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Identifying Market Power in Electric Generation

Fortnightly Magazine - February 15 1996

To what extent should regulation yield to market forces in setting wholesale electric prices? The Federal Energy Regulatory Commission (FERC) posed this question when it sought comments on whether open transmission access would eliminate the need for anything like traditional rate regulation. But when the comments came back, the Department of Justice and others answered, "not necessarily."

Surely that is the correct answer. Transmission constraints and other factors can combine to produce pockets of substantial market power. The question is how to identify these pockets when they arise.

Market power on the part of sellers is the ability profitably to maintain prices above competitive levels by restricting output below competitive levels. This definition applies both to a single seller and to the collective market power exercised by a group of sellers.1 In this definition, the term "competitive price" means the equilibrium price in a competitive market (em i.e, the marginal cost of the most costly unit necessary to satisfy industry demand.

Which costs are marginal depends on the timeframe of a transaction. For a short-term sale of energy, marginal cost would be principally fuel costs, which would vary according to the type of generating unit (em from gas turbine and diesels units at the high end, to nuclear and hydro units at the low end. For a long-term sale of capacity, all costs would be marginal.

Some Basic Tenets

No firm or group of firms can possess substantial market power if industry demand for their product is highly elastic due to the availability of good substitutes.

The degree of market power depends upon factors that affect the costs and benefits of restricting output. Of the greatest importance is industry demand, which economists characterize by its "elasticity." The elasticity of demand indicates how quantity responds to a change in price. Elasticity of demand also indicates how the price would respond to a change in output, if output were restricted to drive up price.

If demand is very elastic, the benefit from a given reduction in output is relatively quite small; no firm or group of firms can possess significant market power. What makes demand for a product very elastic is the availability of good substitutes. For example, the demand for red bowling balls is probably very elastic, because blue and black bowling balls offer very good substitutes.

The demand for electric power, however, is surely not so elastic that no group of firms could collectively exercise significant market power. Thus, we should consider what factors might affect the market power of a single firm when all firms, acting collectively, might exercise market power. Take the hypothetical example in Figure 1 of an electric industry containing only seven generating units, each having a constant marginal cost over its entire range of possible output, with no two units having the same marginal cost.

Figure 2 (see page 18) adds an industry demand curve and illustrates the competitive equilibrium. Competitive price and quantity are determined by the intersection of the industry demand curve with the industry marginal cost schedule. The competitive equilibrium serves as a baseline

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