Optimal regulation of network expansion

We model the optimal regulation of continuous, irreversible, capacity expansion, where a regulated firm has private information about capacity costs, investments are financed from the firm's cash flows, and demand is stochastic. The optimal mechanism can be implemented as a revenue tax that increases with the level of the price cap. If the asymmetric information has large support, then the optimal mechanism consists of a laissez-faire regime for low-cost firms. That is, the firm's price cap corresponds to that of an unregulated monopolist, and it is not taxed. This `maximal distortion at the top' is necessary to provide information rents, as direct subsidies are not feasible.