Partial regulation in vertically differentiated industries∗

This paper provides theoretical foundations for a price-and-quality cap reg-ulation 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 industries. We establish that optimal weights in the cap 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. However, in unit de-mand frameworks, regulation can be performed as if the incumbent were still a monopolist, provided its decisions have no impact on the quality of the un-regulated firm’s products. In all cases, the proposed regulatory mechanism is evidenced to be robust to small errors in the social value of quality