INFORMATION

ECONOMICS
AND POLICY
Information Economics and Policy 17 (2005) 231–246
www.elsevier.com/locate/econbase

Price cap regulation in the Mexican

telephone industry
Daniel Flores
Facultad de Economı́a, Universidad Autónoma de Nuevo León, Loma Redonda 1515 Pte., Col. Loma
Larga, 64710 Monterrey, México

Received 1 January 2001; received in revised form 18 May 2004; accepted 3 June 2004
Available online 23 August 2004

Abstract

This paper presents a model to analyze price cap regulation of the Mexican telephone
industry. There is a vertically integrated firm that is a monopolist in the local service market
and a duopolist in the long-distance service market. A regulator sets the access price and a
price cap on the basket of final services provided by the integrated firm. We show that this type
of price cap can increase the profits of this firm in the downstream market. Moreover, this con-
straint can actually increase its overall profits and reduce the profits of the downstream rival.
Ó 2004 Elsevier B.V. All rights reserved.

JEL classification: D42; D43; L51

Keywords: Access; Price cap regulation; Telecommunications

1. Introduction

The Mexican telephone industry was privatized and opened to competition during
the nineties. At the beginning of the decade, regulation was established to privatize
the state-owned company Teléfonos de México (TELMEX). After privatization,
TELMEX remained as the sole provider of local and long-distance telephone

E-mail addresses: danflore@ccr.dsi.uanl.mx, danflore_mx@yahoo.com.mx.

0167-6245/$ - see front matter Ó 2004 Elsevier B.V. All rights reserved.
doi:10.1016/j.infoecopol.2004.06.002
232 D. Flores / Information Economics and Policy 17 (2005) 231–246

services for several years. This was part of an agreement where TELMEX was
granted a temporal monopoly in exchange for the compromise to expand and im-
prove the local telephone network. 1 However, the monopoly in the long-distance
market ended in 1997 when other firms were allowed to enter the market and com-
pete with TELMEXÕs long-distance service subsidiary.
The basic problem in the Mexican telephone industry, since the moment long-dis-
tance service was opened to competition, has been to regulate a firm that owns the
local telephone network and competes with other firms in the long-distance market.
Since the local network is essential to produce long-distance service, there is concern
on the incentive that TELMEX has to provide itself competitive advantage in the
downstream market.
When competition was introduced, the regulatory framework for TELMEX in-
cluded a combination of an access price, a price cap and price floors. A national reg-
ulator (Comisión Federal de Telecomunicaciones or COFETEL) was in charge of
setting the price at which TELMEX provides access to its downstream rivals; 2
the maximum price for a basket of services that TELMEX provides to final consum-
ers, including local and long-distance telephone services; and minimum prices for
each of the services in the basket based on long run incremental costs. 3
TELMEXÕs downstream competitors complained about the regulatory frame-
work, arguing that it was designed to favor TELMEX. By September 2000, after
a long legal process, COFETEL issued additional regulation for TELMEX in an at-
tempt to foster downstream competition. Among other things, COFETEL estab-
lished a new criterion for calculating price floors for national and international
long-distance services. The new regulation stated that the weighted average price
of national (international) long-distance services should not be lower than its total
average cost, including the cost of capital. Apparently, price floors calculated on
TELMEXÕs long run incremental cost were not high enough to prevent a price
squeeze.
It is easy to understand that the access price generates a conflict between access
seekers and TELMEX. Also, that price floors are useful to avoid predation. 4 But
other aspects of the regulation are difficult to understand. For examples, the effects
of a price cap, like the one faced by TELMEX, when there is imperfect competition
in the downstream market. Torre (2000) claims that the price cap is an important
flaw in the Mexican regulatory framework because it harms TELMEXÕs downstream
competitors. However, there is no formal analysis to support this statement.

