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medium, and important presence of SEFs. It reports the average number
of licenses per chemical producer.
9. Our measure of product differentiation was computed as follows. CAPF
classifies the chemical plants within each sub-sector in more
disaggregated process technology classes. We use the counts at this
disaggregated level to compute an equidistribution index at the sub-
sector level. Our index of product differentiation takes the value of 0 if the
products are homogeneous and the value of 100 if they are totally
differentiated. We have also tried alternative measures of product
differentiation, such as the entropy index and the Herfindahl index, with
substantially similar results.
10. In some instances, seemingly minor variations in side chains can have
significant biological effects. Therefore, what is a "minor" variation is itself
determined by the state of the current understanding of the relation
between structure and function.
11. A Markush structure is best understood as a language for specifying
chemical structures of compounds, which allows generic representation
for an entire set of related compounds. See Maynard and Peters (1991, p.
71) for details.
Policy Issues”Anti-Trust and Regulation
Part VII:

of Public Utilities
Chapter 22: Inter-Company Agreements and EC Competition Law
Chapter 23: Incentive Contracts in Utility Regulation
Chapter 24: Contractual Choice and Performance”The Case of Water Supply in
France
Chapter 25: Institutional or Structural”Lessons from International Electricity Sector
Reforms
Chapter 26: Electricity Sector Restructuring and Competition”A Transactions-Cost
Perspective
Inter-company Agreements and EC
Chapter 22:

Competition Law
Michel Glais
1 Introduction
In a free-market economy, suppliers are supposed to adopt their strategic decisions in a
totally independent manner. In this respect both tacit and explicit agreements are
forbidden by the texts governing competition within Europe, as in the United States.
However, Community law has seen fit to include a proviso for possible dispensations
from the rule concerning independence of behavior between competitors, when
agreements between them enhance production, distribution, or the promotion of
economic progress and so long as competition in the ongoing market be maintained to a
sufficient degree. Many agreements may therefore be considered to be in accordance
with this principle when the advantages they represent outweigh the accompanying
competition restraints. Given the impossibility of making an individual examination of
each agreement because of their number, the Brussels Commission is now authorized to
decree "exemptions by category" for certain types of agreements. Candidates for a
cooperation operation are presented with two procedures when they seek validation by
community authorities of the operation in question. In accordance with the contractual
clauses of their project within the legal framework laid down by the exemption,
regulations also afford them, in principle, exemption from any prior notification.
Otherwise, companies are required "to present the Commission with the supporting
documents needed to establish justification of individual exemption and, where the
Commission might raise objections, to propose alternative action."[1]
One of the greatest merits of Community authority intervention in the field of free-market
functioning control is to have recognized very early that the promotion of technical
progress could be ensured only if companies could be made largely exempt from the
principle of independence (section 2). Conditional validation of certain distribution
contracts duplicates this desire to see the promotion of economic efficiency when the
positive results to be expected significantly outweigh the effects of restrictions (section 3).

[1]
CJCE, 17/01/84, VBVB, no. 52; decision dated February 5, 1992, "Construction aux Pays
Bas."
2 A voluntarist concept of the promotion of technical
progress
A more rapid diffusion of economic progress within the Community represents one of the
priorities the Commission has assigned itself. License or patent agreements, formerly
covered by various regulatory texts, have become since 1996[2] the object of a unified
legal framework (sub-section 2.1). Cooperation projects established at the research-
development stage also fall under a specific regulation. Established between competitors
holding substantial market shares, they are nonetheless validated on the basis of
individual rulings in which the Commission has shown real concern for the most recent
developments of economic analysis (sub-section 2.2).

2.1 Block exemption to certain categories of technology transfer agreements

This concerns equally licenses for patents and know-how, and "mixed" licenses covering
both types of transfer.

Principally established to validate transfer technology agreements between non-
competing firms in the markets concerned, this regulation is nonetheless open, under
certain conditions, to cooperation agreements between rivals.
Exempt by nature from the principle of independence, transfer agreements within this
Community legal framework must leave sufficiently effective competition in the market
concerned. This is why exemption from certain competition restriction provisions is
granted only for a limited duration and applies only so long as the agreeing parties
refrain from including certain clauses considered illicit per se (so-called black clauses).
2.1.1 Agreements covered by the new exemption: regulation 240/96
The standard contract to benefit from block exemption comprises three main
characteristics. The agreement must be concluded between two companies only, neither
of which are to be competitors or to have any contractual links. The agreement should
contain only obligations relative to the Common Market territories. Any contract of this
type which respects the provisions laid down by the regulation is, a priori, exempt from
the provisions of article 81 §1 of the Community Agreement Law.

However, the Commission reserves the right to withdraw such exemption benefit when:
"the effect of the agreement is to prevent the licensed products from being exposed to
effective competition in the licensed territory from identical goods or services or from
goods or services considered by users as interchangeable or substitutable in view of
their characteristics, price and intended use" (article 7-1).

This may be the case when (1) the licensee holds a market share of more than 40
percent, (2) circulation of goods is illicitly hindered within the community space.

The very restrictive nature of the obligation preventing companies from being rivals on
the same market is nonetheless lessened by the existence within the regulation of two
significant adjustments:
1. Exemption applies to licensing agreements concluded between
competitors with participation in a joint venture (or between one of
the two and the joint venture) when the licensed products and other
goods and services of companies involved (considered as
interchangeable or substitutable) represent only: (a) no more than
20 percent, in cases of a license limited to production, (b) no more
than 10 percent, when extended to production and distribution of the
whole range of interchangeable or substitutable products competing
on the market in question (article 5 §2-1).
2. This also applies to agreements concluded between competitors
granting reciprocal technology transfer licenses when the parties are
not bound by any territorial restriction within the common market
concerning manufacture, use, and commercial application of the
products concerned by the agreement or the use of technologies in
common (article 5 §2-2).
2.1.2 Contractual clauses concerned in this new regulation
Three types of contractual clauses are evoked by the new block exemption regulation.
Clauses or restrictions declared exempt are those considered to be favorable to the
diffusion of technological progress, since by their nature they incite the holder of a patent
or of a certain know-how to concede licenses to companies which, in turn, will readily
agree to investments (and assume further expenses) necessary to the diffusion of these
new products on their geographical markets. Thus, for limited periods of time, non-active
and passive competition clauses are declared exempt.

The aim of the former (restriction of active competition) is to oblige the licensor not to
exploit his license (in any way whatsoever) within the territory of the license holder nor to
authorize other companies to do so, the licensee making a similar commitment to the
licensor as well as to other licensees within the territories conceded to them. The aim of
the latter is to forbid each partner to reply to unsolicited demands on the part of buyers
situated outside the territory of the licensee concerned (territory of the licensor or other
licensees). Investments set up by licensees often fall into the category of sunk costs
expenses and as such the exemption of such clauses proves indispensable to the
efficiency of a technical progress diffusion policy. Nevertheless, these provisions should
not protect the parties in question beyond the period deemed reasonably necessary to
cover the expenses incurred and the initial risk of putting the product or technology
[3]
covered by the license onto a new geographical market.
Clauses which do not prevent exemption first concern the obligations imposed on
licensees to respect the quality level of the goods under license and to ensure the
protection of the technology conceded (non-disclosure of the know-how communicated,
interdiction to grant a sub-license, obligation to inform the licensor of misappropriation of
the know-how or of infringement of the licensed patent, etc.). They also cover (1)
provisions relative to access by the parties to improvements or to new applications which
each of the parties could apply to the technology in question (for example, reciprocal
obligations to grant licenses, exclusive or not, in these fields), (2) financial aspects of the
agreement (calculation of fees, clause of "most favored nation," etc.), (3) conditions for
anticipated termination of contract (for example, in the case of contesting of the secret or
substantial nature of know-how or of the validity of the patent, of non-respect of
active/passive competition restrictions, etc.), and (4) provisions relative to second-source
agreements (in particular, concerning the limitation of production volume when the
license was granted solely with the aim of supplying a number of customers with a
second source of supplies within the conceded territory).
In accordance with well-established case law forbidding, per se, any prior consultation
concerning prices and any other interference in strategic rulings falling under the rule of
independent behavior, exemption is refused when the agreement comprises "black
clauses" such as: (1) fixing, by the licensor, of prices imposed or of a discount system
granted to the licensee's customers, (2) limiting of the quantities of products
manufactured under license[4] beyond those necessary to manufacture on the part of the
licensee for his own products, and (3) reciprocal interdiction to compete in fields such as
research and development (R&D), manufacture, use, or distribution of competing
products.
Equally important is the need to allow free play to "parallel imports" within the Common
Market, and with this aim the Community authorities refuse to grant block exemption to
agreements comprising restrictions without objectively justified reasons for the free
circulation of products in question when companies fix different prices according to the
geographical areas concerned.

Finally, the authorities also forbid the following clauses: (1) obliging the licensee to cede
all or part of his rights to improvements he has made to the conceded technology without
reciprocal agreement of this sort on the part of the licensor, and (2) having for object or
effect to be exempt from the regulations limiting exclusive rights or export prohibition.

