Regulating Horizontal Diversification

This paper investigates the optimal design of diversification rules for regulated enterprises. Diversification by a regulated firm generates profit in non-core markets that can be shared with core customers. However, a diversified firm may divert its attention and effort to its non-core operations, causing consumer welfare in the core market to decline. When diversification is permitted, lower prices and higher-powered reward structures are generally implemented in the core market. Surprisingly, diversification is not always directed into the non-core markets where the expected contribution of the regulated firm is most pronounced. Furthermore, diversification may be permitted more often as the potential losses from effort diversion increase.