1
A similar privatization process took place in Argentina. However, the market for local telephone
service was divided in two parts, each licensed to a different firm for a period of 7 years. See Baumol and
Beker (1998) for an analysis on the privatization of telephone industry in Argentina.
2
Before this regulation was established, TELMEX and access seekers had the opportunity to negotiate
the terms of access. However, negotiations were not successful and COFETEL ended up determining the
terms of access. See King and Maddock (1999) for a study of access based on negotiation.
3
See Weisman (2002) for an explanation on price floors or imputation constraints.
4
See Sappington and Weisman (1996).
 D. Flores / Information Economics and Policy 17 (2005) 231–246 233

This paper uses a Cournot model to analyze the effects of price cap regulation in
the Mexican telephone industry. TELMEX will be represented by a vertically inte-
grated firm. This firm is a monopolist in the upstream market and a duopolist in
the downstream market. We find that a small decrease of the price cap can increase
the profits of this firm in the downstream market. Moreover, it can actually in-
crease the overall profits of this firm and reduce the profits of its downstream
competitor.
This paper differs from most of the literature on the regulation of telephone indus-
try in several ways. The main difference is that most of the literature studies optimal
access price design but this paper will examine the effects of access price changes or
price cap changes on firmsÕ profits. The motivation for this approach is to identify
potential ways in which a regulator can use common regulatory tools, such as the
access price or the price cap, to benefit a vertically integrated firm. The main results
of the paper can be related to the works of Economides (1998), King and Maddock
(1999) and Mandy (2000) on sabotage; similarly, to the work of Bulow et al. (1985)
on the behavior of multi-market oligopolies.
The remaining of the paper is organized as follows. Section 2 presents the basic
elements of the model. Section 3 considers a benchmark setting with no price cap
to analyze whether a vertically integrated firm would increase the access price to ex-
clude its downstream rival from the market. Section 4 derives the main result of the
paper regarding the effects of a price cap reduction on firmsÕ profits. Section 5 illus-
trates this result with a numerical example. Section 6 summarizes the results of the
paper.

2. The model

There is a vertically integrated firm, hereinafter called the operator, that provides
local and long-distance telephone services. There is also a firm called the rival. This
firm requires access to the local network of the operator in order to provide long-
distance service. Assume that consumers regard local and long-distance services as
independent goods. In particular, suppose that inverse market demand for local
telephone service is

pl ðql Þ ¼ max f0; al
bl  ql g; ð1Þ

where ql denotes the output of the operator. Similarly, that inverse market demand
for long-distance telephone service is

pðqo þ qr Þ ¼ max f0; a
b  ðqo þ qr Þg; ð2Þ

where qo and qr represent the output of the operator and the rival, respectively.
The cost structure is shown in Fig. 1. For simplicity, we ignore fixed costs and as-
sume that each unit of long-distance service requires a unit of local service. The oper-
ator provides local telephone service at constant marginal cost cl and long-distance
234 D. Flores / Information Economics and Policy 17 (2005) 231–246

Local network External network

cl
co
Operator

w cl
cr
Rival

Fig. 1. The cost structure.

service at cl + co. The rival provides long-distance service at constant marginal cost
w + cr, 5 where w is the regulated access price. Note that the operator receives w
cl
as net payment for each unit of long-distance service that its rival sells.
We model competition in the downstream market as a Cournot game where firms
choose output levels simultaneously. Each firm takes its output to the market and
sells it at the market-clearing price. It is beyond the scope of this paper to determine
whether a Bertrand or Cournot framework is more appropriate to model imperfect
competition in the telephone industry. Some authors like Lewis and Sappington
(1999) model downstream competition as a Bertrand game with differentiated prod-
ucts, others like Weisman and Kang (2001) or Mandy (2000) follow Economides
(1998) by considering a Cournot game instead. It is not difficult to argue in favor
of either model. For instance, we recognize in favor of BertrandÕs model that firms
choosing prices seems a more natural assumption than firms choosing output levels.
However, it also seems natural to assume that firms providing long-distance tele-
phone services produce perfect substitutes. If this is the case, CournotÕs model yields
a more convincing result than BertrandÕs. 6
In addition to the access price, a national regulator determines the maximum
price,
p, for a basket of services that the operator provides to final consumers. As-
sume for simplicity that this basket contains one unit of local service and one unit
of long-distance service. 7 In the context of this model, the constraint on prices im-
plies that the operator has to choose ql and qo to keep the sum of its corresponding
prices below certain value (i.e., pl ðql Þ þ pðqo þ qr Þ 6
p).
Let po and pr denote profits of the operator and the rival, respectively. The oper-
ator chooses ql and qo to maximize
po ¼ ½pl ðql Þ
cl ql þ ½pðqo þ qr Þ
cl
co qo þ ðw
cl Þqr ð3Þ
subject to pl ðql Þ þ pðqo þ qr Þ 6
p, while the rival chooses qr to maximize

