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External Markets and Regulation

James J. Anton and Paul Gertler

Journal of Public Economics 37: 243-260, 1988

Abstract: Regulated firms often sell to 'external' markets in addition to their regulated or 'internal' markets. The welfare of consumers in these 'external' markets is typically outside of the regulator's domain of concern. As a result, 'external' markets provide the regulator with additional policy options for the strategic influence of firm behavior in the presence of asymmetric information. Without an 'external' market, asymmetric information introduces an incentive cost and, consequently, the optimal policy is forced to distort 'internal' production below the first-best level. We show that profit opportunities presented by an 'external' market can be used to absorb some (all, when the firm is an 'external' price-taker) of the incentive cost, and thus insulate the 'internal' market from quantity distortions.