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Market Power

Economics-III Industrial Economics

Market Power

Market Power

Market power is the ability of a business to set their prices above a level that would exist in a highly competitive market. Higher prices then allow a firm with market power to earn higher supernormal profits. Market power then allows firms to maintain their profits by using barriers to entry to successfully prevent the profitable entry of new firms. If only a few firms have considerable market power, then a market can be described as an oligopoly. In this situation, power is said to be highly concentrated.

Measuring Market Power - The Lerner Index

The Lerner Index is a measure of market power in an industry. The Lerner index measures the price-cost margin - it is measured by the difference between the output price of a firm and the marginal cost divided by the output price Under conditions of perfect competition, output prices equal marginal costs (leading to an electively efficient equilibrium output) while prices move increasingly above marginal cost as market power increases and we head towards an oligopoly, duopoly or monopoly.We can interpret the index by saying that the Lerner index lies between zero (perfect competition) and one (strong market power)

The chart below tracks the estimated Lerner Index for the UK commercial banking industry and suggests that the industry was becoming more concentrated in the years leading up to the Global Financial Crisis.

Whether or not the entry of a number of challengers banks eventually causes the retail banking sector in the UK to become significantly more competitive remains to be seen. Most of the challenger banks are very small relative to the existing established commercial banks. Some including Metro Bank have already run into significant financial difficulty. When we calculate the assets of the three largest commercial banks as a share of total commercial banking assets in the UK we find that the leading banks have nearly 70 per cent of assets - a clear indication of an oligopoly.

2.1 Defining market power

(i) Different definitions,

• Economics and regulatory definitions of market power typically differ in several ways. Economics definition The ability to profitably alter prices away from the competitive price.

• Concerned with deviation from competitive level, whether above or below competitive levels.

• Does not qualify extent or duration of this ability.

Regulatory definitions Examples:

• The ability to “withhold” (sell less than if behaving competitively).

• The ability to increase prices for a significant period of time.

(ii) Regulatory focus,

• Regulatory definitions often focus on a particular identified action or “exercise,” such as withholding.

• Focus on a particular action may not identify all situations that satisfy the economic definition of market power and may not consider whether the action is profitable: – In the homework exercise, you were prohibited from physical withholding, but this does not prevent you from other actions

• Regulatory agencies such as the Department of Justice have historically been concerned about the possibility of collusion (explicit agreements between suppliers to withhold) or of the effect of mergers, rather than with “unilateral” market power.

• Although collusion is a concern, we will not consider it in detail: – In the homework, I hope that you did not collude with other groups – Regulatory history focusing on collusion means that regulatory analysis applied to electricity markets may not be able to identify unilateral market power.

(iii) Economic focus,

Economics definition focuses on the outcome of the effect on price and profit.

• Unilateral actions by a generator that result in this outcome: – offering energy at a price higher than marginal costs (“economic withholding”), or – not offering all of its capacity (“physical withholding”) also resulting in higher prices.

• If this action would increase profit (because increase in prices (and decrease in production costs) compensates for decrease, if any, in sales) then the generator has market power.

• Market power on the supply side is called “monopoly power” or “oligopoly power.”

• Other actions can also correspond to market power: – For example, a buyer of energy with flexibility in the amount consumed could purchase less than consistent with willingness-to-pay, depressing the price for all energy purchased, “monopsony power.”

Most firms have some market power in that some of the time they could profitably alter prices:

– Economics definition counts this as market power.

– Public policy issue is then whether market power occurs enough of the time and produces enough distortion of price from competitive levels (or other measure of market power) in a particular market to be “significant,” according to some particular notion of significant, to warrant the cost of action to reduce market power.

– Regulatory definition tries to capture this issue, but by not being explicit about the criterion for “significant,” fails to be useful as a definition without further elaboration.

• It will develop quantitative measures of deleterious effects of market power.

• Public policy decision involves trading off the deleterious effects of market power with the cost of mitigating it to assess when the exercise of market power is significant enough to warrant action.

• Profitability is part of definition: – otherwise, participants that choose to offer at price cap into the ERCOT up-balancing market (and who are never dispatched for any balancing up energy and never profit) would be defined as having exercised market power. – otherwise, a baseload nuclear plant would be defined as having market power, even if withholding production would be unprofitable.

