Price-Cap Regulation and the Scale and Timing of Investment

Abstract

This paper shows how scale economies affect welfare-maximizing regulation and regulated firms’ investment behavior. Price-regulated firms take less advantage of scale economies than social planners, with greater investment distortions for greater economies of scale. Price caps should be below the caps implied by planners’ investment programs for moderate economies of scale, and above them otherwise. Despite quantity regulation raising the average cost of building capacity, price caps should be lower when quantity is regulated. Immediately after firms make their initial investment, regulators want to transfer surplus from customers to shareholders by raising the price cap in order to fund service improvements.

Keywords: regulation, natural monopoly, economies of scale, investment, real options

JEL Classification: D21, D42, D92, G31, L51, L98