On the scope of indirect regulation of monopolies in the presence of large entry cost

This paper reexamines the ingenious regulation scheme put forward by Burnovsky and Zang (1991), that features a regulator who promises to subsidize entry into a market, which exhibits properties of a natural monopoly. If the subsidy promise is sufficiently high, the monopolist is led to increase output and lower price at no cost of regulation. The assumption that the monopolist always honors his pre-entry commitment has been shown to be crucial for the results obtained. This motivated our inquiry into the scope of costless indirect regulation in situations in which the incumbent's commitment cannot be inforced. It then turns out that no commitment on behalf of the incumbent can be credible that deters entry by choosing an output (capacity) at a level in excess of the monopoly output after successful entry deterrence. This represents an additional constraint for the regulator's behavior.I like to thank Deutsche Forschungsgemeinschaft and the Economics Department at Boston University for generous support.