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Price Cap Regulation and Investment Incentives under Demand Uncertainty

Fabien Roques () and Nicos S. Savva

Cambridge Working Papers in Economics from Faculty of Economics, University of Cambridge

Abstract: We study the effect of price cap regulation on investment in new capacity in an oligopolistic (Cournot) industry, using a continuous time model with stochastic demand. A price cap has two mutually competing effects on investment under demand uncertainty: it makes the option of deferring investment very valuable, but it also reduces the interest of strategic underinvestment to raise prices. We show that there exists an optimal price cap that maximizes investment incentives. As with deterministic demand, the optimal price cap is the clearing price of the competitive market. However, unlike the deterministic case, we show that such a price cap does not restore the competitive equilibrium; there is still under-investment. Sensitivity analyses and Monte Carlo simulations show that the efficiency of price cap regulation depends critically on demand volatility and that errors in the choice of the price cap can have detrimental consequences on investment and average prices.

Keywords: real options; stochastic games; price cap regulation; electricity markets (search for similar items in EconPapers)
JEL-codes: C73 D92 L51 L94 (search for similar items in EconPapers)
Pages: 32
Date: 2006-05
New Economics Papers: this item is included in nep-ene, nep-mic and nep-reg
Note: IO
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