Competition and Regulation in Vertically Related Markets

Author(s): John Vickers

Source: The Review of Economic Studies, Vol. 62, No. 1, (Jan., 1995), pp. 1-17
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Reviewof EconomicStudies(1995) 62, 1-17 0034-6527/95/00010001$02.00
? 1995The Reviewof EconomicStudiesLimited

Competition and Regulation in

Vertically Related Markets
JOHN VICKERS
Institute of Economics and Statistics, University of Oxford

First versionreceivedDecember1990;final versionacceptedJuly 1994(Eds.)

In an industrywherenaturallymonopolisticand competitiveactivitiesare verticallyrelated,

should the naturalmonopolistbe allowedalso to operatein the deregulatedcompetitivesector?
Unlike much of the literatureon verticalintegration,this paperassumesthat monopolypricing
behaviouris regulated,and thereforethe effectof verticalintegrationon the task of regulationis
centralto the analysis.In the modelthereis bothimperfectinformationandimperfectcompetition.
Whenverticalintegrationby the monopolistis allowed,the regulator'stask is madeharderinsofar
as the monopolisthas anticompetitiveincentivesto raiserivals'costs. On the otherhand,integra-
tion may lead to therebeing fewerfirmsin the deregulatedsectorand hence less duplicationof
fixedcosts. The overallwelfarecomparisonbetweenseparationand integrationis ambiguous,as
two simpleexamplesillustrate.Variousextensionsto the analysisare also considered.

1. INTRODUCTION
One of the centralquestionsin debateson regulatoryreformis how to organizeindustries
that containboth naturallymonopolisticand potentiallycompetitiveactivities.Electricity
transmissionand distributionare characterizedby natural monopoly cost conditions,
but electricitygenerationis not. In the gas industry,pipeline servicesmay be naturally
monopolistic,but supplyto largercustomersis not. In telecommunications, naturalmono-
poly is more a featureof local networkoperationsthan of long-distanceoperations,and
is not presentin apparatusmanufactureand supply or in the provisionof value added
services.In railways,while the infrastructureof trackand stationsis naturallymonopolis-
tic, the supplyof train servicesmight not be.
Policy developments,notably those associatedwith privatizationin Britainand de-
regulationin the United States, have sometimesled to radicalstructuralreformin these
industries.'AT&T,for decadesa verticallyintegratedmonopolist,was requiredunderthe
1982 settlementof its long-runningantitrustcase againstthe U.S. Governmentto divest
itself of its local networkoperations.The CentralElectricityGeneratingBoard (CEGB)
in Englandand Wales was restructuredboth vertically-transmissiongrid activitieswere
separatedfrom generation-and horizontallybeforeprivatizationin 1990-1991.
By contrast,BritishTelecomwas privatizedas a verticallyintegrateddominantfirm.
BT now facescompetitionfromMercuryand others,especiallyin the long-distancemarket,
but its dominanceof local networkoperationsmight affectcompetitionthereand in other
areassuch as apparatussupply.The local networkmonopolywould of coursehave to be
regulatedin any event, but its link via ownershipto verticallyrelated and potentially
competitiveactivitiesposes additionalregulatoryquestions. Many of the efforts of the
regulatorybody Oftel-notably in relationto interconnectionbetween BT's and rivals'
1. For a generalaccountof the theoryand Britishexperienceof regulatoryreformin the utilityindustries,
see Armstrong,Cowanand Vickers(1994).
l
2 REVIEWOF ECONOMICSTUDIES

networks-have been concernedto check the opportunityand incentivethat BT might

have to use its monopoly power in one activityto distort competitionin its own favour
in others.BritishGas was also privatizedas a verticallyintegratedmonopolist/monopson-
ist, but verticalintegrationhas increasinglybeen seen as an obstacleto competition,and
the Monopolies and MergersCommissionin 1993 recommendedverticalseparationof
the company.The governmentdid not follow this recommendation,but BritishGas is
now requiredto run its pipelineoperationsas a separateunit.
At a generallevel, a distinctioncan be drawnbetweentwo approachesto problems
of competitionand regulationin relatedmarkets.Policy towardsAT&T and the CEGB
has included an importantelement of structureregulation,in the form of divestiture,
designedto removeor diminishthe incentivefor anticompetitivebehaviour,whereaspolicy
towardsBT and BritishGas, whicheschewedstructuralreform,has placedmore reliance
on conductregulation.Like all such distinctions,this one is not perfect,but it appliesto
some extent in a varietyof settings,includingfinancialservicesand some professionsas
well as the utilities.
This paper offers a theoreticalanalysis of some of the pros and cons of vertical
separationin an industrywherenaturallymonopolisticand potentiallycompetitiveactivi-
ties areverticallyrelated.The followingverysimplifiedsituation,whichobviouslyabstracts
fromnumerousimportantfeaturesof the industriesabove,is analyzed.Thereis an industry
supplyinga singlefinal product.One unit of that productis made by combiningone unit
from the naturallymonopolistic'upstream'sectorof the industrywith one unit from the
potentiallycompetitive'downstream'sector.(All that is meantby this terminologyis that
the 'downstream'sector takes as given the price of the component supplied by the
'upstream'firm.)The model containsboth imperfectcompetitionand imperfectinforma-
tion. Therefore,althoughderegulationof the downstreamsector will bring some of the
benefitsof competition-prices more or less in line with costs, etc.-it does not in general
do so perfectly.In particular,deregulationmay lead to excessiveentryand duplicationof
fixedcosts downstream.Similarly,the presenceof imperfectinformationhampersregula-
tion-first-best solutionsgenerallycannotbe implemented,becauseincentivecompatibility
constraintshave to be met. The respectivedegreesof these competitionand information
imperfectionswill featureprominentlyin the analysisbelow.
One way to organizean industryof this kind would be to have verticallyintegrated
monopoly over both sectorsand to regulatethe final productprice.However,the aim of
this paperis to examinethe questionof verticalseparationthat arises,as in the practical
examples above, when there is deregulation of the downstream sector-should the
upstreammonopolistbe allowedinto the deregulateddownstreamactivity?
This questionis not the same as that addressedin the extensiveliteratureon vertical
integrationand merger,2which is for the most part concernedwith the pros and cons of
verticalintegrationwhenthereis no regulationof monopolypricing-the only policy issue
is whetherto allow integrationor permitverticalmerger.The presentanalysisis about
the effects of verticalarrangementswhen there is regulationof monopoly pricing.The
verticalintegrationliteraturehas neverthelessexploreda numberof importantissues that
bearon the generalquestionat hand, includingeconomiesof scope and verticalexternali-
ties, variableproportionsin production,possibilitiesfor pricediscrimination,and mono-
polistic competition between differentiatedproducts. The model below abstractsfrom
these issues, but centralto it are two other factors that the verticalintegrationliterature
has addressed-imperfectcompetitionand economiesof scalein the downstreamindustry.

