We examine the effectiveness of price caps to regulate imper-fectly competitive markets in which the demand is uncertain. To that effect, we study a monopoly that makes irreversible ca-pacity investments ex-ante, and then chooses its output up to capacity upon observing the realization of demand. We show that the optimal price cap must trade off the incentives for ca-pacity investment and capacity withholding, and is above the unit cost of capacity. Moreover, while a price cap provides in-centives for capacity investment and mitigates market power, it cannot eliminate inefficiencies. Capacity payments provide a useful complementary instrument.

The OECD's recommendation that transfer prices between multinational enterprises and their subsidiaries be consistent with the Arm's Length Principle (ALP) for tax purposes does not restrict internal pricing policies.However, we show that under imperfect competition firms may choose to keep one set of books (i.e., to set transfer prices consistent with the ALP), as a way of softening competition in the external market. As a result, firms' profits are greater, and the surplus is smaller, than under vertical integration. In contrast, when firms keep two sets of books (i.e., their transfer prices differ from those used for tax purposes), competition intensifies in both markets relative to vertical integration.