Investment Incentives of a Regulated Dominant Firm

We study the investment incentives of a regulated, incumbent firm in a deregulation process. The regulator cannot commit to a long-term regulatory policy, and investment decisions are taken before optimal regulatory policies are imposed. We characterize the regulated incumbent's incentive to invest when a deregulation process is initiated and an unregulated firm enters the market as a result. The change in the marginal return to investment depends on how the investment changes the firm's virtual cost—the sum of its physical production and information costs. When the marginal return to investment increases due to deregulation, social welfare increases as a result of higher investment and more competition. Otherwise, the change in social welfare depends on the total of the effects in the fall of investment and increased competition. We also present conditions under which deregulation enhances welfare.