Investment under uncertainty with price ceilings in oligopolies

We study the impact of price cap regulation on the level and timing of investment in an oligopolistic (Cournot) industry facing stochastic demand. We find that a price ceiling affects investment decisions in two mutually competing ways: it makes the option to defer investment more valuable, but at the same time it reduces the incentive for firms to strategically underinvest in order to raise prices. We show that while sensible price cap regulation speeds up investment, a low price cap can be a disincentive for investment. There exists an optimal price cap independent of market concentration the competitive investment price trigger - that maximizes investment incentives and in the long term increases industry installed capacity. This optimal price cap becomes less effective and less robust as the market becomes more competitive and as demand volatility increases. Errors in estimation of the optimal price cap have asymmetric effects: underestimation has more dire consequences than overestimation. (C) 2008 Elsevier B.V. All rights reserved.