RETAIL PRICE REGULATION AND THE OPTION TO DELAY

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.     

Incentive Regulation of Prices When Costs are Sunk

We present a model featuring irreversible investment, economies of scale, uncertain future demand and capital prices, and a regulator who sets the firm’s output price according to the cost structure of a hypothetical replacement firm. We show that a replacement firm has a fundamental cost advantage over the regulated firm: it can better exploit the economies of scale because it has not had to confront the historical uncertainties faced by the regulated firm. We show that setting prices so low that a replacement firm is just willing to participate is insufficient to allow the regulated firm to expect to break even whenever it has to invest. Thus, unless the regulator is willing to incur costly monitoring to ensure the firm invests, revenue must be allowed in excess of that required for a replacement firm to participate. This contrasts with much of the existing literature, which argues that the market value of a regulated firm should equal the cost of replacing its existing assets. We also obtain a closed-form solution for the regulated firm’s output price when this price is set at discrete intervals. In contrast to rate of return regulation, we find that resetting the regulated price more frequently can increase the risk faced by the firm’s owners, and that this is reflected in a higher output price and a higher weighted-average cost of capital.     

Bertrand versus Cournot revisited

Summary. Bertrand criticized Cournot's analysis of the competitive process, arguing that firms should be seen as playing a strategy of setting price below competitors' prices (henceforth, the Bertrand strategy) instead of a strategy of accepting the price needed to sell an optimal quantity (the Cournot strategy). We characterize Nash equilibria in a generalized model in which firms choose among Cournot and Bertrand strategies. Best responses always exist in this model. For the duopoly case, we show that iterated best responses converge under mild assumptions on initial states either to Cournot equilibrium or to an equilibrium in which only one firm plays the Bertrand strategy with price equal to marginal cost and that firm has zero sales. Received: December 11, 1995; revised version October 2, 1996     

Monopoly Price Dispersion Under Demand Uncertainty

When a monopolist sets its price before its demand is known, then it may set more than one price and limit the availability of its output at lower prices. This article adds demand uncertainty and price rigidities to the standard model of monopoly pricing. When there are two states of demand and the ex post monopoly price is greater when demand is high then the monopolist's optimal ex ante pricing strategy is to set two prices and limit purchases at the lower price.     

Optimal regulation of lumpy investments

We study optimal timing of regulated investment in a real options setting, in which the regulated monopolist has private information on investment costs. In solving the ensuing agency problem, the regulator trades off investment timing inefficiency against the dead-weight loss arising from high price caps. We show that optimal regulation is implemented by a price cap that decreases as a function of the monopolist’s chosen investment time.     

Forward Markets and the Behaviour of the Competitive Firm with Production Flexibility

This paper examines the production and hedging decisions of the competitive firm under output price uncertainty when a forward market for its output is available. The firm possesses production flexibility in that it makes its production decision after the resolution of the output price uncertainty, albeit subject to a capacity constraint on production. We show that the firm optimally acquires a higher level of capacity investment than an otherwise identical firm with no production flexibility. We further show that production flexibility allows the firm to implicitly hedge against its output price risk exposure by the ex post production decision. The firm as such under‐hedges its output price risk exposure in the forward market wherein the forward price contains a non‐positive risk premium.     

Optimal pricing and capacity choice for a public service under risk of interruption

We develop rules for pricing and capacity choice for an interruptible service that recognize the interdependence between consumers’ perceptions of system reliability and their market behavior. Consumers post ex ante demands, based on their expectations on aggregate demand. Posted demands are met if ex post supply capacity is sufficient. However, if supply is inadequate all ex ante demands are proportionally interrupted. Consumers’ expectations of aggregate demand are assumed to be rational. Under reasonable values for the consumer’s degrees of relative risk aversion and prudence, demand is decreasing in supply reliability. We derive operational expressions for the optimal pricing rule and the capacity expansion rule. We show that the optimal price under uncertainty consists of the optimal price under certainty plus a markup that positively depends on the degrees of relative risk aversion, relative prudence and system reliability. We also show that any reliability enhancing investment—though lowering the operating surplus of the public utility—is socially desirable as long as it covers the cost of investment.     

DO INVESTMENT‐SPECIFIC TECHNOLOGICAL CHANGES MATTER FOR BUSINESS FLUCTUATIONS? EVIDENCE FROM JAPAN

The observed decline in the relative price of investment goods to consumption goods in Japan suggests the existence of investment‐specific technological (IST) changes. We examine whether IST changes are a major source of business fluctuations in Japan, by estimating a dynamic stochastic general equilibrium model using Bayesian methods. We show that IST changes are less important than neutral technological changes in explaining output fluctuations. We also demonstrate that investment fluctuations are mainly driven by shocks to investment adjustment costs. Such shocks represent variations of costs involved in changing investment spending, such as financial intermediation costs. We find that the estimated series of the investment adjustment cost shock correlates strongly with the diffusion index of firms' financial position in the Tankan (Short‐term Economic Survey of Enterprises in Japan). Therefore, we argue that the large decline in investment growth in the early 1990s was due to an increase in investment adjustment costs stemming from firms' financial constraints after the collapse of Japan's asset price bubble.     

