Price-cap regulation and technical change

Existing analyses of the implications of price-cap regulation for the development of cost-reducing technologies assume that all R&D is done by the regulated industry. This is unrealistic. We present a simple model of non-cooperative R&D by a regulated firm and a single 'external' developer under a price-cap regime of the sort characterised by Cabral and Riordan. In equilibrium the external developer exerts less R&D than is socially optimal, the regulated firm may exert more or less. A 'tightening' of the regulatory regime impacts the R&D incentives of both players, though in different ways. The optimal regulatory-adjustment parameter may be bigger or smaller than that suggested by existing studies. Despite the scope for duplication of results, research by an outsider necessarily enhances welfare.