SUCCESSIVE MONOPOLIES AND REGULATION IN A SPATIAL MODEL* by JOHN S. HEYWOOD University of Wisconsin-Milwaukee and University of Birmingham and DEBASHIS PAL † University of Cincinnati A government authority regulates an upstream monopolist only if there is a sufficient welfare increase to justify doing so. A downstream firm strategically increases costs in order to force regulation upstream. The decision to regulate increases profit downstream, reduces profit upstream and reduces welfare relative to a model with no possibility for welfare- enhancing regulation. 1 I  Recent policy initiatives make clear that regulation may apply to only one stage of a vertical stream. Deregulation in North America and privatization in Europe has often left a regulated monopoly at one stage of production while removing regulation at another. 1 For example, in Canada the produc- tion of natural gas is now deregulated, although the distribution of natural gas is not. 2 Similarly, the original break-up of AT&T deregulated long- distance service while local operating companies remained regulated. The economic literature on partial regulation has often focused on the welfare consequences of allowing a regulated upstream monopolist to operate downstream. Vickers (1995) presents a tradeoff between the incen- tive for the integrated firm to raise the costs of downstream rivals and the resulting reduction in downstream firms which reduces duplication of fixed costs. Lee and Hamilton (1999) consider a regulated upstream monopolist and a regulatory agency that can impose one of a variety of downstream market structures. They derive the optimal contracts to offer the monopolist under each market structure and show that the ability to set the downstream structure can limit the rent extraction of the upstream firm. The issue of © Blackwell Publishing Ltd and The Victoria University of Manchester, 2004. Published by Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK, and 350 Main Street, Malden, MA 02148, USA. 167 The Manchester School Vol 72 No. 2 March 2004 1463–6786 167–178 *Manuscript received 28.1.03; final version received 26.6.03. † The authors thank Avik Chakrabarti and seminar participants at the University of Wisconsin- Milwaukee for helpful comments on a previous draft. 1 See Armstrong et al. (1994) for a review of the British experience with privatization and regu- latory reform. 2 Canada is not alone as the World Bank identifies a worldwide trend toward substantially more deregulation of the production of natural gas than of its distribution (World Bank, 1999).