Partial regulation in vertically differentiated industries∗

This paper offers theoretical foundations to price-and-quality cap regulation of recently liberalized utilities in which vertically differentiated services are provided by a regulated incumbent and an unregulated entrant competing in price and quality. The model may equally well represent competition across asymmetrically regulated industries. We establish that, in a variety of strategic settings, optimal weights in the cap targeted to the incumbent depend also on the market served by the entrant, despite the latter is not directly concerned by regulation. This calls for the possibility that regulators use information about the whole industries, rather than on the sole incumbents. We also evidence that the proposed regulatory scheme is robust to small errors in the estimation of the social value of quality