On Optimal Scarcity Prices

This article contributes to the debate of missing money (e.g. Joskow(2007)) which has seriously questioned the desirability of caps on 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 caps in order to mitigate the exercise of market power at the spot markets. In order to shed light on the still incompletely explored impact of such caps in the long run we analyze investment of strategic firms in base–load and peak–load technologies in a market with fluctuating demand. We show that under imperfect competition appropriately chosen caps on scarcity prices not only are beneficial in the short run but also in the long run, since they lead to a strict increase of investment in the peak–load technologies, leaving investment in the base–load technologies unchanged. We furthermore characterize the optimal cap on scarcity prices.