2. See Perry's (1989) survey for example.

 VICKERS VERTICALLY RELATED MARKETS 3

Imperfectcompetition,for exampleCournotbehaviour,leadsto the well-knownprob-

lem of successivemarkups.Withintegrated(and unregulated)monopoly,the finalproduct
priceis based on a markupover the truemarginalcost, whereasindependentdownstream
firms will add a markup to the wholesale (or access) price charged by the upstream
monopolist,whichalreadycontainsa markupover marginalcost if thereis no regulation.
In the modelbelow,therewill be a markupdownstreambut accesspriceregulationcontrols
the upstreammarkup.There may be a case for offsettingthe downstreammarkupby
subsidizingaccess,i.e. chargingless than marginalcost for access,3so as to bringthe final
product price into line with true marginalcost, but account must also be taken of the
effect on downstreamproductioncosts.
In the model below, entry involvesa fixed cost, and marginalcost is constant.The
numberof entrants,and hence the numberof times that fixed costs are incurred,may be
affected by the terms of access, and by whether the upstreammonopolist is allowed
downstream.In homogeneousgoods Cournotmodels with increasingreturns,there is a
tendencyto excess entry.4The effect of access pricingon the numberof entrantsdown-
stream depends on demand conditions, in particularthe elasticity of the slope of the
inversedemandcurve,whichis often importantin oligopolycomparativestatistics.5These
influenceswill appearin the analysisbelow.
The literatureon raisingrivals'costs and verticalforeclosureis also directlyrelevant.
A naturalandwell-foundedconcernaboutallowingtheupstreammonopolistto participate
downstreamis that it will seek to raiserivals'costs. The strategicadvantageof doing this
is that the rivals are induced to contract their market share, leaving a larger slice of
downstreamoligopoly profitsfor the upstreammonopolist.Anticompetitivepracticesto
raiserivals'costs in this way havebeenexaminedby Salopand Scheffman(1987,especially
SectionV) and by Ordover,Salonerand Salop (1990).6
The literatureon networkaccess pricingincludesWillig (1979) and Baumol (1983),
who studynetworkaccessin a contestablemarkets/Bertrandcompetitionframework,and
Baumoland Sidak (1994, Chapter7). Accordingto theirefficientcomponentpricingrule
(ECPR), the access price should be set equal to the directincrementalcost of accessplus
the opportunitycost (i.e. downstreamprofit foregone) to the upstreammonopolist of
providingaccess. The ECPR impliesthat rivalswill take downstreambusinessfrom the
monopolistif and only if they are more efficientproducers.The optimalityof the rule is
contingentupon the absenceof monopoly profitsupstream.
The analysis that follows differs in several respects. First, regulationof upstream
monopoly power is imperfectbecause of asymmetricinformation.Second, downstream
competitionis imperfect(Cournot) ratherthan perfect(Bertrandor contestable).In the
lattercase each unit of businesswon by rivalsis a unit lost by the monopolist,but this is
not the case with Cournotcompetition,and so the opportunitycost of providingaccess
is ratherdifferent.One of the aimsof the analysisis to see how optimalregulationbalances
welfarelosses arisingfromimperfectregulationupstreamagainstthosearisingfromimper-
fect competitiondownstream.Third,the focus of the analysisbelow is on the questionof
verticalstructure,and in particularthe effect it has on the effectivenessof competition
and regulation.

3. See Spencerand Brander(1983).

4. See Mankiwand Whinston(1986), and Suzumuraand Kiyono (1987).
5. See Seade(1985).
6. For a generalanalysisof verticalintegrationand marketforeclosure,whichdoes not restrictthe form
of verticalarrangements,see Hart and Tirole(1990).
4 REVIEWOF ECONOMICSTUDIES

Laffont and Tirole (1992; 1993, Chapter 5) analyze network access pricing in a
setting where the regulatorcan control not only the access price but also the final
product price of the monopolist.7The optimal access price exceeds the marginalcost
of access for Ramsey reasons. Moreover,if the competitivefringe is operatingunder
decreasingreturns-and hence making positive profits-and if those profitshave lower
welfareweightthan the monopolist'sprofit,then thereis a furtherreasonfor the priceof
access to exceed its marginalcost. In the model below, regulationapplies only to the
monopoly activityand thereis competitionin the other activity,and the focus is on the
structuralquestion.
A paperthat does addressthe verticalstructurequestionin the presenceof regulation
is Gilbertand Riordan(1992).8 Theycompareverticallyintegratedmonopolywith vertical
separationwhere the monopolistis confinedto one activity and there is competition,in
the form of an auction,for the rightto supplythe complementarycomponent.Integration
has the advantageof avoidingan informationcost analogousto the double-markupprob-
lem, and the benefitsof competitivebiddingmay or may not outweighthis. Though the
general theme of interactionsbetweenverticalstructureand regulationis common, the
presentpaperaddressesthe differentquestionof whetherthe monopolistshouldbe allowed
into the competitivesector.
The plan of the paperis as follows. The next sectionintroducesthe main framework
for the analysis.It is essentiallya combinationof Baronand Myerson's(1982) model of
monopoly regulationunder asymmetricinformation,which is applied to the upstream
sector, and Cournot oligopoly with free entry in the downstreamsector. It would be
nice to examinea model in which the regulatorwas uncertainabout both upstreamand
downstreamcost levels. But the analysisof such a model with two-parameteruncertainty
seems formidablydifficult,and it is assumed that regulatoryuncertaintyis just about
upstream(i.e. the monopoly sector's)cost. Ratherthan simplyassumingthat the down-
streamsectoris deregulated,ideallyit would be shownwithinthe model that downstream
deregulationis optimal,but this is not so in the simplemodel used to addressthe policy
questionthat the paperis about. However,it is arguedthat the analysisis justifiedgiven
the questionat hand and in view of the (probablydesirable)fact that thereis deregulation
in the industriesmentionedabove.
Taking it as given that there is downstream deregulation,optimally regulated
access prices and their associated final product prices are derived in Section 3, and
the (ambiguous) welfare comparison between integration and separation is made in
Section 4. Two simple examples, involving linear and unit-elasticdemand, illuminate
the natureof the ambiguity.Verticalintegrationhas the disadvantagethat the regulator's
task is made harderinsofar as the monopolist has incentivesto raise rivals' costs, but
it may have the advantageof offsettingexcess entry and hence allowinga more efficient
productionstructurein the competitiveindustry.Section 5 discussesseveralextensions
of the analysis, includingthe case of cost reductionwhen there is a moral hazard (as
distinct from adverse selection), alternativeforms of the participationconstraint,non-
price anti-competitivebehaviour, oligopoly with a fixed number of firms, product
differentiation,the no transferscase, and cost asymmetriesbetween firms. The final
section concludes.