5
Similar cost structure is adopted in Laffont and Tirole (1996) and Lewis and Sappington (1999).
6
Kreps and Scheinkman (1983) show that Cournot outcome can arise in a two-stage game where firms
first choose production capacities and then compete in prices. This can be used as an argument to favor the
use of CournotÕs model.
7
For an analysis of different price cap regulation plans see Sappington and Weisman (1996) or Laffont
and Tirole (1996).
 D. Flores / Information Economics and Policy 17 (2005) 231–246 235

pr ¼ ½pðqo þ qr Þ
w
cr qr : ð4Þ

3. Benchmark setting with no price cap

In this section, we consider a benchmark setting where the integrated firm faces
either no price cap regulation or a non-binding price cap. If this occurs, the operator
can choose ql and qo independently. The optimal local service output is
al
c l
ql ðcl Þ ¼ : ð5Þ
2bl
The optimal long-distance service output for each firm depends on the choice of
its competitor. Simple calculations lead to the reaction functions:
a
bqr
cl
co
qo ðqr ; cl ; co Þ ¼ ; ð6Þ
2b
and
a
bqo
w
cr
qr ðqo ; w; cr Þ ¼ : ð7Þ
2b
The Nash equilibrium is a pair (qo, qr) that solves (6) and (7) simultaneously, that
is
a þ w þ c r
2ð c l þ c o Þ
qo ðw; cr ; cl ; co Þ ¼ ; ð8Þ
3b
and
a þ cl þ co
2ðw þ cr Þ
qr ðw; cr ; cl ; co Þ ¼ : ð9Þ
3b
Some implications of this benchmark model are obvious from Eqs. (8) and (9).
For example, a higher (lower, respectively) access price allows the operator (rival,
respectively) to increase its share of total output in the long-distance market. In addi-
tion, it reduces (increases, respectively) total output. It is straightforward to deter-
mine the effect of a change in total output on the price of long-distance service.
Proposition 1. A decrease in the access price lowers the price of long-distance service
but has no effect on the price of local service (assuming the price cap is not binding
before and after the change in the access price).
Proof. Eqs. (8) and (9) imply that total long-distance output increases. Thus Eq. (2)
implies a lower price. It follows from Eqs. (1) and (5) that the optimal price for local
service does not depend on the access price. h
The intuition behind the first part of the result is simple, a change in the access
price is equivalent to a change in the marginal cost of the rival. Thus, a reduction
in the rivalÕs marginal cost leads to an increase in total output and consequently to
a lower price. The second part of the result, that a change in the access price has
no effect on the price of local service, is not difficult to understand. A multiproduct
236 D. Flores / Information Economics and Policy 17 (2005) 231–246

firm alters the price it charges in one market in response to a shock in other market
when there is market interdependence. There are three ways in which markets could
be interdependent: demand interdependence, cost interdependence and a composite
binding price cap. 8 None of these alternatives takes place in the model so far.
Several issues can be addressed with this model before considering a binding price
cap: among others, whether the integrated firm would maximize profits by setting an
access price that is high enough to exclude its competitor from the long-distance
market. 9 This can be an important issue, in spite of access price regulation, if there
is sufficient evidence to believe that regulatory capture is taking place. A similar con-
cern arises when an upstream monopolist is able to increase the marginal cost of its
downstream rivals, presumably through quality degradation. In this context, Econo-
mides (1998) claims that regardless of the relative efficiency of competitors with re-
spect to its downstream subsidiary, the monopolist has an incentive to increase the
cost of its competitors until they are driven out of the market. 10
In the current model, the relative efficiency of the operator and the rival in the
production of long-distance service is crucial to determine whether the vertically inte-
grated firm has an incentive to exclude its rival from the market.
Proposition 2. Let ŵ be the minimum access price that drives the rival out of the
market. 11If the operator is allowed to set the access price, w, then it would choose:

(i) cl < w < ŵ, not excluding its rival from the market, if the rival is relatively more
efficient in the production of long-distance service (i.e, cr < co),
(ii) w P ŵ, excluding its rival from the market, if the rival is relatively less efficient in
the production of long-distance service (i.e., cr P co).

