Regulatory Mechanisms to control Market Power

What is it about?

Understanding optimal ways to regulate market power is an important question in social sciences. A traditional way involves fixing the price of the regulated good (e.g. a price cap). A less usual one is to fix the quantity to be produced (e.g. a service level). Is there any comparative advantage of using one instrument over the other? The answer is positive when there are informational frictions between the firm and regulator. We show that when the demand for the regulated good is unknown to the regulator, but known to the monopoly, the quantity and price regulatory mechanisms are very different: the first one is fully separating menu, whereas the other is a one-item menu. Perhaps surprisingly, either mechanism may dominate the other. The comparison critically depends on the cost structure of the firm and the sophistication of the regulator.

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Why is it important?

There are many settings in which authorities have considered implementing quantity-based mechanisms to induce a desire outcome. To the best of our knowledge, this is the first paper that systematically studies quantity-based mechanisms as an option to regulate market power, and shows that quantity regulation can in fact be welfare improving. We characterize both the optimal quantity and price mechanisms, and show exactly when one mechanism dominates the other. The cost technology of the regulated firm plays a key role. For instance, if the marginal costs of the firm are decreasing (e.g. learning-by-doing effect), then quantity regulation maximizes the gains from trade.

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