Price Regulation and Investment: A Real Options Approach
This paper examines a three-period model of an investment decision in a network industry characterized by demand uncertainty, economies of scale and sunk costs. In the absence of regulation we identify the market conditions under which a monopolist decides to invest early as well as the underlying overall welfare output. In a regulated environment, we first consider a monopolist facing no downstream competition but subject to a price cap on the downstream retail (final good) market. We identify the welfare-maximising regulated prices using the unregulated market output as a benchmark. In particular, we show that the optimal regulation depends on market conditions (that is, the nature of demand) and there are three possible outcomes: (i) price regulation does not improve welfare; (ii) regulated prices include an option to delay value and provide a positive payoff to the firm; and (iii) regulated prices yield a zero payoff to the firm. Second, we consider a vertically integrated network provider that is required to provide access to downstream competitors. We show that when the regulator has only one instrument, namely the access price, an option-to-delay pricing rule generates (weakly) higher welfare than the Efficient Component Pricing Rule (ECPR), except under very specific conditions.
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- Robert Breunig & Jeremy Hornby & Scott Stacey & Flavio Menezes, 2006. "Price Regulation in Australia: How Consistent Has It Been?," The Economic Record, The Economic Society of Australia, vol. 82(256), pages 67-76, 03.
- Robert S. Pindyck, 2004.
"Mandatory Unbundling and Irreversible Investment in Telecom Networks,"
NBER Working Papers
10287, National Bureau of Economic Research, Inc.
- Pindyck Robert S., 2007. "Mandatory Unbundling and Irreversible Investment in Telecom Networks," Review of Network Economics, De Gruyter, vol. 6(3), pages 1-25, September.
- Elizabeth Olmsted Teisberg, 1994. "An Option Valuation Analysis of Investment Choices by a Regulated Firm," Management Science, INFORMS, vol. 40(4), pages 535-548, April.
- Jean-Jacques Laffont & Jean Tirole, 1993. "A Theory of Incentives in Procurement and Regulation," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262121743, June.
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