Efficient regulated entry in competitive markets with demand uncertainty

Abstract

It is well‐known that, in a competitive market, the numberof firms in a free‐entry equilibrium is the efficient one.This paper shows that this textbook result breaks down iffirms face demand uncertainty. In this case, entry isexcessive relative to the optimum and, therefore, regula-tion improves market efficiency. This occurs because, inthe absence of regulation, entry is motivated by the profitsthat firms expect to receive if market demand turns out tobe high. However, when choosing the optimal regulatedentry, the planner also considers that some surplus is lostif demand turns out to be low.