Production Externalities and Investment Caps: A Welfare Analysis Under Uncertainty

Abstract

In markets where production has adverse externalities, policy makers may wish to increase welfare by imposing a cap on market entries. In this paper, we examine the implications that the cap has on the firms’ investment equilibrium policy and on social welfare in the presence of market uncertainty. In contrast with previous literature, we explicitly model the present externality and then let the social planner choose the cap level maximizing welfare.

We find that:

i) if the consideration of the option value triggers investment at price above the social marginal cost of production, then it is optimal to have no cap at all;

ii) otherwise, the cap should be set on the current market quantity and a ban on further market entries should be announced.

Keywords: Investment, Uncertainty, Caps, Competition, Externalities, Welfare

JEL Classification: C61, D41, D62