Double Yardstick Regulation for Vertically Integrated Network Firms

Vertically integrated network firms own a natural monopoly infrastructure and compete in downstream markets for products which use the services of this facility as an essential input. Such a firm can shift costs between the network and final product sectors to foreclose efficient entry into the downstream market without triggering the traditional incremental cost test for cross-subsidies. We propose an alternative test for strategic cost shifting which is more sensitive than the incremental cost test. Our procedure is based on econometric exploitation of data drawn from a number of similar firms and uses a simple, though non-standard, hypothesis test. The method is illustrated through a study of the electricity retailing industry in New Zealand. * This paper builds on earlier work with Emma Gilbert. Helpful comments from David Giles, Tim Hazledine, Norman Ireland, and seminar participants at the Universities of Auckland and Canterbury and at the New Zealand Econometrics Study Group are gratefully acknowledged.