2.2 An analysis of requests for individual exemption in accordance with
contemporary economic theory
Breaking with the very neoclassical methodology analysis of "traditional" agreements
concerning prices or production levels, the Community authorities looked to a much
more "Austrian" framework of analysis to establish an attractive jurisprudence in the field
of validation of agreements non-eligible for block exemption regulations relating to
[5]
transfers of technology or R&D agreements. Analysis methods used for validation of
cooperation operations make a distinction between agreements directly falling under the
provisions of article 81 §1of the EC Treaty (collusive agreements) and those covered by
regulations relative to concentration operations (projects involving the creation of a
concentrate joint venture or a "full function" joint venture").
2.2.1 Conditions for individual exemption from the provisions of
article 81 §1 of the treaty
As P. Laurent points out quite rightly (1993, p. 40): "Even when efficient, an agreement
[between competitors] constitutes an anomaly the legitimization of which may only be
accepted within the strict confines set forth by article 81 §3 [formerly 85 §3]". Only those
competition restrictions indispensable to the efficiency of an agreement allowing the
subsistence of sufficient competition may be eligible for exemption. Therefore it is only
after a precise analysis of the net welfare effects of the project that a projected
consensus agreement between competitors might be validated after an individual
exemption ruling. The demonstration must first be made that the agreement envisaged
will produce beneficial results inaccessible through simple competition and which will
outweigh the disadvantages engendered by restriction of independence of the parties in
coalition.

Objectively, the hoped-for advantages have to be sufficient to justify the agreement,
without comprising restraints superfluous to the individual freedom of the agreement
partners. Moreover, it is necessary that the positive effects be shared equitably with end-
users. Of necessarily limited duration, the agreements favorable to the promotion of
economic progress must not allow the companies involved to be able to eliminate
competition for a substantial part of the products concerned.

In order to remove the presumption of efficiency attributed to competition, partners to an
agreement must therefore establish the fact that their cooperation constitutes the only
means to give increased efficiency. Such proof implies two successive findings. First, it
must be proved that the constraints inherent to competition make it impossible for each
individual partner to accede to a new market, or to create a new product, given the
significance of the investments involved and the risks run. Second, there must be clear
demonstration of the fact that the projected consensus agreement alone can achieve the
efficiency objectives aimed at by the agreement. The proof of the efficiency of an
agreement therefore supposes that a causal link be established between it and the
advantages invoked as well as the indispensable and unavoidable character of the
agreement.

It is encouraging that Commission jurisprudence sanctions several advances in
contemporary economic analysis which underline the importance of: (1) the temporal
dimension of production, (2) sunk costs' commitments stemming from theory of
contestable markets, and (3) coordination needs of both complementary and competitive
investments, resulting from information failings and insufficient mobility of productive
resources. Thus, innovation as the creation of new resources constitutes the typical
example of qualitative changes causing firms to lose stability (Amendola and Gaffard
1998), that is, towards a situation where they are required to manage the progressive
destruction of their former production capacities and the creation of new productive
schemes. The difficulty posed by such management comes from the fact that, during
transition, the costs for each period are disassociated from receipts for reasons of
intertemporal complementary natures and coordination failings. Only cooperation
between complementary firms, though often in competition, may make it possible to
manage this transition phase efficiently (Glais and Gaffard 1999).

In 80 percent of the main individual rulings made by the Commission since 1990, the
gestation periods for innovation and the risks run by the companies concerned have
been explicitly recognized as sufficient to allow validation of organizational structures
which nonetheless may comprise significant accessory competition restrictions over time
periods lasting up to fifteen years (see Glais 1996).
Although a number of projects submitted for the appreciation of the Community
authorities link companies possessing specific resources of different natures but strongly
complementary, it is not unusual that at the same time partners to the agreement are
currently in competition (or potentially competitive) on the markets concerned. So it is in
perfect conformity with an economic analysis founded on production theory that the
rulings applied took account of the fact that the innovations envisaged would have
required excessively long gestation periods and might not even have been implemented.
Moreover, the promotion of more incremental technical progress is recognized by the
Commission when it implies, for the companies concerned, substantial irrecoverable
investment costs. Specialization agreements are also validated when their positive
effects are proved, particularly in the case of their contribution to the reduction of
transaction and distribution costs. This is the case when agreements affect products
subject to a vertically differentiated offer, liberating each partner from the worries of
small-series production and are accompanied by a standardization and normalization
program whose effects may, finally, prove favorable to the emergence of stronger
competition. Therefore, the speedier diffusion of know-how resulting from these
cooperation operations is now taken into account in individual exemption rulings made
by the Commission. However, the benevolence with which cooperation projects targeting
the promotion of efficiency are received does not prevent the Commission from carefully
checking that the exemption period corresponds to the time limit necessary for the
execution of the innovations envisaged.
Once the objectives fixed by its members have been reached, the coalition no longer has
any reason to continue. It should be dissolved immediately to give way to fresh
competition. However, whatever the quality of information available to the Commission, it
remains difficult to define with precision the time limit needed for the agreement to
produce its beneficial effects. This is why the provisions relative to the application of
community competition law (regulation no. 17, article 8) specify that any individual
exemption ruling for a determined period may be renewed, or modified, or even revoked,
when an excessive time limit granted would unduly prolong a situation harmful to the
Community economy. Too short a time limit would disproportionately weigh down
administrative control by multiplying the numbers of exemption requests and weaken
efficient supervision of competition within the Community. Initially not lasting more than
five years, the exemption time limit has since 1990 been extended to ten years,
sometimes even longer, depending on the length of the gestation period for research
innovation. However, in such cases, the Commission generally accompanies its
decisions by precise charges allowing effective supervision of the evolution of the
agreement (regular activity reports, communication of quantities sold and fixed prices,
modifications made to the agreement and, where applicable, any arbitration rulings made
in cases of conflict between associates, etc.).
2.2.2 A new analysis procedure of joint venture creation projects
(new provisions of regulation no. 1310/97)
It is rare that agreements limit cooperation to the initial stage of R&D. More often this is
extended to production and commercialization of the products in question within the
companies created for this reason. Until the adoption of the CE no. 4064/89 regulation
(December 21, 1989) relative to control of concentration operations, this type of
agreement could be only validated under the provisions of collusive agreement law.
When the no. 4064/89 regulation appeared, Community authorities sought to operate a
distinction between two types of joint ventures. A specific type of concentration may be
constituted following this regulation: "The creation of a joint venture durably fulfilling all
the functions of an autonomous economic entity without involving any coordination of
competitive behavior between founder companies, either between themselves or the
joint venture" (article 3 §2 of the regulation). Such a company, also called "full function,"
must be able to dispose of all necessary resources (financial, staff, tangible and
intangible assets) in order to carry out durable activity. It should therefore be able to
operate on a market, carrying out all the functions usually carried out by other companies
present on this market. Thus, the following companies were excluded from the regulation
on concentrations: (1) joint ventures applying only one of the functions specific to the
activity of a company (joint ventures limited to the promotion of R&D or production when
this merely represents a sales counter), (2) companies, while fully operational, may allow
[6]
the coordination of competitive parent companies on the same market. Initially the
dissociation operated between a joint concentrative venture and a full function joint
venture, but deemed cooperative, led to analysis methods which were very different in
their effects on competition. The compatibility of a concentrative project with the
maintaining of sufficient competition was (and still is) declared after a purely competitive
analysis, the purpose of which is to check the absence of any risk of strengthening (or
creating) a dominant position consecutive with the emergence of the new company.
Conversely, a full function cooperative joint venture had to continue to be subjected to
the "economic analysis" stipulated by the application of article 85 §3 (now 81 §3), its life
expectancy being furthermore limited.
Aware of the difficulties inherent in the interpretation of these initial rulings and thus of
the relatively tenuous nature of the distinction between the two types of joint venture
evoked by the regulation on concentrations, the Community authorities amended their
initial text in order to include, within regulation no. 4064/89 all full function joint ventures
(regulation no. 1310/97 EC, consideration no. 5). Since 1998, the creation of a joint
venture performing on a lasting basis all the functions of an autonomous economic entity
therefore lies in the field of concentration control.

However, when its purpose or effect enables coordination of the competitive behavior of
companies remaining independent, this coordination is assessed, within the framework
of the procedure established by the concentration regulation, according to the criteria
cited in article 81 §3 of the EC Treaty.[7]
Finally, during the creation of a joint venture, it is not unusual for the project submitted for
assessment by the community authorities to be accompanied by "ancillary restraints"
(non-competition clause, buying or delivery commitments, transfer of know-how, patent
licenses, etc.). Such restrictions are validated only if they are linked to and necessary to
the carrying out of the concentration project. Thus, they should not entail limits on
freedom of behavior except between the parties, and in no case should they be
detrimental to a third party. Second, they may not concern any object different in nature
from that directly resulting from the operation concerned. Tangible proof must be given of
their necessary character (cost savings, reduction of risk, or time periods pertaining to
the application of the projected innovation obtained thanks to these restrictions).

The legal security obtained by the parties following a decision reached through the
application of the regulation on concentrations, and the speed with which this decision is
made, have no doubt been related to the increase in the number of concentrative joint
venture projects witnessed since 1990. It would therefore be justified to ask whether
some of these legal arrangements have not occasionally been adopted in order to avoid
the regular controls operated by the Commission in the case of simple cooperation
agreements (or of the creation of common cooperative channels). But the question may
also be asked whether the proliferation of concentrative joint companies will not entail
structural rigidities in market functioning. Even if a concentrative joint venture may have
to disappear or see its shareholders change identity, the life expectancy of such an
organizational structure is often lengthened beyond those generally imposed on simple
cooperation agreements. Very often, agreements restricted as to time periods are quite
as profitable regarding the promotion of technical progress but contribute more efficiently
to the protection of more intensive competition.

[2]
Regulation no. 240/96 dated January 31, 1996 (JOCE L. 31 dated February 9, 1996)

[3]
Active competition may be forbidden: (a) as long as the patent under license is protected by
parallel patents granted in the territories of the licensees (case of pure patents license), (b) for
up to ten years (pure know-how license), or according to the more advantageous of the two
time limits just mentioned (mixed licenses). The validity of a non-passive competition clause is
limited to five years from the date when the licensed product was first put on the market by
one of the licensees within the Common Market.

