UNIT –III

MARKET POWER AND STRUCTURE 3. 1 Market Power
One of the main anti-competitive practices or difficulties that may prevent competition in the electric power industry, especially in generation, is Market Power. When an owner of a generation facility in a restructured industry is able to exert significant influences monopoly! on pricing or availability of electricity, we say that market power exists, and if so it prevents both competition and customer choice. Market Power may be de !"ed a# ow!"$ t%e ab!&!ty by a #e&&er' or a $ro() o #e&&er#' to dr!*e )r!+e o*er a +om)et!t!*e &e*e&' +o"tro& t%e tota& o(t)(t or e,+&(de +om)et!tor# rom a re&e*a"t market or a #!$"! !+a"t )er!od o t!me. Other than price, any entity that exercises market power would reduce competition in power production, service "uality and technological innovation. #he net result of practicing market power is a transfer of wealth from buyers to sellers or a misallocation of resources. Market Power is exercised either intentionally or accidentally. $or example in the generation sector, market power can be exercised by having an excessive amount of generation in the relevant market intentionally!, by transmission constraints that could limit the transfer capability in a certain area accidentally!, or by running certain generating units during certain periods of time for purposes of maintaining reliability while other units could have been less expensive accidentally!. %n the constrained transmission case, some units are restricted to provide power while dominant providers can drive prices up by determining which units to run and which units to keep back from the market. &nother example is the case when hourly metering is unavailable for customers, where customers could reduce their consumption as prices go up such as in peak periods. %n this case, generating unit owners drive market prices up for energy and capacity to their own benefit.

3.- Ty)e# o Market Power
#wo types of market power exist in electricity markets a. 'ertical Market Power b. (ori)ontal Market Power .ert!+a& Market Power arises from a single-firm*s or affiliate*s ownership of two or more steps in a production and market delivery process where one of the steps provides the firm with a control of a bottleneck in the process. #he bottleneck facility is a point on the system, such as transmission line, through which electricity must pass to get to its intended buyers. & control of a bottleneck process enables the firm to give preference to itself or its affiliate over competitive firms. #his concept is applicable to electricity restructuring in the +nited ,tates where most utilities are vertically integrated in the sense that they own or control generation, transmission, and distribution facilities to deliver electricity to end-user customers in their service territories. Possible vertical market power misapplication arises from the ability of a

though very often this takes the form of /financial withholding/ which simply means charging more than buyers are willing to pay. to which. #o this end consider an extremely simple case in which one supplier with only baseload plants shuts down one plant. & successful development of a well planned and fully functional %ndependent . #he result is to shift the competitive supply curve to the left by the "uantity withheld and to raise the price from P2 to P e.1 $igure 0. thereby withholding the plants output as shown in figure 0. Once shifted.3 Market Power E e+t o" Pr!+e a"d 1(a"t!ty 2Pr!+e31(a"t!ty O(t+ome#4 Mo"o)o&y )ower is the market power of sellers. all retail providers must have access. . 3. but for the sake of discussion.1 . and hence prices. and what are their relative si)es determine the market dominance.ystem Operator. the firm can influence the supply-demand e"uilibrium. 5et6# !"*e#t!$ate t%e e e+t o market )ower o" e&e+tr!+!ty )r!+e a"d 7(a"t!ty. the actual price in this market. simply by withholding production.firm to abuse its control of transmission and distribution facilities. %t arises from a firm*s local control or ownership concentration of a single process step in productive assets within a defined market area. #he principle method of exercising monopoly power is termed withholding of output. it is no longer the competitive supply curve.asic strategy of withholding and the price-"uantity outcome. two of each are defined by the competitive e"uilibrium P2. who want lower prices. as opposed to buyers. this strategy might or might not be profitable. to the advantage of its own generation and retail sales of electricity.e. who want higher prices.ecause market power must move price away from the competitive e"uilibrium. how many firms exists in the market. i. %f such concentration is sufficient with respect to certain other market conditions. monopolistic e"uilibrium P e.! 3epending on the amount of generation withheld and the amount of generation remaining in the market.ystem Operator may resolve vertical market power problems. -oncentration in a market measures the market dominance degree of monopoly experienced by a firm in a competitive market! using market share data. . /or!0o"ta& Market Power is the ability of a dominant firm or group of firms to control production to restrict output and thereby raise prices. #hree prices and three "uantities are of interest. assume it is. the result is always a price that is higher than the competitive price. 42! and the actual. #his type of market power can*t be resolved by %ndependent .

