In recent years, many regulated industries have been opened up to competition. In Discussion Paper No. 1078, Research Affiliate Gianni De Fraja investigates the effects of the entry of a new firm on the pricing policy chosen by the regulator, and the incentives for cost reduction in the regulated firm. He does so by means of a simple model, where three players interact: a regulator, an incumbent regulated firm, and an unregulated entrant, which, if it enters the market, supplies a product which is a close substitute for the incumbent's. The regulator chooses the price at which the incumbent can sell the product, and any subsidy to be paid to the entrant in the event of entry.

The author compares two possible regulatory regimes: in the first, the regulator can commit to the policy they have chosen; in the second, it is unable to persuade the entrant that it will not alter its regulatory policies after entry. The analysis shows that the effect of entry on prices and incentives for cost reduction, depends on the extent of the regulator's commitment: if it is possible to commit to the chosen policy, then the market outcome following entry is less competitive than it would be without the possibility to commit; prices are higher and incentives for cost reduction weaker.

Entry, Pricing and Incentives: The Role of Regulatory Commitment
Gianni De Fraja

Discussion Paper No. 1078, June 1995 (IO)