The Optimal Institutional Design of Vertically Related Markets with Unknown Upstream Costs

Abstract This paper examines the design of vertically related industries with a regulated monopolistic upstream input and competitive downstream activities. Two institutional patterns are investigated. Ownership separation entails full unbundling between upstream and downstream activities. Legal separation allows a downstream firm to own the upstream monopolist but requires the two entities to be legally unbundled so that each service is stand-alone profitable and only upstream profits are regulated. Under regulatory limited information about upstream costs, the legally separated monopolist exhibits countervailing incentives to manipulate costs. This alleviates the regulator’s control problem and yields higher welfare than ownership separation.