[4]
Except in second-source contracts.
[5]
Regulation no. 4/8/85 dated December 19, 1984 (JOCE L. 53 dated February 22, 1985)
modified by text 161/93 dated December 23, 1992 (JOCE L. dated January 29, 1993). This
R&D regulation is presented in a form similar to that concerning technology transfers (same
typology of contractual clauses, for example). Competing firms holding, at the time of the
agreement, a market share of over 20 percent of the products concerned (or a substantial
part of the latter) are unable to benefit from the categorical exemption.

[6]
The case of founding companies continuing to carry out significant activities on the same
markets as those of the joint venture, on neighboring markets or on upstream or downstream
markets, the joint venture being their main economic partner (supplier or customer).

[7]
It should be noted that a venture may not be defined as "joint venture" without supervision
by at least two shareholders who are to reach understanding on all major decisions relative to
the activity of the company under supervision. It is not a joint venture when one of the
founders may alone supervise its own activity or when no minority shareholder holds a veto.
3 Conditional freedom of vertical agreements: new category
Regulation dated December 22, 1999
In the early 1980s the Community authorities engaged in deeper reflection concerning
the effects of exclusive distribution contracts and franchising agreements on the play of
competition as well as on the promotion of economic efficiency.[8] Moreover, at that time,
theoretical work on these specific vertical relations were of only very moderate interest to
the community of economists. Abundant jurisprudence first allowed the Commission to
fine-tune the limits of its benevolence regarding this type of contractual formulae. The
new category Regulation no. 2790/1999 dated December 22, 1999, aimed at unifying
their legal framework (apart from the sector of automobile distribution), therefore
represents the fruit of this experience, backed up by certain works of economic theory
carried out since 1990.
Although the often beneficial character of these vertical contracts has been reaffirmed
from the viewpoint of the objective of promoting economic efficiency (section 3.1), the
risks of excessive infringement of the freedom of behavior of resellers as well as freedom
of entry onto the markets concerned has nonetheless been abundantly clearly described
in the very structuralist "guidelines" accompanying this new regulation framework
(section 3.2).

3.1 Vertical contracts and efficiency promotion

The creation of intangible assets potentially able to build consumer loyalty constitutes
one of the fundamental reasons for the success of a company on a market, as well as its
contribution to economic efficiency. To invest in the promotion of recognized and
appreciated brands is not enough to ensure the promoter of durable commercial success
in the absence of similar actions on the part of those whose aim is to ensure the retail
sale of the products concerned. The respective interests of both parties do not always
converge, so only sufficiently incentive contracts prove able to avoid the adoption of
discretionary behavior detrimental to producers.

To ensure perfect conformity with the commercial strategies of suppliers and resellers
does not, however, represent the sole objective of such contracts. The temporal
coordination of investments by each of the partners may also justify the introduction, in
such agreements, of specific clauses able to further limit their strategic latitude. The state
of dependence in which certain signatory retailers to commercial agreements with one
supplier sometimes find themselves in fact may bear economic and financial risks which
can be reasonably covered only by specific measures of protection such as territorial
exclusivity whose second advantage is also to stimulate inter-brand competition.
3.1.1 Vertical restrictions and brand protection
Breaking with traditional economic analysis which considers the cost of brand promotion
as vector of reduction of competitive rivalry, the developments of contemporary
microeconomic analysis have worked to rehabilitate informative content. The brand
name, also underlined forcefully by management experts, must be analyzed as a kind of
implicit contract which, in the long term, links a manufacturer to his customers. According
to these analyses, it would be as if the latter agreed to grant the products offered by
promoters of recognized brands increased confidence, based on the fact that these
brands represent the symbol of a gradual accumulation of knowledge and the permanent
search for excellence. Conversely, costly communication about mediocre-quality
products would have little impact since the trick would soon be apparent during the
learning stage undertaken by the end-users. A brand, even a well-known one, may
nevertheless become an wasting asset when the efforts made by its owner are not
sufficiently followed through with similar activity by the resellers.

Distributors are the drive belts between manufacturers and consumers, and as such may
behave as loyal partners or not, according to how they define their role as service
providers. The risk of seeing these partners behaving uncooperatively would entail the
producers opting for an organizational plan based on total integration of the channel in
question, unless the cost of such a strategy proved prohibitive. The logic of seeking
optimal sharing out of resources has thus led manufacturers to opt in favor of contractual
solutions consisting in giving distribution activity to specialists spread over the
geographic market concerned. But can all candidates for the role of distributor be taken
on without prior selection and restrictive contractual clauses?

Both business experience and contemporary economic analysis shows this to be out of
the question as soon as one recognizes the possibility for distributors to behave in an
opportunistic manner when carrying out contracts lacking in incentives. Permanent
supervision of distribution activities would involve prohibitive costs, especially since the
number of distribution agents is often high. Forcing resellers to invest in sunk costs
assets and imposing contract clauses detailing the precise commitments to which they
would be held makes it possible to avoid the danger of commercial parasitism (such as:
the call price technique, pirating of selective networks, or insufficient supply of advice
and services).

In the recent past and particularly during disputes raised by dissatisfied distributors,[9] the
Community authorities had already engaged in recognizing the strong interest of
protection strategies for the value of intangible assets created by manufacturers. The
merit of the guidelines laid down by the Commission in support of its new category
exemption regulation is to recognize explicitly that:
A vertical restriction may enable a manufacturer to increase his/her sales by imposing a
certain uniformity and certain quality standards on distributors so as to acquire a good
brand image and attract end-users. Selective distribution and franchising are examples
of this. (JOCE C 270, September 24, 1999, p. 27)
However this does not imply that this type of commercial relations may be applied to the
resale of any product. In compliance with the teachings of economic analysis considering
that vertical restrictions are really justified only when there is insufficient information on
the end users arising from sporadic purchases of the product in question, the guidelines
expressly specify that to benefit from a favorable a priori, the restrictive contract should
cover a new or technically complex product and have a certain value. (JOCE C 270,
September 24, 1999, p. 26)
3.1.2 Time coordination of suppliers' and distributors' investments
Within the context of a more long-term development strategy of their activities, producers
must be confident that their resellers are in a position to increase their production
capacities at the same rhythm as theirs.
In compliance with certain developments in the theory of incomplete contracts, the
introduction of appropriate contractual clauses can enable them first to limit the resellers'
rights of control over variations in their volume of activity and to control ex ante the
investment choices of the commercial partners. In some theoretical constructs like those
proposed by Grossmann and Hart (1986), the fact that one of the parties can fail to
persuade its partner to increase its activity in its favor when the latter has other openings
at its disposal is particularly stressed. By acquiring the "residual" control rights (vertical
integration) or by limiting their use (contractual formula) the coordination of
complementary activities can be carried out in a more optimal manner. In this theoretical
construct, the by-contractors' investment decisions are nevertheless made independently.
It is however more efficient to draw up contracts allowing (as shown by Perry 1989) prior
control over the commercial partner's investment choices. The risk of seeing the former
choose levels of production capacity differing highly from those of their by-contractor
appears frequently in the case of high indivisibility of the capital factor, all growth of
capacity and supplementary expenditure on investment at sunk costs expenses being
redeemable only over a relatively long period.

The right to add contractual clauses allowing the management of this type of problem is
also recognized today by the guidelines under clearly stated conditions:
They first specify that certain investments must be made, either by the supplier or by the
purchaser, as in the case of special equipment or specific training It is then possible
that the by-contractor should not commit himself to carrying out the necessary
investments before having reached an agreement with this partner as to certain
arrangements in terms of supplies. (JOCE C 270, September 24, 1999, p. 27)

The legal validation of such commitments nonetheless implies that certain conditions be
met. The assets concerned must first be undeniably characterized as sunk costs
investments, redeemable only after a fairly long period; the projected investments must
secondly be asymmetrical, one of the parties investing more than the other. Two specific
situations are particularly taken into consideration within the guidelines. First, specific
investments made on the premises of the other party may not have been completely
recovered on expiry of the commercial cooperation contract. Their resale to the partner
concerned generally proves to be the best solution in consideration of the high cost of
their recovery by the investor. In this case the Commission considers that a vertical
restriction of limited length can be justified when such a resale leads to high transaction
costs. According to whether the investment has been made by the supplier or the
distributor, restrictions may be applied in the form of non-competition or purchase quotas
[10]
clauses (first hypothesis), or exclusive distribution or supply rights (second case).
Imposing an exclusivity clause on one's by-contractor constitutes, secondly, an
obligation proportional to the degree of benefit conferred on a distributor in the case of
granting of substantial know-how; such a clause constitutes in fact protection for the
[11]
assignor from the risk of very rapidly seeing his know-how benefit some of his
competitors. Moreover, without such protection, it is only with the greatest reservation
that its holder would accept to share the sum total of his knowledge in the domain of
activity concerned.
3.1.3 Territorial protection, promotion of inter-brand competition,
and risk limitation of resellers
To allow one's distributor the sales monopoly of a well-known brand over a particular
geographical area appears on the first analysis to be hardly compatible with the free
market ideal of neoclassical theory. The introduction of a territorial protection clause for
each reseller seems nonetheless to benefit from the application of a favorable economic
analysis when it appears to arise from a search for a balance in the contractual
relationship between the parties involved and to reserve for the final users an equitable
part of the resulting profit. It is moreover in the area of franchising that this type of
contractual clause proves most justified.
The reasons adduced from several court decisions of individual exemption made by the
European Commission prior to the adoption of its first ruling of category exemption are
particularly pertinent.[12] The restriction of intra-brand rivalry to which territorial protection
leads is often, in fact, more than compensated for by the growth of more active inter-
brand competition, particularly when it is stimulated by producers who are efficient but
new arrivals on the market and not having at their disposal enough of their own
resources to allow them the rapid extension of their commercial circuits. It is, in fact,
franchise applicants who make the necessary investments to establish new sales points.
Per contra, the exclusive territorial rights the franchises are allowed can be considered
indispensable:
No franchise applicant would realistically have been willing to make the investments
necessary and to pay a not inconsiderable standard charge to integrate such a
distribution system if he had not been sure of a certain territorial protection from the
competition of other franchisees and from the franchiser himself. (Y. Rocher et Pronuptia
verdict, JOCE L. 8 and L. 13 of January 10 and 15, 1987, no. 36)
As a factor of inter-brand competition, this type of contract undeniably contributes
particularly to the improvement of consumer welfare. Gaining first from the advantages
provided by a coherent distribution network offering products of uniform quality, the
former also reap the benefits of the interest the franchisee, as an independent reseller
and with a personal interest in the management of his business, finds in "looking after,
helping and carefully following up his clientèle" (Y. Rocher et Pronuptia, JOCE L. 8 and L.
13 of January 10 and 15, 1987, no. 35).

