Ownership Structures in Network Industries When the Rationality of Regulators Is Bounded

This paper analyses the implications for allocative efficiency of different ownership structures of vertically related industries in a simple game-theoretic setting. The upstream sector is monopolized and regulated, while the downstream sector is imperfectly competitive. Regulation is imperfect in that the regulatory authority suffers from bounded rationality, and is not able to enforce optimal regulation. We consider both homogenous and differentiated composite goods. It generally turns out that when the regulator's enforcement capabilities are limited, preventing the upstream monopolist from entering the downstream industry is socially undesirable, unless the independent downstream rival enjoys a substantial production cost advantage. This holds true in spite of the incentive of the vertically integrated monopolist to manipulate accounts in order to raise the costs of the downstream rival. Such reasoning especially applies when composite goods are close substitutes for one another. Copyright 1997 by Oxford University Press.