownership

The extent of government ownership ofthe dominant incumbent supplier also canaffect both the merits and the most appro-priate form of liberalization. A firm that islargely owned by the government can be lessresponsive to the oversight and demands ofshareholders than are privately ownedfirms.33 Furthermore, state-owned enter-prises (SOEs) can face softer budget con-straints than their privately ownedcounterparts in the sense that the govern-ment may be more willing to tolerate lossesby the firm and to finance the firm’s contin-ued operation despite poor historic financialperformance. Because of the correspondingdiminished incentive to minimize produc-tion costs,34 an SOE may operate with high-er costs than a privately owned monopoly.35

Therefore, liberalization may have greaterpotential to reduce industry costs when theincumbent monopoly supplier is owned pri-marily by the government than when it isowned primarily by private investors.36

4.5 Regulatory Independence andAccountability

The simple models considered in section 3presumed the regulator faithfully pursuedthe social objective. In practice, a “captured”



37 See George J. Stigler (1971), Richard A. Posner(1974), Gary S. Becker (1983, 1985), Laffont and Tirole(1993, chapter 11), and James F. Dewey (2000), for exam-ple, for models of capture and the strategic choice ofexpenditures to influence regulators.

38 See Yeon-Koo Che (1995) and David J. Salant(1995), for example.

39 Bengt Holmstrom and Paul Milgrom (1991),Holmstrom (1999), and Mathias Dewatripont, Ian Jewett,and Tirole (1999) examine the effects of long-term careerconcerns on short-term behavior. Such concerns can, forexample, induce a regulator to focus primarily on per-formance dimensions that are readily observed (e.g., short-term price reductions) and less on performancedimensions that are more difficult for potential employersto observe in a timely fashion (e.g., prospects for viablelong-term industry competition).

regulator may not do so. A regulator is said tobe captured by the firm he regulates whenthe regulator generally implements policiesthat further the interests of the firm at theexpense of the broader social interest.37

Many factors increase the likelihood of regu-latory capture. For example, a regulatoryagency with limited expertise and resourcesmay be forced to rely heavily on the adviceand information supplied by the firm whenformulating policy. Alternatively, the firmmay routinely offer attractive employmentopportunities to regulators who have provedto be cooperative, and the country’s laws maynot preclude such offers.38 Also, the firmmay provide a sizable portion of the regula-tor’s ongoing budget and may have some dis-cretion over the timing and magnitude of itscontributions to the regulator’s budget.When factors like these lead to a high likeli-hood of regulatory capture, the entry of addi-tional competitors may be the best way toimpose meaningful discipline on the incum-bent supplier and otherwise ensure long-term gains for consumers.39

The importance of regulatory independ-ence from short-term popular opinion also isapparent. Producers in network industriestypically incur substantial sunk (nonrecover-able) costs. These producers also often deliverservices to a large portion of the population,and so the prices of these services are of sub-stantial public concern. Together, thesetwo elements create substantial risk of

40 See Oliver Williamson (1975) for a pioneering treat-ment of the problem and Newbery (1999) for an extensivediscussion of the problem of regulatory commitment.Some authors (e.g., Witold J. Henisz 2000) have devel-oped indices to measure expropriation risk in differentcountries. Jamison, Holt, and Berg (2005) review theseindices.

41 Wallsten (2001) finds that the privatization of state-owned telecommunications providers in Latin Americaand Africa is associated with improved industry perform-ance when the industry regulator is independent (in thesense of not being directly under the control of a govern-ment ministry), but not otherwise. Geoff Edwards andLeonard Waverman (2006) find that regulatory independ-ence is associated with lower charges for access to the net-work infrastructure of state-owned incumbent suppliers oftelecommunications services.

expropriation by well-meaning but short-sighted regulators. In response to public pres-sure, regulators may reduce prices as far aspossible toward variable production costs. Aslong as regulated prices allow the firm torecover its variable production costs, the firmwill prefer to continue to produce than to ter-minate its operations. Thus, in the short run,the regulator gains by securing low prices andongoing production of key services. Althoughsuch a policy may provide short-term gains, itcan have substantial long-term costs. Potentialand actual producers will realize they areunlikely to recover any sunk costs they incur.Consequently, they will be reluctant to incursuch costs, and so existing network infrastruc-ture will be permitted to decay and new net-work infrastructure will not be built. Thus, ifregulators are to design and implement poli-cies that best serve the long-term interests ofconsumers, they must be able to develop pol-icy credibility by resisting short-term pressuresto renege on long-term promises.40

A regulator’s commitment powers can beenhanced by a variety of factors, includingstrong legal institutions and a long tenure.Strong legal institutions can thwart attemptsby other government agencies to intervene inthe day-to-day operations of the regulatoryagency and can thereby enhance a regulator’scommitment powers by reducing the likeli-hood that the terms of announced regulatorypolicies will be changed.41 In particular, stronglegal institutions can enforce long-term



42 Kessides (2004, p. 102) describes settings where gov-ernments have changed the terms of legal contracts.

43 See Newbery (1999), Salant and Glenn A. Woroch(1992), and Paul Levine, Stern, and Francesc Trillas (2005)for formal analyses of this effect. Levine, Stern, and Trillas(2005) also emphasize the potential value of delegatingauthority to an independent regulator with substantial con-cern for the welfare of the firms he regulates.

44 Timothy Besley and Stephen Coate (2003) employdata from the United States to examine the effects of themethod by which state regulators are selected on perform-ance in the state’s electric power industry. The authors findlower prices and reduced investment (as proxied by thefrequency of power outages) in states where regulators areelected than in states where regulators are appointed.

45 See Maskin and Tirole (2004) for a formal analysis ofthis trade-off.

contracts between the regulator and the firm,and can prevent a regulator from changing theterms of announced policies (including prom-ised returns on investment) in response topressure from other government agencies orthe citizenry at large. When legal institutionsare weak, pressure groups may anticipate sub-stantial benefits from convincing the regulatorto renege on the promises he has made to thefirm.42 Thus, the independence of a country’sjudicial system and the ability of a country toenforce the terms of legal contracts can affectthe optimal design of industry policy.

A regulator may also be better able to pur-sue policies (such as delivering promisedrewards to the regulated firm) that promotethe long-term, rather than the short-term,interests of consumers if his tenure as regu-lator is relatively long. Long-lived regulatorswith sufficient concern about future industryoutcomes will realize that short-term expro-priation of an incumbent producer’s invest-ment will discourage future investment bythe same firm or its successor.43 In addition,a regulator may feel less pressure to panderto popular opinion if he is not elected bydirect vote of the citizenry.44 Thus, a settingwhere the regulator serves a fairly long termand faces reappointment by the governmentmay provide an appropriate trade-offbetween independence and accountability.45

There is an additional benefit of a reason-able degree of regulatory independence fromdirect intervention by other government

46 In this respect, regulatory independence can deliverbenefits similar to those provided by the privatization of astate-owned enterprise. Privatization increases the cost tothe government of intervening in the day-to-day opera-tions of the firm, and thereby renders more credible thegovernment’s promise to refrain from such intervention(Sappington and Stiglitz 1987). Regulatory independenceenhances the commitment powers of regulators in similarfashion, once the mission and goals of the regulatoryagency are stated clearly.

47 Spiller and Vogelsang (1997) and Tonci Bakovic,Bernard Tenenbaum, and Fiona Woolf (2003) emphasizethe value of coupling substantial regulatory independencewith a clearly specified regulatory contract (e.g., a regula-tory license). Under such coupling, regulators will have theindependence required to implement impartially thedetails of a politically popular contract, but will not beempowered to implement any policy of their choosing.Using a large dataset of monopoly franchise auctions,Guasch (2004, table 1.16) reports that the original terms ofthe franchise contract were renegotiated 61 percent of thetime when there was no separate regulatory body respon-sible for contract administration. The corresponding per-centage was only 17 percent when the contracts wereadministered by a separate regulatory body.

48 The independence granted the telecommunicationsregulator in Jamaica is believed to have led to a decline inindustry investment as investors feared the regulatorwould use his autonomy to expropriate investments (Levyand Spiller 1994).

49 See Laffont and David Martimort (1999) andMartimort (1999b).

agencies. A government that is unable tointervene in the short-term operations of aregulatory agency is compelled to state asfully and clearly as possible the mission of theregulatory agency. Failure to do so will affordthe regulatory agency the opportunity to pur-sue its own mission and goals, rather thanthose of the government more broadly.46 Acoherent and transparent statement of theprinciples that will guide industry policy pro-vides greater certainty for industry partici-pants, which can encourage investment andfacilitate long-term planning.47

When regulatory capture is likely, explicitrestrictions on the regulator’s autonomy andcommitment powers may be desirable inorder to limit the regulator’s ability to pursueinterests other than the long-term socialinterest.48 For example, key powers mightbe dispersed among multiple regulators ordivided between a regulator and other gov-ernment agencies.49 Alternatively or in addi-tion, the regulator’s discretion in formulating



50 See Laffont and Tirole (1990b).51 Martimort (1999a) shows that it can be optimal to

impose more severe restrictions on a regulatory agencyover time as the potential for regulatory capture increases.

52 If competition undermines a regulator’s (otherwisesubstantial) powers to promise attractive returns to theincumbent monopoly supplier, it is possible that competi-tion may be inadvisable when the incumbent monopolist isinvesting and otherwise satisfying the long-term needs ofconsumers reasonably well. In extreme cases, unregulatedmonopoly might be the most effective way to deliverstrong investment incentives if the absence of regulation,itself, constitutes a meaningful commitment not to expro-priate a monopolist’s earnings. Notice that, although a reg-ulator may have particularly pronounced ability toexpropriate investors because of his direct control over abroad range of industry policies, other government entitiesalso may have substantial ability to expropriate investors byimposing excessive profit taxes or indirect taxes, for exam-ple.

53 Wesley M. Cohen and Richard C. Levin (1989)review empirical studies of the relationship between mar-ket structure and innovation.

policy might be substantially restricted.50

The tenure of individual regulators mightalso be limited.51

Competition can play a particularly valu-able role in disciplining and motivating theincumbent supplier to pursue the best inter-ests of consumers when the regulator’s pow-ers to do so are (inherently or intentionally)limited. However, competition is not neces-sarily a panacea. Weak commitment powersmay limit nonfungible investment underboth unregulated competition and regulatedmonopoly. Competitors, like the incumbentsupplier, will recognize that their invest-ments may be expropriated by a regulatorwith substantial expropriation powers andlimited commitment powers, and so may bereluctant to undertake the investmentrequired to improve industry perform-ance.52 Thus, there is seldom an effectivesubstitute for strong commitment powers.

