Could ex ante regulation create incentives for anti-competitive behaviour?

The paper “Could ex ante regulation create incentives for anti-competitive behaviour?” will be presented at the 10th FSR Annual Conference (10-11 June, 2021).

ABSTRACT:

Setting the right regulatory incentives to ensure that firms with market power behave in a way that benefit consumers is a hard task.  Economic regulators suffer from a significant asymmetry of information and have significantly less resources and weaker incentives than the regulated firms.  This paper highlights a specific risk: that ex ante regulation, mostly in the form of revenue caps, intended to curb the market power of regulated firms, such a public utilities in telecom, energy, water and other infrastructure providers, may in some circumstances provide the latter with both the ability and incentives to exploit their market power via exclusionary and/or exploitative behaviour.  This could interpreted as a negative competition externality from designing ex ante regulation.

This paper covers two main concerns and discusses examples when a negative competition externality has arisen or may arise.  First, we argue that under some circumstances caps, especially but not solely in the form of revenue caps, can provide strong incentives for the regulated firms to exploit their market power and enjoy significant mark-ups for the elastic services included in the cap.  This takes place when the regulated firm can raise its price but reduce demand in a way that it allows it to increase its profits but still meet the overall revenue cap.  We show how this effect, first identified by Crew and Kleindorfer, can arise in a wider set of circumstances than previously identified.  This includes the case when the revenue cap includes some services whose demand is elastic, even when the regulated services as a whole are price inelastic.  Second, we turn our attention to incentives to engage in exclusionary practices and, in particular, predatory behaviour. Such concerns arise when a binding cap includes both non-contestable and potentially contestable services.  We show how this setting considerably strengthens the regulated firm’s incentives to engage in predation in contestable services and recoup from the non-contestable services.

We use examples illustrate our two main concerns.  All the regulatory interventions we have closely examined come from NRAs in the UK, such as the Office of Communications (Ofcom), the Water Services Regulation Authority (Ofwat) and the Office of Gas and Electricity Markets (Ofgem).

PRESENTATION

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