Transition and the output fall

We present a model to explain why in the transition economies of Central andEastern Europe an important output fall has been associated with price liberalization. Its key ingredients are search frictions and Williamsonian relation-specific investment, implying that new investments are made only after having found a new long-term partner. When all firms search for new partners, output may fall because of three effects: a) disruption of previous production links, b) a fall in investment, and c) capital depreciation due to the absence of replacement investment. We show that forms of gradual liberalization like the Chinese 'dual-track' price liberalization may avoid the transitory output fall.
JEL classification: D21, D50, E30, E61, P41, P51.     

Capacity expansion and dynamic monopoly pricing

We substitute to the plant size problem, as investigated by Chenery [Chenery, H., 1952. Overcapacity and the acceleration principle. Econometrica], a new version in which a profit-maximizing monopolist may combine its investment policy with a price policy adjusting demand upwards or downwards over time. We characterize the optimal price and investment policies. The optimal price policy determines an investment pattern either with constant increments of capacity over time, or becoming constant after a finite time. The existing capacity is either fully used at each instant between two investment dates; or the monopolist first quotes the instantaneous monopoly price and, thereafter, the price dampening instantaneous demand at the optimal installed capacity level.     

The optimality of nominal contracts

Summary. This paper presents a model in which agents choose to use money as a medium of exchange, a means of payment, and a unit of account. The paper defines conditions under which nominal contracts, promising future payment of a fixed number of units of fiat money, prove to be the optimal contract form in the presence of either relative or aggregate price risk. When relative prices are random, nominal contracts are optimal if individuals have ex ante similar preferences over future consumption. When the aggregate price level is random, whether from shocks to the money supply or aggregate output, nominal contracts (perhaps coupled with equity contracts) lead to optimal risk-sharing if individuals have the same degree of relative risk aversion. Finally, nominal contracts may be optimal if the repayment of contracts is subject to a binding cash-in-advance constraint. In this case, a contingent contract increases the risk of holding excessive cash balances. Received: March 29, 1996; revised version: February 25, 1997     

Access pricing and investment: a real options approach

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 overall welfare generated by this decision. In a regulated environment, we consider a vertically integrated network provider that is required to provide access to downstream competitors and compare two distinct access pricing methodologies: the Efficient Component Pricing Rule (ECPR) and the Option to Delay Pricing Rule (ODPR). We identify the welfare-maximizing access prices using the unregulated market output as a benchmark and show that optimal access regulation depends on market conditions (that is, the nature of demand) with two possible outcomes: (i) access prices that provide a positive payoff to the incumbent, that is, provide a positive compensation to account for the option to delay; and (ii) access prices that yield a zero payoff to the incumbent. Moreover, unlike the earlier literature that argues in favor of an ECPR-type methodology to account for the interaction between irreversibility and demand uncertainty, we find that, except under very specific conditions, an access price that accounts for the option to delay value is welfare-superior to the ECPR.      

A theory of competitive industry dynamics with innovation and imitation

Empirical evidence on industry life-cycle reveals a pattern in which innovation rates remain fairly stable or are perhaps even higher at early stages, while patenting increases sharply as the industry matures. This increase in patenting in later stages is accompanied by net exit and lower rates of output growth and price decline. In this paper, we develop a dynamic model of a competitive industry with innovation and imitation that is consistent with these stylized facts. We derive an equilibrium growth path, along which leading firms invest in increasing the stock of technological knowledge and choose not to prevent imitation by other firms as long as the industry remains relatively small. As the industry expands including new entry, the leaders' optimal amount of investment gradually declines. We show that under some rather general conditions, there would exist a scale of the industry where innovating firms would choose to start preventing free imitation, bringing further expansion of the industry through new entry to a halt and causing net exit.     

The analysis of a price war strategy under market demand growth

We use the finite repeated Prisoners' Dilemma game model herein to discuss how firms choose their optimal strategy under a price war with market demand growth. This model has two players: one is an R-type player and the other is a TFT-type player. Each player has two strategies to choose from: a preemption strategy and a “wait” strategy. Our results indicate that: (i) if the probability that the opponent is an R-type (TFT-type) player is high, then the time when the opponent adopts a preemption strategy will be early (late); (ii) Market demand growth is an incentive for cooperation among firms; (iii) if the market demand growth rate is high, then the R-type player will not have an evolutionary advantage. We use the competition between cell phone manufacturing firms Nokia and Motorola in China as an example. When Nokia is an R-type player and adopts a preemption strategy, Motorola should preferably use a preemption strategy rather than a “wait” strategy. However, as a TFT-type player, this will benefit Motorola under the situation of market demand growth.     

