Modeling investment behavior under price cap regulation |
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Authors: | Thomas Nagel Margarethe Rammerstorfer |
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Institution: | (1) Institute for Corporate Finance, Vienna University of Economics and Business, Heiligenstaedter Strasse 46-48, 1190 Vienna, Austria |
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Abstract: | Motivated by the frequently observed criticism of the regulatory practice arising from companies in the industries concerned,
we investigate the impact of regulation on investment behavior. Therefore, we model the investment timing and volume of a
firm acting in a regulated market. When capping prices, the regulatory authority imposes a price ceiling on market prices.
Accordingly, we use a real option approach where the price cap that limits possible future firm values enters the firm’s portfolio
in form of a short call option position. By comparing this framework to a competitive benchmark model, we derive an optimal
price setting rule for regulators. Moreover, it can be shown how deviations from this optimum affect the investment behavior
of firms.
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Keywords: | Regulation Regulatory risk Price cap Real option |
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