7. Laffontand Tirole(1992, Section7) also consider'restrictedregulation'-that is, as in this paper,just

regulatingthe monopolist'saccesspricingand not its behaviourin the finalproductmarket.
8. Dana (1993)analyzesthe optimal'horizontal'structureof a regulatedmultiproductindustry,in particu-
lar the tradeoffbetweeninformationaleconomiesof scopeand the benefitsof relativeperformancecomparisons.
 VICKERS VERTICALLY RELATED MARKETS 5

2. THE MODEL
2.1. Outline
There is an industrysupplyinga single homogeneousproduct. Aggregateutility from
consumingQ unitsof industryoutputis U(Q).Thereareno incomeeffects.Inversedemand
is thereforeP(Q) = U'(Q), and P(Q) is assumedto be twice differentiable.Let Q(P) be
the correspondingdemandfunction.Eachunit of the finalproductis made from one unit
suppliedby the monopolizedupstreamsector of the industryand one unit suppliedby
the potentiallycompetitivedownstreamsector.Marginalcosts are constant,and thereare
no economiesof scope. Let 0 denote upstreammarginalcost. Thereare largefixed costs
upstream,makingthat activitynaturallymonopolistic,but the fixedcosts are nevertheless
not so large in relation to consumers'valuation of the product that it would ever be
desirablefor productionnot to occur. (Upstreamfixedcosts play no part in the analysis
and will be ignoredhenceforth.)Firm M is the upstreammonopolist.The level of down-
streammarginalcost is constant and common to all producers.To focus as clearly as
possibleon the questionof verticalintegration,it is assumedthat everyone,includingthe
regulator,knows the level of downstreammarginalcost, which (without furtherloss of
generality)is assumedto be zero. It is assumedthat each downstreamfirm,includingfirm
M if it operatesdownstream,incursa fixed cost K, and let k->K.
The downstreamsector is deregulated:there are n downstreamfirms.This number
is determinedendogenouslyby free entry.Integerconstraintsare ignored,and n is deter-
mined by the condition that independentdownstreamfirmsmake zero profits.Whether
or not M is allowed to operatedownstreamdependson policy towardsthe industry.The
accesspricethat M chargesindependentdownstreamfirms(i.e. ones that it does not own)
for upstreamunits is regulated.Let a denote this price,whichis assumedto be a uniform
price.Thus a downstreamfirmnot owned by M has marginalcost a. (Recall that down-
streammarginalcost is zero.) But if M owns a downstreamfirm, its marginalcost is 0.
It is assumed that firms share common knowledgeabout cost conditions when entry
decisionsare made (though the regulatordid not know 0 when setting termsof access),
and that they operateat Cournotequilibrium.If M owns a downstreamfirm,this equilib-
riumwill not be symmetricunless a= 0.
The objectiveof the regulatoris to maximizethe expectedvalue of social welfare W,
which is definedas the weightedsum of consumersurplusS and industryprofit H:
W=S+an. (1)
Consumer surplus S= U- R - T, where R _PQ is industry revenue, and T is the net
transferpaid to M in the process of regulation(which is to be describedshortly). The
weighta lies betweenzeroand one. Becausethe freeentryassumptionimpliesthatindepen-
dent firmsmake zero profit, H is just M's profit 'r,which must equal [R+ T- 0Q-nK].
Thereforewelfarecan be writtenas
W= U-0Q-nK-(1-a)7r. (2)

2.2 Vertically integrated monopoly

To introducethe Baronand Myerson(1982) modelof regulationunderasymmetricinfor-
mation,whichwill be the vehiclefor the analysisthatfollows,and to providea benchmark,
consider first the case of vertically integrated monopoly. Here M's profit is
[(P- 0)Q(P) + T(P) -K]. The regulator'signoranceabout costs is modelledby supposing
6 REVIEWOF ECONOMICSTUDIES

thathe knowsonly that 0 has support[0o, 01]anddistributionfunctionF(0). It is assumed

that F(0) is continuous,differentiable,and strictlyincreasing.The regulatoryinstrument
is the offerto M of a scheduleT(P) that specifiesthe lump-sumtransferto M as a function
of the pricechosen. This can be interpretedas alternativetwo-partpricingregimes,with
low pricebeing rewardedby a highertransfer,i.e. T'(P) < 0. Of courseM will choose the
most profitablealternativegiven its privateinformationabout costs. The regulatormust
takeaccountof this incentivecompatibilityconstraint.Moreover,the firmmustbe induced
to operate in all states-assuming that to be socially desirable.This is the participation
constraint.In the presentcontext, if this constraintis met in the worst state, 01, then it
will also be met in all other states.
Define ir(0) = Maxp [(P- 0)Q(P) + T(P) - K]. Since P will be chosen optimally for
all 0, an envelopeargumentshows that ir'(0) = -Q(0), whereQ(0) is the optimaloutput
level for the firmin state 0 given the regulatoryregimethat it faces. Integratingby parts
and using the bindingparticipationconstraint T(0) = 0, it follows furtherthat

Er= T H(0)Q(0)dF(0), (3)

whereH(0)_ F(0)/F'(O). For example,if F(O) is the uniformdistribution,then H(O)=

(0- 00). Define B- (1 - a)H. This 'Baronand Myersonterm'will occur frequently.
From (2), expectedwelfare(net of upstreamfixedcosts, whichcan be ignoredbecause
they play no part in the analysis)can now be writtenas
(1
EW= J { U(Q(0))-[0+ B(O)]Q(0)-K}dF(0). (4)
00

Optimizingthisexpressionpointwisewithrespectto Q impliesthatwithoptimalregulation,
pricein state 0 is given by
P(0) = 0 + B(0). (5)
The price-costmarkup (P- 0) is simply equal to the Baron and Myerson term B(0).
Providedthat P(0) is increasing,whichis the case if B'(0) ? -1, M's choice of P as given
by the first-orderconditionis globallyoptimal.This conditionon B(0) is satisfiedby very
many probabilitydistributions,includingthe uniform,and is assumedto hold in what
follows.
The price-costmarkupis zero (i.e. there is marginalcost pricing)in the lowest cost
state, or if a = 1, but it is strictlypositiveotherwise.In generaloptimalregulationinvolves
a compromisebetweenloss of allocativeefficiency(i.e. P> 0), and loss of distributional
efficiency (i.e. r > 0).
The benchmarkcase of verticallyintegratedmonopoly havingbeen established,the
readermay now go directlyto the analysisin Section3 of verticalseparationwhen there
is deregulationdownstream.The nextsub-sectioncommentson somepriormethodological
questions.