4.6 Investment and Innovation

The link between industry structure andthe incentive to innovate and to reduce costsis complex even in the absence of regula-tion.53 Competing firms may have greaterincentive than an unregulated monopolyprovider to reduce operating costs in part

54 See Kenneth J. Arrow (1962). Of course, this argu-ment presumes that intellectual property protection pre-cludes competitors from immediately copying theinnovator’s discovery and thereby eliminating the financialgain from innovation.

55 This argument presumes that capital markets areimperfect. This is a reasonable assumption in the contextof innovation because innovators often are unable to con-vince investors of the merits of their potential innovationwithout revealing the details of the innovation (and there-by forfeiting some of the potential financial gains from theinnovation). See, for example, James J. Anton and DennisA. Yao (1994, 2002).

56 See Joseph Schumpeter (1950) and Glenn C. Loury(1979), for example.

57 Guthrie (forthcoming) provides a more completereview of the literature that examines the impact of regu-lation on infrastructure investment.

58 A regulatory policy that delivers no extra profit to afirm as its realized production costs decline effectivelyexpropriates any investment the firm might make in anattempt to secure lower production costs.

because industry output (and thus thepotential cost savings from a reduction inmarginal production cost) is greater undercompetition than under unregulatedmonopoly.54 In contrast, substantial marketconcentration can encourage innovation forat least two reasons. First, the profit amonopolist generates can serve as a valuablesource of research and development (R&D)funding.55 Second, the prospect of substan-tial monopoly profit can be a compelling rea-son to undertake R&D investment.56

Regulatory policy can affect infrastructureinvestment differently than it affects innova-tive effort and investment designed toreduce operating costs.57 To illustrate thispoint, first consider rate of return regulation,which promises a fair return on prudentlyincurred investment. When expropriationcan be avoided, such a promise can deliverstrong incentives for infrastructure invest-ment. In contrast, because it requires rev-enues to track costs closely, rate of returnregulation (like other forms of “cost-plus”regulation) typically provides limited incen-tive for innovation and cost reduction.58

Now consider price cap regulation, whichtypically permits revenues to diverge fromrealized costs for a specified period of time(e.g., four years) but does not promise



59 The regulatory policy implemented for British Gas in1986 (which permitted the average price of natural gas toincrease at the rate RPI + Y − X) is an example of price capregulation. Sappington (2002) provides an overview ofprice cap regulation plans. Also see Jan Paul Acton andVogelsang (1989), Jordan Jay Hillman and Ronald R.Braeutigam (1989), Armstrong, Cowan, and Vickers(1994), and Jeffrey I. Bernstein and Sappington (1999), forexample. Notice that a promise to allow revenues todiverge from realized costs can play much the same role asintellectual property rights protection that allows an inno-vator to derive substantial financial gain from her innova-tion.

60 A. Michael Spence (1975) observes that, when qual-ity cannot be regulated directly, rate of return regulationmay provide stronger incentives to supply quality thanprice cap regulation. Sappington (2005a) reviews the liter-ature on service quality regulation in utility industries.

61 Regulatory policies that deliver a consistent rate ofreturn on investment also can reduce the variance ininvestors’ financial returns, and thereby reduce the regu-lated firm’s cost of capital.

62 Alternatives to these two forms of regulation alsomerit consideration. As Schmalensee (1989) notes, earn-ings sharing plans (which specify explicit rules for sharingthe firm’s realized earnings with consumers) can help toavoid extreme distributions of rent that can prove difficultto enforce in practice. Sappington (2002) provides a dis-cussion of earnings sharing plans and relevant referencesto the literature. Vogelsang (2005) explains how earningssharing policies might be coupled with other regulatoryregimes to provide appropriate short-term incentives forcost reduction and long-term incentives for investment.

specific long-term returns on investment.Although such a policy can provide substan-tial incentive for short-term innovation andcost reduction,59 it may provide limitedincentive for long-term infrastructure invest-ment.60 Therefore, the choice between rateof return regulation and price cap regulationwill depend in part on the type of investmentthat is most important to secure. In settingswhere the top priority is to induce the regu-lated firm to employ its existing infrastruc-ture more efficiently, price cap regulationmay be preferable. In contrast, in settingswhere it is important to reverse a history ofchronic underinvestment in key infrastruc-ture, rate of return regulation may bepreferable.61

The appropriate choice between rate ofreturn regulation and price cap regulationalso is influenced by industry volatility andregulatory commitment powers.62 As costsand demands change over an extended time

63 This is the case even if the price cap plan makesexplicit adjustments for changes in economywide outputprices and changes in key input prices.

64 Of course, if a regulator has considerable discretionover which of the firm’s investments qualify for the prom-ised rate of return, serious problems of opportunism canarise under rate of return regulation, just as they can ariseunder price cap regulation.

65 Guasch (2004, table 1.16) reports more widespreadrenegotiation of franchise contracts under price cap regu-lation than under rate of return regulation.

66 Harold Demsetz (1968) provides the seminal discus-sion of this observation. Laffont and Tirole (1987), R.Preston McAfee and John McMillan (1987), and Riordanand Sappington (1987), among others, provide formalanalyses of the optimal design of monopoly franchises.

period, prices and costs will invariablydiverge under price cap regulation, possiblyleading either to financial distress or to par-ticularly large profit for the regulated firm.63

Neither of these outcomes is likely to becredibly sustained in settings where thecountry’s institutions are weak. Therefore, insuch settings, rate of return regulation maybe preferable to price cap regulation in thepresence of considerable industry volatility,particularly if infrastructure investment isdesirable.64 The cost-plus nature of rate ofreturn regulation, which ensures profits areneither excessive nor insufficient, can renderits implicit commitment to set prices thattrack costs closely more credible than theprice commitments encompassed in a pricecap plan.65

5. Franchise Bidding

Even when pronounced scale economiesrender direct competition in the market pro-hibitively costly, competition for the right toserve as a regulated monopoly supplier (inthe form of franchise bidding) can sometimescapture for consumers much of the surplusthat strong competition in the market wouldgenerate.66 To illustrate the potential value offranchise bidding, return to the simple modelconsidered in section 3 and suppose twofirms bid for the right to serve as the soleprovider of the product in question underterms specified by the regulator. Each firm is



67 The regulator can achieve the ideal (full-information)outcome in this setting if the firms’ costs are correlated.See, for example, Joel S. Demski and Sappington (1984)and Jacques Crémer and Richard P. McLean (1985).

privately informed about its own marginalcost of production (c ∈ {cL,cH}). The twopossible cost realizations again are equallylikely for each firm. Furthermore, for sim-plicity, the firms’ cost realizations areuncorrelated.67

The optimal franchise bidding policy in thissetting takes the following form. The twofirms report their cost realizations simultane-ously. If only one firm reports the low costrealization (cL), that firm is selected to be themonopoly supplier, sell the product at unitprice pL, and receive transfer payment TL. Ifboth firms report low costs, one of the firms isselected at random to operate the (pL,TL) con-tract. If both firms report high costs (cH), oneof the firms is selected at random to operateunder the (pH,TH) contract.

The contracts are optimally designed toensure the firms report their costs truthfully.Consequently, a firm with the low marginalcost will be selected to serve as the monop-oly supplier with probability 3/4. (Thus, fran-chise bidding secures the sampling benefitof competition.) A firm with the high mar-ginal cost will operate with probability 1/4.Truthful reporting by the low cost firm willbe a best response to truthful reporting bythe rival potential producer if

(7) −34 UL � 1−4 [UH + ∆q(pH)],

where Ui ≡ [pi − ci] q(pi) − F + Ti for i = L,H.The binding participation constraint will bethat of the firm with the high marginal cost,so UH is optimally held to zero. Inequality (7)will optimally be satisfied as an equality tolimit the rent afforded a firm with the lowmarginal cost. Consequently, expected wel-fare under the optimal pricing policy is:

(8) −34 [wL(pL) − 1−3[1 + λ − �]∆q(pH)]

+ 1−4 wH(pH).

68 This is the case because v(cH + [1 − �]∆) ≥ v(cH) − [1 −�]∆q(cH). Therefore, expression (9) will exceed expression(4) if 2[v(cL) − v(cH)] ≥ ∆q(cH)[1 + �]. This inequality holdsfor all values of � ≤ 1.

69 In practice, franchise auctions often take differentforms. For example, firms often are invited to specify aprice at which they are willing to supply the product inquestion to consumers, and the firm that bids the lowestprice might be awarded exclusive production rights. Thisauction, which involves no transfer payments from firms tothe government (or vice versa), typically will result in themost efficient firm serving consumers at a price thatreflects its average cost of production. Such an auctionresembles normal price competition but has the addedadvantage that it can permit profitable operation even inthe presence of scale economies. Alternatively, the supplyprice might be determined in advance and firms could bidon the amount they will pay the government (or the pay-ment they will require from the government) for the right(and obligation) to provide the service at the stipulatedprice.

Expression (8) reveals that pH is optimallychosen to maximize wH(.) − [1 + λ − �]∆q(.),while pL is optimally chosen to maximizewL(.). Therefore, prices in this franchise bid-ding setting are the same prices that areimplemented in the regulated monopoly set-ting. (Recall expression (2).) The transferpayment (TL) to the low-cost supplier isreduced in the franchise bidding setting,though. The firm will reveal its superior capa-bilities despite being promised a smallertransfer payment because cost exaggerationentails substantial risk of being excluded fromthe industry. (Thus, franchise bidding securesthe rent-reducing benefit of competition.)

Because franchise bidding and monopolyregulation implement the same price for agiven cost realization, total expected welfareis the same under the two regimes except thatthe likelihood of a low-cost supplier increasesfrom 1/2 to 3/4. In the case where there is nocost of social funds (so λ = 0), expected wel-fare in the franchise bidding setting is:

(9) −34 v(cL) + 1−4 v(cH + [1 − �]∆).

