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Price cap regulation with capacity withholding

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  • A. Lemus

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  • Diego Moreno

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    Abstract

    A monopolist facing an uncertain demand makes ex-ante capacity decisions involving irreversible investments, and then chooses its output up to capacity upon the realization of demand. In equilibrium, capacity is low and underused. Imposing a binding price cap leads to an increase of capacity as well as expected output and total surplus, and to a decrease of expected price. The optimal price cap trades off the incentives for capacity investment and capacity withholding, and is well above the marginal cost. Price cap regulation alone cannot eliminate inefficiencies. When the unit cost of capacity is high the comparative static properties of price caps relative to the price cap than maximizes capacity investment ?* are analogous to those obtained when the demand is known with certainty, and the optimal price cap is ?*. When the unit cost of capacity is low, however, the expected output and surplus decrease with the price cap above and around ?*, and therefore the optimal price cap is below ?*.

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    Bibliographic Info

    Paper provided by Universidad Carlos III, Departamento de Economía in its series Economics Working Papers with number we1309.

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    Date of creation: May 2013
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    Handle: RePEc:cte:werepe:we1309

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    Keywords: Monopoly; Market power; Price cap regulation; Capacity investment; Capacity withholding; Demand uncertainty;

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    1. Reynolds, Stanley S. & Wilson, Bart J., 2000. "Bertrand-Edgeworth Competition, Demand Uncertainty, and Asymmetric Outcomes," Journal of Economic Theory, Elsevier, vol. 92(1), pages 122-141, May.
    2. Dixit, Avinash, 1991. "Irreversible Investment with Price Ceilings," Journal of Political Economy, University of Chicago Press, vol. 99(3), pages 541-57, June.
    3. Jean J. Gabszewicz & Sougata Poddar, 1997. "Demand fluctuations and capacity utilization under duopoly," Economic Theory, Springer, vol. 10(1), pages 131-146.
    4. Cabral, Luis M B & Riordan, Michael H, 1989. "Incentives for Cost Reduction under Price Cap Regulation," Journal of Regulatory Economics, Springer, vol. 1(2), pages 93-102, June.
    5. Ian M. Dobbs, 2004. "Intertemporal price cap regulation under uncertainty," Economic Journal, Royal Economic Society, vol. 114(495), pages 421-440, 04.
    6. Roques, Fabien A. & Savva, Nicos, 2009. "Investment under uncertainty with price ceilings in oligopolies," Journal of Economic Dynamics and Control, Elsevier, vol. 33(2), pages 507-524, February.
    7. Grimm Veronika & Zöttl Gregor, 2010. "Price Regulation under Demand Uncertainty," The B.E. Journal of Theoretical Economics, De Gruyter, vol. 10(1), pages 1-34, June.
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