Proof. Consider the derivative of the operatorÕs profits with respect to the access
price. It follows from the envelope theorem that
dpo 2qo 2
¼ þ qr
ðw
cl Þ: ðÞ
dw 3 3b
It is not difficult to see that the derivative is positive for any w 6 cl and that the prof-
it function po(w) is concave (i.e., p00o ðwÞ ¼
10=9b) as long as qo > 0 and qr > 0.
Thus, the operator will always choose w > cl. Note also that increasing the access
price is inconsequential once the access price is high enough to drive the rival out

8
Bulow et al. consider demand or cost interdependence to explain that a shock in one market may
affect the profits of a multimarket firm by influencing rivalsÕ strategies in a second market.
9
For instance, ‘‘If the network operator is also a supplier of final products, there is the obvious danger
that this integrated firm will seek to exclude competing final product suppliers by setting high access prices,
thereby raising rivalÕs cost’’ (Armstrong et al. (1996, p. 131)).
10
Other authors use similar models to explain that this claim is not generally true. For instance, Mandy
(2000) says that the incentive to non-price discriminate is theoretically ambiguous but likely to occur
according to US telecommunications industry data, while Weisman and Kang (2001) find that large
efficiency superiority of downstream rivals is required to eliminate the incentives of the monopolist to non-
price discriminate.
11
It is not difficult to find that qr ¼ 0 implies w^  aþc2l þco
cr .
 D. Flores / Information Economics and Policy 17 (2005) 231–246 237

of the market, that is, w > ŵ is equivalent to w = ŵ). Thus, the problem of the oper-
ator can be simplified to the choice of w2(cl,ŵ].
Evaluate (*) at w = ŵ (remember that qr ¼ 0 in this case) and substitute Eq. (8) to
find

dpo  2q 2 2
 ¼ o
ðw
cl Þ ¼ ða þ cl
2co
2w þ cr Þ: ðÞ
dw w¼^w 3 3b 9b
^ ¼ aþc2l þco
cr it follows that
Since w

dpo  2
¼ ðcr
co Þ:
dw w¼^w 3b
The concavity of po(w) implies that the operator sets w < ŵ, not excluding its rival
from the market, if cr < co; similarly, that it sets w P ŵ, excluding its rival from
the market, if cr P co. h
In principle, it is not difficult to see that a higher access price does not necessarily
benefits the operator. This firm profits from three sources: local, long-distance and
access services. Profits from local service can be ignored because they do not depend
on the access price. Profits from long-distance service increase because a higher ac-
cess price raises the marginal cost of the rival. However, the effect on access profits is
ambiguous because the access price is higher but the rivalÕs output is lower. Thus, it
is possible that higher profits from the downstream market are not sufficient to com-
pensate lower profits from access services.
Why is relative efficiency crucial to determine whether the operator excludes its
downstream competitor? Consider an integrated firm that increases the access price
to the point where its competitor exits from the downstream market (i.e., w = ŵ). If
this is the case, the operator sets the monopoly price pm for long-distance service. 12
The surplus of this firm for each unit of long-distance service it sells is pm
co
cl.
However, by letting its rival produce long-distance service instead of its subsidiary at
the margin, the operator could make ŵ
cl. Since ŵ = pm
cr, it follows that
ŵ
cl = pm
cr
cl. In other words, the operator can use the access price to extract
all the surplus of its downstream rival at the margin. This surplus is higher than the
one the operator currently obtains if and only if the rival is relatively more efficient.
In spite of the similarity between access price and quality degradation as tools the
upstream monopolist can use to increase the rivalÕs cost, there is no conflict between
Proposition 2 in the current paper and the claim in Economides (1998). There is a
fundamental difference between the two variables in question. While the only effect
of quality degradation is to increase the rivalÕs marginal cost, a higher access price
has the additional effect of increasing the marginal profitability of access services.
Therefore, the upstream monopolist has less incentive to exclude its downstream riv-
al from the market by increasing the access price than by increasing its marginal cost
through quality degradation.