It is apparent that expression (9) exceedsexpression (5). Expression (9) also exceedsexpression (4) when ρ = 1/2.68

In summary, franchise bidding outper-forms both monopoly regulation and duop-oly competition in this simple setting.69 It



70 This possibility is known as the “winner’s curse.” SeeVijay Krishna (2002, pp. 84–85), for example.

71 The terms of the franchise contract can be altered tocounteract the problems that arise when bidders have lim-ited financial resources. For example, rather than bid on alump-sum franchise fee, potential operators might bid onthe fraction of realized profit (or revenue) that they arewilling to share with their customers. See Tracy R. Lewisand Sappington (2000) for details. Che and Ian Gale(1998, 2000) provide related analyses.

does so by employing both transfer pay-ments and price regulation to pursue socialgoals by ensuring the benefit of scaleeconomies through the selection of a singlesupplier and by securing the sampling andrent-reducing benefits of competition.

More generally, franchise bidding canhave its drawbacks. If potential operatorsdo not have comparable skills, accurateinformation, and substantial financialresources, bidding for the right to serve asthe monopoly supplier may not be intense.Firms will have little interest in bidding fora contract they expect to lose to a morecapable operator. In addition, a firm will bereluctant to bid aggressively on a contractif it may win the contract not because it isthe most capable producer but because itunderestimates most severely the true(common) cost of operating the fran-chise.70 A firm may be similarly reluctantto bid for a contract when it suspects otherbidders (e.g., an incumbent provider of theservice in question or a firm that providessimilar services in another geographicregion) have better information regardingthe financial returns the contract is likelyto provide. Furthermore, a firm cannot bid more for a contract than its financialresources allow.71 When pronounced dif-ferences in skills or information and/or adearth of qualified bidders with substantialfinancial resources limit the intensity offranchise bidding, such bidding will not capture for consumers the surplus they would enjoy if multiple, well-informed firms with similar capabilities

72 A decision to exclude foreign investors from the bid-ding process (to promote nationalism or to further nation-al security, for example) can limit substantially theintensity of franchise bidding. Such exclusion also canreduce the value of the franchise since the skills andexpertise of the successful bidder affect the profit theenterprise can generate. Roman Frydman, Cheryl Gray,Marek Hessel, and Andrzej Rapaczynski (1999) report thatenterprise revenues increase substantially when an SOE issold to outside managers, but not when it is sold to indi-viduals who managed the SOE before its privatization.

73 Guasch (2004) analyzes more than 1,000 franchiseauctions in Latin America and the Caribbean between1985 and 2000. He finds that more than 50 percent ofelectricity franchise contracts and 75 percent of waterfranchise contracts were renegotiated. The average timebetween franchise award and renegotiation was approxi-mately two years. Renegotiation was initiated by the cho-sen operator more often than it was initiated by thegovernment.

74 When all relevant dimensions of performance are notspecified clearly in a regulatory contract, a potential sup-plier may be able to bid the highest franchise fee, notbecause it is the least-cost supplier of the services in ques-tion, but because it will deliver the least on all of the per-formance dimensions that are not specified in theregulatory contract. Alejandro M. Manelli and Daniel R.Vincent (1995) identify conditions under which considera-tions of this sort render it optimal for a regulator to nego-tiate a contract with a single selected supplier rather thanto award the franchise to the firm that bids the most tooperate under a contract that does not specify fully all rel-evant dimensions of performance.

competed against each other in the marketplace.72

Franchise bidding also may provideopportunities for the selected producer to“hold up” the government. After it is award-ed the monopoly franchise, the chosen pro-ducer may attempt to renegotiate the termsof the original contract in order to securemore favorable terms.73 The governmentmay be susceptible to renegotiationdemands in order to avoid the appearance offailure in the procurement process or toavoid substantial transaction costs associatedwith reauctioning the franchise.74

Franchise bidding also can fail to provideideal incentives for investment. If the dura-tion of the franchise contract is short relativeto the useful life of a desirable sunk invest-ment, the chosen supplier may be reluctantto undertake the investment if the firm’stenure as the monopoly supplier is likely to



75 See Williamson (1976), for example.76 Robin A. Prager (1989), Mark A. Zupan (1989a,

1989b), and Yasuji Otsuka (1997) present evidence whichsuggests that these difficulties with franchise competitionare not always insurmountable in practice.

77 See Laffont and Tirole (1988). Investment also mightbe encouraged by adopting technologies that employ morefungible physical assets (e.g., wireless rather than wirelinefacilities in the telecommunications industry).

end before it can fully recover the cost of theinvestment. Consequently, the chosen sup-plier may adopt an inefficient productiontechnology (one that employs an undulysmall level of sunk costs) and all potentialsuppliers may reduce their bids for the rightto serve as the monopolist.

Although long-term contracts can, inprinciple, help to overcome this problem,long-term contracts seldom are a panacea.In practice, it typically is impossible todelineate all relevant contingencies in acontract.75 Furthermore, rigid contractscan preclude valuable adaptations to chang-ing industry conditions. In addition, eventhe most carefully crafted long-term con-tracts may not be enforced if the prevailinglegal institutions are weak. For all thesereasons, even long-term contracts typicallyare unable to deliver ideal investmentincentives. In some settings, it may be pos-sible to adjust franchise bidding policies tocounteract some of these problems.76 Forexample, auction rules that favor theincumbent supplier can enhance theincumbent’s incentive to undertake sunkinvestments in the presence of short-termcontracts.77

In summary, auctions for the right to bethe sole supplier can help to limit monopolyrents and to select the most efficient indus-try supplier. However, franchise auctionsseldom eliminate the need for regulation.Moreover, the same strong regulatory insti-tutions that are necessary for effectivemonopoly regulation are required for thesuccess of franchise bidding contracts.When these institutions are present,

78 Regulators can sometimes benefit by ensuring thatalternative suppliers are available to replace the incum-bent supplier as needed. Although it can be costly to main-tain a second source of production, the ability to readilyshift some or all production to the second source canimpose useful discipline on a monopoly supplier. See, forexample, Rafael Rob (1986), Anton and Yao (1987),Demski, Sappington, and Speller (1987), Riordan (1996),Riordan and Sappington (1989), James D. Dana, Jr. andKathryn E. Spier (1994), and Anton and Paul J. Gertler(2004).

though, franchise bidding can constitute auseful additional instrument that regulatorscan employ to select and discipline soleproviders in network industries.78

In concluding this section, we note thatyardstick competition can secure many ofthe same benefits as franchise bidding insettings where different monopolists oper-ate in distinct geographic markets. (Forexample, different water distribution com-panies often serve different regions of acountry.) In such settings, each monopolistmight be compensated on the basis of howits performance compares to the perform-ance of other monopolists. For example,the compensation delivered to each firmmight be set equal to an index of the real-ized costs of the other firms, rather than itsown costs. This and other forms of yardstickcompetition can provide strong incentivesfor efficient performance by all monopolistswhen they are known to operate in similarsettings. When the firms operate in envi-ronments that differ substantially (in geo-graphic area, terrain, weather, orpopulation density, for example), explicitcorrections for relevant differences can beimportant. Such corrections typically willbe necessary to avoid compensation that isunduly generous for some firms and undu-ly meager for others. Appropriate handi-capping can be difficult in the presence oflimited information about the precisenature of the variation in the firms’ operat-ing conditions. However, some relativeperformance comparisons generally can



79 See Andrei Shleifer (1985), Joel Sobel (1999), RogerCarrington, Tim Coelli, and Eric Groom (2002), andMehdi Farsi, Massimo Filippino, and William Greene(2005), for example. Armstrong and Sappington (forth-coming, section 4.1) provide further discussion and refer-ences. Notice that the entire benefit of yardstickcompetition arises from the rent-reducing impact of oper-ation by multiple firms. Yardstick competition does notadmit a sampling benefit because the firm that supplies agiven market is fixed exogenously.

80 This discussion draws in part from Armstrong,Cowan, and Vickers (1994, chapter 4).

help to discipline and motivate monopolysuppliers.79

6. Entry Assistance and Anti-CompetitiveLiberalization Policies

The foregoing discussion suggests thegreatest potential gains from competitionwill tend to arise when: (1) industry scaleeconomies are limited relative to consumerdemand; (2) the industry regulator has limit-ed information, limited resources, and limit-ed instruments with which to craft policy; (3)the regulator’s commitment powers are lim-ited; and (4) subsidization of the consump-tion of some of the dominant supplier’sservices is either not critical or can beachieved by means other than regulating thesupplier’s price structure.

The design of liberalization policy is ofparamount importance in settings wherecompetition is deemed to be a superioralternative to a prevailing monopoly regime.The purpose of this third segment of thepresent essay is to discuss the principles thatunderlie the design of sound liberalizationpolicy.80 After considering the subtle issue ofexplicit entry assistance, this section focuseson liberalization policies that can hinder(rather than promote) vibrant, long-termindustry competition. Section 7 reviewspreferable competition-enhancing liberal-ization policies.

It is important to emphasize at the outsetthat the discussion in both this section andthe next necessarily entails some subjective

judgments. Furthermore, even though thepolicies considered in this section generallyare not recommended, some of the policiescan, in theory, enhance welfare in certainsettings if the regulator is particularly wellinformed. Therefore, definitive, unequivocalconclusions about liberalization policies aredifficult to draw. The ensuing discussion isintended to provide general guiding princi-ples (to the extent possible) rather than pre-cise, comprehensive prescriptions anddefinitive conclusions.

Successful liberalization is seldom as sim-ple as removing all legal restrictions on entryinto the regulated industry. Entrants facemyriad economic barriers to entry, evenwhen legal barriers are removed. Theseentry barriers include (1) customer inertiadue to switching costs or ignorance, forexample; (2) incumbent control of key inputsthat entrants require for profitable opera-tion; and (3) the prospect of aggressive pric-ing by incumbent suppliers. Policies thatreduce or limit the effects of entry barriersconstitute vital components of a successfulliberalization plan, as explained in section 7.However, is the reduction of entry barrierssufficient, or should liberalization effortsinclude additional policies that provideexplicit assistance to competitors?

Although such direct assistance has manyimportant drawbacks (as explained furtherbelow), it can in principle increase total wel-fare under some conditions. To illustrate,suppose competition would drive pricesclose to the entrant’s marginal cost of pro-duction, as it would, for example, in the set-ting of section 3.2 when the competitors’costs are highly correlated. In such a setting,an entrant will anticipate limited variableprofit from industry operations. Con-sequently, if the entrant must incur a sub-stantial sunk cost in order to enter theindustry, the potential competitor willdecline to enter, even if it faces no legalrestrictions on entry. Therefore, entry maybe least likely to occur without assistance



81 Entrants may require little assistance when they arecompeting against an inefficient incumbent supplier thathas historically delivered poor service quality to con-sumers. Consumers often will be anxious to secure servicefrom an alternative supplier under such conditions.