3.2 Validation conditions of vertical contracts
Adhering faithfully to economic analysis methodology, the Community authorities have
taken particular care to restate that these contracts should nevertheless not allow an
unconsidered reduction of the action of intra-brand and inter-brand competition.
3.2.1 Maintaining sufficient intra-brand competition
Contingent on the restrictive contract complying with the efficiency criteria previously
mentioned, it is still important to ascertain that the selection means are not discriminatory
(the case of selective distribution) and that the contractual clauses allow real competition
between the selected distributors.
1. The new legislation first considers that selective distribution founded
on purely qualitative criteria[13] is not covered by article 81 §1[14] in
so far as it imposes no direct limit on the number of re-sellers.
Furthermore, the selection criteria must be objective and non-discriminatory.
The exclusion from a selective network of large-scale distribution companies
would thus not be acceptable when they agree to respect the totality of the
criteria defined by the manufacturer. In the two cases described previously
(Leclerc v. Commission) the Court thus particularly stressed that a
hypermarket may not be excluded from a selective network simply because
other products are sold there. According to these two rulings, such a sale is
not in itself harmful, for example, to the image of luxury products since the
location or space allocated to the sale of similar products is so arranged as to
present them in an attractive way. One can, however, have reservations
about adopting the court's way of thinking. In fact there can be a real problem
of image compatibility between suppliers of highly well-known brands and
large-scale distribution resellers. It is not usually in the interests of a
manufacturer having always chosen to position himself in the "up-market"
segment to accept that part of his sales should be made by a distribution
circuit having chosen to position itself on the sale of products which come
from far more downmarket segments. The fact of accepting to respect the
qualitative criteria imposed by a provider of superior quality products (or from
the luxury market) on only this type of product is not sufficient for its less
prestigious image to be modified. It is thus legitimate to wonder if
commercialization by large-scale distribution (particularly food products) of
products packaged with a well-known brand name might not lead to a certain
trivializing and affect the value of the producers' intangible assets. Large-
scale distribution being considered (and often rightly so) to privilege
competition by price, it is not irrelevant to consider that in the eyes of
competition authorities this form of rivalry should be encouraged and take
over from any other forms of competition, and this, whatever the
characteristics of the products concerned. So the break with the
"neoclassical" competition model would be far from sufficient.
2. Secondly, in spite of the reservations of economic analysis concerning
an absolute prohibition of the strategy of fixed prices, the new
legislation excludes from category exemption the agreements which
intend, directly or indirectly, to restrict the buyer's capacity to freely
determine his sales price.[15] The effects on competition of a
minimum price or a fixed price are twofold according to the
guidelines: total elimination of intra-brand competition in terms of
price and, secondly, the reinforcement of transparency favorable to
the emergence of horizontal collusion between manufacturers and
distributors in relatively concentrated markets.

While it cannot be denied that fixing imposed prices may constitute a factor favorable to
the emergence of collusive agreements in oligopoly markets, such is not the primary
objective of producers when they use this type of price scale. According to an exhaustive
study of lawsuits filed in the United States between 1890 and 1983, against companies
having had recourse to imposed prices practices, it is only in a third of cases that the
former could possibly have served to support a horizontal agreement. In all the other
cases, the adoption of imposed prices had been carried out by only one company
(Ornstein 1985). Now, in such a case, this practice can simply serve to incite distributors
to offer a better quality of service (see, for example, Posner 1976[16]; Tirole 1985[17]), or to
stop some from succumbing to the temptation of using the technique of loss leader
(Marvel and McCafferty 1984). In a more general manner (Rey and Tirole 1986), the
choice of an optimal control policy over the distributors' action cannot take place without
an in-depth analysis of the sources of uncertainty affecting the resellers' activity as well
as the importance of the latter's aversion to risk-taking. The conclusions of the model
designed by these authors illustrate that there is no objective reason to analyze vertical
practices differently whether or not they focus on the variable of price.

If free circulation of products between participants in the same network constitutes a rule
which tolerates no exceptions, the prohibition of delivery to distributors outside the
network can not only be licit but is judged to be the most effective means of guaranteeing
protection of the distribution circuit concerned (case of selective distribution). On the
other hand, the restriction of passive or active sales to final users by the members of a
selective distribution system operating as resellers on the market means loss of eligibility
for category exemption for the contract. What is authorized, however, in an agreement
such as a franchise or exclusive distribution is:

the restriction of active sales into the exclusive territory or to an exclusive customer
group reserved to the supplier (or allocated by the supplier to another buyer) where such
a restriction does not limit sales by the customers of the buyer. (article 4 of Regulation no.
2790/1999)
3.2.2 Maintaining efficient inter-brand competition
A distribution agreement can quite clearly obtain exemption from the terms of article 81
§1 only to the extent that this does not substantially contribute to a reduction of inter-
brand competition for a given market. Rather than relying on expertise based, for
example, on calculation of concentration indexes (such as, for example that of
Herfindahl-Hirschman) the Commission has opted for the criteria of market share:

Over the market share threshold of 30 percent there can be no presumption that vertical
agreement following within the scope of article 81 §1 will usually give rise to objective
advantages of such a character and size to compensate for the disadvantage which they
create for competition. (Sub section 9 of Regulation no. 2790/1999)

In such a case, the Commission services will be invited to carry out a virtual "check-up"
of the market in question, based on the analysis of its structural characteristics, when
they are called on to evaluate the probability of seeing the agreement in question
produce anti-competitive effects.

Therefore, contracts which force a purchaser to procure goods or a given service from
the same supplier (the case, for example, of mono-brands), as well as situations where a
juxtaposition of restrictive contracts leads to added effects generating closure of markets
with potential competition, are particularly relevant. At this level, the position adopted in
the guidelines proves in conformity with jurisprudence established by the Court of Justice
[18]
on the occasion of disputes in the area of the beer industry.

However, in spite of an often mixed analysis of the effects on inter-brand competition of
the most common types of restrictive contracts, the guidelines nonetheless have what
could be qualified as surprising reservations about selective distribution contracts. These
are often judged first to be of a nature to create strong barriers to entry insofar as they
apply particularly to branded products: "It will often take a long time and considerable
investments for foreclosed resellers to launch their own brand or indeed to obtain
competitive supplies."

Such a statement clearly gives the impression that the combination "selective
distribution" and "well-known brands" comes from the phenomenon of an artificial rise in
competitors' (or of distributors') costs described by Krattenmaker and Salop (1986).
Contemporary economic theory refuses nonetheless to evoke the concept of barriers to
entry (along with the attendant negative connotations) when the absence of a total
porosity of the frontiers of a market is explained essentially by the fact that companies in
place have succeeded (thanks to continuity and the seriousness of their business
relations) in building up business goodwill, allowing them not to be afraid of losing their
market position at any moment.

Numerous studies (see, for example, Von Weizs¤cker 1981) have also concentrated on
demonstrating that the "goodwill" possessed by a company does not fall into the
category of inefficient barriers. Secondly, free entry into the market does not mean "easy
entry." It is, in fact, in the nature of the competitive process to recognize as legitimate the
fact that a new entrant should work (as the sellers in place did in their time) to find a
durable position in the market.

The guidelines accompanying the new legislation tend therefore to confirm the
somewhat unfortunate jurisprudence prohibiting the exclusivity clauses featuring in
certain distribution contracts with the motive that, given the large market share of the
company in question, it would prove difficult for other competitors to penetrate the market
concerned. It is thus that Unilever was prohibited from continuing to include an
exclusivity clause in their freezer supplies contracts on the Irish market for ice-cream for
immediate consumption. The size of the Unilever market share, the quasi-impossibility
for most distributors of using several freezers in their commercial spaces certainly made
the entry of new competitors difficult. Nevertheless, in this instance the Commission
made light of the degree of satisfaction displayed by the distributors in terms of their
commercial relationships with their supplier and moreover did not pay enough attention
to the existence of powerful potential competitors such as Nestl© or Mars. Within the
framework of a more "Austrian" analysis of the competitive process it would not have
been superfluous to recognize that, according to Kirzner's (1973) definition, the company
in place would have been the first to discover a non-exploited opportunity on the market
concerned, that the market position the former had achieved was economically legitimate,
and finally that followers would logically have to assign large investments to compete
with this position. The solution adopted by the Commission, prohibiting the leading
operator from using a distribution strategy that his competitors, on the other hand, were
allowed to use, largely amounts to penalizing the operator who showed signs of
alertness (a particular state of vigilance) in the sense used in competitive process theory.