12
It is not difficult to find that pm ¼ aþc2l þco .
238 D. Flores / Information Economics and Policy 17 (2005) 231–246

4. Analysis of a setting with a binding price cap

A composite price cap can establish a link between two apparently unrelated mar-
kets. For instance, once the operator chooses output for the long-distance market,
the price cap and the choice of its rival automatically determine output in the other
market. That is,
pl ðql Þ þ pðqo þ qr Þ ¼ al
bl ql þ a
bðqo þ qr Þ ¼
p ð10Þ
implies:
al


p þ a
bð q o þ qr Þ
ql ð

p ; qo þ qr Þ ¼ : ð11Þ
bl
If the problem is defined in this manner, the equilibrium is a pair (qo, qr) such that
qo is an optimal response to qr, and vice versa. Since the rival is not subject to the
price cap, it still maximizes (4) and its reaction function is still (7). However, the
operatorÕs reaction function is now
ð2b þ bl Þða
bqr Þ þ bal
2b
p
cl ðbl
bÞ
co bl
qo ð qr ; c l ; c o ;

pÞ ¼ : ð12Þ
2bðb þ bl Þ
The Nash equilibrium is given by:
2bða þ w þ cr þ cl þ al Þ þ bl ða þ w þ cr
2co
2cl Þ
4b
p
qo ¼ ð13Þ
bð2b þ 3bl Þ
and
bl ða þ co þ cl
2w
2cr Þ
bðal þ cl þ 2w þ 2cr Þ þ 2b
p
qr ¼ ; ð14Þ
bð2b þ 3bl Þ
which can be used to find the equilibrium price of long-distance service
bl ða þ co þ cl þ w þ cr Þ
bðal þ cl Þ þ 2b
p
p ¼ ; ð15Þ
2b þ 3bl
the price of local service
bðal þ cl Þ
bl ða þ co þ cl þ w þ cr Þ þ 3bl
p
pl ¼ ð16Þ
2b þ 3bl
and finally, to calculate the equilibrium local service output
bðal
cl Þ þ bl ða þ co þ cl þ w þ cr þ 3al Þ
3bl
p
ql ¼ : ð17Þ
bl ð2b þ 3bl Þ
As mentioned before, the price cap links the two markets. Thus a shock in one of
the markets, for example a change in the access price, can affect the operatorÕs behav-
ior in the other market.
Proposition 3. A decrease in the access price generates a lower price for long-distance
service but a higher price for local service (assuming the price ceiling is binding before
and after the change in the access price).
 D. Flores / Information Economics and Policy 17 (2005) 231–246 239

Proof. Eq. (15) implies that the price for long-distance services decreases and Eq.
(16) that the price for local services increases. h
It is not difficult to provide an intuitive explanation of this result. When the price
cap is binding, the operator is forced to provide more output than the unconstrained
optimum in the local service market. Since a lower access price generates a lower
price for long-distance service, it allows the operator to reduce output in the local
service market and approach the unconstrained optimum.
The main point of this paper is to analyze the effect of a price cap on firmsÕ profits.
A constraint is usually considered a disadvantage for the firm and in most of the
cases it is. However, the opposite can occur in the context of an oligopoly model
due to the strategic effect. A firm can actually obtain higher profits when facing a
constraint because its rivalÕs strategy changes once it knows that the firm has to sat-
isfy the constraint. A similar argument is used to explain the counterintuitive result
in Bulow et al. where the total profits of an integrated firm are reduced when it re-
ceives a per unit subsidy in its monopoly market. In their example, market demands
are independent but the integrated firm has joint diseconomies of scope.
Before showing that a price cap can increase the overall profits of the incumbent,
it is useful to define B as the point where the price cap just binds and po ð
pÞ as the
maximized profits function of the incumbent under a binding price cap. 13 That is
al
B  13ða þ w þ cr þ co Þ þ 56cl þ ; ð18Þ
2
and
 
pÞ  pl ð

po ð
pÞ
cl ql ð

pÞ þ ½p ð
pÞ
cl
co qo ð
pÞ þ ðw
cl Þqr ð
pÞ; ð19Þ
Note that profits with and without the price cap are equal at the point where the
constraint just binds. In other words, we can obtain unconstrained maximized profits
by evaluating (19) at
p ¼ B. For the purpose of this analysis, imposing a price cap is
equivalent to reducing it from the point where it just binds.
The first step towards the main result of the paper is to establish the shape of the
maximized profit function under the constraint.
Proposition 4. The profit function of the incumbent under a binding price cap, po ð
pÞ, is
strictly concave.
Proof. Consider the first and second derivatives of po ð
pÞ with respect to
p. That is,
pÞ  
dpo ð
 oql ðp
Þ op ð

pÞ oq ð
pÞ op ð
pÞ
¼ p l ð

p Þ
cl þ ql ð

pÞ l þ ½p ð
pÞ
cl
co  o þ qo ð
pÞ
d

p o
p o

p o
p o
p
oqr ð
pÞ
þ ðw
cl Þ
o
p
and

13
In other words, B is the least upper bound of the set of binding price caps. It is not difficult to see that
p ¼ B makes (5), (8) and (9) equal to (17), (13) and (14), respectively.


