Price caps with capacity precommitment

- Consider imperfectly competitive, demand uncertain, capacity precommited markets.
- A well chosen price cap (discourages) incentivizes capacity (withholding) investment.
- An optimal price cap trades off its effects on capacity investment and withholding.
- An optimal price cap is below the capacity maximizing one if cost of capacity is low.
- A Capacity payment combined with a price cap allows for a further surplus increase.

We examine the effectiveness of price caps to regulate imperfectly competitive markets in which the demand is uncertain. To that effect, we study a monopoly that makes irreversible capacity investments ex-ante, and then chooses its output up to capacity upon observing the realization of demand. We show that the optimal price cap must trade off the incentives for capacity investment and capacity withholding, and is above the unit cost of capacity. Moreover, while a price cap provides incentives for capacity investment and mitigates market power, it cannot eliminate inefficiencies. Capacity payments provide a useful complementary instrument.