Investment Incentives under Price-Cap Regulation*

In the literature on price regulation, the price-cap mechanism is seen as a very powerful incentive mechanism towards efficiency improvements. What about quality investments? The empirical literature is not univocal: Some studies sug-gest a deterioration of quality, while others do not find any statistically significant impact. We analyze the incentive provided by price-cap regulation in a setting in which the investment decisions of the regulated firm suffer from hold-up, and contacts are incomplete. We show that the incentives to invest in cost-saving innovations can be fostered by a price-cap contract with a “sufficient ” regulatory lag, while for other types of investments, such as quality enhancement, the same contract does not help. Furthermore, we show that if the firm faces a binding resource constraint the price-cap contract generates a crowding-out effect between the two types of investment. This might explain the non univocal em-pirical evidence