2.3. Why deregulate at all? Some methodological issues

The verticallyintegratedmonopoly outcome describedabove is imperfectbecauseof the
informationasymmetrybut it involvesno furtherinefficiencyarisingfrom duplicationof
fixed costs. When there is competitiondownstream,however, there is both imperfect
informationand duplicationof fixed costs, and hence two sourcesof distortion.Indeed,
 VICKERS VERTICALLYRELATEDMARKETS 7

in the model taken literallyas it stands there is no advantagein having downstream

deregulation.The use of the model to comparealternativeformsof deregulation-i.e. with
and withoutthe upstreammonopolistallowedinto thedownstreamactivity-is thereforein
need of comment.9The basicjustificationis that deregulationis a fact, and probablyvery
desirablefor reasonsoutside the model, in severalformerlyintegratedmonopolies;that
the question of verticalseparationwhen there is regulationis thereforeof considerable
policy importancebut one that the existingliteraturehas not addressedextensively;that
the model gives a simple and naturalway of analyzingthe problem;and that a grand
model that simultaneouslyexplainedthe optimalityof deregulationwould be much less
tractable.

3. ACCESS PRICE REGULATION

From now on it will be assumedthat there is deregulationof the downstreamsector of
the industryand that M's accesspriceis what is regulated.It is assumedthat the regulator
offersM a scheduleT(a) relatingthe transferT to the accesspricea. Sections3.1 and 3.2
respectivelylook at what happens with M out of, and in, the downstreamsector, and
Section 3.3 comparesprice, output, profits,and welfarein the two cases.

3.1 Access pricitngwith vertical separation

When M is kept out of the downstreamindustry,its profit (net of upstreamfixed costs)
is

Iro(O)= Max. [(a- O)Q(p(a)) + T(a)], (6)

wherep(a) is the final product price determinedby downstreamimperfectcompetition
when the access priceis a-see (11) below. (The subscripton 7r refersto M being out of
the downstreammarket.)For M the problemis muchthe sameas with verticalintegration,
exceptthat the relevantdemandcurveis now the derived demandfromdownstreamfirms.
As in that case, the derivativeof M's profitfunctionis
7ro(0)= - (0), (7)
where NO(O)is the total output level in state 0 inducedby M's optimalchoice of a given
the regulatoryregimethat it faces, and
1
Efr= { H(0)Qo(0)dF(O). (8)

Let q be the output of a typicaldownstreamfirm.The zero-profitconditionis

(P-a)q = K. (9)

9. In the modelthereis deregulationof the downstreamindustryin two respects-thereis unrestrictedfree

entryand thereis no price(or equivalentlyoutput)regulationfor the finalproduct.Lessextensivederegulationis
possible.For example,entrycouldbe restrictedto a few firms,and/or the downstreamfirmscouldbe regulated.
Those possibilitiesare not consideredhere, however.In the model, as is almost alwaysthe case in practice,
oligopoly pricingis not regulated.Again, the reasons(informationasymmetries,risks of strategicbehaviour,
capture,etc.) lie outsidethe scope of this paperand are exogenousto the deliberatelysimplifiedmodel of the
downstreamindustry.
8 REVIEWOF ECONOMICSTUDIES

The first-orderconditiongiven Cournotbehaviouris

(P-a) =-P'q, (10)
and the second-ordercondition 2P'+ qP"<O is assumedto hold. From these conditions
it follows that q2 =K/(-P'), or q=kk/(j1FiP'), and hence that
P-a=kv-P'. (1 1)
This implicitlydefinesthe relationshipp(a) betweenP and a. The second-ordercondition
for firmsimpliesthat p(a) is strictlyincreasing.Since n = Q/q, we have that nK= QK/q,
and hence that
nK=kQ -F. (12)
From (2) and (12) it follows that expectedwelfareis

EWo=f {U(Q)-OQ-kQ/-P'(Q)-B(O)Q}dF(O), (13)

where Q= QO(0).
Let E(Q) -QP"(Q)/P'(Q) be the elasticityof the slope of the inversedemandcurve.
(With iso-elasticdemandP= caQ-', for example,E= ? + 1.) This term regularlyfeatures
in the comparativestatisticsof Cournotoligopoly.Pointwiseoptimizationof the integrand
in (13) with respectto Q revealsthat with optimalaccesspriceregulation,the finalproduct
pricein state 0 is given implicitlyby'?
Po(0) = 0 + B(0) + k( 1-E) -P, , ( 14)
whereE and P' are evaluatedat Q= QO(0)_P-' (PO(0)). The optimallyregulatedaccess
price is
do(0) = 0 + B( 0)- kE -F (15)
For concreteness,considertwo examples,which will be examinedin more detail later.

In Exaniple A demandis linear:P= 1- Q. In this case -P' = 1 and E= 0, so

Po(0) = 0 + B(0) + k (14a)
and
do(0) = 0 + B(). (1Sa)
Comparingwith (5), we see that with optimal regulationin this case, the final product
priceis higherby k than underverticallyintegratedmonopoly.This is to avoid too much
duplicationof fixed costs.

ElxampleB has demandelasticityof one: P= 1/Q. (Thus U(Q)= ln (Q) plus a con-
stant.) In this case _p' = p2 and E=2, so
PO(0)= 0 + B(0) (14b)
and
I - ( + B(O)).
JO(0)=I(1- k)Po(O) 1-k) (I51b)
10. Pointwiseoptimizationwith respectto Q is equivalentto pointwiseoptimizationwith respectto a,
becauseQ(p(a)) is a monotonicfunctionof a.
 VICKERS VERTICALLYRELATEDMARKETS 9

With optimal regulationin this case, the final productprice is exactlythe same as under
verticallyintegratedmonopoly. The level of the access price does not affect the number
of times that fixed costs are incurred,becausen= 1/k, which is independentof a. This is
in effect an instanceof the result (Seade (1985)) that Cournot oligopoly profits do not
vary with the level of costs if E= 2. More generally, it follows from (14) that
[Po-(O+B(O))] has the same sign as (2-E).

