Deregulation by Vertical Integration

Regulators often confront the question of whether they should allow a regulated firm to vertically integrate. The relevant policy concerns are whether the downstream price will rise from the vertical integration and what, if any, additional constraints must be placed on the integrated firms to prevent a potential price increase. The extant literature does not have much to offer the regulators in the analysis. This paper fills the gap by providing an analysis. of the effects of upstream vertical integratio9 by a regulated firm. The analysis considers integration into the production of an intermediate input whose costs are automatically transferred to the downstream customers. The analysis indicates that, absent additional constraints, vertical integration effectively "deregulates" the firm. The analysis also suggests which additional constraints are necessary to make regulation effective. Given errors in regulation, however, a firm can vertically integrate, increase profits, and increase the downstream price.