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THE ECONOMICS OF REGULATION: THE ECONOMICS OF REGULATION: THE ECONOMICS OF REGULATION: THE ECONOMICS OF REGULATION:

COMPETITIVE ACTIVITIESCOMPETITIVE ACTIVITIESCOMPETITIVE ACTIVITIESCOMPETITIVE ACTIVITIES

Rudi Hakvoort

FSR TRAINING COURSEOCTOBER 10TH – OCTOBER 14TH

2011

2

Outline

• Market functioning – the basics

• Perfect markets

• Imperfect markets

3

Outline


• Perfect markets


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Incomplete information

Transaction costs

Public goods and

externalities

Internalisation

Indirect Intern.

Direct intern.

Allocation prop. rights

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Micro-economics

Classification of markets

• From the standpoint of the government, markets can be classified under one of two major categories:

– free market, or – regulated market.

• From the standpoint of pricing transparency, markets can also be classified into two major categories:

– transparent, or– opaque markets.

A market is said to be transparent when all buyers and sellers end up paying and

charging the same price for a given product, regardless of the price initially

offered by each.

• Finally, from the standpoint of the degree of competition, markets may be broadly classified as:

– perfect, or

– imperfect. Perfect competition is said to exist when no agent is large enough to be able to

take advantage of its size to affect the price of its products.

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Micro-economics

Type of market by number of participants

Demand →→→→

Supply ↓↓↓↓Many buyers Few buyers Sole buyer

Sole seller Monopoly Partial monopoly Bilateral monopoly

Few sellers Oligopoly Bilateral oligopoly Partial monopsony

Many sellers Perfect competition Oligopsony Monopsony

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• The central question of microeconomics is: What forces determine how much of a given good is produced and the price at which is bought and sold?

– two essential tools to reply suitably to this question: the demand curveand the supply curve

• Consumer demand is indicated by the concept of ‘total utility’:– Utility is a concept that represents the degree of satisfaction obtained by a

consumer of goods or services (‘willingness-to-pay’).

– The increase in the level of satisfaction is called marginal utility, where marginal means the additional utility obtained from consuming one additional unit of a given product or service.

– The law of diminishing marginal utility asserts that successive units of a good or service provide less and less satisfaction to a consumer.

Consumers buy a product whenever their satisfaction, measured in terms of marginal utility, is greater than the price.

Micro-economics

Consumers

9

PRICE

P*

QUANTITY

demand curve

Q*

Micro-economics

Demand curve

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• Supply curve explains producers’ market behaviour. – This function expresses the relationship between the quantities of a product

that firms are willing to supply and the selling price on the market

• Producer behaviour, and the supply curve, depend heavily on two factors:– Production costs.

– The number and size of companies competing on the same market.

• Optimum producer behaviour:– companies offer their products on the market seeking the highest possible

earnings, which means that they must take account of both the cost of

producing one additional unit and company revenue for the sale of that unit.

Micro-economics

Producers

Producers sell a product whenever their (marginal) production costs are lower than the price.

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P*

PRICE

QUANTITY

supply curve

Q*

Micro-economics

Supply curve

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The market

Law of supply and demand

In other words, the point where the supply and demand curves intersect .

– At this point and at this point only, price balances supply and demand, since consumers buy all the units with greater utility than the price and reject the purchase of the units whose utility is lower than the price.

– This same reasoning can be applied to producers

Market equilibrium is reached at a point where the quantity supplied equals demand, where for each unit:

– the price actually paid by consumers is lower than their willingness-to-pay, and

– the actual production costs for suppliers are lower than the price received.

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PRICE

QUANTITY

P*

supply curve

Q*

demand curve

The market

Demand and supply

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The market

Market clearing

• In most real electricity markets, the equilibrium point of the market is

reached by an auction mechanism.

– The negotiating unit is normally the price of electric power for a given

hour on the following day.

• In general, each hour is not auctioned separately: rather, bids

are placed for electric power for

whole days.

– This procedure for establishing the price and determining the amount of

power to be generated by specific

sets in accordance with demand is

what is known as market clearing.

PRICE

QUANTITY

P*

supply curve

Q*

demand curve

16

Outline


• Perfect markets


17

The perfect market

Perfect competition (1)

• The perfect market concept provides the theoretical economic grounds for the social and political system known as the free market.

