Bargaining for Interconnection in a Light-Handed Regulatory Regime Simon Wakeman 1 June 23, 2003 This paper examines a firm’s integrated market and non-market strategy. The scenario studied here is based on the New Zealand telecommunications market in the 1990s, where the ‘light-handed’ regulatory regime aimed to encourage commercial outcomes but leave open the option of prescriptive regulation if commercial negotiation fails. The paper presents a model of two firms operating under such a regime, where each has the choice whether to bargain for an interconnection agreement with its competitor or to lobby the regulator to set the terms of interconnection. The model predicts that firms will choose to bargain when the potential gain in profits from cooperation is small, but lobby when the potential gain is large. When the benefits from lobbying are asymmetric there is an equilibrium where the firm with higher benefits lobbies while the other firm bargains. 1 Introduction The public interest theory of regulation, stemming from Pigou (1938) and oth- ers, holds that "regulation is imposed by a government to correct market fail- ures in order to benefit consumers and enhance social welfare" (Priest, 1993, p289). This theory was challenged by Stigler (1971) who proposed that reg- ulation is supplied in response to the demands of interest groups attempting to maximize the incomes of their members. Since Stigler’s seminal article, this economic theory of regulation has developed into a productive field of research, variously known as the "economic theory of regulation", "interest group the- ory", or "positive political theory", that has been well supported by empirical evidence (see Peltzman, 1989). However, the focus of much of this literature (for instance, Weingast & Marshall (1988) and Krehbiel (1991)) has been on the machinations of government and how these are vulnerable to capture by firms. The non-market strategy literature, such as Baron (2001), exploits this understanding of government by explaining how interest groups influence reg- ulation. However, there appears to be little attention to how a firm combines its non-market strategy with its ‘market’ or ‘competitive’ strategy (as defined by Porter (1980) and others) in order to improve overall economic performance. (An exception is Baron (1995), which sets out informally how a firm can benefit from an integrated market and non-market strategy, and provides several case studies.) In this paper I analyze a firm’s choice between market and non-market in- struments to attain its economic goals. Using a simple game theoretic model, I study how firms use their ability to influence regulation to affect the threat 1 I wish to thank Peter Coughlan, Pablo Spiller, Emerson Tiller, Julian Wright, and partic- ipants in the Management Strategy in Business Environment Conference at Harvard Business School for their helpful comments and suggestions on earlier drafts of this paper. 1