How to Auction a Bottleneck Monopoly

In recent years a number of seaport facilities have been awarded in Demsetz auctions to the operator that bidding the lowest cargo-handling fee. A major concern is that the port operator may integrate into shipping and sabotage competitors, thereby rendering the competitive auction irrelevant. The standard policy recommendation to mitigate this problem, is to ban the seaport from operating in the shipping market. Yet such a prohibition may be useless if it can be circumvented by an (illegal) underhand agreement between the port operator and a shipper. In this paper we show that a ban on vertical integration, even when underhand agreements are possible, increases welfare if combined with a (sufficiently high) floor on the cargo-handling fee that operators can bid in the auction. In the absence of such a floor, however, a Demsetz auction is worse than having no regulation of the bottleneck monopoly. Our results apply beyond the port and shipping markets, to any monopoly bottleneck that can monopolize a downstream market. The results only require that profits with an underhand vertical agreement be lower than with legal vertical integration.