82 Unassisted entry by the first firm in a market gener-ates positive external effects in that market. The first pro-ducer causes consumer surplus to increase and does notaffect the profits of other producers.

83 The information required to assess the magnitude ofrelevant external effects includes the details of consumerdemand, the extent and nature of product heterogeneity,and the production technologies of actual and potentialproducers. See N. Gregory Mankiw and Michael D.Whinston (1986) for additional analysis of this issue.

precisely when, due to its intensity, competi-tion is most effective relative to regulation.81

In such settings, entry assistance (perhaps inthe form of a subsidy financed by publicfunds to cover the sunk entry cost, for exam-ple) could increase social welfare in theory.However, the appropriate magnitude of suchentry assistance can be difficult to determinein practice. Furthermore, such assistancecan promote regulatory capture and unpro-ductive use of public funds.

The general merits of entry assistancedepend in part on the external effects ofentry. External effects refer to the effects ofentry on consumer surplus and the profits ofincumbent producers. External effects maycause entry to be unprofitable for an individ-ual firm even though entry would increaseconsumer surplus and total welfare, as in thesetting just described. External effects alsomay cause entry to be profitable for an indi-vidual firm even though entry would reducetotal welfare. Such a setting (in which it canbe more appropriate to discourage entrythan to assist entry) arises naturally when theprofit an entrant anticipates from industryparticipation is derived in part from profitthat would otherwise accrue to incumbentproducers.82

Because the most appropriate level ofdirect entry assistance can be difficult todetermine and because such entry assistancecan have undesirable consequences,83 itgenerally is not recommended. The follow-ing liberalization policies (some of which

84 Recall that British Gas was permitted to retain itsmonopoly status (albeit in continually shrinking marketsegments) during the initial stages of liberalization.

85 See Woroch (2000) for evidence of this effect.

entail entry assistance and some of which failto reduce entry barriers adequately) alsogenerally are not recommended.

6.1 Provide a Temporary Monopoly orOligopoly

A common form of liberalization is toannounce a future (sometimes distant) dateat which competition will be admitted, butexplicitly preclude widespread competitionbefore that date.84 A temporary monopoly(or oligopoly) policy of this sort often isadopted in part to secure the incumbentsupplier’s support for liberalization. Suchsupport may be important, for example,when the incumbent supplier is a state-owned enterprise with substantial authorityto set industry policy or when the incumbentsupplier employs a large labor force and sohas substantial political power.

In principle, a temporary monopoly poli-cy can have some merit. Intense competi-tion can increase the risk of and limit thereturn from investment, and therebyreduce the investment of the incumbentsupplier. Therefore, in principle, a tempo-rary monopoly could increase the incum-bent supplier’s investment, to the benefit ofconsumers.

However, the temporary monopoly alsopostpones investment by new suppliers, andso may reduce aggregate investment in boththe short run and the long run.Furthermore, investment by new entrantsmay spur retaliatory or defensive effort bythe incumbent supplier.85 This added impe-tus for investment by an incumbent supplieris eliminated in the short run by a temporarymonopoly policy, and potentially reduced bya temporary oligopoly policy. A temporaryoligopoly policy also can limit entry to a fewselected competitors. Such selection runsthe risk of allowing less efficient suppliers to



86 See Federal Communications Commission (2003).87 See Philip M. Parker and Lars-Hendrik Röller

(1997).

compete, while excluding the most efficientsuppliers from the market. A priori restric-tions on the number of competitors also canlimit product innovation, facilitate collusionamong the selected incumbent producers, andlimit industry pressure to reduce operatingcosts and prices.

A temporary duopoly is sometimes sug-gested as a means to assist at least one addi-tional industry participant on the groundsthat no entry would occur if an entrant werenot promised the security of a temporaryduopoly. This rationale is not entirely com-pelling. If a second entrant would render thefirst entrant unprofitable, the second entrantseems unlikely to enter unless it is more effi-cient than the first entrant. Furthermore, anincumbent producer may benefit greatlyfrom entry assistance of this type, which sug-gests such assistance may be poorly targeted.

An additional potential drawback to atemporary monopoly is that it may provideample time for an incumbent supplier todevise ways to limit the likely success offuture competitors. In addition, “tempo-rary” monopolies can become permanent orsemipermanent monopolies in settingswhere the incumbent supplier has substantialpolitical power and where the regulator’scommitment powers are limited.

The welfare losses from temporarymonopolies and oligopolies can be substan-tial. In the United States, for example, serv-ice quality increased and prices for wirelesstelecommunications services declined sub-stantially once the relevant markets wereopened to more than two providers.86

During the mandated duopoly period, how-ever, industry prices remained close to theirmonopoly levels.87 Similarly, the prices ofwireline telecommunications services didnot decline substantially in Australia duringits mandated duopoly period. In contrast,prices dropped significantly in countries

88 See Spiller and Cardilli (1997), for example. TheUnited Kingdom adopted a seven year duopoly policy in itstelecommunications industry. Newbery (1999, table 7.4)reports that the productivity of the incumbent producer inthe United Kingdom improved significantly only when theduopoly policy was relaxed.

89 These concerns may be particularly strong in coun-tries where colonial rule has only recently ended.

90 Recall that target market shares were specified in theU.K. natural gas industry.

(like Chile and Guatemala, for example) thatdid not adopt duopoly policies.88

6.2 Exclude Foreign Investors

Feelings of nationalism and concerns withnational security can lead to the impositionof limits on foreign participation in keydomestic industries.89 Although such limitscan reduce foreign control of domesticindustry, they can impose significant costs onthe domestic economy. Limits on foreignownership can reduce the flow of much-needed capital to the domestic industry. Thelimits can also serve to exclude the mostknowledgeable and experienced operatorsfrom the industry, and thereby reduce indus-try performance. In cases where operatinglicenses are sold by a domestic government,limits on foreign participation can alsoreduce the license revenue that accrues tothe domestic government.

6.3 Specify Market Share Targets

In an attempt to ensure adequate compet-itive pressure in a liberalized industry, regu-lators sometimes specify the market sharethey would like to see competitors achieve.90

Such a policy suffers from at least two majordrawbacks. First, market share is not neces-sarily a good measure of market power. Inparticular, an incumbent supplier may havesubstantial ability to raise the prices itcharges for its services even when competi-tors presently serve a significant portion ofcustomers. This ability to raise prices prof-itably may stem from the incumbent’s supe-rior products or control over key inputs, forexample. Consequently, the specification ofa target market share for competitors may



91 It is also possible that an incumbent’s market sharemight overstate the firm’s market power. For instance,consider Bertrand price competition in a setting whereone firm has slightly lower unit cost than its rivals. In equi-librium, this firm will have a 100 percent market shareeven though it has limited ability to raise the market price.

not ensure that substantial discipline isimposed on the incumbent supplier.91

Second, the specification of market sharetargets can reduce the intensity of marketcompetition. An incumbent supplier maychoose not to compete aggressively against arival in order to ensure that the rivalachieves its market share target. When mar-ket share targets are specified, the incum-bent may rationally refrain from aggressivecompetition, recognizing that it may causethe regulator to impose more stringent regu-lations on the incumbent when competitorsfail to achieve their market share targets.The resulting diminution in competitiveintensity can result in higher prices andlower service quality for customers and canenable competitors to survive in the market-place even though they have higher coststhan the incumbent supplier.

6.4 Implement Vague or ExcessivelyGenerous Network Access Policies

Many network industries entail a verticalstructure that contains a massive networkinfrastructure segment (e.g., a basictelecommunications network or a gas orelectricity transmission system). The incum-bent supplier of retail services often owns oroperates the infrastructure segment. Giventhe prohibitive cost of constructing multipleinfrastructures, rival retail operators oftenare compelled to procure key inputs (e.g.,network access) from the incumbent, verti-cally integrated supplier. The appropriatedesign of the terms that govern competitors’access to the incumbent’s network poses aformidable challenge for regulators. Someundesirable (but not uncommon) elementsof network access policy are mentioned

92 Recall that competing suppliers of natural gasenjoyed little success until the terms of access to BritishGas’s infrastructure were explicitly regulated. Weisman(1995), Nicholas Economides (1998), David Reiffen(1998), David M. Mandy (2000), T. Randolph Beard,David L. Kaserman, and John W. Mayo (2001), and Mandyand Sappington (forthcoming), among others, analyze theincentives of a vertically integrated supplier to disadvan-tage retail competitors. Of course, a vertically integratedincumbent supplier may not wish to disadvantage a retailcompetitor if the competitor is substantially more efficientthan the incumbent and if the incumbent can secure suffi-ciently high profit margins on the inputs it sells to the retailcompetitor. See, for example, Sibley and Weisman (1998)and Rey and Tirole (forthcoming).

here. More desirable elements of networkaccess policy are reviewed in section 7.

One inappropriate element of networkaccess policy is a vague or incomplete state-ment of the incumbent producer’s obliga-tions to supply access to rivals during theliberalization process. If, for example, anincumbent producer is afforded substantiallatitude in setting the terms and conditionsof network access, the incumbent should beexpected to employ this latitude to disadvan-tage retail rivals. For example, the incum-bent should be expected to set high accessprices, limit the quality of the inputs deliv-ered to rivals, and delay the provision ofaccess.92

A second inappropriate element of net-work access policy is the failure to establisha timely, functional dispute resolutionprocess. When they operate as rivals at theretail stage of production, the incumbentproducer and retail competitors naturallywill have divergent interests regarding theterms and conditions of access. These diver-gent interests often will lead to disputes,even when the incumbent’s obligations arereasonably well specified. Prompt resolutionof these disputes is necessary to ensure thetimely implementation of the liberalizationprocess. By specifying clearly the details of arapid dispute resolution mechanism, a regu-lator can help to ensure that an incumbentproducer does not disadvantage competitors



93 Recall that few interconnection agreements werenegotiated in Chile until after strict mandates for timelynegotiation and an effective dispute resolution mechanismwere implemented. Spiller and Cardilli (1997) explain howfinal-offer arbitration of the type implemented inGuatemala’s telecommunications industry can facilitatetimely negotiation of interconnection agreements.