• Trying to increase or maximize profit is not in itself anti-social behavior:

– Simply a model of “rational,” self-interested market participant behavior that can be useful to predict or understand outcomes,

– Does not always model behavior

– Data in model may be uncertain

– Effort to be rational may exceed benefits

• Given the fundamental economic assumption that rational behavior entails trying to maximize profits, if a market participant “has” market power then it will “exercise” its market power:

– economics does not typically distinguish between “having” and “exercising” (or “abusing”) market power.

Regulators do distinguish between having and exercising market power, implying that market participants are not acting in their own self-interests (at least in “short-term”):

– if short-term profit maximization would result in regulatory action or longer-term entry by competitors then market participants may forbear from maximizing their short-term profits in order to maximize longer-term profits.

• Typically difficult to model these effects.

• Assumption of short-term profit maximization provides upper bound on what might actually occur in practice, given actual forbearance.

(iv) Why is market power a concern?

• Inefficiency of production: – withholding of low variable operating cost generation may result in higher variable operating cost generation being used, – higher overall fuel bill must be paid for.

• Inefficiency of capital allocation: – higher prices may induce too much new construction.

• Inefficiency of allocation: – since demand may be lower because of withheld generation.

• Transfers of wealth from demand to generators.

• Quantitative measures of market power should relate either explicitly or implicitly to these deleterious effects.

(v) Price and quantity measures,

To understand market power, we begin with the absence of it.

• We also ignore transmission constraints for now.

• Assume that each generator specifies an offer function that is equal to its marginal costs: – Price-taking (in the economics sense) or competitive offer, – as in offer-based economic dispatch example.

• Adding up the offers horizontally (taking the sum of the inverses of the offers) yields the competitive supply $q^{c}$ .

• The inverse of the competitive supply function is the industry-wide marginal costs of production $p^{c}$ .

• Also assume that each demand makes a bid that is equal to its willingness-to-pay. – That is, each market participant behaves competitively.

• Adding up the bids horizontally yields the competitive demand $q^{d}$ .

• The result of offer-based economic dispatch is the same as finding the intersection of supply and demand.

• The intersection is specified by the competitive price $P^{*}$ and quantity $Q^{*}$ .

Now suppose that a generator withholds by removing a quantity $\Delta Q_{w}$ of its potential production from the offer.

– For simplicity, assume that all other offers remain based on marginal costs.

• The resulting supply curve $q^{e}$ is shifted, in part, compared to the competitive supply $q^{c}$ .

• This shift will increase the price and decrease the quantity where the supply and demand cross.

• Withholding of supply results in price $P^{e}$ and quantity $Q^{e}$ .

• Note that at the price $P^{e}$ , the production $q^{e}$ ( $P^{e}$ ) is less than the corresponding “competitive” production $q^{c}$ ( $P^{e}$ ) at that price by the “quantity withheld” $\Delta Q_{w}$ .

The quantity withheld is typically larger than the “quantity distortion,” $\Delta Q_{distort}$ = $Q^{*} - Q^{e}$ , which measures the decrease in production compared to the competitive equilibrium.

– The quantity distortion is less than the quantity withheld since the higher price under withholding causes more production by other generators and reduction of demand.

– If the demand is “inelastic,” that is, a constant quantity independent of price, then the quantity distortion would be zero.

• Analogous to the quantity distortion is the “price distortion,” the increase in price above the competitive level, $\Delta P_{distort} = P^{e}-P^{*}$

• Another price-related measure is the “industry mark-up,” the increase in price above marginal costs $\Delta P_{M}$ ?= $P^{e}$ − $p^{c}$ $(Q^{e})$ , where p c is the industry-wide marginal costs of production evaluated at the actual production level $Q^{e}$ :

– price $p^{c}$ $(Q^{e})$ corresponds to industry-wide efficient dispatch at the quantity $Q^{e}$ .

– The price mark-up is typically larger than the price distortion since the industry-wide marginal costs evaluated at the quantity $Q^{e}$ is usually lower than the industry-wide marginal costs evaluated at the larger quantity $Q^{*}$ .

