Reforming a Network Industry: Consequences for Cost Efficiency and Welfare

To introduce competition in an industry with an upstream natural monopoly infrastructure requires vertical separation. However, given the well-known advantages of vertical integration, such a reform would have to reduce costs in order to increase social welfare. We ask whether this would be the case if marginal costs depend on a downstream agency problem. It turns out that the opposite holds true. While entry after vertical separation can be beneficial despite higher costs, the best solution in terms of cost efficiency and welfare tends to be a welfare-maximising vertically integrated or bilateral monopoly. Vertical separation and competition are outperformed even by a profit-maximising integrated monopoly.