240 D. Flores / Information Economics and Policy 17 (2005) 231–246

d2 po ð

pÞ    o2 ql ð
pÞ oql ð

pÞ opl ð
pÞ  o2 pl ð
pÞ opl ð
pÞ oql ð
pÞ
¼ p l ð

p Þ
c l þ þ q l ð

p Þ þ
d
p2 o
p2 o
p o
p o
p2 o
p o
p
o2 p  ð

pÞ op ðp
Þ oqo ð

pÞ o2 qo ð
pÞ
þ qo ð

pÞ þ þ ½p 
ð

p Þ
c l
c o 
o
p2 o

p o
p o
p2
oqo ð

pÞ op ðp
Þ o2 qr ð
pÞ
þ þ ðw
c l Þ ;
o
p o

p o
p2
respectively.
It follows from (13)–(17) that ql ; pl ; qo ; qr and p are linear functions of the
price cap. Thus the second derivative can be simplified to:
    
d2 po ð

pÞ pÞ opl ð

oql ð
pÞ oqo ð

pÞ op ð

pÞ
2 9 2co
¼ 2 þ ¼ þ
d
p2 o
p o
p o
p o
p 2b þ 3bl 2b þ 3bl b þ bl
< 0:

The second step is to establish the slope of the profit function at
p ¼ B. That is, at
the point where the price cap just binds.
Proposition 5. Suppose that the price cap is just binding at the current value of
p (i.e.,
p ¼ B). A small reduction of


p increases the operatorÕs profits if
2co + 2w
cl
cr
a < 0.
Proof. Eq. (19) can also be written as follows:
  

po ðql ð
pÞÞ ¼ pl ðql ð

p Þ þ qo ð
pÞÞ
cl ql ð

pÞ þ p qo ð
pÞ þ qr ð
pÞ
cl
co qo ð
pÞ
þ ðw
cl Þqr ð

pÞ:
Consider the derivative of this function with respect to p
,
   
dpo op oql op oqo
¼ pl
cl þ ql l þ p
cl
co þ qo
d

p oql o
p oqo o
p
 
 
op oqr
þ qo þ w
cl : ðÞ
oqr o

p
Since the price cap is just binding at p
¼ B, the envelope theorem implies that
   
dpo   op

oqr
 ¼ q o þ w
c l :
d

p p¼B

oq r o

p
Eq. (14) implies that the partial derivative of qr with respect to
p is positive. It fol-
lows from (2) and (8) that

dpo 
sign ¼ signð2co þ 2w
cl
cr
aÞ:

p 
p¼B
d

This proposition presents a necessary and sufficient condition for the operatorÕs
profits to increase when the price cap is lowered from the point where it just becomes
binding. It is important to note that this condition is likely to be satisfied because
marginal costs and the access price are usually low figures in comparison to a.
 D. Flores / Information Economics and Policy 17 (2005) 231–246 241

The implications of Propositions 4 and 5 can be explained with the aid of Fig. 2.
The solid curve represents the maximized profit function of the incumbent under a
binding price cap. If the condition in Proposition 5 is satisfied, then the slope of
the profit function at
p ¼ B is negative. It follows that a price cap leads to higher
profits as long as A <
p < B.
An intuitive explanation of the result is provided in the following. In response to a
lower price cap the operator has to increase output levels in both the local and the
long-distance markets. However, for small enough output variations the direct effect
on the operatorÕs profits is negligible. In contrast, the indirect effect of a small change
in the rivalÕs behavior alters the operatorÕs profits significantly. An increase of the
operatorÕs long-distance service output causes a reduction of the rivalÕs marginal rev-
enues, thus induces the rival to reduce output. This small output decrease may be
enough to increase the operatorÕs profits.
The analysis above can also be explained in terms of reaction functions. The oper-
atorÕs optimal strategy as a function of the rivalÕs strategy, qo ðqr ;
p; cl ; co Þ, and the
rivalÕs optimal strategy as a function of the operatorÕs strategy, qr(qo, w, cr), are
shown in Fig. 3. The solid lines are firmsÕ reaction functions for an initial price
cap, p
0 , while the dotted line is the operatorÕs reaction function for a lower price
cap p
00 . The initial Nash equilibrium is at e 0 . Note that a lower price cap shifts out
the operatorÕs reaction function, making it more aggressive in the long-distance mar-
ket. That is, a lower price cap forces the operator to increase output in order to re-
duce the price and satisfy the constraint. Since higher operatorÕs output implies lower
marginal revenues for the rival, the optimal response of the rival is to reduce output.
At the new Nash equilibrium, e00 , the operatorÕs output has increased and its rivalÕs
output decreased. While a small increase in the operatorÕs output has almost no effect
on its profits (i.e., at the point where the constraint just becomes binding profit max-
imization implies opo/oq0 = 0), a small reduction in the rivalÕs output may strictly in-
crease or decrease the operatorÕs profits (i.e., opo/oqr 6¼ 0 ).
A reduction in the rivalÕs output, at the point where the price cap just becomes
binding, affects the operatorÕs profits in two ways. On the one hand, it has a positive

