Merger Incentives Under Yardstick Competition : a Theoretical Model

Are the incentives for firms to merge horizontally under yardstick regulation actually aligned with social and consumer welfare? Natural monopoly operators regulated by yardstick competition, such as electric- ity network operators and water distribution utilities, have merged re- peatedly in recent years. In the context of regulated network industries, yardstick competition implies that firms compete on costs, given that their revenue allowance is based on cost observations from similar firms (peers). Whereas regulators have raised concerns about horizontal merg- ers under yardstick competition, traditional economic theory suggests that this restructuring should not lead to (unilateral) anticompetitive e ects. In our theoretical model, by contrast, firm incentives for horizontal merg- ers involving peers are only aligned with social and consumer welfare if efficiency gains are sufficiently large. We go on to show how regulators can better align firm incentives with welfare considerations and limit the need for costly merger control by adapting the yardstick regime to the domestic industry structure.