Strategic Trade Policy and Vertical Structure

We introduce intermediaries into the Brander-Spencer model of strategic trade policy. A key finding is that in regimes involving independent retailers, output competition and linear pricing (and two-part tariffs under certain restrictions), the optimal policy involves an export tax instead of a subsidy. If firms commit to vertical structure before governments commit to policy then under output competition firms choose integration, whereas if policy precedes structure then at least one firm chooses separation. Under price competition separation is a dominant strategy regardless of whether the structure decision is made before or after the policy decision.     

An investment-function-based measure of capacity utilisation.: Potential output and utilised capacity in the Bank of Italy's quarterly model

Measures of potential output and the output gap are increasingly being developed and used to concisely quantify and monitor the risk of price accelerations stemming from rises in aggregate demand that are not met by a corresponding increase in supply. They often play a prominent role in the price determination mechanisms of macroeconometric models. In this paper we build a measure of potential private-sector value added for the Italian economy that is consistent with the capital accumulation process in the Banca d'Italia's Quarterly Model — and more generally with the rest of the supply-side block of that model. More specifically, we exploit the fact that the investment function can be thought of as a relationship transforming desired gross additions to capacity output into capital accumulation by means of a conversion factor (the optimal capital/output ratio). Thus, if one removes the component of investment decisions that stems from changes in the relative price of the production factors, (i.e. in the optimal capital/output ratio), then a measure of the desired gross addition to capacity may be constructed. The results draw a cyclical picture of the degree of capacity utilisation for the period 1970–1997 that is roughly in line with those produced by the Wharton and Hodrick–Prescott filter approaches, as well as with the pictures resulting from the ISAE, IMF, European Commission and OECD measures of the output gap. Our investment-function-based measure appears to be a promising indicator of the pressure exerted on prices by demand accelerations. Its empirical properties are, on the whole, acceptable and plausible.     

COMMERCIAL ACTIVITY AS INSURANCE: THE INVESTMENT BEHAVIOUR OF NON‐PROFIT ORGANIZATIONS

ABSTRACT ** : We provide a new explanation for commercial activities by non‐profit organizations whose primary concern is to supply mission output. Starting from the observation that donations to individual non‐profits are often highly volatile, we show how investment in commercial activity can constitute a form of insurance for mission activity. Although investment in commercial activity has an opportunity cost in terms of capacity to produce mission output, if donations turn out to be low the commercial revenue will enable cross‐subsidization of mission output. The equilibrium commercial investment is (weakly) positively related to the degree of risk aversion.     

Operating efficiency and output insensitive employment contracts for capital management

Summary This paper considers a problem in which an agent is hired to manage a capital investment and subsequently receives private information regarding the productivity of the capital investment. The capital manager must decide whether to invest capital supplied by the firm (the principal), or to divert these investment funds to perquisite consumption. If the manager decides to invest, the manager must then select the level of operating efficiency (productivity) of the capital investment, this latter choice being unobservable and constrained by the (maximal) productivity of the investment. In this setting we demonstrate that the optimal employment contract, from the perspective of the firm hiring the manager, is the contract whichminimizes the dependence of the manager's compensation on firm output. This contract pays the manager a fixed wage whenever output from the investment exceeds the wage and provides the manager with all of the projects rents whenever output falls below this level. Thus, we provide a setting in which fixed wage contracts are the optimal incentive contract even when agents are risk neutral and contracts can be costlessly written on future output.We would like to thank the participants in the Princeton Economics and Finance Workshop and the Ohio State University Finance Workshop for their comments on an earlier draft of this paper. The second author gratefully acknowledges the research support of the Georgia State College of Business Administration Research Council.     

Semicollusion vs. Full Collusion: The Role of Demand Uncertainty and Product Substitutability

We examine the profitability of two different cartel organizational forms: full collusion, under which firms collude on both price and quality, and semicollusion, under which firms collude on price only. We show that, in the presence of demand uncertainty that cannot be contracted upon in the cartel agreement, firms may be better off limiting their collusive agreement to price only. However, a positive relationship between demand uncertainty and the relative profitability of semicollusion exists only for low levels of demand substitutability. The converse is true for high levels of demand substitutability. Therefore, if demand substitutability is sufficiently high, no level of demand uncertainty will make semicollusion the optimal organizational form. In contrast, semicollusion is guaranteed to be optimal for a sufficiently low level of demand substitutability. The market structure described is motivated by and closely parallels that of shipping cartels. Received September 29, 2000; revised version received December 10, 2001 Published online: November 11, 2002