Price Caps, Commitment and Innovation

Abstract

We analyze innovation incentives under price cap regulation by examining scenarios with endogenous price caps, both with and without regulatory commitment. In a setting without informational imperfections, our analysis reveals two principal conclusions. First, there is no trade-off between static and dynamic efficiency. Strengthening firm incentives by allowing it to charge higher prices, and thus realize greater profits, leads to less innovation because it reduces output. The optimal strategy to boost innovation and maximize welfare is to set a low price (and thus, a low profit) target, as innovation incentives are proportional to output. Second, the benefits of regulatory commitment for innovation and welfare are not unambiguously clear: commitment neither consistently outperforms nor underperforms non-commitment. Under demand uncertainty, when the firm is risk-averse, the static-dynamic efficiency trade-off reappears, and the firm may prefer non-commitment due to risk-shielding. Under asymmetric information about firm demand type, the trade-off between static and dynamic efficiency becomes inherent (due to information rents and contract distortions), and commitment becomes unambiguously crucial for fostering innovation by preventing the “ratchet effect”.