Price Regulation and Investment: A Real Options Approach
Fernando Tavares Camacho
University of Queensland
Flavio M. Menezes
University of Queensland - School of Economics
July 1, 2008
U of Queensland Economics Discussion Paper No. 373
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.
Number of Pages in PDF File: 44
Keywords: real options, option to delay, regulation and investment, access pricingworking papers series
Date posted: November 21, 2008
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