! Qdistort 1(a"t!ty D!#tort!o"' ∆ #he monopoly "uantity distortion. #he other price and "uantity are defined by the competitive supply curve and the actual price-"uantity pair. QW 1(a"t!ty W!t%%e&d' ∆ 4uantity withheld e"uals 42 Pe! -4e.oth values can be read from the competitive supply curve but in different directions. is the difference between the competitive output and the actual output. #he market share is either expressed in per unit or in percent.i is i participant*s market share in per unit or in . competitive e"uilibrium "uantity and will be denoted by ∆ P Pr!+e D!#tort!o"' ∆ distort #he price analog to "uantity distortion is P e . #hese prices and "uantities determine two price differences and two "uantity differences that are essential to the understanding of market power. When the inverse supply function is applied to the monopolistic e"uilibrium "uantity a new price is found which is denoted P2 4e!. %t is defined as the sum of the following s"uares of market shares of all participants. and the amount that actually is produced in the monopolistic e"uilibrium.i is calculated by dividing the contribution of the i th participant by the total contribution of all existing participants. ((% is a weighted sum of market shares of all participants in the market. 42 .(erfindahl %ndex ((%! of market power is a measure of concentration that also reflects the number of participants or firms! and the ine"uality of their market shares.=== in percent basis and 1.: T%ree Sta$e# o Market Power #he market process related to market power will be more clearly understood if conceptuali)ed as occurring in three stages8 . . a market with <ust one participant would have an ((% of 1=.9 /!r#+%ma" 3 /er !"da%& I"de. When the supply function is applied to the monopolistic e"uilibrium price a new "uantity is found which is denoted simply by 42 P e!. the lowest competitive supply at that price 5lowest 42 Pe!6 should be used. P e. #he competitive supply curve can be represented as a supply function 42 p! or as an inverse supply function P8274. which is the gap between the marginal cost of competitive suppliers supplying market "uantity 4e.Pe. #his is called the monopoly price distortion. denoted by ∆ distort and can be used as a reliable indicator of market power. %f the marginal cost curve is flat at the market price. $or example. (irschman . and the actually price in the monopolistic e"uilibrium. the difference between the actual price P and the competitive price. 2//I4 Market power has been extensively examined in power markets with different methods like concentration indexes such as the (irschman . PM Mark()' ∆ Markup e"uals P2 4! . %t is given by the following e"uation8 HHI = ∑ S i i =1 th N 9 Where : is a number of participants and .4e.(erfindahl %ndex ((%! or more direct measures of market power like the 7erner indexes. 3.P2. 3. which is the gap between the total amount that would be produced by competitive suppliers at the monopolistic price. #his is the amount by which market power has distorted the Qdistort .. . #he first is the 7(a"t!ty w!t%%e&d and second is the 7(a"t!ty d!#tort!o".= in per unit basis.4e!.

before physical withholding is identified as a market rule violation. (ence. to the extent that there is no other explanation for the gap. a proxy is re"uired for the competitive bid for the unit. it has exercised market power. #his could result from unscheduled outages that cannot be <ustified ex post. #he simplest definition of the output gap is econ prod Qi − Qi where8 Qiecon is the economic level of output for unit i given the market price and competitive bid for the unit. of capacity! it may provide some comfort that economic withholding is not a serious problem. where output is not bid into the market at all. and 0! conse"uences. %n order to determine. which is defined as the difference between the unit*s capacity that is economic at the prevailing market price and amount that is actually produced by the unit. & positive value of an estimate of the output gap implies the existence of economic withholding. including both units that are self-scheduled and those offered into the auction. &s mentioned earlier. it is . but was not. looking for generation capacity that would have been profitable to run at prevailing market prices. changes in a generator*s physical parameters in its offer that cause it to reduce its output. #he actual production. the focus on assessment of market power in electricity should not be on price but on output.ecause a monopolist is free to shift different parts of its supply curve by different amounts. such as a percentage share of a generator*s available capability withheld or percentage deviation from a dispatch instruction. and other factors that affect the actual production which are not due to market power conduct. assuming the market price would not change. E+o"om!+ w!t%%o&d!"$ is measured by estimating an >output gap*. #his measure was introduced by @oskow and Aahn in an analysis of market power in the -alifornia electricity market. and physical withholding.er+!#e o market Power #he two components of market-power strategy are 7(a"t!ty w!t%%o&d!"$ reducing output! and !"a"+!a& w!t%%o&d!"$ raising the price of output!. Qiecon.Os have adopted certain measures. it is impossible to tell whether a monopolistic shift of a linear supply curve is a leftward shift to reduce output or an upward shift to increase price. . where output is reduced because it is bid into the market above competitive prices. $orced outages and scheduled maintenance are obviously not considered physical withholding. less than 1. but can be difficult to prove as intentional exercise of market power in the absence of clear evidence. Sta$e 1. $or example. according to this view. and failure to respond to an %.O*s dispatch instructions.1! exercise. %. Physical withholding is typically simple to detect. and the generator chooses not to sell. economic withholding and physical withholding are e"uivalent strategies. forced outages. #hus. #he aim of >withholding analysis* is to identify generation capacity that would have been profitable at prevailing market prices but was withheld from sale. . 9! price-"uantity outcome. of a unit also needs to be ad<usted in order to take account of transmission constraints. and Qi prod is actual production of unit i. P%y#!+a& w!t%%o&d!"$ refers to any withdrawal of physical generation capacity from the market. the economic level of output. Qi prod.g. Strate$!+ E.toft has argued that the most basic approach to detecting market power is to look for >missed opportunities*8 if a generator would profit in expectation! from the sale of an additional unit of electricity. that could be construed as an attempt to raise the market price. Where this gap is small e. %n most cases. there are two types of withholding ? economic withholding.