94 See Joshua S. Gans and Stephen P. King (2004) foran analysis of this issue. Of course, if access prices areunduly high, competitors may build their own infrastruc-ture even though short-term and long-term industry costswould be minimized if the competitors employed theincumbent’s infrastructure.

by delaying unduly their access to key network infrastructure.93

A third inappropriate element of networkaccess policy is the implementation of termsof access that are unduly generous forentrants. To reduce the costs that new sup-pliers incur when entering a market, regula-tors may afford new suppliers access toessential infrastructure at prices that arebelow the incumbent’s costs of supplying theaccess. Short-term subsidies of this naturecan reduce the costs that new suppliers incuras they begin to provide service in a former-ly monopolized industry. In doing so, suchsubsidies may help to attract new competi-tors to the industry and thereby “jump start”competition.94

While short-term subsidies could, in prin-ciple, prove beneficial in this regard, subsi-dies that are intended to be in effect for onlya short period of time often remain in effectfar longer. Long-term subsidies of this sortintroduce at least two important problems.First, the subsidies may permit inefficientfirms to operate profitably in the industry,thereby increasing industry costs and reduc-ing industry welfare. Second, subsidizedaccess to infrastructure can induce competi-tors to employ inefficient operating tech-nologies. In particular, a competitor maydecide to employ the subsidized access tothe incumbent’s infrastructure even thoughthe competitor would employ fewer socialresources if it built and employed its owninfrastructure. Thus, by distorting the tech-nological choices of competitors, subsidized

95 See, for example, Hausman (1997), Hausman and J.Gregory Sidak (1999, 2005), Gregory Rosston and Noll(2002), and the discussion in section 7.7 below.

96 Recall that uniform retail prices and distance-basedaccess charges to British Gas’s transport pipeline mayencourage competitors to serve customers located close togas landing points.

infrastructure access can increase industryoperating costs. It can also reduce productand process innovation in the industry bylimiting the extent to which competitorsconstruct their own infrastructures.95

6.5 Restrict the Incumbent Asymmetrically

Stringent, asymmetric regulation of anincumbent supplier that limits the incum-bent’s ability to compete against entrants canhelp to attract entry. However, even whenentry is desirable, the costs of asymmetricregulation often outweigh its benefits.

To illustrate this more general principle,consider a policy that embeds cross subsi-dies in the incumbent supplier’s pricingstructure and prohibits the incumbent fromreducing any of its prices in response tocompetitive pressures (even prices thatexceed production costs by a substantialmargin). Such a policy has at least fourpotential drawbacks. First, the cream-skim-ming induced by cross-subsidies can jeop-ardize the financial integrity of theincumbent supplier. It can do so by reduc-ing the incumbent’s sales of the profitableservices targeted by competitors withoutany offsetting reduction in the sales of theunprofitable, subsidized services. Second,the cross subsidies can increase industrycosts by allowing inefficient suppliers toserve customers. Third, when competitorsfocus their efforts on selling the most prof-itable services, customers of unprofitable,subsidized services are denied the benefitsof competition.96 Fourth, as explainedmore fully in section 7.7 below, the designof appropriate access charges can be com-plicated considerably when the incumbentsupplier’s retail tariffs do not reflect thesupplier’s costs.



97 Service quality may also decline when universal serv-ice obligations require incumbent suppliers to offer serv-ice at uneconomic rates. Reductions in service quality canboth reduce the cost of supplying the uneconomic serviceand reduce customer demand for the service. Both effectsincrease the profit of an incumbent supplier that is saddledwith uneconomic universal service obligations.

As one further illustration, consider anasymmetric policy that precludes an incum-bent supplier from expanding its productline (e.g., an incumbent supplier of tele-phone service might be precluded from pro-viding cable television service). It isapparent that such regulations can lead tohigher prices, reduced product variety, andlower product quality. When a strong, viablecompetitor is precluded from a market, theremaining operators may not be compelledto compete as aggressively as they otherwisemight. Consequently, prices may rise, supe-rior products may be introduced less fre-quently, and the quality of existing productsmay decline.97 Consumers are harmed byeach of these outcomes.

In summary, although restrictions on thescope of an incumbent supplier’s operationsdo not necessarily reduce welfare (see sec-tion 7.6 below), they have substantial poten-tial to do so if they are not appliedjudiciously. Similarly, many of the othertypes of liberalization considered in this sec-tion can, in principle, increase welfareunder some conditions. However, these lib-eralization policies generally are not thebest way to promote vigorous, long-termindustry competition. Preferable policiesare considered next.

7. Pro-Competitive Liberalization Policies

The purpose of this section is to describeliberalization policies that generally can helpto foster vigorous long-term industry compe-tition while avoiding many of the potentialdrawbacks discussed in section 6. The liber-alization policies discussed in this sectionfocus more on removing entry barriers and
98 See Asher Wolinsky (1997) for a model in which a
regulator often allows firms to compete directly for cus-tomers rather than specifying market boundaries becausecustomers can better discern service quality than the reg-ulator.

99 Recall that many consumers continue to purchasenatural gas from British Gas, even though it tends tocharge more for gas than its competitors. This behaviormay be explained in part by consumer ignorance regardingthe prices charged by competitors.

unleashing the full force of competitionrather than on handicapping or favoring cer-tain competitors. Such policies provideincreased potential for ultimately relying onmarket forces rather than on ongoingdetailed regulatory oversight to ensure thatconsumers are well served.

7.1 Reduce Customer Switching andSearch Costs

Competition can compel providers todeliver high-quality products to consumersat low prices if consumers are able to easilyidentify and secure service from the firmsthat offer the best products at the lowestprices.98 Therefore, liberalization policiesthat help to ensure consumers are wellinformed and are able to switch their serviceprovider easily can stimulate vibrant, endur-ing competition that may ultimately substi-tute for regulatory oversight.99 Specificpolicies that can be helpful in this regardinclude the following three.

First, consumers might be afforded readyaccess to information about the services thatcompetitors offer. Relevant informationincludes both price and (objective, verifi-able) quality information. If consumers gen-erally have access to the Internet, relevantinformation might be made available at agovernment (or government accredited)web site. The web site address might beprinted on the bills that customers receivefrom the incumbent supplier. Price compar-isons will be most transparent when theservices the firms supply are fairly homoge-nous (such as gas and electricity). Price com-parisons can be less meaningful when



100 Models of unregulated oligopoly (e.g., Hal R. Varian1980) often predict that the average equilibrium price inan industry declines as more consumers become informedabout the prices competitors charge. Thus, policies thatmake some consumers more aware of prevailing prices canbenefit all consumers.

101 See Joseph Farrell and Paul Klemperer (forthcom-ing) for an overview of the economics of switching costs.

102 Of course, the benefits of policies like numberportability must be weighed carefully against the associat-ed costs (e.g., the costs of designing and installing the req-uisite technology).

industry suppliers offer heterogeneous serv-ices (e.g., certain types of telecommunica-tions services). Even when it is impractical toprovide comparative information, though,basic information about how to contact com-peting suppliers can increase consumerawareness of competitive alternatives andthereby enhance industry competition.100

Second, steps might be taken to reducethe costs that customers incur when theyswitch suppliers.101 For example, providersof local telephone service might be requiredto install technologies that allow a customerto retain the same telephone numberregardless of the supplier from which thecustomer secures service. Absent such“number portability,” a consumer might bereluctant to switch suppliers because theswitch would require the consumer toinform all friends and associates of her newnumber or reprint business cards and sta-tionery on which the number appears, forexample.102

Third, policies might be implemented toreduce asymmetries in the costs that con-sumers incur when they choose differentsuppliers. For example, carrier preselectionpolicies in the telecommunications industryallow customers to designate in advance thelong-distance carrier that they would like tocomplete all of their long-distance telephonecalls. When a carrier preselection policy is inplace, customers do not need to dial addi-tional numbers or otherwise undertake cost-ly or time-consuming activities in order todirect their long-distance telephone businessto their preferred carrier. Consequently, new

103 Michael Waterson (2003) discusses the potentialmerits of requiring customers to choose their supplierannually, along the lines of annual policy renewals that arecommon in the insurance industry. While such a require-ment can reduce the differential costs that customers incurin choosing to receive service from a new entrant ratherthan continuing to receive service from the incumbentsupplier, the policy increases transactions costs for all con-sumers, not only for those who switch suppliers. The sameis true of Chile’s equal access policy, which, recall, requirescallers to specify their preferred carrier every time theyplace a long distance call.

carriers do not need to convince customers toincur substantial costs in order to win theirloyalty. The new carriers need only providehigher quality and/or lower prices thanincumbent carriers.103

More generally, liberalization policiesthat provide objective information to con-sumers about the options available to them,reduce customer switching costs, and limitany differential costs that consumers mustincur to obtain service from their preferredsupplier can foster vibrant, long-term industrycompetition.

7.2 Ensure Adequate Monitoring and DataReporting

Accurate information about the activitiesand capabilities of both incumbent suppli-ers and new operators is of great valuewhen designing regulatory and liberaliza-tion policies. This information is essential inassessing the nature and intensity of indus-try competition and, thus, the extent towhich stringent regulatory controls can berelaxed.

Accurate information about the servicesthat competitors supply is important in orderto identify the services on which the incum-bent supplier might reasonably be affordedmore substantial pricing flexibility. Marketconcentration (as measured by theHerfindahl Index, for example) can some-times serve as an imperfect indicator of theintensity of market competition. Informationabout the installed capacity of competitorscan be of greater value in assessing both thecurrent and likely future intensity of market



104 Regulators may rationally choose to keep some ofthe reported data confidential. Confidentiality can protectproprietary business plans and limit undesired informationsharing among industry participants.

105 Sappington and Sidak (2003) note that an SOE’sreduced focus on profit can increase its incentives toengage in anticompetitive activities. If, for example, anSOE is more concerned with market share than profit, theSOE may be more willing than a profit-maximizing firm toimplement below-cost pricing for an extended period oftime.

competition, as can detailed knowledge ofthe entry barriers that competitors face.