We can also consider:

– the mark-up compared to a firm’s own marginal costs at the quantity it is actually producing, and

– the average of these firm mark-ups over all firms.

(vi) Economic versus physical withholding,

• Market power can be exercised by: – not offering all capacity to market (physical or quantity withholding), or – offering at a price higher than marginal costs (economic or financial withholding).

• The outcome of both is a quantity withheld.

• If capacity is known publicly then economic withholding is less detectable than physical withholding:

– outcome of both can be similar,

– in homework exercise, could have reached similar outcomes with physical withholding.

(vii) Auction rules,

As mentioned previously, electricity market auction pricing rules may deviate from setting the market clearing price:

– Using the offer price of the last accepted offer, (that is, the marginal offer price) is not always the market clearing price.

– The marginal offer price may be lower than the market clearing price if demand is curtailed or if a demand bid price would have set the market clearing price.

• If the price is below the market clearing price then there will not be adequate remuneration from the market and, in the longer term, investment will be inadequate:

– ongoing concern about “resource adequacy” in ERCOT is indicative that prices may be below competitive prices on average.

• “Thin” hockey stick offers (offer matches marginal costs until just below capacity, then offer price increases significantly) can be interpreted as an attempt to circumvent pricing rules that depress prices below the market clearing price:

– Offer is reflecting “right-hand marginal costs” at full output.

– So, should not be deemed market power unless price is actually above competitive price!

– In absence of demand specifying willingness-to-pay, such thin hockey sticks still do not determine competitive price.

• “Thick” hockey stick offers (offer price is well above marginal costs for a sizeable proportion of capacity) is withholding.

(viii) Market power on the demand side.

• Market power on the demand side is called “monopsony power” or “oligopsony power” and involves reducing price compared to the competitive price.

• Withholding demand tends to decrease the price.

• A typical example involves interruptible demand and the independent system operator (ISO) in its role as monopsony buyer of energy on behalf of demand.

• Suppose that interruptible demand agrees to interrupt for some side-payment by the ISO.

• The ISO may find that, by interrupting the demand, the market price is depressed enough to more than compensate for the side-payment to the interruptible demand.

• Although this action may save money for consumers, it can decrease welfare in the short-term (assuming offers and other bids were competitive), and it discourages investment compared to optimal level (also decreasing welfare in long-term).

• Initial proposals for ERCOT “emergency interruptible load” program involved such a side-payment.

2.2 Exercising market power

2.2.1 Real-time market

• Administered by the ISO, which sets “real-time prices:”

– in ERCOT currently, called the “balancing market,”

– in ERCOT nodal, will be called the “real-time” market.

• Arranges for physical delivery of power.

• Would be called the “spot market” in other commodities and the market price would be called the “spot price.”

2.2.2 Forward markets

• In addition to the “real-time” market, there are “forward markets” and other “forward contracts:”

– the day-ahead energy market is a short-term (one day ahead) forward market and is also administered by the ISO:

• ERCOT does not currently have an ISO-administered day-ahead market for energy,

• ERCOT will administer a day-ahead market for energy and ancillary services in ERCOT nodal, but we will not focus on ancillary services in this course,

• ERCOT will also consider unit commitment decisions, but we will not focus on unit commitment in this course,

– there are longer-term forward markets not administered by the ISO (see, for example, Intercontinental Exchange, www.theice.com),

– two parties can forward contract “over-the-counter” between themselves for any contract term and with a variety of conditions:

• month ahead, season ahead, year ahead, multiple years,

• off-peak hours, on-peak hours, all hours in contract term.

Forward markets “hedge” (or reduce) exposure to price volatility (variability) by arranging a trade at an agreed quantity and agreed fixed price for the contract term.

• Forward trade could, in principle, be made for “physical delivery,” where seller intends to produce energy.

• However, forward markets in most commodities involve “financial commitment,” where seller can make good on commitment by paying the difference between the spot (real-time) and the agreed price:

– as in “contract for differences.”

2.2.3. What constitutes significant market power?

• Fleeting high prices may not translate to significant increases in average:

– Forward markets protect against risk of being “caught out” by occasional high prices, at least for hedged quantity.

