The Use of Oligopoly Equilibrium for Economic and Policy Applications

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The Use of Oligopoly Equilibriumfor Economic and
Policy Applications

• Jim Bushnell, UC Energy Institute
• and Haas School of Business

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A 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

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Oligopoly 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

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A Simple Oligopoly Model

• Concentration measures

where m is Cournot equilibrium margin.
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Surprising 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

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Empirical 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

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Oligopoly 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)

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Green and Newbery (1992)
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Simple 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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Three 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

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Western 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

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Cournot Equilibrium andCompetitive Market Price
for Base Case - Elasticity -.1
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Table 1 Panel A, California Firm
Characteristics

• HHI of 620

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Methodology 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

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Modeling 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)

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Residual Demand function

• The demand curve is fit through the observed
  price and quantity outcomes.

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Simulation ResultsCalifornia 2000
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Impact of Further Divestiture(summer 2000)
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The 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

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Simple 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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Green and Newbery (1992)
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Bounds on Non-Cooperative Outcomes

Cournot
Dmax
Bound on NC Equilibrium outcomes
Dmin
competitive
Qsupplied
0
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Contracts Reduce Bounds

Dmax
Cournot
Bound on NC Equilibrium outcomes
Dmin
competitive
0
Qsupplied
Contract Q
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Over-Contracting can drive prices below
competitive levels

Dmax
Cournot
Dmin
Bound on NC Equilibrium outcomes
competitive
0
Qsupplied
Contract Q
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Vertical 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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Methodology

• 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

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Methodology

• 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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Summary

• 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