π o (p )

π o (p )
π o ( B)

p
A B

Fig. 2. Maximized profits under a binding price cap.

242 D. Flores / Information Economics and Policy 17 (2005) 231–246

qr

q o (q r , p , c l , c o )

e′
q r*( p ′)
e″ q r (q o , w , c r)
q r*(p ″)

* * qo
0 q o (p ′ ) q o ( p ″)

Fig. 3. Reaction functions.

indirect effect on long-distance service profits because it allows the operator to sell
the same output at a higher price. On the other hand, it has a negative direct effect
on access service profits. The condition in Proposition 5, that is, the sign of
2co + 2w
cl
cr
a, determines which of the two effects dominates.
If a price cap leads the operator to higher profits, then why canÕt the operator
impose it on itself? In principle, the operator can impose the price cap on itself by
claiming that it will produce more output. However, it is key for this strategy to
work that the rival believes the operator will actually do it. In a sense, the setting
is similar to one in which a Cournot duopolist, say firm A, claims that it will pro-
duce StackelbergÕs leader output instead of CournotÕs output. If the other duopol-
ist, say firm B, believes this is true, it would produce StackelbergÕs follower output
which is the best response to firmÕs A claimed behavior. It seems that just by mak-
ing this threat firm A can make higher profits at the expense of firm B. The prob-
lem is that firm B may not believe that firm A will produce StackelbergÕs leader
output. If firm A anticipates this, then it would rather produce CournotÕs output.
In other words, the threat is not credible unless firm A is able to convince firm B
that it is committed to produce StackelbergÕs leader output. In StackelbergÕs model,
the leader ‘‘convinces’’ the follower that it is committed to produce more than
CournotÕs output by doing it before the other firm is able to undertake any action.
In the current model, the commitment device is the regulatorÕs capacity to enforce
the constraint.

5. Numerical example

A numerical example can help to illustrate the result in Proposition 5. Suppose

that al = a = 100, bl = b = cl = 1, cr = co = 2 and w = 3. FirmsÕ long-distance service
output and the operatorÕs profits for different price caps are shown in Table 1.
The first value corresponding to the price cap (i.e., 86.5) is the point where the
restriction just becomes binding. That is, the operator would freely choose qo ¼ 33
 D. Flores / Information Economics and Policy 17 (2005) 231–246 243

Table 1
Production and benefits with a binding price cap
p

ql qo qr p0 L.D. Local Access
86.5 49.5 33 31 3601 1089 2450.25 62
85.5 50.1 33.8 30.6 3613 1102 2449.89 61.2
75.5 56.1 41.8 26.6 3655 1195 2406.69 53.2
65.5 62.1 49.8 22.6 3562 1225 2291.49 45.2
55.5 68.1 57.8 18.6 3332 1191 2104.29 37.2
45.5 74.1 65.8 14.6 2967 1092 1845.09 29.2