BQdistort C Q⋆DQe. Pro !t. 4uantity withheld. so a positive markup or 7erner index proves market power. Eather their conse"uences for market outcomes and conse"uences should be analy)ed. but market power can still exist and transfer wealth.< Pr!+e31(a"t!ty O(t+ome# to S%ow Market Power Market power is not defined in terms of strategies and proof of its existence should not be attempted by analy)ing strategies directly. all are positive. BPdistort. #his is simply the price distortion. Sta$e 3. and if the demand curve is hori)ontal. #he first conse"uence is profit. BPdistort. there is no chance of the demand curve being hori)ontal. the market price is often depressed below the competitive price by auction rules. #hese relationships are summari)ed as follows8 Tab&e 3. Dead3we!$%t We& are 5o##. provided the profitability condition is met. When it does not occur there will be no dead-weight loss. or BPM are strictly positive then there is market power on the supply side in an electricity market. which is part of the definition of market power. BQW C qc Pe!DQe. times the total market "uantity. 4uantity distortion. or BPM are positive. BQdistort. market power has been exercised and if market power has been exercised. %f the supply curve is vertical market power can be exercised without causing "uantity distortion. 3. Sta$e -. Pr!+e31(a"t!ty O(t+ome# a"d t%e E. c. Price distortion. %n a power market. So+!a& Co"#e7(e"+e# o Market Power a. %f demand is inelastic then there can be market power on the supply side with no "uantity distortion. %n fact market power may be more profitable for those who do not exercise it because the exercise costs can be significant and the resulting increase in the market price affects all suppliers in proportion to their output b. Wea&t% Tra"# er. 4uantity distortion is most weakly linked to market power.1 . BQdistort. #here are two exceptions. so these play the useful role of shielding the stage-0 analysis from the complexities of market power strategies. +. supply curves are often vertical or nearly vertical. but for all suppliers. #he third conse"uence is called the /deadweight/ welfare loss and is the inefficiency resulting from monopoly power.er+!#e o Market Power8 =QW > ? ⇔ Market Power =Pd!#tort ⇔ Market Power ⇐ ⇒ =PM Market Power BQdistort Market Power 2 Profitability is assumed #he two most fundamental connections with market power involve price distortion. and quantity withheld. W ith vertical supply curves. b. %f any of BQW. BPdistort.impossible to distinguish price increases from "uantity reductions for any upward sloping supply curve. #he social conse"uences of the exercise of market power are fully determined by the stage-9 price-"uantity outcomes. %n power markets. . d. not <ust for the exerciser of market power. %f any of the four price "uantity differences B QW. %ndustry mark-up. #he second conse"uence is the transfer of wealth from consumers to producers. Pr!+e31(a"t!ty O(t+ome# Price-"uantity outcomes are usually well described by the following four price differences as discussed earlier8 a. BPM C PeD pc Qe!. BPdistort C PeDP⋆. a positive markup does not indicate that market power has been exercised.