3.2. Access pricing with vertical integration

Now suppose that M owns a downstreamfirm. This changes M's incentives,becauseit
stands to gain-in termsof downstreamprofits-by putting its rivalsat a disadvantage
by raisingthe accessprice.In this case, Al's profit (net of upstreamfixed cost) is
iri(O)= Maxa[(a- 0)Q+ (P(Q) -a)x+ T(a) -K],
where M's downstreamoutput, denotedby x, and total output Q dependon a and 0 as
explained below. (The subscripton 7f refers to M being in the downstreammarket.)
The first and second terms in this expressionare M's upstreamand downstreamprofits
respectively.Imperfectcompetitiondownstreamand the free entry condition determine
Q, x, and n, the numberof firms(includingM). Continuingto denote the output of each
independentdownstreamfirm by q, equations(9) to (1 1) still apply, and it remainstrue
that q = k/( /-P'). Thus the relationshipp(a) betweenP and a is exactlyas in the vertical
separationcase, and independentfrom 0 in particular.But x generallydiffersfrom q, and
is given by the first-orderconditionfor M's downstreamoutput decision
(P-0)=-P'x. (16)
The second-ordercondition2P'+ xP"< 0 is assumedto hold. Using this fact and equations
(9) and (10), Al's profitcan be expressedas
7ri(0)=Maxa [(a-0)(Q+q) + T(a)] (17)
Recall that Q and q dependon a but not 0. Applyingan envelopeargumentto (17), it
follows that
lr(O) = -[Q0(0) + qi(0)]. (18)
whereQj(0) and qUO)are respectivelythe total output level and outputlevel per indepen-
dent downstreamfirmin state 0 inducedby M's optimalchoice of a given the regulatory
regimethat if faces.
Integratingby parts, and given that 7ir(01)=0, it follows furtherthat

E7rj= H(0)[Q+ k/ (Q)]dF(0), (19)

where Q-=Q(O). The numberof firmsin state 0 is given by

n = 1 + (Q-x)/q= I + [Q- (P- 0)/(-P')]J-P/k. (20)
Combiningthe equationsabove, expectedwelfareis
01
EW,= J { U(Q) - OQ- K- [Q- (P- 0)/(-P')]k-P- B(0)(Q +k/ -P)}dF(0).

(21)
10 REVIEWOF ECONOMICSTUDIES

Pointwiseoptimizationrevealsthat with optimalaccesspriceregulation,the finalproduct

pricein state 0 satisfies
Pj(0) = 0+B(0)[l +2'kEIQV_--] +k[2- '(I +s)E]V=i_, (22)
where s=_x/Q is M's downstreammarket share, and terms on the R.H.S. of (22) are
evaluatedat Q= oi(0)= P-'(P(0)). The access price that achievesthis is
aj(0) = 0 + B(O)[1 + 2kE/Q-P'] +k[1--(1 +s)E]-iP'. (23)
The second term on the R.H.S. of (23) relates to the informationasymmetrybetween
regulatorand firm, and the final term relatesto the duplicationof fixed costs.
These expressionstake simpleforms in the two examples.In the linearExample A,
P,(0) = 0 + B(0) + 2k (22a)
and
ai(o) = 0 + B(0) + k. (23a)
Comparing these expressions with (14a) and (15a), note that Pi-P0=ai-ao=k>0 for
all 0 in this example.
In the unit-elasticExamnpleB,
Pj(0) = (1 +k)(O + B(O)), (22b)
and
a,(o) = (1 -k)Pi(0) = ( -k2)(0 + B(O)). (23b)
Comparingwith (14b) and (15b), we see that Pi and ai are both (1 + k) timesgreaterthan
P0 and ao respectively.

4. COMPARISONOF OUTCOMES
Ratherthanattemptinga welfarecomparisonof verticalseparationand verticalintegration
for generaldemandconditions,attentionwill now be restrictedto the two examples.

4.1. The linear exatnple

The comparisonbetweenoutcomesin this exampleis relativelystraightforward. WhenM
is allowedinto the downstreammarket,the optimallyregulatedprice is higherby k, and
output is correspondinglylower, than when M is excludedfrom that market.The price-
cost markupis higher, and to that extent allocativeinefficiencyis greater.The welfare
triangleloss" in state 0 increasesby
I[P(O) - 01]2 [P(0) - 0]2 = 2k2+ k(B + k).
However,the numberof firms,and hence the numberof times that the fixed cost K= k2
is incurred,is lower when M is in the market. Indeed, the reason why the optimally
regulatedpriceis higherwhenM is in the marketis that the higherpricelowersthe average
cost of productionby giving M a largermarketshareat the expenseof the other firms,
and consequentlyincreasesthe ratioof outputto fixedcosts. This tradeoff betweenraising

I1. Welfaretriangleloss calculationsare still appropriatewhen a < l, becausewelfarecan be writtenas

the traditional(unweighted)welfaremeasure(S+ H) minusa distributionalloss (1- a)n. See equation(1).
 VICKERS VERTICALLYRELATED MARKETS 11

the price-costmarginand reducingthe averagecost of productionis obviouslynot available

if M is not in the market. In fact the numberof firms falls from [(1 -0-B - k)/k] to
[(1 -0- 2B - 3k)/k], for an overallfixed cost saving of k(B + 2k). The derivativeof M's
profit r(0) with respectto 0 is -QO(O)when M is out of the market,and -[Q,(0) +k]
when it is allowedin. Thesetwo amountsare preciselythe samebecausePj(0)= PO(O) + k,
and Q= 1-P. Thus M's profit is the same in both situations:reductionsin net transfer
paymentsexactlyoffset greaterproductmarketearningsdownstream.
Summarizingthese effects,welfareoverall-in each state and thereforeon average-
is higherby
WI-WO K (24a)
underverticalintegrationin this example.The reductionin the duplicationof fixed costs
more than offsets the greaterprice-costmarkup.