To ensure the timely availability of theinformation required to formulate appropri-ate liberalization policies, it is important toestablish data reporting requirements. Therequirements should specify clearly whatdata must be reported, how often it must bereported, and which entities must report thedata. The data reporting requirementsshould be changed as infrequently as possi-ble, so as to limit the costs imposed on thereporting entities (and to provide a consistenttime series of data).104

7.3 Privatize State-Owned Enterprises

When the incumbent supplier is owned(wholly or primarily) by the governmentrather than by private investors, privatizationof the state-owned enterprise (SOE) can bean important element of a successful liberal-ization policy. By hardening soft budget con-straints and promoting profit maximization,privatization of an SOE (i.e., selling the firmto private investors) can (1) serve to focusthe firm’s efforts on reducing its operatingcosts and delivering high-quality services toconsumers and (2) reduce a firm’s incentiveand ability to engage in below-cost pricingwhich can preclude the efficient operationof more efficient competitors.105

In settings where a government’s commit-ment powers are limited, partial privatiza-tion of an SOE may be preferable to fullprivatization. When the government retainsan ownership stake in the firm, the govern-ment, like private investors, will suffer finan-cially if it implements policies that reduce

106 See, for example, Enrico C. Perotti and Serhat E.Guney (1993), Perotti (1995), and Germa Bel (2003).

107 See Armstrong, Cowan, and Vickers (1994), BrunoBiais and Perotti (2002), and Bel (2003).

108 In the presence of scale and scope economies, itmay not be possible to set tariffs that reflect marginal pro-duction costs without inflicting a financial deficit on theincumbent supplier.

the firm’s earnings. Consequently, a promiseby the government not to expropriate privateinvestors may be more credible when thefirm is partially privatized than when it isfully privatized.106 Widespread domestic dis-tribution of the privately held shares of the(partially) privatized firm can have a similareffect. In the presence of such widespreaddomestic ownership of the privatized firm,any policy the government might implementthat seriously erodes the earnings of the firmwould likely evoke widespread, popularopposition. Fearful of the political ramifica-tions of any such widespread opposition, thegovernment will be reluctant to expropriatethe privatized firm.107

7.4 Rebalance Retail Tariffs to BetterReflect Costs

Vibrant long-term industry competition canalso be fostered by rebalancing the prices theincumbent supplier charges for its services.Rate rebalancing occurs when prices arealigned more closely with incremental pro-duction costs. Ideally, the desired rate rebal-ancing should be completed at the outset ofthe liberalization process in order to provideappropriate signals to potential competitorsabout their likely returns from long-termindustry operation. Although prices thatdiverge from cost can help to achieve desiredincome distribution, pricing structures thatembed cross-subsidies are inappropriate whenindustry liberalization is under way becausethey introduce the problems identified in section 6.5.

To avoid these problems, the pricecharged for each of an incumbent’s servicesshould be set at or above the firm’s incre-mental cost of providing the service.108 Such



109 Recall that Chile implemented a program to subsi-dize the purchase of basic telephone service by citizens inrural regions and low-income urban areas (Laffont 2005, p.216).

110 See Atkinson and Stiglitz (1976) and Laffont andTirole (2000, chapter 6).

111 Armstrong (2002, section 2.1) discusses the designand implementation of such taxes.

rate rebalancing helps to direct the forces ofcompetition to those services that competi-tors can supply more efficiently than theincumbent supplier and allow the incum-bent supplier to deliver the services that itcan supply more efficiently than its rivals.

In settings where rate rebalancing wouldrequire dramatic increases in the prices ofcertain essential services, strong oppositionto the rebalancing may arise. To amelioratethis opposition, rates might be rebalancedgradually over time, even though completerebalancing at the outset of liberalization ispreferable, when it is feasible. Alternatively,or in addition, financial support might beprovided directly to the customers thatwould find the price increases to be mostburdensome. Such a policy can replaceimplicit subsidies to all consumers withexplicit subsidies to those with the greatestneed for financial assistance.109 If the coun-try’s tax system is relatively efficient, generaltax revenue can be the best source of fundsfor the explicit, targeted subsidies in the reg-ulated industry.110 If the subsidies must befunded entirely within the regulated indus-try, taxes can be imposed on services that aredeemed to be less essential (e.g., the servic-es whose prices were set well above theincumbent’s costs prior to liberalization).Any such commodity taxes should applysymmetrically to all suppliers, so as not todistort the competitive process.111

7.5 Allow Adequate, But Not Unlimited,Pricing Flexibility

If it has no freedom to change the prices itcharges for its services, the incumbent sup-plier will have limited ability to respond tothe challenges presented by competitors.

112 Recall that some observers believe the successenjoyed by new suppliers of local telecommunicationsservices in Chile may be due in part to the limits placed onCTC’s ability to reduce prices selectively in response tocompetitors’ prices (Paredes 2005).

113 Armstrong, Cowan, and Vickers (1994, section7.5.4) describe how British Telecom used the pricing flex-ibility it was afforded by price cap regulation to reduceprices substantially on long distance telephone calls (thatwere also supplied by competitors) while raising prices forlocal telephone calls (for which there were essentially noother suppliers).

Consequently, competitors may survive inthe market even if they are less efficient thanthe incumbent supplier.112

Price cap regulation can provide incum-bent suppliers some pricing flexibility whilelimiting undue exercise of market power.Price cap regulation plans typically con-strain the rate at which the regulated firm’sprices can rise on average, without specify-ing the exact price that must be charged forany particular service. The application ofdistinct price cap constraints to distinctgroups of services can afford the incumbentsupplier some flexibility to respond to com-petitive challenges without allowing thefirm to abuse its market power. To illustrate,the firm might be permitted to increase byfive percent annually the average of theprices it charges for services that are sup-plied by competitors. The firm might alsobe allowed to increase by one percent annu-ally the average of the prices it charges forservices that generally are not supplied bycompetitors. Pricing restrictions like thesethat impose different and separate con-straints on different groups of services canprovide adequate protection for customerswho have no competitive alternatives whileaffording the incumbent supplier a reason-able opportunity to respond to emergingcompetitive challenges.113

In addition, incumbents should generallybe precluded from pricing an establishedservice below the incremental cost of pro-viding the service (unless they are requiredto do so as part of a universal service obliga-tion). As explained above, below-cost pricing



114 In settings where an incumbent, vertically inte-grated producer (VIP) otherwise has considerable pric-ing flexibility, the relevant price floor can include an“imputation” requirement in order to prevent a pricesqueeze. A price squeeze occurs when a VIP sets a pricefor a key input that exceeds the price of the VIP’s rele-vant retail service. An imputation requirement obligatesthe VIP to price its retail service above the sum of theVIP’s (downstream) unit cost of producing the retailservice and the unit price the VIP charges its retailscompetitors for the key input. Thus, the lower bound onthe price of the VIP’s retail product is the usual incre-mental cost floor, with one exception. The VIP’s cost ofproducing the key input is imputed as the input cost thatthe VIP imposes on its retail competitors. This pricefloor is thus the incremental cost the VIP would incur ifit faced the same input cost as its rivals. This imputationprocedure avoids price squeezes, and thereby helps toensure that the most efficient providers supply the retailservice.

115 See Armstrong and Vickers (1993).

can preclude the operation of more efficientsuppliers, and thereby raise industrycosts.114 Below-cost pricing also encouragesexcessive consumption (i.e., consumptionbeyond the point at which the marginal ben-efit of consumption is equal to the marginalcost of production).

It is particularly important to monitor andimplement procedures to preclude below-cost pricing by a firm that operates underprice cap regulation. This is because such afirm can have a particularly strong incentiveto price below cost the services on which itfaces particularly intense competition.Under a price cap plan that restricts the rateat which all of the firm’s prices can increaseon average, a substantial reduction in theprice of one service can authorize a pro-nounced increase in the price of anotherservice. By permitting increases in net rev-enue on some services that offset correspon-ding reductions from below-cost pricing onother services, price cap regulation plans canenhance the incentives of an incumbent reg-ulated firm to set predatory prices that canserve to drive its rivals from the market.115

Therefore, safeguards against below-costpricing are an important component of pricecap regulation plans.

116 Laffont and Tirole (1996) note that when wholesaleand retail services are treated as separate baskets of serv-ices in this manner, a VIP’s ability and incentive to imple-ment Ramsey prices may be reduced.

117 Reiffen, Laurence Schumann, and Michael R. Ward(2000) and Paul R. Zimmerman (2003) provide some evi-dence of this effect.

118 Lisa V. Wood and Sappington (2004) discuss thedesign of such reward structures.

7.6 Prevent Disadvantaging of DownstreamCompetitors

Vertically integrated producers (VIPs) thatboth sell essential inputs to retail producersand supply the retail service themselves candisadvantage their rivals through anticom-petitive actions other than predatory pricing.For example, consider a setting where a VIPoperates under price cap regulation.Suppose the price cap regulation planimposes a single overarching restriction onthe prices of all of the VIP’s services, bothretail and wholesale services. Under such arestriction, price reductions on retail servic-es effectively authorize price increases onwholesale services. Both price changes aredisadvantageous for retail competitors whomust purchase the VIP’s wholesale services.To limit such disadvantaging of rivals, it gen-erally is advisable to place separate restric-tions on the rate at which a VIP’s wholesaleservice prices can rise and on the rate atwhich its retail service prices can rise.116

VIPs can disadvantage retail competitorsthrough means other than strategic pricing.For example, as indicated in section 6.4, aVIP could intentionally reduce the quality ofthe inputs it delivers to its downstream com-petitors and thereby limit the competitors’ability to deliver high quality services to theircustomers.117 To limit undesirable strategicdisadvantaging of rivals, careful monitoringof the quality of the inputs that a VIP deliv-ers to its downstream rivals can be advisable,as can an explicit schedule of penalties forunduly low service quality and, perhaps,rewards for exceptionally high levels of serv-ice quality.118 Structural separation of the



119 Hausman and Sidak (2005) review the form of struc-tural separation currently required by Ofcom, the U.K.communications regulator. The separation includes thecreation of a separate division of British Telecom to supplywholesale services on the same terms and conditions to allretail competitors and an “equality of access” board tooversee the operations of this division.

120 Vertical divestiture of the incumbent also can sim-plify the design of access charges by eliminating the effectsof access charges on the incentives of a VIP to disadvan-tage retail competitors. Beard, Kaserman, and Mayo(2001), among others, consider how access charges affectthe incentives of a VIP to disadvantage rivals.

VIP’s wholesale and retail operations canfacilitate accurate monitoring of the relativeprices and qualities of the inputs that theVIP supplies to its own retail affiliates and tocompeting retailers.119 In assessing themerits of structural separation, this potentialbenefit should be weighed against any asso-ciated costs, including foregone economiesof scope.

