Price regulation and investment: a real options approach

Camacho, Fernando T. and Menezes, Flavio M. (2008). Price regulation and investment: a real options approach. 373, School of Economics, University of Queenland.

Author Camacho, Fernando T.
Menezes, Flavio M.
Title Price regulation and investment: a real options approach
School, Department or Centre School of Economics
Institution University of Queenland
Report Number 373
Publication date 2008
Language eng
Abstract/Summary 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.
Keyword Real options
Option to delay
Regulation and investment
Access pricing

Document type: Working Paper
Collection: School of Economics Publications
 
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Created: Fri, 27 Feb 2015, 14:27:56 EST by Tammy Crealy on behalf of School of Economics