Description

We study the optimal regulation of an upstream monopoly in a vertical market, such as transportation infrastructure, where the regulator can only contract with the upstream firm (a setup we call delegation). In our model, the upstream firm has private informa-tion on investment costs, and the downstream firm has private information on demand. We compare outcomes under delegation to a centralized benchmark where the regulator contracts directly with both firms. Theoretically, we show that delegation can replicate the centralized outcome only under restrictive conditions, implying it generally entails a welfare loss. We therefore analyze a practical alternative: a simple linear contract providing a per-unit subsidy to the upstream firm based on downstream output. Our main finding is that this linear contract is remarkably effective. We demonstrate that its performance improves with market size and then quantify the welfare loss by cal-ibrating our model to the San Francisco Bay Area airport market. The results show a welfare loss (regret) from this simple contract of around 2% compared to the cen-tralized ideal, while a policy without a subsidy yields a regret of 27-33%. Our analysis suggests that a simple subsidy is a powerful tool for regulating vertical markets under asymmetric information.