Forward Contracts and the Curse of Market Power

Transcription

1 Forward Contracts and the Curse of Market Power Jeff Lien Presented at the Sixth Annual POWER Research Conference on Electricity Industry Restructuring March 16, 2001 Introduction Features of power generation Economies of scale are limited Markets are concentrated Markets are open to entry Questions In the absence of economies of scale, can markets with large firms be efficient? Are forward sales effective at deterring entry?

2 Outline Informal example of the curse of market power Forward sales as a cure for the curse of market power Results of theoretical model involving forward sales and entry Conclusion An informal example 100 identical power plants 1 firm owns 50 plants 50 firms own 1 plant Firms simultaneously submit supply functions to maximize profits Markets clear as a uniform price auction

3 Small firms free-ride on large firm Plant controlled by a small firm Plant controlled by the large firm P Price Operating Profits Supply MC P Supply MC Foregone Profits Output Q Output Q Informal example with entry Incumbent owns 50 plants Large pool of potential entrants each can build 1 plant After entry, firms submit supply functions

4 Large firm s operating profit per plant Each entrant s operating profit Construction Cost Large firm s equilibrium operating profit per plant Equilibrium entry Number of entrants The curse of market power Large firms incur the cost of withheld output, but all firms benefit from high prices Free entry sets upper bound on operating profits per plant at the cost of entry Large firm uses resources inefficiently and fails to reach the upper bound

5 Forward contracts and aggressive spot market behavior Less output clears in the spot market Less incentive to push up spot price Forward sales make a rival duopolist produce less Cournot spot market Allaz and Villa (1993) Uniform price auction spot market Green (1992, 1999) Newbery (1998) Participants in my model One large incumbent producer Competitive fringe of producers which expands in anticipation of profit opportunity Forward market traders All participants are risk neutral fully rational

6 Sequence of events Incumbent signs forward contracts (1) Entry Incumbent signs forward contracts (2) All participants submit supply functions Demand is realized and markets clear Optimal spot market behavior Price Supply Marginal cost overstates costs understates costs net buyer Forward position net seller Quantity

7 Original forward position is credible Traders in the forward market recognize that if the large producer buys forward contracts spot prices will be high It is expensive for the large producer to undo forward sales with forward purchases The large producer has no incentive to trade in forward market after entry is complete $/Plant Entry deterrence Construction Cost Entrant s profit: less forward sales Entrant s profit: more forward sales Entry

8 Original choice of forward sales Consider three cases No uncertainty in demand Uncertainty in demand baseload entry Uncertainty in demand linear marginal costs Optimal choice of forward sales No uncertainty in demand The large producer sells all output in the forward market produces such that price equals marginal cost eliminates the curse of market power Entry and production are efficient

9 Optimal choice of forward sales Uncertainty in demand baseload entry The large producer sells forward such that its expected marginal cost equals the expected spot price submits a supply function that is steeper than marginal cost earns more profits than it would if it committed to submitting marginal cost Production is not completely efficient Optimal choice of forward sales Uncertainty in demand linear marginal costs The large producer sells forward less than its expected spot market production submits a supply function that is steeper than marginal cost does not use its resources as efficiently or profitably as entrants does not entirely cure the curse of market power Production is not completely efficient

10 Conclusions Forward sales reduce the curse of market power Forward sales increase the large firm s profits No uncertainty - large firm achieves the upper bound on profits Uncertainty profits may be more or less than in the case of marginal cost commitment Efficiency is enhanced by a forward market No uncertainty - first-best efficient outcome Uncertainty - efficiency gains are not complete Forward contracts allow large firms to be successful in competitive markets with free entry