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...markets. conclude that the regulated firm can have the incentive to block the entry. This strategy leads to the reduction of the price in both markets. However, the final effect of the entry deterrence strategy on total consumer surplus is not always positive.
Keywords price cap regulation * entry
JEL Classification L11 * L51
Introduction
Price cap regulation was an important innovation in regulatory policy in the 1980s. Since then it has been extensively applied in many economic sectors and countries around the world, namely in network industries as telecommunications and electricity. (1) Typically, in network industries firms are multiproduct and price cap regulation is applied to the prices of a basket of products from markets with different levels of entry attractiveness. There are innumerable examples of price cap regulation applied to multiproduct firms. For instance, the British Airport Authority, the British regulator for the largest airports in United Kingdom, applies price cap regulation to a basket of airport charges. Also, in telecommunications sector in United States, price cap regulation is applied to the long distance access charges defined by the Local Exchange Carriers. (2)
In this paper we study the way a multiproduct firm, regulated through a dynamic price cap, can develop a price strategy that uses the regulatory mechanism to deter entry. We consider a regulated firm that initially operates as monopolist in two markets but, in a second period, entry is possible in one of those markets. As, accordingly to the regulatory policy considered, the price cap of the second period depends on the prices defined in the first period, the incumbent firm might strategically reduce the first period prices in both markets. Then, with the resulting price cap of the second period, entry is not attractive. From this analysis we conclude that the regulated firm has the incentive to follow an anticompetitive strategy to prevent the entry of a new firm in the market where entry is possible, as long as the fixed entry cost is above a critical level.
Our conclusion is in the same line of Armstrong and Vickers (1993). Armstrong and Vickers compare two types of price regulation, average cap and separate cap, applied to a firm that operates simultaneously in a potentially competitive market and in a captive market. The authors conclude that under average cap the firm has an incentive to choose a lower price in the competitive market and a higher price in the captive market than it would have in the case of separate caps. However, the comparison of the two types of price regulation is developed in a static framework which does not allow the study of strategic manipulation of the prices by the regulated firm. Differently, we consider two decision periods to study the effects of the first period prices' definition on the second period's decisions about entry. We conclude that the entry deterrence strategy leads to the reduction of the price not only in the market where entry is possible but also in the captive market.
Bos and Nett (1990) have also studied the entry in markets where there is an incumbent firm regulated by price caps. Considering only one market and the existence of capacity constraints, they showed that the incumbent firm is able to deter entry for high capacity costs of the entrant. However, in Bos and Nett's model there is also only one decision about the price which does not allow the study of strategic price definition.
Foreman (1995) and Law (1997) studied the intertemporal manipulation of price's weights by a regulated monopolist. In spite of considering different models, both authors conclude that the strategic manipulation of price weights by the monopolist regulated firm can have negative consequences on aggregate welfare. Differently from Law and Foreman models, we assume that the price's weights are fixed, that entry is possible in one of the markets and that the price cap of the second period is endogenously defined. The last feature mentioned brings our approach closer to the model of Iozzi (2001). Considering a model with two periods and a regulated firm that might face entry in its market, Iozzi identifies the conditions under which the firm has incentives to follow an anticompetitive strategy. Differently from Iozzi we consider a multiproduct firm. Also, we assume a homogenous product and quantity competition while Iozzi assumes product differentiation and price competition. The consideration of a multiproduct firm regulated by an average cap rises particular questions related to the credibility of the entry deterrence strategy, which are discussed in this paper. Mainly, in the multiproduct framework we find that the incumbent firm can deter entry with a smaller reduction in price than in the one market framework. We also conclude that the effect of the entry deterrence strategy on total consumer surplus is not always positive as it happens when only one market is considered. From the results of the multiproduct firm analysis we also extract some guidelines for the regulator's decision about the initial price cap level.
The structure of the paper is the following. The next two sections present the model of dynamic price cap and describe the effects of the entry deterrence and the entry accommodation strategies on consumer surplus. The last section presents the main conclusions of the paper.
The Model
Introduction
We adopt a very simple framework with two decision periods to highlight the strategic behavior of the regulated firm. In the first period the regulated firm (firm i) is monopolist in two markets, A and B. However, in the second period entry is possible in market B. We assume that entry is not possible in market A due to entry barriers (legal, technological or others). If entry occurs the incumbent firm decides in the second period the quantity and price considering the best reply function of the new firm (firm e) in its profit function, i.e., we consider Stackelberg competition. (3) The entrant decides whether or not to enter after observing the first period's prices. Entry occurs if firm e forecasts strictly positive profits and, in that case, firm e bears a fixed entry cost of [f.sup.2].
We suppose that the marginal production costs are known, equal and normalized for zero to both firms. We assume linear and stationary demands. For market A the inverse demand function is [p.sub.t.sup.A]([q.sub.ti.sup.A]) = 1 - [q.sub.ti.sup.A] with t=1, 2 for the first and second periods, respectively. The inverse demand function for market B is [p.sub.t.sup.B] ([q.sub.ti.sup.B]) = 1 - [q.sub.ti.sup.B] for the first period and for the second period without entry. If entry occurs the inverse demand function of market B for the second period is [p.sub.2.sup.B] ([q.sub.2i.sup.B], [q.sub.2e.sup.B]) = 1 - [q.sub.2i.sup.B] - [q.sub.2e.sup.B].
The dynamic price cap regulation has the following features: in the first period the regulator exogenously sets the maximum value for the average price ([bar.[P.sub.1]]) considering equal weights for prices in both markets, (4) such that [[p.sub.1.sup.A]+[p.sub.1.sup.B]]/2 [less than or...
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