and ql ¼ 49:5, while its rival chooses qr ¼ 31. It is important to emphasize that the
operatorÕs profits in this scenario (i.e., p0 = 3601) are equivalent to the profits that
this firm would obtain in the absence of price cap regulation.
Note that the overall profits of the operator increase for a small initial reduction
in the price cap. In this sense, it can be said that for values of
p within a certain
range, price cap regulation can result in higher profits for the operator in comparison
to profits under no price cap regulation. The last three columns in Table 1 decom-
pose profits into three parts that correspond to long-distance, local and access serv-
ices. A lower price cap generates a minor decrease in profits from local and access
services but an increase in profits from long-distance service. However, if the price
cap continues to be lowered, profits from the three sources will eventually start
decreasing.
In order to illustrate the point, we can set the price cap at 75.5 and compare to the
situation where the price cap is not binding. When the price cap is 75.5, the incum-
bent chooses qo ¼ 41:8 and ql ¼ 56:1, while its rival chooses qr ¼ 26:6. The opera-
torÕs profits increases from 3601 to 3655. One could argue that the incumbent is
able to choose these quantities (i.e., qo ¼ 41:8 and ql ¼ 56:1) in the absence of the
price cap to increase profits. Why not doing it? Behaving as having a constraint is
not enough for the incumbent to increase profits. The rival needs to know that the
incumbent must meet the constraint and act accordingly. 14 Otherwise, the incum-
bent will be worse off.
The curve in Fig. 4 represents incumbent profits from local service. The initial
equilibrium given a non-binding price cap is at eo. It is clear that the incumbentÕs free
choice production (i.e., ql = 49.5) maximizes profits. However, when the price cap is
set at 75.5 the incumbent is forced to increase production. At the new equilibrium, e 0 ,
the incumbent produces more local service (i.e., ql = 56.1) than the optimum. Thus,
profits from this source are reduced.

14
Ross (2003) explains that: ‘‘. . .the Spanish conqueror Cortez, when landing in México with a small
force who had good reason to fear their capacity to repel attack from the far more numerous Aztecs,
removed the risk that his troops might think their way into a retreat by burning the ships on which they
landed. With retreat having thus been rendered physically impossible, the Spanish soldiers had no better
course of action but to stand and fight.’’ Later on Ross adds: ‘‘. . .from CortezÕs point of view, his action
had a discouraging effect on the motivation of Aztecs. He took care to burn the ships very visibly, so that
the Aztecs would be sure to see what he had done’’.
244 D. Flores / Information Economics and Policy 17 (2005) 231–246

3000

eo e′
2500

2000

$ 1500

1000

500

0
30
32
34
36
38

42
44
46
48
50
52

56
58
60
62
64
66

70
72
40

54

68
ql

Fig. 4. Incumbent profits from local service.

The two curves in Fig. 5 represent incumbent profits from long-distance service.
The lower curve corresponds to a rival that produces 31 units of long-distance serv-
ice. In other words, a rival who thinks that the price cap is not binding and assumes
that the incumbent will produce 33 units of long-distance service. The other curve
represents profits given that the rival produces 26.6 units. That is, assuming that
the rival thinks the incumbent produces 41.8 instead of 33 to satisfy the constraint.

1400
e′
1200

1000
eo e″
800
$
600

400

200

0
20
22
24
26
28
30
32
34
36
38
40
42
44
46
48
50
52
54
56
58
60
62

qo

Fig. 5. Incumbent profits from long-distance service.

 D. Flores / Information Economics and Policy 17 (2005) 231–246 245

Note again that at the initial equilibrium, eo, the operator maximizes profits from
long-distance service. When the price cap is impossed, the incumbent increases pro-
duction of long-distance service above the optimum to meet the constraint. How-
ever, the rivalÕs reaction shifts out the incumbentÕs long-distance profits function.
At the new equilibrium, e 0 , the incumbent profits are higher in spite it is not produc-
ing the unrestricted optimum. Note that profits would decrease, as in point e00 , if the
incumbent increases production but the rival does not think it will actually happen.

6. Conclusion

In this paper, we introduced a theoretical framework to analyze the effects of price

cap regulation in the telephone industry. We considered a vertically integrated firm
that is a monopolist in the local service market and a duopolist in the long-distance
service market. We showed that the vertically integrated firm can benefit from price
cap regulation. In particular, that price cap regulation can lead the firm to higher
overall profits and its downstream rival to lower profits. We also showed that the
relative efficiency of the integrated firm and its rival in the production of long-dis-
tance service is crucial to determine whether the vertically integrated firm has an
incentive to increase the access price and exclude its rival from the downstream
market.

Acknowledgements

I am grateful to the editors and anonymous referees for their valuable comments.
Also to Alba Hernández, Enrique Flores and Leo Torre for their help reading pre-
vious versions of this paper.

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