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Price caps regulation with capacity precommitment

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  • A. Lemus

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  • Diego Moreno

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    Abstract

    Contrary to a recent literature that questions whether price caps are effective, and even sensitive, under demand uncertainty, we show that in the absence of quantity precommitment the effects of a price cap are the same whether the demand is uncertain or deterministic. Next we study the effectiveness of a price cap to regulate a monopoly that makes irreversible capacity investments ex-ante, and then chooses its output up to capacity upon observing the realization of demand. In this more interesting scenario the optimal price cap, which must trade off the incentives for capacity investment and capacity withholding, is well above the unit cost of capacity, and may be below the price cap that maximizes capacity. Further, under standard assumptions on the demand distribution the comparative static properties of price caps above the optimal price cap are analogous to those they have in the absence of capacity precommitment. Nevertheless, a price cap alone cannot eliminate inefficiencies.

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    File URL: http://e-archivo.uc3m.es/bitstream/handle/10016/19349/we1309.pdf?sequence=1
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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
    Date of revision: Aug 2014
    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. Roques, Fabien A. & Savva, Nicos, 2009. "Investment under uncertainty with price ceilings in oligopolies," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 33(2), pages 507-524, February.
    2. Grimm Veronika & Zöttl Gregor, 2010. "Price Regulation under Demand Uncertainty," The B.E. Journal of Theoretical Economics, De Gruyter, De Gruyter, vol. 10(1), pages 1-34, June.
    3. Reynolds, Stanley S. & Wilson, Bart J., 2000. "Bertrand-Edgeworth Competition, Demand Uncertainty, and Asymmetric Outcomes," Journal of Economic Theory, Elsevier, Elsevier, vol. 92(1), pages 122-141, May.
    4. GABSZEWICZ, Jean J. & PODDAR , Sougata, 1995. "Demand Fluctuations and Capacity Utilization under Duopoly," CORE Discussion Papers, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE) 1995051, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
    5. Cabral, Luis M B & Riordan, Michael H, 1989. "Incentives for Cost Reduction under Price Cap Regulation," Journal of Regulatory Economics, Springer, Springer, vol. 1(2), pages 93-102, June.
    6. Ian M. Dobbs, 2004. "Intertemporal price cap regulation under uncertainty," Economic Journal, Royal Economic Society, Royal Economic Society, vol. 114(495), pages 421-440, 04.
    7. Dixit, Avinash, 1991. "Irreversible Investment with Price Ceilings," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 99(3), pages 541-57, June.
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