– In practice, however, the conditions guaranteeing the existence of a perfect

market are difficult to meet.

• Perfect competition is said to exist when each producer is too small relative to the

market to exert individual influence on

price

– In other words, when all suppliers are ‘price takers’ who must sell their production at the going market price.

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The perfect market

Supply curve

Price

Output

Optimal output for company f

( )f fp CM q=

In perfect competition companies see demand as a straight horizontal line

Company f’s supply curve = MCe

p

19

The perfect market


The conditions requisite to perfect

competition are met when

– a large number of small firms produce a homogeneous good or service in quantities too small to exercise influence on the market

price.

– all the actors must have perfect information on the going price

which is tantamount to saying that the

market is transparent, with no poorly

informed buyers (or sellers) paying (or

charging) a less advantageous price than

other actors in possession of better

information.

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• The conditions guaranteeing perfect competition are not usually in place in real electricity markets:

– Normally only a few large producers operate

– Consumer behaviour is very inelastic to price, i.e., demand is very nearly vertical since consumers don’t take the price of electricity into

account when deciding on whether or not to consume it.

• On the generating market, electricity is regarded to be a homogeneous good, regardless of the producer or the source of

primary energy used.

• In the supply business, each company can be considered to offer a distinguishable product depending on tariff type, terms

of contract, peak and off-peak times, interruptibility, price

indexation to the price of international fuel markets, etc.

The perfect market


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Market clearing

Equilibrium between product supply and demand

Price

Demand

Market equilibrium

Supply curve

Demand curve

Equilibium price

Satisfied demand

Consumer’s surplus

Generator’s surplus

Generator’s costs Costs of unsatisfied demand

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Market clearing

Consumer & producer surplus

The consumer’s surplus is defined to be total utility less total price paid –

i.e., the area located between the

demand curve and the equilibrium

price

The producer’s surplus is defined to be total earnings for a company

(quantity x market price) less total

costs for production – i.e., the area

located between the supply curve and

the equilibrium price

The cost of unsatisfied demand, which represents the aggregate

consumer utility that is not satisfied

because marginal utility is lower than

the equilibrium price.

Price

Demand

Market equilibrium

Supply curve

Demand curve

Equilibium price

Satisfied demand


Generator’s surplus

Generator’s costs Costs of unsatisfied demand

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Market optimization

Economic efficiency (1)

• Economic efficiency is attained when the welfare of society as awhole is maximised.

• This welfare is defined to be the net social benefit (NSB), calculated as the sum of the consumer’s and the generator’s surplus.

• Efficient market equilibrium is reached when consumer marginal utility is equal to producer marginal utility.

– This, intuitively, means that under optimum conditions, if production is increased by one unit, the additional or marginal cost of producing that

unit is equal to the additional increase in satisfaction of demand,

measuring such additional satisfaction as marginal utility.

– Consumers decide to buy as long as prices are less than or equal to marginal utility

– Producers operating in perfect competition decide to sell as long as the price they can command is greater than or equal to their marginal costs

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Price

Demand

Supply curve

Demand curve

Equilibrium price

Satisfied demand

Consumer’s surplus = Total utility− Purchase cost

Generator costs

Utility ofunsatisfied

demand

Generator’ssurplusGenerator’s surplus = Total

income − Production cost


economic efficiency = net social benefit (NSB), calculated as the sum of the consumer’s and the

generator’s surplus.

Market optimization

Economic efficiency (2)

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• When consumers and producers operating on a perfectly competitive market negotiate who sells, who buys and the

transaction price, the result is economically efficient, since total

economic welfare is maximised.

• Furthermore, the price is the signal that tells each agent whether or not to effect a transaction: buyers compare the price with their

marginal utility and sellers with their marginal cost.

Market optimization

Summary

27

Price

MC ππππ

Output

Super-normal profit

q*

MCe = Average cost = Total cost / q

marginal cost (MC): additional cost of producing one more unit

average cost (MCe) – total cost divided by total output for each level of production

The market price and production cost

Marginal cost versus average cost (1)

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Price

MC

ππππ

Output

Losses

q*

MCe = Average cost = Total cost / q


Marginal cost versus average cost (2)

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Long term perspective

In the long run, companies competing on a market where entry is free

and all players have access to the same technological opportunities

will end up having similar cost structures.

