Price caps with capacity precommitment

Abstract

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.

Price caps, oligopoly, and entry

“…We show that the sufficient condition for existence of a welfare improving price cap for the no-disposal model carries over to the model with disposal. Our results for the model with disposal are complementary to results in Lemus and Moreno [2013] on the impact of a price cap on a monopolist's capacity investment. They show that a price cap influences welfare through two separate channels: an investment effect, and an effect on output choices made after realization of a demand shock.…”

“…In the third period, firms observe θ and simultaneously choose how much to sell, with firm i choosing sales quantity q i ∈ [0, x i ]; unsold output may be disposed of at zero cost. 13 The effect of price caps in this model with a fixed number of firms has been analyzed by Earle et al [2007], Grimm and Zottl [2010], and Lemus and Moreno [2013].…”

Information, Bertrand–Edgeworth competition and the law of one price

“…The main mechanics of our results operate as follows: In the complete information benchmark, the only candidate for a pure strategy equilibrium is the competitive price (see Dixon, 1992;Shubik, 1959) but the incentive to charge a higher price and 4 Demand uncertainty can also stem from inter-temporal variations in demand as identified in domestic electricity markets (see Green and Newbery, 1992;Lemus and Moreno, 2017).…”

Pro‐Consumer Price Ceilings under Regulatory Uncertainty*

“… In related models, Reynolds and Rietzke () consider endogenous entry and identify conditions under which a price cap is welfare improving, while Lemus and Moreno () explore the optimal ceiling when a monopolist pre‐commits to a capacity level before the demand is realized. …”

“…Furthermore, some of the instruments required for optimal regulation (e.g., transfers) might not be available in practice. SeeArmstrong and Sappington (2007) for discussion of practical regulatory policies, and seeCrew and Kleindorfer (2002) for more on the limitations of optimal regulation models.8 In related models,Reynolds and Rietzke (2018) consider endogenous entry and identify conditions under which a price cap is welfare improving, whileLemus and Moreno (2017) explore the optimal ceiling when a monopolist pre-commits to a capacity level before the demand is realized. 9Neven and Röller (2005) analyze how institutional settings, such as transparency and accountability, interact with the choice of an appropriate standard.…”