Incomplete Regulation, Competition, and Entry in Increasing Returns to Scale Industries

The paper analyzes the effects of liberalization in increasing returns to scale industries. It determines the optimal regulation of an incumbent competing with an unregulated strategic competitor, when public funds are costly. The model reveals the trade-off between productive and allocative efficiency. Moreover, the welfare gains from liberalization, as compared with regulated monopoly, are a nonmonotonic function of the cost of public funds. Finally, in the case of severe governmental cash constraints, incomplete regulation may dominate the full regulation of duopoly.