sealed-bid auction! or successively. demand is greater than supply. When it does not. & common example is the auction rule that sets the market price at the offer price of the last accepted supply bid. #he award is based on the results of clearly specified financial bids. or by customers. contracts! on the basis of a financial bid. Withholding demand tends to decrease the price. %n this case.@ Mo"o)o&y !" Power A(+t!o" & monopoly is a market that has many sellers but only one buyer. &t the market price determined by the auction. namely i! bidding.ometimes this clears the market and sometimes it does not. 3. $or example. #he monopolist withholds output below the point where the price is e"ual to the marginal cost in order to maximi)e his profits. as opposed to monopoly power. %t is difficult to exercise in a power market because it re"uires withholding of demand or something e"uivalent.and this causes confusion when computing the markup. %f the supplier whose bid set the auction price were to raise its bid. %t is transparent due to the fact that it is based on a set of rules determined by the auctioneer and known by the bidders before the auction. and iii! pricing. so the market price is not a market clearing price. &n auction may be described by its three key rules. %f the auction sets market price e"ual to the price of the highest accepted bid. not away from it.e. #he bidding rules define how offers should be structured and when they can be submitted. P a. . Eaising the bid price above P2 would raise the market price above the competitive level. it is because demand is greater than supply at this price.e. and a pre-defined publicly available set of rules designed to allocate or award ob<ects or products e. &gain the "uantity withheld is a more reliable indicator of market power. the competitive price may be much higher than the market price. monopsony power can be exercised by physical withholding or by bidding a price lower than the powerHs marginal value.ut for monopsony. Monopsony power. the rules can specify that bidders have to bid <ust a price. #he clearing rule states how bids will be compared in order to determine the winner s! and the allocation of the ob<ect s! or product s!. & monopsonist can generate power at a cost greater than the market price in order to depress the market price see figure 0. but it would raise the price toward the competitive price.. &n auction is an allocation procedure based on a precise evaluation criterion specified by the auctioneer. 3. #his price is P 2 and is the price paid by all load and paid to all suppliers.9 right!. and demand is generally uncontrollable.g. ii! clearing. Many power markets are run as auctions. that would raise the market price. in response to the bids made by other auction participants or calls to bid by the auctioneer i. #his is the opposite of exercising market power.@ Market Power o" t%e Dema"d S!de Market power on the demand side is called Fmonopsony powerG or Foligopsony powerG and involves reducing price compared to the competitive price. . #he rules may also specify that bids are to be submitted only once i. there is a third alternative. #he pricing rule determines the price at which the deal will be closed. or a set of prices and "uantities. is market power exercised on behalf of. dynamic auction!. Ixercising monopsony power moves the market price lower and away from the competitive level. . and auctions set the price with formal rules which may or may not specify a market clearing price.ecause it is not market clearing price it cannot be the competitive price. 7ike monopoly power. #his would constitute an exercise of market power if it were profitable. . bidding higher and raising the market price to a level below the competitive price is not an exercise of market power..

O to withhold !"terr()t!b&e &oad 2+(#tomer dema"d4 refer figure 0.9 Ixercising monopsony power by withholding demand and by generating at a cost above the market price. #he two effects of market power are a. not because it believes it is unimportant. the most obvious effect is the transfer of wealth from consumers to suppliers. (owever. #he most straightforward approach to monopsony power is for the %. but the system operator could interrupt it anyway. #he price increase reduces benefit to . More power will be available internally. the %. Tra"# er o Wea&t%. either implicit or explicit.)&a!" t%e +o"#e7(e"+e# o w!t%%o&d!"$ $e"erator +a)a+!ty by $e"erat!"$ +om)a"!e# !" e&e+tr!+!ty market. E. the load should not be interrupted. b. A"#wer 1. $inally.)&a!" t%e two e e+t# o market )ower !" e&e+tr!+!ty market. #his is an exercise of monopsony power. #here are various types of interruptible load contracts and all have some price. pay the cost. and lower the market price. this does not preclude the policy maker from taking it into account. thereby saving much more for customers than the cost of interrupting the load. T%e Deadwe!$%t We& are 5o## o Mo"o)o&y. monopsony power has been exercised. 1(e#t!o"# a"d A"#wer# 1(e#t!o" 1.9 left!. %f that price is above the competitive price. Iconomics is more concerned with efficiency and in this case.O may exercise monopsony power by controlling imports and exports. OR E. %f this saves more than it costs. %f the internal market price is J1K= and the external price is J9==LMWh. When monopoly power is exercised. reducing the price for the internal market. the %.$igure 0. Iconomics often ignores the problem of wealth transfer. is concerned that high monopoly prices will lead to inefficiently low levels of consumption. but because it has no way to evaluate it.O can curtail exports.

