On optimal scarcity prices

This article contributes to the debate of missing money (compare Joskow(2007a)). This debate has seriously questioned the desirability of limiting scarcity prices in markets with fluctuating demand by emphasizing their potentially negative impact on firms' investment decisions in the long run. A prominent example are recently liberalized electricity markets, where competition authorities have imposed price caps(3) or adopted other measures to mitigate high scarcity prices. The impact of reduced scarcity prices in the long run still is only incompletely explored. We thus analyze investment of firms in base load and peak load technologies in a market with fluctuating demand under imperfect competition. We show that an appropriately chosen limitation of scarcity prices is not only beneficial in the short run but also in the long run. It leads to a strict increase of investment in peak load technologies, leaving investment in base load technologies unchanged. Furthermore, we characterize the optimal limit on scarcity prices. (C) 2011 Published by Elsevier B.V.