A more radical alternative to structuralseparation is ownership separation. Understructural separation, wholesale and retailoperations are physically separated but com-mon ownership and control of both opera-tions is permitted. In contrast, ownershipseparation precludes common ownershipand control of wholesale and retail opera-tions. While structural separation can help tolimit the ability of a VIP to disadvantage itsretail competitors, ownership separation canserve to reduce the incentive a producer ofkey wholesale services might have to disad-vantage the (retail) firms that purchase thewholesale services. When it does not provideretail services, the wholesale provider doesnot secure any direct gains in the retail mar-ket from disadvantaging retail producers. Infact, a reduction in the quality of the inputs itsells generally will reduce the demand forthese inputs and thereby reduce the rev-enues of the wholesale producer. Con-sequently, by eliminating the key source ofpotential gains from disadvantaging down-stream operators, ownership separation cansubstantially reduce, if not eliminate, incentives for such disadvantaging.120

121 See Vickers (1995), Paul J. Hinton, J. Douglas Zona,Schmalensee, and William Taylor (1998), Sand Hyup Leeand Jonathan H. Hamilton (1999), Robert Crandall andSidak (2002), Stefan Beuhler, Dennis Gärtner, and DanielHalbheer (2005), and Crew, Kleindorfer, and JohnSumpter (2005), for example, for analyses of these andrelated considerations.

122 See Armstrong (2002) and Vogelsang (2003) formore detailed surveys of this topic.

Of course, the costs of ownership separa-tion must be weighed carefully against itspotential benefits. Ownership separation,like structural separation, may sacrifice sub-stantial economies of scope and economiesassociated with integrated planning ofwholesale and retail operations. Ownershipseparation may also preclude a particularlyefficient competitor (the producer ofwholesale services) from participating in theretail market and thereby raise industrycosts and retail prices. Ownership separa-tion also can entail substantial divestiturecosts in cases where a VIP is already provid-ing both wholesale and retail services whenownership separation is considered.121 Themerits of ownership separation also candepend on the prevailing regulatory institu-tions. A regulator with ample resources,considerable experience, and substantialauthority to collect relevant data may beable to prevent a VIP from disadvantagingits rivals. In contrast, a regulator with limit-ed resources, limited experience, and limit-ed information might be unable to do so,rendering vertical separation the best(albeit a costly) way to promote effectivecompetition.

7.7 Establish Appropriate Access Prices

The prices that retail competitors mustpay to access the infrastructure of an incum-bent VIP can have a substantial impact onwelfare. A comprehensive assessment of theeffects of access prices on welfare is complex.However, some of the key effects can beillustrated in the following simple setting.122

Suppose an incumbent VIP incurs mar-ginal cost c1 in supplying a retail service and



123 Notice that this discussion takes the incumbent’sretail tariff as given. Ideally, wholesale and retail pricesshould be set simultaneously to achieve social goals, fol-lowing standard Ramsey principles (Laffont and Tirole1994).

124 See Robert Willig (1979) and William J. Baumol(1983) for early discussions of this rule.

marginal cost c2 in supplying a networkinput to a single retail competitor. This com-petitor, the entrant, incurs constant unitcost c in converting one unit of the accessservice into one unit of its own retail service.(The production technology is fixed propor-tions, so exactly one unit of the access serv-ice is required to produce each unit of theretail service.) The retail services of theincumbent and the entrant are homoge-neous, and consumers purchase the productfrom the firm that sets the lowest retailprice.

Suppose the regulator sets retail price pand access price a for the incumbent’s serv-ices in this setting. Then the entrant will findit profitable to operate if the highest price(p) it can charge for its retail service exceedsits unit cost (a + c) of producing the service.Industry production costs are minimizedwhen the least-cost supplier serves all retailcustomers. The entrant is the least-cost sup-plier in this setting when (c2 + c) is less thanc1. Therefore, for fixed regulated retail pricep, the following access price ensures theentrant will operate when and only when it isleast-cost industry supplier:123

(10) a = c2 + [p − c1].

The access price in equation (10) reflectsthe efficient component pricing rule (ECPR),which states that the access charge should beset equal to the sum of the incumbent VIP’scost of supplying access (c2) and the opportu-nity cost (or lost profit, p − c1) the VIP incurswhen it loses a unit of business to theentrant.124 The ECPR implies that when theVIP’s regulated retail price exceeds its cost ofsupplying the retail service (so p > c1), theaccess charge should exceed the VIP’s cost ofproviding access. This increase in the access

125 This increase in the access charge above the cost ofsupplying access can help to mitigate the cream-skimmingproblem discussed in section 7.4 above.

126 When access charges reflect the ECPR, a VIP iscompensated for the profit reduction it incurs when itloses a retail customer to a rival supplier. Consequently,access prices that reflect the ECPR can limit a VIP’s incen-tive to disadvantage retail rivals.

127 Armstrong, Chris Doyle, and Vickers (1996) providethe details of this and other extensions of the ECPR, alongwith a more general characterization of optimal accessprices.

charge serves to limit the operation of ineffi-cient entrants. To see why, notice that, if aVIP is obligated to both supply networkaccess at cost and set the price of its retailservice above cost (p > c1), an inefficiententrant (i.e., one for which c2 + c > c1) mightfind it profitable to enter the market, raisingindustry production costs. This inefficiententry can be precluded by raising the accesscharge above cost by the same amount theretail tariff is held above cost (p − c1).

125

Similarly, if the VIP is required to offer aretail service at a price below cost (p < c1),network access can be subsidized accord-ingly to encourage efficient entry into thesubsidized retail market.126

Intuitively, one might view the VIP as pay-ing a unit tax of p − c1 when it is required tosupply the retail service to consumers at unitprice p. To ensure profitable entry only bycompetitors that are more efficient than theVIP, entrants must pay the same tax the VIPpays. The ECPR implements this tax by rais-ing the access charge above the VIP’s cost ofsupplying access by p − c1.

This simple analysis requires modificationin richer settings. Suppose, for example, theretail services of the entrant and the VIP arenot homogeneous. In this case, one unit ofsupply by the entrant does not necessarilyreduce the VIP’s retail output by exactly oneunit, and so the ECPR must be adjustedaccordingly.127 Alternatively, suppose theVIP’s retail price is not immutable (perhapsbecause the VIP operates under a price capregulation plan that affords the firm somediscretion in setting retail prices). In thiscase, the established access charge will affect



128 See Armstrong (2002, section 2.6) for further dis-cussion of this issue.

129 See Armstrong (2002, section 2.4) for further dis-cussion of this point.

130 Sappington (2005b) notes that if retail prices are notregulated, efficient make-or-buy decisions may arise evenwhen access charges do not reflect the incumbent’s pro-duction costs.

131 Hausman (1997) and Hausman and Sidak (1999,2005), among others, note that competitors will rely undu-ly on an incumbent supplier’s infrastructure if access pricesare set below the full cost of supplying access. This full costincludes a capital cost that reflects prevailing technologicaland market risks.

the VIP’s choice of retail tariff. The ECPRrequires additional modification to reflectthis interaction.128

The design of access prices becomes morecomplicated if an entrant can supply theinput itself, by investing in its own infra-structure, for instance. In such a setting,care must be taken to ensure that accesscharges provide the entrant with appropriate(“make-or-buy”) incentives to supply inputsitself rather than purchase them from theincumbent VIP. Two distinct regulatoryinstruments would be ideal in such a setting.To deliver appropriate make-or-buy incen-tives to entrants, the VIP’s access chargeshould be set equal to the VIP’s cost (c2) ofproviding the input. This policy ensures anefficient pattern of production given thatentry takes place. Such cost-based accesspricing may not ensure industry cost mini-mization, though, because inefficient retailcompetitors may find entry profitable or effi-cient competitors may find entry unprof-itable when retail prices diverge from theVIP’s production costs (p ≠ c1). To ensureefficient entry decisions, cost-based accesscharges should be accompanied by a tax onthe outputs of entrants that reflects the devi-ation of the VIP’s retail price from its cost(p − c1).

129 When the regulator is unable toimplement output taxes, the access charge isforced to perform the dual task of providingefficient make-or-buy decisions and efficiententry decisions.130 Typically, a single instru-ment cannot achieve two goals, making somecompromise inevitable.131

132 Access prices in the U.S. telecommunications indus-try reflect estimates of an efficient incumbent supplierwould incur in supplying access, which can differ from theactual costs of the incumbent supplier. (See Rosston andNoll 2002, for example.) This pricing policy is intended toinduce incumbent suppliers to operate efficiently.

In summary, the appropriate design ofaccess charges can require considerableinformation. Furthermore, the delivery ofappropriate incentives for efficient make-or-buy and industry participation decisions canrequire an extensive set of regulatory instru-ments (e.g., access prices and output taxes).In settings where a regulator has limitedinformation and limited powers, the designof access charges can present extremely chal-lenging problems. However, these problemscan be mitigated if the incumbent VIP’s retailtariffs reflect its production costs, as pro-posed in section 7.4 above. When retail ratesreflect costs (so p = c1) in the simple settingconsidered here, the ECPR in equation (10)collapses to a particularly simple rule: theaccess charge should be set equal to the VIP’scost of providing access. As noted above, thisrule also provides appropriate make-or-buyincentives. Notice that this policy can requirelittle knowledge of consumer demand, anddoes not require the regulator to be able tocontrol the activities of entrants. In sum, aneffective rebalancing of the incumbent VIP’sretail tariff greatly simplifies the regulator’stask of setting appropriate access charges,and allows access charges to focus on the sin-gle task of ensuring appropriate make-or-buydecisions.

Access prices also can affect incentives fornetwork innovation and cost reduction. Forexample, access prices that provide profitmargins on access services that vary inverse-ly with the incumbent VIP’s realized accesscosts can create incentives for the VIP toreduce its costs of supplying access.132

Clearly, the appropriate design of accesscharges becomes more complex when accesscharges serve to motivate cost reduction inaddition to securing industry cost minimiza-tion and inducing efficient make-or-buydecisions.



133 See Woroch (2002). David Boles de Boer, ChristinaEnright, and Lewis Evans (2000) note that New Zealandencouraged facilities-based competition among Internetservice providers while Australia relied more on regulationto protect consumers. The authors report lower prices inNew Zealand than in Australia.

134 Armstrong (1998) and Laffont, Rey, and Tirole(1998) demonstrate these possibilities formally. PatrickDeGraba (2004) and Sharkey (2004), among others, ana-lyze the effects of different intercarrier compensationarrangements.