– Where there are companies that earn super-normal profits, new entrants will be attracted into the industry by its high profitability based on short-

term high prices (ST price). These new entrants will cause the long-term

price (LT price) to drop, since according to the demand curve prices fall

as the supply rises.

– Companies posting losses will exit the market under the pressure of low short-term prices (ST price). Their disappearance will cause the long-term

price (LT price) to rise because, again according to the demand curve, a

decline in supply raises prices.

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Perfect market equilibrium dynamics at the break-even point

MCe

Price

Output

MC

q*

LT price ST price

Super-normal profit

New entrants

Final supply

Price Initial supply

Demand

Output

Final equilibrium

MCe

Price MC

q*

Loss

Output

LT price ST price

Price

Output

Initial supply

Final equilibrium Market exit

Final supply Demand

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Break-even point

Note that the average cost must include a return on capital, so this point

does not imply nil earnings, but rather a long-term sustainable profit in

keeping with the investment risk involved.

On the short term, prices are in line with marginal cost.

On the long term, all companies adapt their cost structure to

reach what is known as the break-even point, in which price equals average cost.

32


Economies of scale

Economies of scale are defined to be the case when:

– Where economies of scale exist, average costs drop as the size of production plants increases → only companies with large-scale

production centres are cost-effective.

– When the entire production of a given industry is added up and average costs can still be reduced by increasing output, the market will

ultimately tend towards a monopoly, as smaller and less efficient

companies gradually exit the industry.

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Development of ‘economies of scale’

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The electricity market

Variables affecting final price

Fuel marketsFuel marketsFuel marketsFuel markets GenerationGenerationGenerationGeneration NetworksNetworksNetworksNetworks SupplySupplySupplySupply

Domestic resources

Import-dependency

Price volatility

Number of companies

Import competition

Ownership

Level of utilisation (unit

cost)

Regulatory regime

Existence of price subsidies

Social tariffs

Tax policy

36

Outline


• Perfect markets


37

Market imperfections

Imperfect competition

• Imperfect competition is said to exist when one or several companies on a given market are large enough to exercise some

degree of control over price (market power)

• Sources of market imperfection:

– Existence of economies of scale – downward average cost curve – that fathers firms that are too large to ensure perfect competition.

– Such large companies, moreover, generate substantial information asymmetries, making bigger firms even more competitive.

– Legal restrictions such as patents, which encourage and protect research and invention, or barriers to entry, such as in the case of

certain products traditionally regarded to be public services (water,

gas, communications, electricity, banking and so on).


Efficient and distorted markets

EFFICIENT MARKET DISTORTED MARKET

Many players in the marketOne or few players

(monopoly, oligopoly)

Easy entry to and exit from the market (contestable market)

Legal entry / exit barriers

Fully informed market participants Imperfectly informed players

Most of the players are private

(seeking for maximum profits)

Players do not have to pay for the full

social cost of their activities

(subsidies, externalities)

Most of the players are publicly

owned (seeking for maximising

growth and influence)

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Market power

• A perfect monopolist would typically have a steep (inelastic) demand curve as entry of competitors is blocked and there are no

close substitutes.

• Under monopolistic competition, the demand curve tends to be more elastic. Market power exists but is more limited, due to

(close) substitutes.

You could for example still choose Pepsi instead of Coca Cola.

• Under monopolistic competition, the elasticity of the demand curve (i.e. market power) depends on how unique the product can

be made (in the perception of the clients).

If uniqueness is small, monopolistic competition comes close to

perfect competition.

Oligopoly

Definition

• Situation with a few (often 2 or 3) dominant suppliers.

• Often strong brand names (due to extensive advertising) act as

an entry barrier to their market.

• Oligopolists can produce homogeneous products (steel,

paper, cement, aluminium) or

differentiated products

(Pampers, Guinness, Tempo).

• Oligopoly behaviour (price setting, choice of output) is hard

to predict.

Oligopoly

Prisoner's dilemma

Profits (million Euro) for two firms (X and Y) at different prices

Price of FIRM X

Price of FIRM Y

2.00 euro 1.80 euro

2.00 euroA

Profit:10 each

BProfit: 5 for Y

12 for X

1.80 euro

CProfit:

12 for Y5 for X

DProfit:8 each

Oligopoly

The kinked demand curve under oligopoly

Quantity

Pri

ce

Our price cuts will be

followed by price cuts

of our competitors

and therefore we gain

only little extra sales

Our price increases will not be

followed by our competitors

and therefore we loose sales

Typical for

oligopoly:

price stability

Oligopoly

Concern for anti-trust authorities:

• Strong interdependence:Each oligopolist’s decision will affect the behaviour of the others.