Secondly, should the doctrine of the cumulative effect of similar contracts be applied to
purely selective contacts, as is suggested by the guidelines?

The real business world shows, quite on the contrary, that the existence of selective
distribution networks constitute a highly favorable factor for the penetration of a market
by new providers. The latter are not, in fact, constrained to invest heavily at the
distribution stage to be able to offer their products to end-users. In fact there are already
numerous specialized resellers, recognized as such, on the market, ready to receive new
products in their sales spaces insofar as these products correspond to the criteria of
quality and distinctiveness appropriate to the concept of selective distribution. It is indeed
the distributors rather than the suppliers already in place who then judge the advisability
of accepting new brands in their shelf-space. The error of analysis in the guidelines, in
this particular case, is clearly through a hasty assimilation of the effects of selective
distribution to those of exclusive distribution in terms of risks of market closure. The
selective distributor retains real freedom in the choice of an assortment of brands that he
intends to offer to the end-purchasers. If there was a time when, in certain contracts
offered by suppliers, there were clauses said to be of "brand environments" likely to
allow the birth of collusions within a group of suppliers, this risk has disappeared today
following the prohibition of such procedures by manufacturers.

In other words, by allowing the emergence of distributor networks selected only on the
basis of qualitative selection criteria whose objectivity and character in proportion to the
demands which they are required to meet are verified by the competition authorities, the
supplier "first entrants" on the markets concerned offer, to some extent, positive
externalities to new entrants who are providers of products of a comparable quality. The
ease with which the latter may have access to these networks allows them, moreover, to
valorize their brands more rapidly and reduces their communication and promotion
expenditure.

[8]
Reflection which was sanctioned by the adoption of categorial exemption regulations
relative to: exclusive distribution contracts (no. 1983/83 dated June 22, 1983); distribution and
after-sales service automobile agreements (no. 123/85 dated December 14, 1984, modified
by regulation no. 1475/95 dated June 28, 1995); franchising contracts (no. 4087/88 dated
November 11, 1988).

[9]
Thus in two notable judgments, the Communities' courtof first instance implicitly validated
the thesis supported by the manufacturers according to which "competition targeted on
elements other than price has advantages, given the substantial investments required and the
need to prevent ˜parasite' resellers from living at the expense of those who accept the
economic constraints of the manufacturer's economic policy" (Affaires "Groupement d'achat E.
Lerclerc c./Commission," rulings dated December 12, 1996).

[10]
Such vertical restraint may also allow avoidance of the parasitism of this investment by the
investor's competitors.

[11]
Furthermore, the competition authorities have responsibility for verifying the essential
character. In compliance with the present, well-established jurisprudence, this know-how (as
a whole or in the configuration or precise assembly of its components) may not be already
known or easily assimilated. It must provide the reseller with significant information in the area
of sales techniques or of supplementary services. Finally, it should reasonably allow the latter
to improve his/her competitive position by aiding penetration of new markets and increased
profits.

[12]
See for instance, the following rulings: Y. Rocher et Pronuptia: JOCE L. 8 and L. 13 of
January 10 and 15, 1987; Computerland: JOCE L. 222 dated August 10, 1987; Service
Master: JOCE L. 332 dated December 3, 1988; Ch. Jourdan: JOCE L. 35 dated February 7,
1987.

[13]
Such as the training of sales personnel, service provided by the supplier, the range of
products sold, the quality of the outlet site, and its facilities.

[14]
Such would not necessarily be the case of quantitative selection criteria (limiting the
number of resellers, fixing minimal or maximal sales levels ).

[15]
A maximal or suggested sales price is nevertheless authorized in so far as it is not equal to
a fixed or minimal sales price after pressure applied by one of the parties or incentive
measures taken by them.

[16]
An analysis of the reasons for the existence of imposed retail prices constitutes one of the
tests suggested by Posner when it is a question of separating situations of tacit agreements
from those arising from simple parallel behavior. In the eyes of this author, it is only when
imposed prices are adopted by a group of companies belonging to the same market that this
test can have any conclusive value.

[17]
According to Tirole (1985), this type of practice, by guaranteeing a sufficient profit margin
for the reseller, can incite him/her to provide a better service. Otherwise, the advantages thus
offered to consumers when they improve the manufacturer's reputation are not totally
internalized by the reseller. Fixing a retail price confers on the reseller/purveyor of commercial
information property rights pertaining to the information supplied to his/her supplier.
[18]
On several occasions, the Court has considered that a contract for the supply of beer was
prohibited, in compliance with the agreement law when two cumulative conditions combine.
First, on account of the economic and legal context, the national market should be difficult to
access by competitors who could operate there (or who could expand their market share).
Secondly, the litigious contract should contribute significantly to the blockage effect generated
by the entirety of these contracts.
4 Conclusion
This brief analysis of the texts adopted by the Community authorities and the broad
tendencies of jurisprudence relative to cooperation agreements leads to a slightly
attenuated evaluation.

As far as contractual relations aiming for the promotion of technical progress are
concerned, the Community authorities have shown real open-mindedness concerning
the integration of certain currents of thought (in particular of "Austrian" essence) They
have, thereby, published decisions endorsing the merits of an analysis based on the
process character of competitive rivalry. On the other hand, in other areas of inter-firm
cooperation they have shown a greater reluctance to integrate the developments of
contemporary theory of company and market organization. A real wish for transparency
in their methods of appreciation of the competitive effects of the agreements concerned
should certainly be noted as a positive result of their action.

Nevertheless, as far as the area of distribution contracts is concerned, the guidelines
which have been divulged prove to be relatively casuistic and particularly still over-
influenced by the teachings of traditional theory. The role of non-price competition, while
it is tentatively recognized, clearly does not carry as considerable a weight as that of
price as the vector of promotion of economic efficiency. Secondly, the fear (permanent
within the guidelines) of seeing the markets concerned with the extension of restrictive
agreements polluted by the emergence of situations of collusion is witness of an
extremely insecure belief in the fundamental robustness of competitive rivalry.
Notes
Chapter 22 was originally published as "Les accords inter-entreprises et le droit
communautaire de la concurrence," in Revue d'Economie Industrielle (92, 2000).
1. CJCE, 17/01/84, VBVB, no. 52; decision dated February 5, 1992,
"Construction aux Pays Bas."
2. Regulation no. 240/96 dated January 31, 1996 (JOCE L. 31 dated
February 9, 1996)
3. Active competition may be forbidden: (a) as long as the patent under
license is protected by parallel patents granted in the territories of the
licensees (case of pure patents license), (b) for up to ten years (pure
know-how license), or according to the more advantageous of the two
time limits just mentioned (mixed licenses). The validity of a non-passive
competition clause is limited to five years from the date when the
licensed product was first put on the market by one of the licensees
within the Common Market.
4. Except in second-source contracts.
5. Regulation no. 4/8/85 dated December 19, 1984 (JOCE L. 53 dated
February 22, 1985) modified by text 161/93 dated December 23, 1992
(JOCE L. dated January 29, 1993). This R&D regulation is presented in a
form similar to that concerning technology transfers (same typology of
contractual clauses, for example). Competing firms holding, at the time of
the agreement, a market share of over 20 percent of the products
concerned (or a substantial part of the latter) are unable to benefit from
the categorical exemption.
6. The case of founding companies continuing to carry out significant
activities on the same markets as those of the joint venture, on
neighboring markets or on upstream or downstream markets, the joint
venture being their main economic partner (supplier or customer).
7. It should be noted that a venture may not be defined as "joint venture"
without supervision by at least two shareholders who are to reach
understanding on all major decisions relative to the activity of the
company under supervision. It is not a joint venture when one of the
founders may alone supervise its own activity or when no minority
shareholder holds a veto.
8. Reflection which was sanctioned by the adoption of categorial exemption
regulations relative to: exclusive distribution contracts (no. 1983/83 dated
June 22, 1983); distribution and after-sales service automobile
agreements (no. 123/85 dated December 14, 1984, modified by
regulation no. 1475/95 dated June 28, 1995); franchising contracts (no.
4087/88 dated November 11, 1988).
9. Thus in two notable judgments, the Communities' courtof first instance
implicitly validated the thesis supported by the manufacturers according
to which "competition targeted on elements other than price has
advantages, given the substantial investments required and the need to
prevent ˜parasite' resellers from living at the expense of those who
accept the economic constraints of the manufacturer's economic policy"
(Affaires "Groupement d'achat E. Lerclerc c./Commission," rulings dated
December 12, 1996).
10. Such vertical restraint may also allow avoidance of the parasitism of this
investment by the investor's competitors.
11. Furthermore, the competition authorities have responsibility for verifying
the essential character. In compliance with the present, well-established
jurisprudence, this know-how (as a whole or in the configuration or
precise assembly of its components) may not be already known or easily
assimilated. It must provide the reseller with significant information in the
area of sales techniques or of supplementary services. Finally, it should
reasonably allow the latter to improve his/her competitive position by
aiding penetration of new markets and increased profits.
12. See for instance, the following rulings: Y. Rocher et Pronuptia: JOCE L. 8
and L. 13 of January 10 and 15, 1987; Computerland: JOCE L. 222
dated August 10, 1987; Service Master: JOCE L. 332 dated December 3,
1988; Ch. Jourdan: JOCE L. 35 dated February 7, 1987.
13. Such as the training of sales personnel, service provided by the supplier,
the range of products sold, the quality of the outlet site, and its facilities.
14. Such would not necessarily be the case of quantitative selection criteria
(limiting the number of resellers, fixing minimal or maximal sales
levels ).
15. A maximal or suggested sales price is nevertheless authorized in so far
as it is not equal to a fixed or minimal sales price after pressure applied
by one of the parties or incentive measures taken by them.
16. An analysis of the reasons for the existence of imposed retail prices
constitutes one of the tests suggested by Posner when it is a question of
separating situations of tacit agreements from those arising from simple
parallel behavior. In the eyes of this author, it is only when imposed
prices are adopted by a group of companies belonging to the same
market that this test can have any conclusive value.
17. According to Tirole (1985), this type of practice, by guaranteeing a
sufficient profit margin for the reseller, can incite him/her to provide a
better service. Otherwise, the advantages thus offered to consumers
when they improve the manufacturer's reputation are not totally
internalized by the reseller. Fixing a retail price confers on the
reseller/purveyor of commercial information property rights pertaining to
the information supplied to his/her supplier.
18. On several occasions, the Court has considered that a contract for the
supply of beer was prohibited, in compliance with the agreement law
when two cumulative conditions combine. First, on account of the
economic and legal context, the national market should be difficult to
access by competitors who could operate there (or who could expand
their market share). Secondly, the litigious contract should contribute
significantly to the blockage effect generated by the entirety of these
contracts.
Incentive Contracts in Utility
Chapter 23:

