Abstract
This article shows how scale economies affect regulated firms’ investment behavior and welfare‐maximizing regulation of price and quantity. Regulated firms invest in smaller, more frequent, increments than social planners, with greater investment distortions the greater the economies of scale. Regulators cap prices at lower levels than planners when economies of scale are moderate, and at higher levels when they are substantial. When quantity is also regulated, the average cost of building capacity increases but the price cap decreases. Immediately after firms make their initial investment, regulators want to transfer surplus from customers to shareholders by raising the price cap to induce additional investment.
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