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Retail Price Regulation And The Option To Delay

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  • Fernando T. Camacho
  • Flavio M. Menezes

Abstract

ABSTRACT**: This paper examines a two‐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 consider a monopolist who faces no downstream (final good) competition but is subject to retail price regulation. We identify the welfare‐maximizing regulated prices when the unregulated market outcome is set as the benchmark. We show that if the regulator can commit to ex post regulation – that is, regulated prices that are contingent to future demand realization – then regulated prices that allow the firm to recover its total costs of production are welfare‐maximizing. Thus, under ex post price regulation there is no need to compensate the regulated firm for the option to delay that it foregoes when investing today. We argue, however, that regulators cannot make this type of commitment and, therefore, price regulation is often ex ante – that is, regulated prices are not contingent to future demand. We show that the optimal ex ante regulation, and the extent to which regulated prices need to incorporate an option to delay, depend on the nature of demand uncertainty.

Suggested Citation

  • Fernando T. Camacho & Flavio M. Menezes, 2009. "Retail Price Regulation And The Option To Delay," Annals of Public and Cooperative Economics, Wiley Blackwell, vol. 80(3), pages 451-468, September.
    • Handle: RePEc:bla:annpce:v:80:y:2009:i:3:p:451-468
    DOI: 10.1111/j.1467-8292.2009.00393.x
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    References listed on IDEAS

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    1. Elizabeth Olmsted Teisberg, 1994. "An Option Valuation Analysis of Investment Choices by a Regulated Firm," Management Science, INFORMS, vol. 40(4), pages 535-548, April.
    2. Robert S. Pindyck, 2005. "Pricing Capital Under Mandatory Unbundling and Facilities Sharing," NBER Working Papers 11225, National Bureau of Economic Research, Inc.
    3. Pindyck Robert S., 2007. "Mandatory Unbundling and Irreversible Investment in Telecom Networks," Review of Network Economics, De Gruyter, vol. 6(3), pages 1-25, September.
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