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Price Cap Regulation Preliminary version

We study the effect of price cap regulation on investment in new capacity in an oligopolistic (Cournot) industry. We use a continuous time model with stochastic demand. The contribution of this paper is both theoretical and practical. On the theoretical side, we show that there exists an optimal price cap that maximizes investment incentives. Just as in the case of deterministic demand, the optimal price cap is independent of market concentration. However, unlike the deterministic case, we show that this price cap does not restore the competitive equilibrium; there is still under-investment and companies are still enjoying positive rents. On the practical side, we perform sensitivity analysis, comparative statics and monte carlo simulations to examine the effect of price cap regulation at different levels of demand volatility, market concentration and lead times. The findings demonstrate that price cap regulation is ineffective in increasing investment in volatile markets, with high concentration and significant lead times. This casts doubts to whether price cap regulation can be effective in mitigating market power in liberalized electricity markets.