Regulating a Dominant Firm: Unknown Demand and Industry Structure

In this article, we study the optimal regulation of a dominant firm when an unregulated firm actively competes. Generally, the existence of an active rival imposes new and binding constraints on regulatory problems. We characterize optimal policies both when demands are known (complete information) and unknown (incomplete information) to the regulator. Optimal policies under complete information may set the price at the dominant firm above or below its marginal cost. Optimal policies under incomplete information may be either pooling or separating, constant over a range of the prior distribution of the firm's private information, and leave no information rent to the firm.