Regulating Bypass

This paper examines optimal regulatory response to a customer considering bypass: service from an unregulated, fringe supplier. Bypass is costly to a regulator concerned with the allocation of a franchise monopoly’s revenues among consumers. I analyze how a regulatory agency should respond to a bypass threat if the regulator is uncertain of the potential bypasser’s reservation price. Under mild regularity conditions, I derive an explicit bypass policy as a function of the regulator’s assessment of the potential bypasser’s willingness-to-pay, and prove the optimality of this policy given the regulators’ limited information. In contrast to existing literature, this paper demonstrates that is is not necessarily optimal for a regulator to distort prices from marginal costs to reduce information rents accruing to informed parties. In particular, an optimal bypass policy involves uniform marginal cost prices but third-degree price discrimination through fixed charges reflecting the likelihood of bypass. In addition, I demonstrate that even under an optimal policy there is an inefficiently high likelihood of bypass relative to a full-information environment. This policy is derived in a traditional rate-of-return regulatory context, allowing one to identify some remediable adverse consequences of current regulatory practice. Particular attention is given to the telecommunications and electric power industries.