This paper examines the intertemporal price cap regulation of a firm that has market power. Under uncertainty, the unconstrained firm 'waits longer' before investing or adding to capacity and as a corollary, enjoys higher prices over time than would be observed in an equivalent competitive industry. In the certainty case, the imposition of an inter-temporal price cap can be used to realise the competitive market solution; by contrast, under uncertainty, it cannot. Even if the price cap is optimally chosen, under uncertainty, the monopoly firm will generally (a) under-invest and (b) impose quantity rationing on its customers.Price cap regulation has been extensively studied over recent years in both atemporal and inter-temporal contexts. In the atemporal context, the focus has often been on how to deal with multiple and new products, on efficiency and incentive issues, or on how to regulate complex tariffs (Hillman and Braeutigam, 1989; Laffont and Tirole, 1990a, b;Armstrong et al. 1995), whilst in the intertemporal context, the construction of price adjustment processes and their potential manipulation by regulated firms has been examined (Hagerman, 1990; Braeutigan and Panzar, 1993). This paper by contrast focuses on the impact of inter-temporal price cap regulation on the firm's choice of investment in capacity when such investment is largely irreversible and when evolution of key variables such as product demand, technology etc. are governed by stochastic processes.

Replacement investment is essentially a regenerative optimal stopping problem; that is, the key decision concerns when to terminate the life of existing plant - and hence when to start over again. This paper examines this optimisation problem within a continuous time framework and studies the qualitative and quantitative impact of uncertainty on the timing of new investment (and the criteria that should be used for terminating the life of existing plant). Copyright Blackwell Publishers Ltd, 2004.

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