4.2. The unit-elastic example

When M is allowed into the downstreammarket,the optimallyregulatedprice is higher
by a factor of (1 +k), and output is lower by the same proportion, than when M is
excludedfrom that market.As in the other example,the price-costmarkupis higherand
so allocativeinefficiencyis greater.It is convenientto compareutility U(Q), total produc-
tion costs (OQ+nK), and M's profit nrin turn. First, we have
U(Qo(0)) - U(Qi(0)) =ln (Qo(O)) -In (Qj(0)) =ln (1 +k).
Second, it is simpleto show that noK=k, and that njK=K+k0Qj(0). Therefore
[0Qo(0) +nOK]-[0Qj(0) +njK] = [0QO(0)+k]-[0(1 +k)Qj(0) +K]
= k-K, or k(l -k).
Third,the derivativeof M's profit r(O) with respectto 0 is -QO(0) when M is out of the
market, and -(1 +k)Qi(O) when it is allowed in. As in the other example, these two
amountsare preciselythe same, and M's profit is the same in both situations.
Overall,therefore,welfareis higherunderverticalseparation-in eachstateand there-
fore on average-by
Wo- Wi=ln (1 +k)-k(l -k)>O. (24b)
(The R.H.S. of (24b) is certaintlypositivewhen k>0, becauseit is zero at k = 0 and has
a strictlypositivederivativewith respectto k.) Unlikethe linearexample,therefore,welfare
is higherwhen thereis separationin this case.

4.3. Underlyingeconomic effects

The simplicityof the expressionsfor the welfaredifferencesin (24a) and (24b) masks the
underlyingeconomic effects.The followingexercisemay help to illuminatethese effects.
Fix the relationshipa(O), or equivalentlyP(O), betweenpriceand the cost parameter,and
consider whether this price schedulecan be implementedat lower welfare cost under
separationor under integration.Since P(O) is held fixed in this exercise, U(Q) and OQ
are the same in eithercase. The only welfareeffectsarisefrom the fact that ir and n differ.
From (18) it follows that, for given Q(O), ;r(O) is higher under integrationthan
separationfor all 0<01. This is relatedto the fact that M has a strongerincentiveto
12 REVIEW OF ECONOMIC STUDIES

raise a when there is integrationand so has to be 'bribed'more at the margin by the

transferscheduleT(a) to inducethe same a(O). The incentivefor M to raisea is stronger
when thereis integrationbecause,apartfrom fixed costs and differenttransferschedules,
the differencebetweeniri and irois (P- a)x, which is increasingin a.'2 This effectcounts
againstintegrationbecauseM's profitis distributionallycostly.
Comparison of (12) and (20) shows that (no- ni) has the same sign as (x - q), which
has the sign of (a - 0). Therefore,if the desiredprice schedulesatisfiesa(0) ! 0, thereare
at least as many downstreamfirms,and so fixedcosts are incurredat least as many times,
with integrationas with separation,in which case separationis superioron fixed cost as
well as rent extractiongrounds. This condition is satisfiedby ao(0) in the unit-elastic
demandexampleprovidedthat (I - k)B(0) < kO-see (1Sb). In thatcase, thepriceschedule
that is optimalunderintegrationcould be implementedbetterunderseparation,in which
case separationis certainlysuperior.In the linear example,however, the optimal price
schedulesare such that a(0) > 0, and integrationhas the advantageon fixedcost grounds,
but not in terms of rent extraction.In the linearexampleit so happensthat separation
and integrationimplementao(0) equallywell-the rentextractionadvantageof separation
and the fixed cost advantageof integrationare both equal to B(0)k in state 0. But of
course it is betterstill to implementZj(0) underintegration.
To summarize,there are two sources of inefficiencyin the model: the information
asymmetry,whichallowsfirmM to get distributionallycostlyrents,and imperfectcompeti-
tion downstream,which leads to excess entry. Verticalintegrationhas disadvantageson
the first of these groundsfor reasonsrelatedto anti-competitiveincentivesto raiserivals'
costs, but it may be advantageousin the secondrespectinsofaras it allowsgreaterproduc-
tive efficiency.

5. EXTENSIONSOF THE ANALYSIS

5.1. Cost reduction and moral hazard
The Baronand Myerson(1982) model that has been used in the analysisis one of adverse
selection-costs are exogenous to the firm but unknown to the regulator.Following
Laffontand Tirole (1986), an alternativeapproachis to assumethat the firmcan reduce
its costs by incurringeffortexpenditure,and that the regulatorcan observethe cost level
but not the cost-reducingeffort of the firm. Thus, for example, the regulatorcannot
observewhethergood fortuneor higheffortis responsiblefor a low cost level.The question
of verticalseparationversusintegrationcan be analysedin a moral hazardmodel of this
sort. In fact the analysisis very similarto the adverseselectioncase.
Suppose that upstreammarginalcost, now denoted by c, dependson the state of
nature0, which has the distributionfunctionF(0) as before,and the firm'seffortlevel e.
Let c= 0 - e. The cost level of independentdownstreamfirmscontinuesto be equal to the
access price a but firm M has marginalcost c if verticalintegrationis allowed. Let the
cost of effort be VI(e), with v/(O)=0, V/'>0, Vi">0, and Vi"'?0. The transfer schedule
T(a, c) dependson c as well as a, becausethe regulatorcan observec (but not 0 or e).
Proceedingin the same manneras above, equations(9) to (11) continueto describe
downstream behaviour, (12) gives the equilibriumnumber of firms in the vertical
separation case, and a simple envelope argument establishes that ir'(0) = - v/'(0 - c). It is

12. The first-orderand zero-profitconditionsfor independentfirmsimplythat (P- a)x=kx=7I>/. Using

the first-orderconditionfor Ats downstreamoutput,it followsthat the derivativeof thisexpressionwithrespect
to a has the same sign as (I -sE)p'(a) >0.
 VICKERS VERTICALLYRELATED MARKETS 13

straightforwardto show that optimalaccessprice regulationimpliesthat

ao= co - 2kE

and
Po = co+ k[-IE] -P', (25)
and hence that Po = co+ k in Example A, and Po =c0 in Example B. The subscript on c
indicatesthat unit cost is endogenousin this version of the model. The chief difference
between(25) and (14) is that the asymmetricinformationrenttermB(O)does not appear.
It does figure,however,in the expressionfor effortincentivesunderoptimalregulation:
Qo= ,'+ B(O) V". (26)
Unless a =1, effort incentivesare sub-optimal(yr'< Q) in the optimal tradeoffbetween
efficiencyand rent extraction,exceptin the lowest cost state.
When there is verticalintegration,the relationshipp(a) between P and a is again
exactlyas in the verticalseparationcase. Equations(16) and (20) describingx and n hold
but with c in place of 0. Applyingthe envelopeargumentto M's profit function yields
7r(0) =-'(0 - c), as with verticalseparation.Optimalprice regulationimplies