Regulation
Matthew Bennett, Catherine Waddams Price
1 Introduction
Incentive contracts transformed the theory and practice of regulation in the last quarter of
the twentieth century. Emphasis shifted from control and prescription to incentives and
discretion, with significant implications both for outcome and for the distribution of
benefits and risk. We trace the development of this change, illustrating it with the British
experience of utility regulation where the shift from public ownership to explicitly
regulated private companies has been particularly stark. This chapter provides a broad-
brush analysis of recent issues and developments in this rapidly changing area of
economics, rather than attempt to detail all the individual problems. Our main focus is on
key issues such as welfare, efficiency, and the development of competition. This last
category has drawn increasing attention from regulatory economists, as governments
race to introduce competition in utilities and theory strives to keep pace with practice.
Where issues are only briefly discussed, we suggest articles that cover specific topics in
more detail, and in particular seek to update the arguments since 1995. In section 2, we
first address the question of why regulation is needed, identify experience in the past,
and examine regulation as a simple principal-agent model. In section 3 we trace the
growth and development of incentive contracts such as the price cap. Section 4 suggests
that introducing competition may not prove to be the regulatory panacea once envisaged,
and identifies practical issues including distribution concerns, which have marred the
original concept of incentive contracts in regulation, and assesses their prospects;
section 5 concludes.
2 Public ownership, cost of service, and incentives in
regulation
2.1 Problems and solutions for natural monopolies

Generally, the market failure which provides the case for regulation in utilities, derives
from the problems created by natural monopolies and 416 economies of scale in
production. Other examples of market failure (for example, externalities) may also
require government intervention, either through direct regulation or through taxation, and
many of the utilities operate in markets which also exhibit such externalities; however,
here we focus on their natural monopoly network characteristics. We include among
utilities the traditional network industries of water, electricity, gas, and
telecommunications (though some now dispute whether telecoms still exhibits these
characteristics); transport is also sometimes included because of its fixed network.
Competition in networks is generally both impractical and inefficient. Moreover a second
market failure, asymmetry of information between firm and consumers, also affects some
of the products; for example a customer cannot know that water is safe until after it has
been drunk. But government intervention itself creates a new information asymmetry,
between the firm and the regulator, which is crucial in devising regulatory mechanisms.
The very nature of the services supplied by the utility industries affects the design and
execution of policies. Their products are essential to household life and participation in
society, and are also crucial to businesses. Economic welfare has traditionally been
divided into efficiency and equity concerns. The classic economists' argument is that
equity is best addressed by instruments specifically devised for this purpose, such as
income taxes and benefit transfers, and that efficiency should be separately analyzed.
We follow this convention, but note that in the case of these particular industries the
political reality may not enable such a separation to be maintained in practice. We return
to this in our assessment in section 4.

Market failure within the utilities may be rectified through some form of government
intervention, and it is useful to identify benchmark positions for reference. Marginal cost
pricing maximizes efficiency under certain assumptions, but where average cost exceeds
marginal cost (as is typical of natural monopolies) a government subsidy is required.
Without such a transfer, marginal cost pricing results in unsustainable losses for the firm,
which then closes down, resulting in lower overall welfare. If lump-sum subsidies are
ruled out, a second-best tariff must be devised to cover the firm's costs. Ramsey“
Boiteux pricing is a benchmark solution to the problem of welfare maximizing in such a
multiproduct monopolist with uniform tariffs. The general method was first defined by
Ramsey in 1927 and applied in the well-known regulation context by Boiteux in 1956.
The regulator maximizes social welfare across a number of products subject to a firm's
budget constraint. In the simple case where product demands are independent, the
optimal departure from marginal cost pricing is inversely proportional to the price
elasticities in each market. Where it is necessary to raise price above marginal cost, it is
better to do so where consumers are least sensitive to increases in price. This minimizes
demand distortion from the first-best levels for a given amount of additional revenue.
Consumers with rigid demand contribute more to cover the fixed costs. Despite the
attraction of Ramsey“Boiteux pricing for economists, there remain problems which
prevent its regular implementation.

First, the optimal pricing rule requires enormous amounts of information on both costs
and demand, and use of incorrect information may actually reduce social welfare; even
when Boiteux directed Electricit© de France a simpler doctrine of uniform increases
above costs was adopted. Secondly, the optimal tariff is discriminatory in the sense that
price depends on demand as well as cost characteristics, and consumers with lower
elasticities pay a relatively higher price. This is a contentious policy to which we return in
considering the regulators' concern for distribution and undue discrimination issues.
The focus on the relation between price and costs has led to the two traditional
responses to market failure in utilities: public ownership (particularly in Europe) and cost
of service regulation (typical of North America). Where the firm is owned by the state it
can be directed to implement the government's chosen policies (including pricing);
alternatively the government may direct a private firm to do the same, in particular
dictating how prices should be related to costs. However in either case the government
suffers from asymmetric information. It does not know enough about the market to define
Ramsey“Boiteux pricing; and, as has become increasingly apparent, even if it can
observe realized costs, it cannot identify efficient cost levels. This raises principal“agent
issues which underlie much of regulation.

When the utilities were nationalized and owned by the government, contractual problems
associated with a separation of ownership and control were internalized. However both
the aims of the nationalized utilities (at least in the United Kingdom), and how far the
managers' incentives were aligned with those of the government, were unclear (see
Markou and Parmar 1999). The managers (agents) were likely maximizing the size of
their operations or bureaucracy (Jackson 1982; Rees 1984) rather than meeting the
government's (principal's) objectives. The latter were particularly difficult to identify
because of typical political reluctance to identify objectives and trade-offs explicitly. The
consequent management discretion and weak incentive structure led to a perception that
the nationalized industries were generally inefficient. In the United Kingdom it was
decided that the best way to rectify this problem (and coincidentally to balance a large
budget deficit) was to privatize the industries and allow the shareholders to incentivize
the firm, rather than create managerial incentives within a nationalized framework. This
raised new problems of the different objectives pursued by government and
shareholders, which are discussed below.

2.2 Cost of service regulation

First, however, we turn to cost of service regulation, an alternative to public ownership
which had been widely practiced in the United States. The most common form of such
regulation was to constrain the firm's rate of return on capital. This "rate of return"
regulation allows the monopolist what is deemed a fair return on capital, to prevent it
from abusing a monopoly position. The "fair" rate of return is generally above the market
cost of capital to ensure the company continues production and may be supplemented
by a requirement that investments are prudent (since the mechanism guarantees their
profitability). Prices are generally set at average cost (including the cost of capital) and
remain fixed until either the regulator, consumers, or the firm initiates a regulatory review.
This can be thought of as direct regulation at a micro level.
[1]
Rate of return regulation has come under heavy criticism. First, Averch and Johnson
(hereafter, AJ) showed, in their influential 1962 paper, that the rate of return reward
induces the firm to engage in inefficiencies. As the level of regulated return approaches
the cost of capital, the optimal ratio of capital to labor, rises above the efficient level for
that output. This may induce the firm to produce more output and charge a higher price
in comparison to an unregulated firm, but not to expand output to the optimal level. Rate
of return regulation does not induce wastage of capital (defined as capital investment
with a negative net present value (NPV)), as the firm produces as large an output as
possible for each capital“labor ratio. However the inefficiently high capital“labor ratio
[2]
sometimes leads to an accusation that the scheme induces wastage. One example of
these perverse incentives is the reluctance of US companies to adopt off-peak pricing
even though it would generally enhance economic welfare. Under rate of return
regulation, the larger the peak demand, the larger the network and the capital base upon
which profit can be earned (Sherman 1989).
A second criticism is that with price always at average cost, there are few incentives for
cost minimization under the continuous time regulatory framework which AJ assume,
since gains are immediately passed onto consumers through lower prices. Bawa and
Sibley (1980) show that although a time lag between regulatory reviews does not get rid
of the capital bias, as the rate of return tends towards the cost of capital, this bias is less
serious than in the static case. The introduction of demand uncertainty may however
increase the bias as firms raise capacity to meet the demand fluctuations (Crew and
Kleindorfer 1979, pp. 140“3). Rate of return regulation is ambiguous in its effect on
quality. There is an implicit incentive to excessive levels in the form of "gold-plating," as
return is guaranteed on investment, but the firm has no direct interest in increasing
quality. Over-capitalization is as likely to take the form of increased managerial expenses
as of quality enhancement.

