Question

In deregulating capital-intensive industries, why might it be a sensible policy to limit investment in capacity by incumbent firms or require the dominant incumbent firm to divest assets?

Answer 1

First lets see what deregulation is. Deregulation means is the restriction or removal of government power and control in an industry. Usually the aim behind this move is to increase competition in the sector as it allows the firms to compete in a free market and arrive at a natural equilibrium.

It can be argued that deregulation is effective only when the market is not dominated by one player. Usually government makes a lot of regulations which limit monopoly. If a market is dominated by one single player and the government deregulates, it is likely that the monopoly of the dominant player will only increase. This is even more true in a capital intensive industry, as it requires very heavy investments which the rivals of the dominant player might not be able to compete on. The dominant player can increase capacity exponentially more than the rivals and drive them out of the market, If the government deregularizes. In this context, it is important that the government first makes a policy to limit the investment in capacity so as to not let it drive other firms out of the market post deregulation. If the incumbent is asked to divest assets, it will also make it less dominant and will result in the industry more suitable for deregulation.