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How to Auction an Essential Facility When Underhand Integration is Possible

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

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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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
Note: IO
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  1. Vickers, John, 1995. "Concepts of Competition," Oxford Economic Papers, Oxford University Press, vol. 47(1), pages 1-23, January.
  2. Eduardo M.R.A. Engel & Ronald D. Fischer & Alexander Galetovic, 1998. "Least-Present-Value-of-Revenue Auctions and Highway Franchising," NBER Working Papers 6689, National Bureau of Economic Research, Inc.
  3. Nicholas Economides, 1994. "Quality Choice and Vertical Integration," Working Papers 94-22, New York University, Leonard N. Stern School of Business, Department of Economics.
  4. 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.
  5. Riordan, Michael H & Sappington, David E M, 1987. "Awarding Monopoly Franchises," American Economic Review, American Economic Association, vol. 77(3), pages 375-87, June.
  6. 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.
  7. Besanko, David, 1985. "Multi-period contracts between principal and agent with adverse selection," Economics Letters, Elsevier, vol. 17(1-2), pages 33-37.
  8. Daniel F. Spulber, 1989. "Regulation and Markets," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262192756, June.
  9. Lourdes Trujillo & Gustavo Nombela, 2000. "Multiservice Infrastructure : Privatizing Port Services," World Bank Other Operational Studies 11417, The World Bank.
  10. 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.
  11. 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.
  12. Jean-Jacques Laffont & Jean Tirole, 2001. "Competition in Telecommunications," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262621509, June.
  13. 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.
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