Modeling investment behavior under price cap regulation
Motivated by the frequently observed criticism of the regulatory practice arising from companies in the industries concerned, we investigate the impact of regulation on investment behavior. Therefore, we model the investment timing and volume of a firm acting in a regulated market. When capping prices, the regulatory authority imposes a price ceiling on market prices. Accordingly, we use a real option approach where the price cap that limits possible future firm values enters the firm’s portfolio in form of a short call option position. By comparing this framework to a competitive benchmark model, we derive an optimal price setting rule for regulators. Moreover, it can be shown how deviations from this optimum affect the investment behavior of firms. Copyright Springer-Verlag 2009
Volume (Year): 17 (2009)
Issue (Month): 2 (June)
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- Dixit, Avinash, 1991. "Irreversible Investment with Price Ceilings," Journal of Political Economy, University of Chicago Press, vol. 99(3), pages 541-57, June.
- M.E. Beesley & S.C. Littlechild, 1989. "The Regulation of Privatized Monopolies in the United Kingdom," RAND Journal of Economics, The RAND Corporation, vol. 20(3), pages 454-472, Autumn.
- Ian M. Dobbs, 2004. "Intertemporal price cap regulation under uncertainty," Economic Journal, Royal Economic Society, vol. 114(495), pages 421-440, 04.
- Arthur Havenner & Thomas Hazlett & Zhiqiang Leng, 2001. "The Effects of Rate Regulation on Mean Returns and Non-Diversifiable Risk: The Case of Cable Television," Review of Industrial Organization, Springer, vol. 19(2), pages 149-164, September.
- McDonald, Robert L & Siegel, Daniel R, 1985. "Investment and the Valuation of Firms When There Is an Option to Shut Down," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 26(2), pages 331-49, June.
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