. must be positive. $igure 0. Market rules solutions. #he various market mitigation methods that may be implemented by a market monitoring or regulatory authority for reducing market power can be loosely collected into three main categories8 a. #he classical structural solution to the problem of market power is to mandate or encourage the divestiture of the dominant generator or generators. #hus.)&a!" *ar!o(# Market Power M!t!$at!o" Te+%"!7(e# !" +om)et!t!*e e&e+tr!+!ty market. Eegulatory solutions.tructural solutions. E.0. a supplier must produce less than the competitive price taking! output level producing more would lower the price and reduce profit!. if monopoly power has been exercised. 1(e#t!o" 3. 1(e#t!o" -. and it is what is meant by /inefficient. b. #o exercise market power. #he gap between this lower amount and the price-taking output at the market price is the "uantity withheld./ #he result of withholding supply by a generator and the conse"uent increase in price is shown in figure 0. Market power cannot be exercised while acting as a price taker. -ompetition is defined by price-taking behavior which means producing as if the market price could not be affected. One of the . A"#wer-. that is. BQW. #his is called a deadweight loss to society. being a perfect competitor.consumers more than it increases profits. and c. W%y t%e mo"o)o&y )ower m(#t !"*o&*e 7(a"t!ty w!t%%e&dA A"#wer-.0 Wealth transfer and dead-weight loss caused by the exercise of monopoly power.

earliest examples of this was in the +A. which in turn were later encouraged to further divest their assets.g. . generation site permits. %n general. economists are not always clear as to what this acceptable level of market power should be. Many countries include such caps as a >safety-net* measure. there have been cases where the right to use electricity generation units has been auctioned off rather than ownership of the assets themselves e. Most economists would agree that it is far more costly to eliminate all market power than to allow some market power to exist. or in 'irtual Power Plant auctions in e.arriers may include licence conditions. the use of price caps has created an enormous debate regarding their effect on revenue sufficiency for peaking plants. governments may provide private generation companies with -ompetition #ransition -ontracts to allow them to recover stranded costs incurred under a previous cost-based regulatory regime as in . .ut even in the short term there is a need to balance the cost of mitigating market power against the costs of the market power itself. $rance and #he :etherlands!. where the conventional generation units of the formerly state-owned monopoly were split into two new companies. rather than a foundation upon which to operate the market. Ixplain in detail the term Market Power in electricity market. encouraging new market participants by reducing or removing barriers to entry is also recommended as a useful means of encouraging a competitive electricity market. . #he third type of market mitigation methods are those market rules or behavioural regulations aimed at the actual operations or decisions of the generators in electricity markets. . perfect competition is not necessarily the appropriate standard to be aiming at.imilarly. there are efficiency benefits of providing flexibility to supply bids but there are potential market power conse"uences as well.g. &nother regulatory tool is to re"uire dominant generators to sell a certain amount of their capacity under long-term contracts at a pre-negotiated or regulated rate. #he most important of these include caps on unit-specific bidding. the encouragement of forward contracting is regarded as an important means of reducing market power. . Iconomists generally refer to >workable competition* as a competitive standard with an acceptable level of market power. Where governments have privati)ed generation companies they have fre"uently provided them with socalled >vesting* contracts as a transitional tool in the development of competitive electricity markets. undesirable side effects. On the demand side. Review Questions for University Exams 1. $or this reason. and discriminatory access to the transmission network. there will not be enough revenue to cover the fixed costs of the plant. %n other cases.pain and -alifornia!. #hey also often re"uire specific company related information that may be difficult to ac"uire. Eegulatory forms of market mitigation include the imposition of system-wide constraints such as market-price caps. $or example. %n addition. #hese are often regarded as the most heavy-handed form of regulation and most liable to have unintended.imilarly. various means of increasing price responsiveness of electricity customers are also seen as a promising way of reducing market power. %f price caps lead to plants only covering their marginal costs. &lberta. Most economists would argue that the regulatory and market rules mitigation solutions should be used as transitional devices on the road to fully competitive markets or only under rare market conditions. Ixpansion of the transmission system is also another means of decreasing concentration of generation by expanding the geographic market over which suppliers are competing. (owever. where divestiture was found to be institutionally or politically difficult. +nfortunately there is little empirical work examining these trade-offs.

M. Ixplain how the Market Power is exercised from the customer demand sideQ OE (ow monopsony power is exercised in electricity marketQ . O. Physical Withholding. -lassify and explain various types of market power in electricity supply industry. Ixplain how Monopoly exists in Power &uctionQ 11. Ixplain the effect of Market Power on electricity price and "uantity in competitive market. 4uantity 3istortion c. Iconomic Withholding b. Price 3istortion d. N. 3efine the term Monopoly and &uction. K. 0. 1=. (ow Price-4uantity outcomes can be used to show market power in electricity marketQ R. 4uantity Withheld b. What do you understand by the following terms a.9. Ixplain three stage market process related to the market power. &lso explain its significance. P. Markup. OE Ixplain the three stages of market power. What do you understand by Monopsony or Oligopsony power in electricity marketQ 19. Ixplain the following terms in reference to the market power8 a. 3efine (irschman-(erfindahl %ndex of market power.

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