Infrastructure Investment in Network Industries: The Role of Incentive Regulation and Regulatory Independence



associated with a significant increase in investment. This result highlights the importance of the
overall coherence of the general regulatory environment in supporting investment incentives.
Furthermore, the cross-sectional empirical analysis suggests that lower entry barriers encourage
investment in the network industries, confirming earlier panel data results by Alesina
et al.
(2005).

The outline of the paper is the following. Section 2 reviews the theoretical arguments with regard
to the relation between the regulatory framework and investment in network industries. Section 3
provides an overview of the empirical literature. Sections 4 and 5 discuss the methodology and
data. Finally, Section 6 presents the results.

2. Investment behaviour under different regulatory regimes

It is well-known that an unregulated monopoly tends to produce lower quantities and charge
higher prices than would be required by welfare maximisation. This may imply that the
monopolist under-invests in network capacity relative to the social optimum. Furthermore, the
monopolist will invest later than is socially optimal because it compares the costs related to its
investment only with producer surplus and fully ignores consumers’ surplus.

One way of raising social welfare is to introduce competition in network industries that are
dominated by a monopolist.2 However, parts of the vertically-integrated network industries
remain natural monopolies and will remain dominated by a single firm because of large fixed
costs and economies of scale or scope relative to demand. But even if competition can be
introduced in other parts of the industry, the state may want to maintain regulation if market
power persists resulting from too few market participants and the small market share of new
entrants, especially in the initial stages of liberalisation. Furthermore, when competition is not
feasible, appropriate regulatory frameworks can, nonetheless, simulate a competitive
environment. The question is, therefore, to what extent these different regulatory regimes
influence investment incentives.

Differences in price regulation have often been seen as particularly important in determining
investment incentives. While cost-based or rate-of-return regulation is generally thought to bring
about over-investment (Averch and Johnson, 1962), incentive price regulation is often considered

2.        Liberalisation and competition can bring large efficiency gains in industries with lower

economies of scale and scope ( such as telecommunications) but efficiency gains may be more
limited in the presence of large economies of scope (like in the railway sector) (Newbery, 2003
and Pittman, 2005).



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