Oligopolists observe each other very carefully!

• Strategic behaviour:What are the most likely reactions of my rivals?

How do they expect me to react to their actions?

• Collusion:Either explicit or ‘tacit’ agreement to limit competition (e.g. set output

quotas; fix prices; limit product promotion)

• Cartels:Setting quotas, fixing prices.

• Price leadership:All other firms choose the same price as the market leader (usually the

largest firm).

What is happening?

€/kwh

Hours of the day

Explanation for price spikes?

• Inelastic demand

• Non-storability

• Concentration

45

Market power in electricity markets

Definition

Market power is the ability to affect the market price profitably (i.e. to your own advantage).

– Normaly, the price is being deduced from the competitive equilibrium price, i.e. companies are price-taker

– Market power depends on the structure, not on the rules in a competitive market

– Distinguish between the existence of market power & the exercise(abuse) of market power!

Load

Price(EUR/MWh)

Market price

Quantity (MW)

Load

Price(EUR/MWh)

Market price

Quantity (MW)


How does market power work?

46

47


Measuring market power (1)

• Hirschman-Herfindahl Index (HHI)– measures market concentration as the sum of the squares of each

participant’s market share

HHI = Σi (si)2

i = 1, …, N firms in the “relevant market”

si = market share of firm i

• If N = 1 (monopoly) HHI = 10,000

• If N → ∞ (atomistic competition) HHI → 0• Generally HHI < 1,000 indicates adequate competition

HHI > 1,800 indicates inadequate competition

• Example:Three companies with market shares of 40%, 40% and 20% yield

HHI of 1600 + 1600 + 400 = 3600

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• Lerner-index– measures market imperfection as overpricing with respect to a perfect

market

– Lerner index requires information on market prices and hence is usually applied to markets once they are in operation. It is a good

index for monitoring and controlling the operation of a given market

Lerner = (P – MC)/P



50



• HHI measures market structure in terms of supply-side concentration,

• Lerner-index measures market operation in terms of pricing.• Both fail to take account certain characteristic features of

electricity generation, such as:

– The different productive structures of the companies involved, which may provoke large variations in the values of the two indices

depending on whether they are applied to peak or off-peak demand

times;

– The existence of differentiated products (power and ancillary services) that give rise to several markets;

– The possible existence of geographically differentiated markets where the transmission grid is factored into the model (esp. resulting from

congestion).

51


Difficulties with the assessment of market power

• In contestable markets, large firms may not have

(horizontal) market power

• Small firms may have vertical market power

• What is the relevant market?

– Geographical dimension: grid constraints

– Product dimension: capabilities of technologies,

times of day

52


Mitigating market power (1)

• Market power is extremely difficult to address successfully• The measures to effectively counter market power should focus on

reducing company size and increasing the number of competitors:

– The most effective and direct manner of kerbing market power consists of atomising companies, requiring all generators with a market share of over 25% or 30% to sell their assets, to reduce the HHI to under 2500. This type

of measures is very difficult to implement in practice due to strong

opposition from the owners of production facilities.

– Another measure consists of facilitating the entry of new producers by removing any regulatory difficulties or uncertainties that might serve as deterrents. This measure is very important if the long-term aim of lower

concentration is to be reached.

– Finally, another way to increase competition is to promote the construction of strong interconnections between neighbouring electric power systems to heighten competition between adjacent markets.

• But experience shows that markets where market power is exercised (and prices are high) do not attract new entrants

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1. Buy out existing IPP contracts to

free capacity to compete in the

market

2. Divest (privatize) existing utility

capacity (or VPPs) into tranches

that are sold to new entities

3. Ensure appropriate exit conditions

for old, uneconomical units

4. Increase load responsiveness

If all fails:

5. Price caps and/or bidding

restrictions and/or profit controls


Mitigating market power (2)

Thanks for your attention!

Rudi Hakvoort

D-Cision B.V.

� +31 88 18 000 81

� [email protected]

� www.d-cision.com

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