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How to Auction an Essential Facility When Underhand Integration is Possible

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  • Eduardo M.R.A. Engel
  • Ronald D. Fischer
  • Alexander Galetovic

Abstract

There are many industries in which potentially competitive segments require services provided by natural monopoly bottlenecks (essential facilities). Since it is difficult to regulate these facilities, developing countries are using Demsetz auctions, where the facility is awarded to the firm that bids the lowest user fee. In this paper we show that when underhand agreements between the monopoly bottleneck and downstream firms are possible, Demsetz auctions need floors on bids, since otherwise welfare can be lower than with an unregulated monopoly. We model an underhand agreement using a standard hidden information model. The essential facility is an uninformed principal randomly matched to a downstream company, which observes its costs after closing the underhand agreement. When the essential facility prefers the option of vertical separation, there is downstream competition, which implies that only low cost firms survive. We find that a sufficiently high floor on bids promotes vertical separation, yielding higher welfare than either an unregulated or a vertically integrated monopoly. Moreover, prohibiting open vertical integration means this floor can be lower, thus enhancing welfare. The incentive compatibility constraints required by underhand agreements imply rent sharing and production distortions that make vertical integration less attractive.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 8146.

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Date of creation: Mar 2001
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Publication status: published as Engel, Eduardo M. R. A., Ronald A. Fischer and Alexander Galetovic. "How To Auction A Bottleneck Monopoly When Underhand Vertical Agreements Are Possible," Journal of Industrial Economics, 2004, v52(3,Sep), 427-455.
Handle: RePEc:nbr:nberwo:8146

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References

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  1. Jean-Jacques Laffont & Jean Tirole, 2001. "Competition in Telecommunications," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262621509, December.
  2. Riordan, Michael H & Sappington, David E M, 1987. "Awarding Monopoly Franchises," American Economic Review, American Economic Association, vol. 77(3), pages 375-87, June.
  3. Oliver E. Williamson, 1976. "Franchise Bidding for Natural Monopolies -- in General and with Respect to CATV," Bell Journal of Economics, The RAND Corporation, vol. 7(1), pages 73-104, Spring.
  4. Eduardo Engel & Ronald Fischer & Alexander Galetovic, 1998. "Least-Present-Value-of-Revenue Auctions and Highway Franchising," Documentos de Trabajo 37, Centro de Economía Aplicada, Universidad de Chile.
  5. Juan Foxley & José Luis Mardones, 2000. "Port Concessions in Chile : Contract Design to Promote Competition and Investment," World Bank Other Operational Studies 11418, The World Bank.
  6. Lourdes Trujillo & Gustavo Nombela, 2000. "Multiservice Infrastructure : Privatizing Port Services," World Bank Other Operational Studies 11417, The World Bank.
  7. Lee, Sang Hyup & Hamilton, Jonathan H, 1999. "Using Market Structure to Regulate a Vertically Integrated Monopolist," Journal of Regulatory Economics, Springer, vol. 15(3), pages 223-48, May.
  8. Economides, Nicholas, 1998. "The incentive for non-price discrimination by an input monopolist," International Journal of Industrial Organization, Elsevier, vol. 16(3), pages 271-284, May.
  9. Vickers, John, 1995. "Concepts of Competition," Oxford Economic Papers, Oxford University Press, vol. 47(1), pages 1-23, January.
  10. Daniel F. Spulber, 1989. "Regulation and Markets," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262192756, December.
  11. Nicholas Economides, 1994. "Quality Choice and Vertical Integration," Working Papers 94-22, New York University, Leonard N. Stern School of Business, Department of Economics.
  12. Harstad, Ronald M & Crew, Michael A, 1999. "Franchise Bidding without Holdups: Utility Regulation with Efficient Pricing and Choice of Provider," Journal of Regulatory Economics, Springer, vol. 15(2), pages 141-63, March.
  13. Besanko, David, 1985. "Multi-period contracts between principal and agent with adverse selection," Economics Letters, Elsevier, vol. 17(1-2), pages 33-37.
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Cited by:
  1. Rodrigo Gutierrez & Pablo Serra & Ronald Fischer, 2003. "The Effects of Privatization on Firms and on Social Welfare: The Chilean Case," Research Department Publications 3150, Inter-American Development Bank, Research Department.
  2. Engel, Eduardo & Fischer, Ronald & Galetovic, Alexander, 2005. "Highway franchising and real estate values," Journal of Urban Economics, Elsevier, vol. 57(3), pages 432-448, May.
  3. Alexander Galetovic, 2003. "Integración Vertical en el Sector Eléctrico: Una guía para el usuario (Vertical integration in the electricity sector)," Documentos de Trabajo 158, Centro de Economía Aplicada, Universidad de Chile.
  4. Eduardo Engel & Ronald Fischer & Alexander Galetovic, 2002. "Competition In or For the Field: Which Is Better?," Cowles Foundation Discussion Papers 1358, Cowles Foundation for Research in Economics, Yale University, revised Jul 2007.
  5. Eduardo Engel & Ronald Fischer & Alexander Galetovic, 2002. "Competition In or For the Field: Which is Better," Working Papers 844, Economic Growth Center, Yale University.
  6. Eduardo Engel & Ronald Fischer & Alexander Galetovic, 2002. "Highway Franchising and Real Estate Values," Working Papers 840, Economic Growth Center, Yale University.
  7. Ronald Fischer & Rodrigo Gutiérrez & Pablo Serra, 2002. "The Effects of Privatization on Firms and on Social Welfare," Documentos de Trabajo 131, Centro de Economía Aplicada, Universidad de Chile.

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