An industrial policy issue which will become increasingly important is the regulation of markets in which a regulated firm interacts with unregulated firms. In Discussion Paper No. 1079, Research Affiliate Gianni De Fraja and Elisabetta Iossa model this interaction in the case where the unregulated sector consists of a fringe of price-taking, profit-maximizing firms, and study the effects of such competition on the incentives for cost reduction in the regulated firm. Their main result shows a highly counter-intuitive effect of this competition: competition by profit-maximizing firms weakens the incentives for cost reduction in the regulated firm. This is because an increase in the supply from the competitive fringe makes it easier for the regulated firm to achieve the price target set by the regulator, and therefore relaxes the pressure to cut costs.

This result has potentially important policy consequences: in the standard regulation model, where the regulated firm is an undisturbed monopolist, it does not matter whether price or output are selected by the regulator: the outcome is the same. When other firms participate in the market, however, it may matter which regulatory mechanism is chosen, and the results therefore draw attention to the role of these mechanisms in enhancing consumers' welfare and the industry's performance.

Competition, Regulation and Managerial Incentives
Gianni De Fraja and Elisabetta Iossa

Discussion Paper No. 1079, December 1994 (IO)