Finally, the practicalities and informational requirements for rate of return regulation
make the regulatory burden very high. Apparent details, such as allocation of costs and
the basis for depreciation, have a huge impact upon the level of permitted profits. These
difficulties with cost of service regulation raised interest in alternatives, especially
incentivebased contracts, in North America at much the same time as the UK
government was privatizing its nationalized industries.

2.3 Introduction of incentive contracts

When the nationalized industries were privatized in the United Kingdom, ownership
moved from government to private shareholders. This new structure of ownership
changed objectives and contract relationships, raising a new set of principal“agent
issues. The new owners (shareholders) are expected to maximize profit rather than
welfare as the government might wish.[3] Consequently the principal (government) may
need to appoint a supervisor (regulator) to oversee the whole process and ensure that
the government's objectives are met. Managers are now answerable to the shareholders
rather than government; their objectives may be aligned more closely with those of the
new owners through share options, but a basic conflict between risk-sharing and the
power of the incentive remains. The best attainable contract for the shareholders has
more highpowered performance incentives the lower is the managers' risk aversion, the
lower the marginal cost of effort, the higher the marginal benefit of effort, and the easier it
is to measure performance (Besanko, Dranove and Shanley 2000).

In reality the regulator's and shareholders' problems are similar, since neither can
observe the level of effort exerted by management, and direct effort-based reward is
therefore impracticable. Left to their own devices, managers will exert less effort (and
generate less overall utility) than that required to deliver both the social and the profit
maximizing optimum. Just like the shareholders, the regulator needs to devise a
regulatory framework that induces firms to achieve the optimal outcome given the market
asymmetries. It is possible to view this as managers being answerable to two principals
(shareholders and regulator). An alternative model is one of principal“supervisor“agent,
allowing for the development of a separate set of objectives by the regulator. However to
illustrate the issues of incentive regulation, and for reasons of space, we treat
management and shareholders as a single agent, the firm/shareholders, with a single
principal, the regulator.
We have noted the divergence between government and firm objectives which makes
regulation necessary. The shareholder-owned firm maximizes profit by pricing above the
social optimum, creating incentives for misrepresenting true costs, or demand, or both.
This poses problems for regulation by detailed prescription, whatever the ownership of
the industries, because of the regulator's inferior information.[4] However, in an ideal
incentive regulation framework, a mechanism is created so that the firm chooses the
socially desirable outcome without the need for detailed knowledge on the regulator's
part. This may be facilitated (and the information asymmetry minimized) by the
introduction of competition to any sections of the industry where it is appropriate, while
regulating remaining elements of natural monopoly. This last outcome is possible only
where the natural monopoly markets in the industry can be separated from those which
are potentially competitive. The benefits of such separation depend on whether the
transactions between different vertical levels of the industry are amenable to external
explicit contracts rather than internal arrangements. Where quality, for example, is very
complex and difficult to define it may be preferable to determine this within a vertically
integrated company. This problem arose with railways where complex contracts and
penalties between train operating companies, rolling stock companies and Railtrack had
to be devised when British Rail was vertically separated. Difficulties in determining
appropriate compensation to train operating companies for delays caused by an
extensive emergency maintenance programme in 2000“1 indicated that many of these
contractual relationships had not been resolved satisfactorily at privatization. Where new
entry results in imperfect competition in a market with a monopolized input, continued
regulation of the upstream industry is required to prevent double marginalization, and
regulation of the new entrants may be needed if they possess significant market power.
Such a partial regulatory/competitive state is currently that of the United Kingdom's
network industries and this interaction of competition and regulation has attracted an
increasing literature to which we return in section 4. Section 3 traces the development of
incentive regulation.

[1]
See Sherman (1989, chapter 8), for a detailed discussion of these criticisms.

[2]
For empirical evidence of the AJ model hypothesis, Courville (1974) finds that for all 110
rate of return regulated plants analyzed, the ratio of input prices exceeds the ratio of marginal
products as the AJ model suggests. He finds that costs are up to 40 percent higher than the
minimum efficient level, with the average being 11.6 percent higher. See also Petersen (1975)
and Jones (1983) for other studies confirming the general bias result.

[3]
The possibility that the government's attitude to industry profits changes post-privatization is
considered in section 3.

[4]
The problem of completely specifying a contract is discussed in more detail at the end of
sub-section 3.2.
3 Development of incentive contracts
3.1 Incentive contracts and introduction of price caps

Incentive regulation contracts were largely developed to meet the criticism of rate of
return regulation described above. Because of information asymmetry the regulator
needs to incentivize the firm to produce at or close to the Ramsey“Boiteux optimum
without the necessity for the firm to reveal cost and demand information (which it may
not even have known completely itself as a nationalized industry subject to different
objectives and constraints). Where demand information is general knowledge but cost
information is known only to the firm, Armstrong, Cowan and Vickers (1995) show that
rebalancing prices away from a single uniform price will generally increase profits whilst
avoiding a reduction in consumer surplus. This model is similar to Ramsey“Boiteux
pricing with profit maximizing subject to a given level of consumer surplus instead of
maximizing consumer surplus subject to a given level of profit.
Although this method reduces the need for cost information, it still requires the consumer
surplus function and demands to be known within a static time framework. Where a
dynamic framework is considered, we assume that the firm's last-period cost and output
information can be learned at the start of the next period. Using this assumption,
Vogelsang and Finsinger (1979) propose a regulatory regime which relaxes the
requirement of current cost and demand information. However this is replaced by other
strong assumptions such as a myopic firm which will not engage in strategic behavior to
maximize future profits. The regulator constrains prices so that with period t prices, the
firm generates no more revenue, with prices weighted by output in period t 1, than that
period's total observed costs. Thus with one product, the current price must be lower
than the previous period's average cost. This produces a long-run stationary equilibrium
with firms making zero profit and charging Ramsey“Boiteux prices, but makes the
fundamental assumption that average costs are non-increasing over time; if this is not
true the regime may produce negative profits. Most importantly, Sappington (1980)
demonstrates that where the firm is not myopic it may indulge in wasteful expenditure in
early periods to ensure higher profits in later periods, although Hagerman (1990) shows
that with lump-sum transfers the wasteful expenditure can be reduced.

Price cap regulation, first introduced in 1982 for contraceptive sheaths (MMC 1992), is
similar to the Vogelsang“Finsinger mechanism as both deal with constraining price over
time. Price caps, like many innovations in regulation, were in place before full theoretical
analysis, which often developed later and produced mixed verdicts. The Littlechild
Report (1983) first proposed RPI-X, the British form of price cap regulation, for the
utilities. Under this regime the firm is allowed to charge any price so long as the average
price of the specified basket does not increase faster than RPI-X. RPI is the UK Retail
Price Index and X is some number set initially by government, and subsequently by the
regulator. At the end of the period, the level of X is reset until the next price review.
Unlike the Vogelsang“Finsinger mechanism, information on past costs is not required
within the price cap period, but is likely to influence the resetting of X. In the original
scheme devised for British Telecommunications (BT) the firm had to choose current
prices so that when weighted by the previous period's revenues, the total (hypothetical)
charge was no higher than the previous period's revenue. Vogelsang (1989) assessed
the price cap scheme based on a Laspeyres index but without the automatic tightening
of the constraint (as under the Vogelsang“Finsinger mechanism). He showed that a non-
myopic firm maximizing the discounted value of its profits subject to the tariff basket
constraint will set prices that satisfy the Ramsey condition.

Since its conception there have been many comparisons between this incentive-based
scheme and rate of return regulation, including Littlechild (1983), Vickers and Yarrow
(1988), and Waterson (1992). Essentially there are three perceived advantages. First,
RPI-X is less vulnerable to cost-plus inefficiency and over-capitalization, because the
firm retains any cost efficiencies it undertakes at least until the next review of X; secondly,
RPI-X allows the company greater flexibility to adjust the structure of prices within the
chosen basket; and lastly RPI-X is simpler and cheaper for the regulator and the
company to operate. However as incentive regulation developed, a number of issues
arose. We discuss these in turn.

3.2 Practical questions in incentive regulation of monopolies

The first is a time consistency problem for the government in determining X. We
discussed above the regulation of the firm in the principal“agent framework, and the
question of who is the principal. Before privatization the firm is owned by the government,
but at flotation, the government sells ownership of the firm to a diversity of shareholders.
After privatization the government is no longer a principal with direct interest in the firm's
financial performance and has more general interests for welfare, with implications for
the level of X at privatization and at the first price review. The initial level of X was set not
only to ensure consumer and producer welfare, but also to maximize the government's
revenue when it sold the company. By increasing producer welfare through lowering X,
the government could raise the striking price and its own revenue, but only before its
shares are sold. So a time consistency problem exists between the optimal initial level of
[5]
X when the government is the owner, and the best level of X at subsequent reviews.
Littlechild (1983) does not acknowledge this time inconsistency problem when he rates
RPI-X as being both the best for "proceeds and prospects from privatisation" and for
"consumers' welfare".