• Appropriate to use average measures over time to assess significance of market power (and decide whether the cost of reducing market power is worth the benefit):

– wealth transfer,

– inefficiency,

– profits.

• Random variations in demand due to weather cause variations:

– The size of “natural” variations due to demand provide a useful gauge of what is significant.

– For example, if yearly weather variation causes a variation in a measure (for example, profit) on the order of 2% then it is probably fruitless to try to reduce withholding to having a less than 2% effect on profits. • Ultimately requires public policy input as to “significant.”

2.3 Modeling market power

2.3.1 Profit maximization for a monopoly

• An extreme case is where there is only one generator, a “monopoly.”

• Fundamental economic assumption is that market participant wishes to maximize its profits .

• The monopolist chooses its production quantity in each particular pricing interval to maximize its profits.

• Market rules typically require specification of offer:

– generator may not be able to literally specify quantity , but

– by understanding demand response to price (or the inverse of this function, the “inverse demand” $p^{d}$ can specify offer that results in a quantity .

– Since monopolist is the only generator, “market clearing” condition requires that demand equals .

• Note that the monopolist is “taking” whatever price clears the market (so is a “price-taker” in electricity market sense) but is not behaving competitively and is not a price-taker in the economics sense!

• The “short-run” profit (per hour) in any pricing interval is:

$\pi monopoly (Q) = p^{d}(Q)Q-c(Q)$

• where c are the total variable operating costs of the generator.

• Ignoring capacity constraints, to find quantity Q m that maximizes profit for monopoly, set derivative of profit equal to zero:

$0=Q^{m}\tfrac{\delta \pi monopoly}{\delta Q}$ = $(Q_{m})Q^{m}\frac{\delta p^{d} }{\delta Q }+p^{d}(Q^{m})-\frac{\delta c}{\delta Q}Q^{m}$ ,

• the term $(Q_{m})Q^{m}\frac{\delta p^{d} }{\delta Q }+p^{d}(Q^{m})$ is called the “marginal revenue:”

– note term due to effect of quantity on price.

• $\frac{\partial c}{\partial Q}$ is the marginal costs, which we will abbreviate as c' .

• Profit maximization occurs when marginal revenue equals marginal costs.

• Equating marginal revenue and marginal costs are the first-order necessary conditions for profit maximization.

• Sufficient conditions for profit to be maximum are that: derivative of profit is zero (that is, first-order conditions are satisfied); costs are convex; and $p^{d}(Q)Q$ is concave in .

• We will usually assume that convexity/concavity aspects of sufficient conditions hold.

(ii) Cournot model of oligopoly,

• Models of interaction require specification of how each participant perceives the effect of the other participants in the market.

– The Cournot model posits that each participant i assumes that each other participant $j\neq i$ commits to a fixed output level $Q_{j}$ .

– Each other participant j somehow specifies its offer so that the quantity $Q_{j}$ is produced independent of the market price (not literally possible in electricity market with “offer caps” and under some market rules).

• One way to think of this situation is that player i is going to maximize its profits as though it is a monopolist facing the “residual demand” defined by $demand-\Sigma _{j\neq 1}Q_{j}$ .

• Models of interaction also require specification of the information available to market participants:

– the basic Cournot model posits that each participant has complete knowledge about other participants and demand,

– true in the homework exercise, but not (exactly) true in reality because of uncertainty about supply of others and demand.

(iii) Herfindahl-Hirschman index,

The HHI is used by several regulatory agencies to estimate the effect of mergers on market power.

• Percentages are often used by regulatory agencies instead of decimals for market share, yielding an index between 0 and 10,000.

• It is also used as a measure of market power exercised by market participants unilaterally.

• The only rigorous justification for using HHI is in the context of the Cournot model using market shares.

• Relationship of HHI to mark-up also requires knowledge of elasticity:

– Price elasticity in electricity market is much smaller than in other markets.

– So, levels of HHI that might correspond to “acceptable” levels of markets power in other markets may not be acceptable in electricity markets.

– Nevertheless, such levels borrowed from other industries are routinely used in regulation of electricity markets!

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