Legal unbundling and auctions in vertically integrated (utilities) markets

This paper addresses the effectiveness of auctions and legal unbundling as regulatory measures to tender a vertically integrated industry more competitive. Specifically, I analyze if implementing auctions and legal unbundling can counter market power in an industry where a Vertically Integrated Corporation (VIC) has a monopoly position in an essential, scarce upstream activity and also owns one of the firms active in the competitive downstream activity. In an earlier paper, Van Koten (2011), I showed that in this configuration the VIC, by having its downstream firm bid more aggressively, can—through increased auction revenue—increase its profit, while disadvantaging downstream competitors and lowering efficiency. Here I analyze the regulatory measure of also legally separating the downstream firm from the VIC. I show that such a measure may only be partially effective; the VIC can formulate a simple compensation scheme that does not violate restrictions typically imposed by legal separation but induces the manager of the VIC-owned downstream firm to bid more aggressively. This increases the profits of the VIC, decreases efficiency, and disadvantages downstream competitors.