In practice, X must be repeatedly reset to ensure that prices do not deviate too far from
costs, creating allocative inefficiencies and welfare loss. Vickers and Yarrow (1988, p. 97)
argue that resetting X on the basis of a fair rate of return will in practice ensure that "RPI-
X is simply another form of rate of return regulation". In his original proposals in 1983,
Littlechild made clear his beliefs on the longevity of explicit regulation (1983, p. 1):
"Competition is by far the most effective means of protection against monopoly.
Vigilance against anti-competitive practices is also important. Profit regulation is merely a
˜stop-gap™ until sufficient competition develops." It is clear that he did not envisage that
aspects of telecommunications would still be regulated seventeen years after
privatization (constraints on retail prices were extended for a further year in 2001).
Waterson (1992) makes the point that while RPI-X incentive regulation is not the zero-
cost option it was once thought to be, the regulatory burden of all the regulators is still
less than the smallest of monopoly welfare loss predictions. He estimated that the
incentive regulation burden was less than one-half the regulatory burden of the US rate
of return.

However in recent years the regulators' budgets have increased, largely because of the
degree of accounting knowledge required to recalculate the price cap, while initial caps
seem to have been snatched from thin air.[6] It is now common to see discussion moving
away from the general form of incentive contract, and centering more on detailed
arguments such as what types of accounting, productivity measure, and forecasting
[7]
determines the initial prices. The price reviews of water and electricity in the United
Kingdom show that these financial forecasts are often the pivotal aspects in determining
the level of price.

Sappington (1994) makes the point that much of the underlying regulatory contract
literature assumes that the firm may be able to control the level and quality of output
through effort; however, where there is no correlation between output and effort incentive
regulation will be ineffectual. Where performance is stochastic in its outcome,
incentivizing this structure is likely to create uncertainty for the firm. This lack of certainty
increases the cost of capital and reduces the level of investment away from the efficient
rate, which in the long run may lead to higher prices and welfare loss.

One suggested way of mitigating this is to link rewards and penalties to average
performance across other firms within the industry. Where the firm performs below the
target, but proportionately better than other firms within the same industry it may well be
due to exogenous factors and hence would not attract a penalty. The creation of this
penalty "dead zone" maintains the incentive to perform but reduces the uncertainty
derived from the contract. However care must be taken that only risks beyond the control
of the firms are linked in this way, as weakening a direct link between effort and outcome
will result in dampening the incentive structure. Such links between the firm's
performance contract and industry performance are an example of yardstick competition,
which has been increasingly used in both the United Kingdom (especially for water,
sewerage and electricity regulation) and the United States.[8]

One means to reduce uncertainty in variables beyond the firm's control is to allow some
form of cost pass-through. In its most basic form this is reflected in the basic RPI-X
formula for BT where inflationary costs may be passed on; other industries' regimes
have adopted some form of explicit cost pass-through. Where complete pass-through is
permitted (that is, the firm is regulated at price equals cost) the firm will make no profit
and allocative efficiency is satisfied; this is essentially cost of service regulation,
providing no incentive for cost reduction and resulting in cost of service regulation and
production inefficiency. Armstrong, Cowan and Vickers (1994) show that the optimal
level of pass-through depends upon the firm's level of risk aversion and the extent of
uncertainty. If the firm is risk neutral or there is no uncertainty, a pure price cap is optimal,
while the optimum degree of cost pass-through increases if the firm is risk averse or
there is uncertainty in costs. The cost pass-through enables the firm to share risk with
consumers, but provides incentives to substitute costs away from those which are fully
within the cap to those which can be passed on. Examples are the initial (1986“91) cap
for gas where gas purchase costs could be passed on, and upstream costs for electricity
supply. More generally it is important to note than any cost pass-through element,
particularly RPI or input costs, should be entirely exogenous to avoid any possibility of
strategic behavior.
There are alternatives to incentive regulation which have been implemented in various
degrees. Instead of encouraging competition within the market some form of competition
for the market can be devised. In such a system firms bid for the right to supply (usually
for a fixed period); the government aims to extract the expected rent from market power
through the franchise fee. The United Kingdom has introduced a form of franchising
through auctions in railways, a similar procedure to that in France for the allocation of
rights to service water. The literature on auctions is extensive and is only briefly
described here; a more thorough treatment of auctions in the framework of regulation
can be found in Laffont and Tirole (1993). The idea of franchising is old, contemplated by
Demsetz in 1968 and developed formally by Riordan and Sappington (1987). Most
franchising models are subject to the criticisms made by Williamson (1976): difficulties in
complete and simple specification, effective competition for first and subsequent auctions,
and ensuring that where the old firm is displaced, it receives proper compensation for
transferable investments it has made. In reality franchising often goes hand in hand with
developing competition, although its success has arguably been limited.

In contestable markets, where there are low sunk costs and a lag between entry and
price response, the monopoly is forced to price at the competitive level to prevent entry.
If the monopoly increases price above this level, entry can occur with the entrant taking
all the market share and making a profit. The criticisms of this theory are well known and
there are many convincing arguments that such a market is seldom found in reality.
However it does provide an interesting insight into the link between market structure and
the level of entry. Where sunk costs are high, as in most utilities, competitive entry is
neither possible nor desirable, but if it is possible to separate the natural monopoly from
the operation of the utility then partial competition can be encouraged, as we have
discussed above.

3.3 Strategic behavior by firm and regulator

As incentive regulation has developed in the United Kingdom, there has been a parallel
debate in the United States on introducing an explicit institutionalized regulatory lag
rather than maintaining the endogenously determined lag. In the United Kingdom the
price cap review, while allowing the consumer to benefit from realigning prices to cost,
provides scope for the firm to engage in strategic behavior much like Sappington's (1980)
"ratchet effect" criticism of the Vogelsang“Finsinger mechanism. Immediately after the
review the incentives for cost reduction are high. As the time before the next review
shortens, the firm's investment and cost decisions will increasingly depend upon the
benefit that manipulating the next price review entails. At some point before the review
period, the immediate gain for the firm from reducing its costs is outweighed by the loss
incurred through their effect in triggering lower prices after the next review. This results in
incentives to reduce effort or increase costs. Hence when looking at the profile of effort
over time, it takes the same ratchet structure as Sappington showed with output under
the Vogelsang“ Finsinger mechanism. Armstrong, Rees and Vickers (1995) explore a
simplified version of such a trade-off in which both regulator and firm have the same
information. They confirm that the firm's effort to reduce costs decreases as the review
approaches. Additionally, as demand elasticity falls and costs become more sensitive to
the effort to reduce them, the regulator may improve welfare through increasing the time
period between regulatory reviews. A valuable extension to this model would include
asymmetry of information, inducing strategic behavior by the firm in an attempt to signal
that it is a high-cost type.

Initial discussion of this type of behavior by Sappington (1994) shows that where firms
differ in ability between high- and low-cost types in a one-period game, the firm should
be allowed to choose between two contracts designed to reveal their ability type. When
the game is extended to multiple periods the firm might choose the steeper reward
schedule in the first period and then reduce expenditure (costs). In the second period it
will choose the flatter reward schedule, undertaking excessive expenditure (costs) to
make up for the lower effort in the first period. The strategic shifting of costs allows the
firm to make a large profit in the first period and incur only a small penalty in the second
period. This results in strategic cycling of effort/costs, potentially reflected in output
quality, to manipulate the contract and raise profits. There is some evidence of such a
cyclical pattern in investment expenditure which is delayed until immediately before the
next review (for example in the UK water industry). BT provided evidence of similar
behavior immediately prior to their first review. Having rebalanced prices in every year
since privatization, they declined to do so in 1987, despite an opportunity to raise prices
within the cap (Bradley and Price 1988b). One interpretation of their behavior is that such
rebalancing gave the regulator "too much" information on potential profits, in this case
through prices rather than costs. Although both price caps and rate of return regulation
suffer from the possibility of manipulation, price caps may be a better means of
regulation owing to the exogeneity of the regulatory lag (as opposed to endogenously
determined reviews within the US system).

Firms may have incentives to manipulate prices across markets as well as over time.
This poses the significant question as to whether welfare is actually enhanced under
price cap regulation even in a static model. Bradley and Price (1988a) first address this
question in their study of an average revenue regulated monopolist such as that applied
to many of the UK industries. In this case the prices are weighted by current demand,
rather than previous consumption or revenue levels, and the firm is induced to restrict
supply to the higher-cost markets (through raising price) and expand supply in the lower-
cost markets (through lowering price). This results in incentives to charge prices in some
markets that may be higher than those charged by an unconstrained monopolist.
(However analysis of the initial years of price caps applied to UK regulated industries
showed that they were much more responsive to informal regulatory guidance than to
the incentives contained within the formal price caps themselves, Giulietti and Waddams
Price 2000.) Armstrong and Vickers (1991) compare the welfare results of allowing price
discrimination with that of uniform pricing under an average revenue constraint. They find
that the welfare result depends upon the tightness of the price constraint, with some
degree of price discrimination being optimal as the constraint is relaxed.

Sappington and Sibley (1992) show that for an average revenue lagged tariff, the
strategic incentive to manipulate prices through a non-linear tariff may result in loss of
welfare even though a linear tariff may enhance welfare. Armstrong, Cowan and Vickers
(1995) strengthen this result by showing that the optimal non-linear tariff is distorted and
other types of regulatory constraint may be preferable to a tight average revenue
constraint. Law (1995) returns to differing costs and shows that a tightening of a price
cap can lower aggregate consumer surplus, confirming Bradley and Price's (1988a)
result that tighter regulation induces the firm to reduce the number of high-cost
consumers by raising the price in this market and lowering the price in the low-cost
market. Cowan (1997a) confirms that total welfare may fall as a result of an average
revenue cap that is "too tight".

Crew and Kleindorfer (1996) consider a total revenue constraint as applied to UK
regional electricity companies. They show that the revenue cap has a much larger

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