ai= ci+ k[lI-2'(1 + s)E]o/,J-

and
Pi= ci+k[2-1(1 +s)E]J -P. (27)
Effortincentivesunderoptimalregulationare given by
Qi=' + B(0) y"-k/ (28)
The final term in (28) reflectsM's incentiveto reducecosts in orderto expandits down-
streammarketshare.It is ambiguouswhetheror not cost-reductionincentivesare subopti-
mal. In Example A, Pi = ci + 2k, and Pi = (1 + k)ci in Example B. Again the parallels with
the adverseselectionmodel are close-compare (27) with (22).
The welfarecomparisonbetweenverticalseparationand verticalintegrationfor the
two examplesis more or less exactly as before. In both cases eo = ei, co = ci, and ro0
= 7C1
for all 0. In the linearexampleA, allocativeefficiencyis higherby 3K under separation
but fixed costs are higher by 2K, so integrationhas the overall advantageby FK,as in
(24a). In the unit-elasticexampleB, consumersurplusis higherby In (1 + k) undersepara-
tion, which exceedsthe k(l -k) cost advantageof integration,just as in (24b).
As with the adverseselectionmodel, it can be asked whetherverticalintegrationor
separationis betterfor implementinga given relationshipbetweenprice, and in this case
also cost, and the unknownparameter0. For a given relationshipa(0), or equivalently
P(0), betweenpriceand the unknownparameter,total outputis the samewith integration
as with separation.For a givenrelationshipc(0) betweencost and the unknownparameter,
firm M also gets the same rent in the two situations, because ir'(0) = -yi'(0 - c) in both
cases. Thereforethe only welfareeffectarisesfrom the differencebetweenthe numberof
firms, and hence the numberof times that fixed costs are incurred.For given a(0) and
c(O) schedules,(no- n,) has the same sign as (a - c). Welfareis higher with integration
than with separationif and only if this is positive. In the linear example,ao>c0 and so
integrationcould achieve the outcome that is optimal under separationat no greater
welfarecost, and in generalit can do better.In the unit-elasticexample,optimallyregulated
14 REVIEW OF ECONOMIC STUDIES

accesspricesare below the level of unit costs, and so they are betterimplementedunder
verticalseparation.

5.2. The participation constraint

Thus far it has been assumedthat the participationconstraintfor M appliesto its profits
overall,includingprofitsfrom the downstreamcompetitiveactivity.But this is not what
tendsto happenin practice.Regulatorybodiesin Britainand elsewheregenerallyset prices
(or price caps) so that the firm can expect a reasonablerate of returnon its regulated
activities (given cost efficiency,etc.). Indeed, it is more in the spirit of deregulationto
allow the firmindependentlyto take its chancesalong with other competitorsin deregul-
ated activities,and not to prejudgethe outcome of competitionthere, which is anyway
unpredictable,whensettingregulatoryarrangementsfor monopolyactivities.This suggests
that a more realisticformulationmight be to requirethat M at least break even in its
upstream regulated activities, in which case [(a - 0)(Q - x) + T] must be non-negative in
all states. Then M will keep its downstreamprofits and there will be a corresponding
distributionalwelfareloss. For a sufficientlyclose to 1 this will not outweighthe welfare
benefitsanalyzedabove, but for smallervalues of a could do so.

5.3. Non-price behaviour by firm M

Price is not the only element of terms of access. Whetheror not firm M is allowed
downstreammay also affect its incentivesfor non-pricebehaviourtowards other firms.
The 'quality'of accesscan also influencethe competitiveposition of those firms,and give
firmM anotherway of raisingrivals'costs.'3Policy to combat any anticompetitiveinflu-
ence of that kind may be termed regulationfor competition,as distinct from price
regulation.
A sophisticatedapproachto this problemwould explicitlymodel the opportunities
and incentivesfor such behaviour,and the informationand sanctions availableto the
regulatoryauthoritiesattemptingto combat it. However, a simpler approach will be
adopted here. Assume that M can affect the unit costs of other downstreamfirms-
upwardsor downwards-by incurringexpenditure.In particular,extendingthe model in
Section 4, suppose that downstreamfirmsnot owned by M have unit cost level (a+b),
wherea is the accessprice,as before,and b is a term(whichmay be positiveor negative)
that reflectsnon-pricebehaviourby M. If M owns a downstreamfirm,its unit cost level
is assumedto be 0 throughout,i.e. the choice of b affectsonly independentdownstream
firms. It is also assumed that b is chosen by M after the regulatoryregime-and a in
particular-has been chosen.
ConsiderM's incentiveto increaseor decreaseb, the non-pricecomponentof unit
costs. If M is out of the downstreamindustry,its net profit(net of transferT and the cost
of affectingb) in state 0 is (a - 0)Q(p(a + b)). The derivativeof thisexpressionwithrespect
to b is (a- 0)Q'p',which has the sign of -(a -0) because Q'<0 and p'>0. M's profit
risesby the margin(a- 0) multipliedby the changein the volumeof sales to downstream
firms.

13. A possibleexampleis the interconnectionof telecommunications networks.Thoughthe pricingterms

on which BritishTelecomwas to give accessto its rival Mercurywere set in 1985,there has been continuing
disputeabout the quality of that access in terms of delays, the qualityof lines and exchanges,etc., and the
impacton Mercury'scompetitiveposition.
 VICKERS VERTICALLYRELATEDMARKETS 15

In the lineardemandexampleabove, optimalregulationimplieda> 0, in whichcase

firm M has positive, but not socially excessive,incentiveswith respectto the quality of
accessif thereis verticalseparation.The situationis verydifferentwithverticalintegration,
however.In that case it can be shown that M's marginalincentiveto worsenthe quality
of access to rivals is -(P-a)O(Q-x)/Ob, which equals 2(b+k) in the linear example.
Intuitively,M's incentiveto raisedownstreamrivals'costs by non-pricemeansis equal to
the downstreammargin(P-a) multipliedby the rivals'output reduction.By increasing
its output by a correspondingamount-which is approximatelyoptimalfor smallchanges
given that M is optimizing-M can shift that profit to itself. In the unit-elasticexample,
althoughMls incentiveswith respectto qualityareambiguousin signwhenthereis vertical
separation(see (15b)), they are certainlyworse underintegration.
This discussion,though very informal,at least suggeststhat incentivesfor non-price
behaviourmay be significantlyworse when M is allowedin the downstreamindustry.

