The "demand side" effect of price caps: uncertainty, imperfect competition, and rationing
Price caps are often used by policy makers to "regulate markets". Previous analyses have focussed on the "supply side" impact of these caps, and derived the optimal price cap, which maximizes investment and welfare. This article expands the analysis to include the "demand side" impact of price caps: when prices can no longer rise, customers must be rationed to adjust demand to available supply. This yields two new findings, that contradict previous analyses. First, the welfare-maximizing cap is higher than the capacity-maximizing cap, since increasing the cap increases gross surplus when customers are rationed. Second, in somes cases, the capacity-maximizing cap leads to lower capacity and welfare than no cap. These findings underscores the importance for policy makers to examine the impact on customers when they impose price caps.
|Date of creation:||27 Jan 2014|
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"Reliability and Competitive Electricity Markets,"
Cambridge Working Papers in Economics
0450, Faculty of Economics, University of Cambridge.
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