Conceivably, access prices might be set atrelatively high levels to systematicallyencourage entrants to construct their owninfrastructure. One reason for doing so(despite the duplicative infrastructure costssuch a policy can promote) would be to pro-mote competition among multiple produc-ers in hopes of fostering industryinnovation and eliminating the need forlong-term regulation of a monopoly suppli-er of key inputs.133 However, competitionamong facilities-based networks will notnecessarily eliminate the need for long-term regulation. Even if all operators in thetelecommunications industry employ theirown infrastructure, each operator must stillinterconnect with other operators in orderto complete calls intended for the cus-tomers of other operators. It is conceivablethat unregulated negotiations among simi-larly situated network operators could pro-duce intercarrier compensation ar-rangements that are broadly consistent withsocial goals. However, this need not be thecase. Firms might negotiate compensationarrangements that inhibit competition orlimit new entry, for example.134

7.8 Limit Cost Shifting

In settings where regulatory controls arerelaxed on some, but not all, of the incum-bent supplier’s operations, it can be impor-tant to limit the supplier’s ability to engage incost shifting. Cost shifting occurs when coststhat actually are incurred in the productionof one set of services (e.g., competitive serv-ices) are recorded as costs incurred in theproduction of a different set of services (e.g.,

135 Braeutigam and John C. Panzar (1989), Timothy J.Brennan (1990), and Weisman (1993), among others, pro-vide formal analyses of this issue.

monopoly services). An incumbent suppliermay benefit from cost shifting when, forexample, its competitive operations are notregulated but the prices it can charge for itsmonopoly services are linked directly to itsmeasured operating costs. In this situation,the incumbent supplier can secure higherregulated prices without affecting its (pretax)earnings on competitive services by shiftingcosts from its unregulated to its regulatedoperations.

The incumbent supplier’s ability to under-take such cost shifting can be limited byrequiring separate books of account for itsregulated and unregulated operations, forexample. The firm’s incentive to engage incost shifting can be limited by reducing theextent to which regulated prices are linkedto measured operating costs. In particular,price cap regulation can reduce incentivesfor cost shifting relative to rate of returnregulation and other forms of cost-plusregulation.135

7.9 Ensure the Integrated Operation of AllElements of Industry Policy

It is important to review industry policy inits entirety whenever a major component ofindustry policy (e.g., liberalization policy) isaltered substantially. The review should bedesigned to ensure the ongoing, effective,integrated operation of all components ofindustry policy.

The experience in California’s electricityindustry illustrates the importance of such acomprehensive review. The deregulation ofwholesale electricity prices can benefit con-sumers when a competitive wholesale supplyof electricity is available. Encouraging majorbuyers and suppliers of wholesale electricityto participate in a common exchange systemalso can provide widespread benefits.Furthermore, a capped retail price for elec-tricity can be a component of a sensible



regulatory policy. However, even thougheach of these policies can have individualmerit, the combination of these policies canlead to highly undesirable outcomes. As inCalifornia, volatile wholesale prices coupledwith capped retail prices can jeopardize thefinancial integrity of retail suppliers of elec-tricity. The problem can become particularlyacute when the volatility of wholesale pricesis increased by limiting the ability of retailsuppliers to negotiate long term contractsfor electricity.

Several of the policies cited above can beviewed as corollaries of the general principlethat effective, integrated operation of allcomponents of industry policy merit carefulexamination whenever liberalization is con-sidered. For example, the need to rebalanceretail prices and to afford incumbent suppli-ers appropriate pricing flexibility reflect pru-dent changes in certain elements of industrypolicy as other elements change.

7.10 Increase Antitrust Scrutiny andEnforcement

A central long-term goal of liberalization isto replace regulatory oversight and controlwith the disciplining forces of competition.Liberalization might be viewed as a processby which competitive forces are fostered andstrengthened to the point where they, alone,can impose effective discipline on some orall of the incumbent supplier’s operations.The more pronounced the disciplinary roleplayed by competition, the more important itis to protect competition and ensure it is notsubverted by powerful industry participants.This is generally the role of antitrust policy.

Antitrust policy and regulatory policy dif-fer in at least three fundamental respects.First, antitrust policy typically sets guide-lines that describe in broad terms acceptablebehavior and outcomes. In contrast, regula-tory policy often specifies detailed rules(often that apply to particular firms) thatdefine fairly precisely the limits on accept-able behavior and outcomes. Second, havingspecified ex ante guidelines, antitrust policy

136 See, for example, Marc Bourreau and Pinar Dogan(2001), Sidak (2003), Martin Cave (2004), and DamienGerardin and Sidak (2005). Dennis Carlton and RandalPicker (2005) note that regulation can allow interestedparties greater ongoing intervention in the control processthan antitrust.

137 Ultimately, explicit regulatory control may bereplaced in some settings simply by the specter of regula-tory intervention. See Amihai Glazer and Henry McMillan(1992), for example.

typically entails ex post investigations of pos-sible violations of the specified guidelines.Regulation, in contrast, often couples exante rules with ongoing industry oversight,rule refinement, and rule enforcement.Third, antitrust policy typically relies onedicts to discontinue anticompetitive behav-ior and associated fines (often in the form ofdamage payments to injured parties), whileregulation often proscribes specific types ofconduct (e.g., price discrimination or expan-sion into particular markets) and establishesdetailed performance requirements andassociated reward and penalty structures.136

Antitrust and regulatory policy can playvital and complementary roles in the liberal-ization process. Indeed, it may be importantto increase both regulatory oversight andantitrust enforcement as competition devel-ops in the liberalized industry. Thus, theroad to deregulation of an industry may notbe a straight one. Increased antitrustenforcement and regulatory oversight mayboth be necessary temporarily to ensure thatcompetition has the opportunity to developto the point where it can eventually replaceregulation as the key source of discipline onthe incumbent firm.137

In the 1990s, New Zealand decided to relysolely on general competition laws enforcedby the courts and by a non-specialized com-petition authority to govern activities in thetelecommunications and electricity sectors.This novel approach was not an immediatefailure. However, problems emerged overtime, leading the government to realize theneed for more orthodox regulatory control.The problems included a heavy case load forthe courts and substantial difficulty in proving



138 Spiller and Cardilli (1997) and Laffont (2005, pp.200–202).

an incumbent supplier had abused its domi-nant position. Moreover, legal proceedingsproved to move slowly at times when quickdecisions were required to keep pace withrapid technological advance. The NewZealand experience suggests that exclusivereliance on competition law may not be suf-ficient in network industries with emergingcompetition, even in countries with well-developed case law, strong legal institutions,and substantial judicial resources.138

8. Conclusions

The foregoing discussion has producedtwo broad conclusions. First, even theapparently simple choice between regulatedmonopoly and unregulated competition isnot always straightforward in practice. Theappropriate choice between these regimescan vary with the relevant technological anddemand conditions, with the regulator’sskills and resources, with the efficiency of taxsystems and capital markets, and with thestrength of other prevailing institutions.Second, in settings where competition ispreferable to regulated monopoly, the roadfrom monopoly to competition can be a par-ticularly long and winding road. There is nosingle ideal path from monopoly to competi-tion. The most appropriate liberalizationpolicy depends upon a wide variety of fac-tors, including those relevant to the choicebetween monopoly and regulation.

The foregoing discussion also has empha-sized that, although there is no single liber-alization policy that is ideal in all settings,some policies typically are superior to oth-ers. Liberalization policies that primarily aidsome competitors and handicap others on anongoing basis can hinder the development ofvigorous long-term competition. Therefore,policies such as establishing temporarymonopolies or oligopolies, excluding foreigninvestors, specifying market share targets forindustry suppliers, providing entrants with

long-term subsidized access to the incum-bent’s infrastructure, restricting unduly theincumbent supplier’s pricing flexibility, andimposing unfunded carrier-of-last-resort obli-gations exclusively on incumbent suppliersgenerally are not recommended.

In contrast, liberalization policies thatremove barriers to entry and empower con-sumers to discipline industry suppliers typi-cally are better methods for fosteringvigorous long-term industry competition. Inparticular, policies like reducing customerswitching costs, rebalancing the incumbentsupplier’s prices to better reflect its operat-ing costs, privatizing state-owned enterpris-es, prohibiting below-cost pricing, andestablishing appropriate (access) prices forthe use of critical infrastructure generallyare recommended.

In addition, careful monitoring of industryoperations can be of critical importance dur-ing the liberalization process. Accurate, time-ly data about the nature and intensity ofindustry competition will allow regulatorypolicy to adjust quickly to changes in industryconditions. Consequently, although liberaliza-tion should ultimately lead to reduced regula-tory oversight and control, more pronouncedregulatory and antitrust oversight may berequired on an interim basis to ensure thatregulatory policy is tailored appropriately tothe evolving level of competition and thatcompetition is protected.

The road from monopoly to competition isseldom straight and smooth. Detours (e.g.,increased regulatory and antitrust scrutiny)may be necessary to ensure safe passage tothe intended destination. Bumps in the road(e.g., widespread opposition to rate rebalanc-ing or privatization of state-owned enterpris-es) should be anticipated in order to facilitatetheir navigation in as smooth a manner aspossible. Thus, the liberalization process canconstitute a challenging journey and one thatentails considerable uncertainty. Detailedroad maps can be of enormous value on suchjourneys. Unfortunately, though, becauseevery setting in which liberalization might be



contemplated is different, road maps thatprovide sufficient granularity and specificityin every relevant setting are not available.Therefore, one generally must embark onthe road to competition armed only with thecoarse route markers on which the foregoingdiscussion has focused.

As emphasized in section 4, the mostappropriate liberalization policy can vary con-siderably according to the institutional settingin which it is being implemented. Therefore,an important role for future research is todevelop detailed maps of the best route tocompetition, i.e., to specify the precise detailsof liberalization policies that will work well inspecific institutional settings. Two approach-es to this task seem particularly fruitful. First,the broad principles reviewed in this papercan be translated into precise policy recom-mendations. (For example, precisely howrapidly should rates be rebalanced, given theprevailing prices, customer wealth, and theoperating technologies of the incumbent sup-pliers and entrants? Alternatively, at precise-ly what level should access prices be set giventhe prevailing industry costs structure andretail prices?) Second, case studies and com-prehensive empirical work can be undertak-en to assess the success and failure ofparticular liberalization policies in differentinstitutional settings. Together, these twoapproaches can expand our knowledge of theliberalization policies that will best harnessthe powers of competition to provide criticalindustry discipline and perhaps ultimatelyreplace the costly, imperfect discipline thatregulatory oversight and control provide.

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