5.4. The case of fixed n

The analysis above has assumed, perhaps naturally,that the number of firms in the
deregulatedsector was determinedendogenouslyby free entry. An alternativeapproach
would be to hold fixed the numberof firmsby assumingeither (i) that there are always
exactlyn downstreamfirms(the questionbeing whetheror not M may own one), or (ii)
that thereare n independentdownstreamfirms,in whichcase M's entrywouldcause there
to be (n + 1).
Let us focus hereon version(i), whichwas analyzedat some lengthin Vickers(1990).
In this case, the duplicationof fixedcosts is not an issue (thoughit is in version(ii)), but
a new issue is that independentdownstreamfirmsmake oligopoly profits,the fixed cost
of entry having been sunk, which are distributionallycostly. Dependingon the form of
the participationconstraint(see above), havingfirmM downstreamgives the regulatora
way to extractsome of those profits.The directeffectof M's presenceon the finalproduct
price P dependson the sign of (a - 0), i.e. upon whetherthe optimallyregulatedaccess
priceis above or below marginalcost. Firm M's incentiveto raiserivals'costs also figures
in the analysis.Overallthe welfarecomparisonbetweenverticalintegrationand separation
is ambiguous,even with linear demand: higher values of a and n favour separation,
because downstreamoligopoly profits are small, (a -0) tends to be negative,and M's
incentiveto raisea is higherwith integrationthan with separation.But lowervaluesof a
and n favour integration,assumingthat the participationconstraintfor M appliesto its
profit overall.

5.5. Product differentiation

The tendencyto excessentry in homogeneousgoods oligopoly modelswas an important
factor in the analysis,but that tendencydoes not necessarilyexist when there is product
differentiation,becausethe benefitto consumersof greatervarietyis an additionalpositive
externalityof entryto consumersthatmay outweighthe negativeexternalityto incumbent
firmsthat arises from 'business-stealing'(see Mankiwand Whinston(1986, Section 4)).
Sincethe excessentryeffectwas an importantreasonfor havingpriceabovemarginalcost
(assumingE<2), this suggeststhat the case for verticalseparationmay be strongerthe
greateris the degreeof productdifferentiation.
16 REVIEWOF ECONOMICSTUDIES

5.6. No lutnp-sumtransfers'4
The analysisabove assumedthat the regulatorcould make the net transferT to or from
firmM. If, however,such transfersare impossible,then a new elemententersthe analysis,
namelythe need to financefrom access price revenuethe largefixed costs upstreamthat
make that activitya naturalmonopoly.This will requirethe accesspricea to exceed the
marginalcost of access, possibly by a large margin. This in turn implies that vertical
integrationwill allow fixedcost savingsdownstream.To see this, supposethat accessprice
a> 0 yields just enough net revenue (a - 0)Q(p(d)) to cover M's upstreamfixed costs
when there is vertical separation.lf a were the access price with vertical integration,
consumerswould be just as well off as with verticalseparation,becauseQ dependsonly
upon a given the free-entryassumption.But firm M would make strictlyhigherprofits,
because its downstreamprofit would exceed that of an independentdownstreamfirm,
which is zero, by virtue of the fact that M's market share is larger than that of an
independentdownstreamfirmbecausethe accesspriceexceedsthe marginalcost of access.
(Firm M makingmore profit with integrationthan with separation,for a given a > 0, is
economicallyequivalentto downstreamfixedcost beingincurredfewertimes:with separa-
tion the positive profitwould be competedaway by entry.) It is thereforeto be expected
that the case for integrationmay be strongerwhen transfersare disallowed.

5.7. Cost asymnmetries

Finally, it is importantto mention a factor that has played no part in the analysisbut
which may be significantmore generallyin the overall comparisonbetween separation
and integration.Vertical separation,unlike integration,creates a 'level playing field'
between firms. Insofar as the competitiveprocess selects more efficientfirms from less
efficientones when thereare cost asymmetriesbetweenfirms,a level playingfield may be
expectedto make selectionmore efficient.If, on the other hand, there is an asymmetry
betweenfirms,which is almost certainas betweena verticallyintegratedfirm M and its
downstreamrivals,then theremay be less effectiveselection.

6. SUMMARY AND CONCLUSIONS

Despite its importancefor policy, the questionof whethera regulatedmonopolistshould
be allowed also to operate in a verticallyrelated industryhas receivedrelativelylittle
theoreticalattention.In this paperthe questionhas been addressedin a model that com-
bines asymmetricinformationon the part of the regulator,in the form of Baron and
Myerson'sadverseselection model of monopoly regulation,and imperfectcompetition,
in the form of Cournotcompetitionwith free entry, in a verticallyrelatedindustrythat
is assumedto be deregulated.This is a simple framework,and of course it leaves many
factors out of account, some of which were mentionedin Section 5 above. Nevertheless,
the model servesto demonstratetwo economiceffectsin particular,namelythe incentive
to raiserivals'costs whenintegrationis allowed,whichhas consequencesfor the regulator's
task, and the effect on downstreamindustrystructureand productioncosts.
Whenthe numberof firmsis sensitiveto the level of the accessprice,whichdepends
on demandconditions,the accessprice is optimallyset above the marginalcost of access
in orderto curb the duplicationof fixedcosts. Sincethe monopolist'smarginalcost is the
14. LaffontandTirole (1992,Section5) examinesome aspectsof optimalaccesspricingin the absenceof
transfers.
 VICKERS VERTICALLY RELATED MARKETS 17

true underlyingcost without any upstreammarkup,verticalintegrationallows a given

total output to be producedat lower averagecost becausefixed costs are incurredfewer
times. This advantagemay offset the disadvantagethat comes from the incentiveto raise
rivals'costs. If, on the other hand, the numberof firmsis not sensitiveto the level of the
accessprice,then priceof accessis optimallyset below its marginalcost in orderto offset
the downstreamimperfectcompetitionmarkup.Then it may be doubly undesirableto
allow the monopolistinto the deregulatedsector.
It will be apparentthat the 'excess entry' result, which holds in models with scale
economies,homogeneousgoods and symmetricfirms,is largelyresponsiblefor any advan-
tage that verticalintegrationhas in this simplesetting, at least if transfersare permitted.
It might be of interestto examine the case for verticalseparationis strongerin richer
circumstances,for example with product differentiationand allowing for asymmetries
betweenfirms.
Acknowledgnments. An earlier version of this paper was presented as the Review of Economic Studies Lecture
at the Royal Economic Society Conference at Bristol University in April 1989. I am grateful to Mark Armstrong,
William Baumol, lan Jewitt, Paul Klemperer, Tracy Lewis, Margaret Meyer, James Mirrlees, John Moore,
Robin Nuttall, Carl Shapiro, Jean Tirole, Robert Willig, two referees, and seminar participants at Boston
University, Cambridge, Gerzensee, MIT, Oxford and Warwick for their helpful comments and suggestions. I
am especially indebted to Tim Besley-this paper stemmed from joint work with him. Of course the usual
disclaimer applies.

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