Title: The Use of Oligopoly Equilibrium for Economic and Policy Applications
1The Use of Oligopoly Equilibriumfor Economic and
Policy Applications
- Jim Bushnell, UC Energy Institute
- and Haas School of Business
2A Dual Mission
- Research Methods - how oligopoly models can be
used to tell us something useful about how
markets work - Potentially very boring
- What makes electricity markets work (or not)?
- Blackouts, Enron, manipulation, etc.
- A new twist on how we think about vertical
relationships - Potentially very exciting
3Oligopoly Models
- Large focus on theoretical results
- Simple oligopoly models provide the structure
for structural estimation in IO - Seldom applied to large data sets of complex
markets - Some markets feature a wealth of detailed data
- Optimization packages make calculation of even
complex equilibria feasible
4A Simple Oligopoly Model
where m is Cournot equilibrium margin.
5Surprising Fact Oligopoly models can tell us
something about reality
- Requires careful consideration about the
institutional details of the market environment - Incentives of firms (Fringe vs. Oligopoly)
- Physical aspects of production (transmission)
- Vertical contractual arrangements
- Recent research shows actual prices in several
electricity markets reasonably consistent with
Cournot prices - Cournot models dont have to be much more
complicated than HHI calculations
6Empirical Applications
- Analysis of policy proposals
- Prospective analysis of future market
- Merger review, market liberalization, etc.
- Market-level empirical analysis
- Retrospective analysis of historic market
- Diagnose sources of competition problems
- Simulate potential solutions
- Firm-level empirical analysis
- Estimate costs or other parameters (contracts)
- Evaluate optimality of firms best response
- Potentially diagnose collusive outcomes
7Oligopoly equilibrium models
- Cournot firms set quantities
- many variations
- Supply-function firms bid p-q pairs
- infinite number of functional forms
- Range of potential outcomes is bounded by Cournot
and competitive - Capacity constraints, functional form
restrictions reduce the number of potential
equilibria - Differentiated products models (Bertrand)
8Green and Newbery (1992)
9Simple Example
- 2 firms, c(q) 1/2 qi 2, c mc(q) qi
- Market supply Q q1 q2
- Linear demand Q a-bp 10 p
- NO CAPACITY CONSTRAINTS
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11Three Studies of Electricity
- Non-incremental regulatory and structural changes
- Historic data not useful for predicting future
behavior - Large amounts of cost and market data available
- High frequency data - legacy of regulation
- Borenstein and Bushnell (1999)
- Simulation of prospective market structures
- Focus on import capacity constraints
- Bushnell (2005)
- Simulation using actual market conditions
- Focus on import elasticities
- Bushnell, Saravia, and Mansur (2006)
- Simulation of several markets
12Western Regional Markets
- Path from NW to northern California rated at 4880
MW - Path from NW to southern California rated at 2990
MW - Path from SW to southern California rated at 9406
MW (W-O-R constraint) - 408 MW path from northern Mexico and 1920 MW path
from Utah
13Cournot Equilibrium andCompetitive Market Price
for Base Case - Elasticity -.1
14Table 1 Panel A, California Firm
Characteristics
15Methodology for Utilizing Historic Market Data
- Data on spot price, quantity demanded, vertical
commitments, and unit-specific marginal costs. - Estimate supply of fringe firms.
- Calculate residual demand.
- Simulate market outcomes under
- 1. Price taking behavior P C
- 2. Cournot behavior P P q C
- 3. Cournot behavior with vertical arraignments
P P (q-qc) C
16Modeling Imports and Fringe
- Source of elasticity in model
- We observe import quantities, market price, and
weather conditions in neighboring states - Estimate the following regression using 2SLS
(load as instrument)
- Estimates of price responsiveness are greatest in
California (?gt5000) relative to New England
(??1250) and PJM (??850)
17Residual Demand function
- The demand curve is fit through the observed
price and quantity outcomes.
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19Simulation ResultsCalifornia 2000
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21Impact of Further Divestiture(summer 2000)
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24The Effect of Forward Contracts
- Contract revenue is sunk by the time the spot
market is run - no point in withholding output to drive up a
price that is not relevant to you - More contracts by 1 firm lead to more spot
production from that firm, less from others - More contracts increase total production
- lower prices
- Firms would like to be the only one signing
contracts, are in trouble if they are the only
ones not signing contracts - prisoners dilemma
25Simple Example
- 2 firms, c(q) 1/2 qi 2, c mc(q) qi
- Market supply Q q1 q2
- Linear demand Q a-bp 10 p
- NO CAPACITY CONSTRAINTS
- Firm 2 has contracts for quantity qc2
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28Green and Newbery (1992)
29Bounds on Non-Cooperative Outcomes
Cournot
Dmax
Bound on NC Equilibrium outcomes
Dmin
competitive
Qsupplied
0
30Contracts Reduce Bounds
Dmax
Cournot
Bound on NC Equilibrium outcomes
Dmin
competitive
0
Qsupplied
Contract Q
31Over-Contracting can drive prices below
competitive levels
Dmax
Cournot
Dmin
Bound on NC Equilibrium outcomes
competitive
0
Qsupplied
Contract Q
32Vertical structure and forward commitments
- Vertical integration makes a firm a player in two
serially related markets - Usually we think of wholesale (upstream) price
determining the (downstream) retail price - Gilbert and Hastings
- Hendricks and McAfee (simultaneous)
- In some markets, retailers make forward
commitments to customers - utilities telecom services construction
- In these markets a vertical arrangement plays the
same role as a forward contract - a pro-competitive effect
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36Methodology
- Use market data on spot price, market demand and
production costs.
- Simulate prices under
- Price taking behavior
- Cournot behavior
- Cournot with vertical arraignments (integration
or contracts)
- The first order condition is
37Methodology
- Data on spot price, quantity demanded, vertical
commitments, and unit-specific marginal costs. - Estimate supply of fringe firms.
- Calculate residual demand.
- Simulate market outcomes under
- 1. Price taking behavior P C
- 2. Cournot behavior P P q C
- 3. Cournot behavior with vertical arraignments
P P (q-qc)
C
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43Summary
- Oligopoly models married with careful empirical
methods are a useful tool for both prospective
and retrospective analysis of markets - Careful consideration of the institutional
details of the market is necessary - In electricity, vertical arrangements (or
contracts) appear to be a key driver of market
performance - The form and extent of these arrangements going
forward will determine whether the success of
the markets that are working well can be sustained