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Demand Uncertainty and Risk-Aversion: Why Price Caps May Lead to Higher Prices

Abstract

Standard oligopoly theory suggests that price caps will tend to constrain the price of a good over the short-term and increase production. Firms become price-takers when the amount produced is less than where the price cap intersects the demand function. Recently imposed price caps in California, however, have resulted in anecdotal evidence that suggests that this might not always be the case. Typical explanations for increases in price and decreases in production are sociological and psychological in nature. While these lines of reasoning may go a long way in explaining the observed fact, the absence of an economic explanation is rather unsatisfying. In this note we give such an economic explanation by examining a simple economic model. We enhance a standard Cournot model through the introduction of demand uncertainty and agents' risk aversion. Multiple examples show that the introduction of a price cap in this model may indeed lead to higher prices and lower production quantities. Very interestingly, even a price cap set above the equilibrium prices obtained with no price cap, can result in lower output and higher prices.

Type

Working Paper

Author(s)

Robert L. Earle, Karl Schmedders

Date Published

2001

Citations

Earle, L. Robert, and Karl Schmedders. 2001. Demand Uncertainty and Risk-Aversion: Why Price Caps May Lead to Higher Prices.

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