Download Market

FSR TRAINING COURSE
OCTOBER 10TH – OCTOBER 14TH
2011
THE ECONOMICS OF REGULATION:
COMPETITIVE ACTIVITIES
Rudi Hakvoort
Outline
• Market functioning – the basics
• Perfect markets
• Imperfect markets
2
Outline
• Market functioning – the basics
• Perfect markets
• Imperfect markets
3
Microeconomics
Price
Consumers
What is
consumed?
Producers
What is
produced?
Market
Law of supply
and demand
Who
consumes
it ?
Types of market
Real
markets
Perfect
markets
Regulated
businesses
Market
power
Economic
efficiency
Who produces
it ?
Market failures
Transaction
costs
Natural
monopolies
H ow i s i t
produced?
Public goods
and
externalities
Incomplete
information
Internalisation
Allocation prop.
rights
Direct
intern.
Indirect
Intern.
5
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.
6
Micro-economics
Type of market by number of participants
Demand →
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
Supply ↓
7
Micro-economics
Consumers
• 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 curve
and 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.
8
Micro-economics
Demand curve
PRICE
P*
demand
curve
Q*
QUANTITY
9
Micro-economics
Producers
•
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.
Producers sell a product whenever their (marginal) production costs
are lower than the price.
•
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.
10
Micro-economics
Supply curve
PRICE
supply
curve
P*
Q*
QUANTITY
11
The market
Law of supply and demand
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.
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
12
The market
Demand and supply
PRICE
supply
curve
P*
demand
curve
Q*
QUANTITY
13
The market
Market clearing
•
In most real electricity markets, the
equilibrium point of the market is
reached by an auction mechanism.
PRICE
supply
curve
– 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.
P*
demand
curve
Q*
QUANTITY
14
15
Outline
• Market functioning – the basics
• Perfect markets
• Imperfect markets
16
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.
17
The perfect market
Supply curve
Price
In perfect competition companies see demand as
a straight horizontal line
p
Company f’s supply curve = MCe
p = CM f (qf )
Output
Optimal output for company f
18
The perfect market
Perfect competition (2)
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.
19
20
The perfect market
Perfect competition (3)
• 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.
21
Market clearing
Equilibrium between product supply and demand
Price
Demand curve
Market equilibrium
Consumer’s
surplus
Equilibium
price
Generator’s
surplus
Supply curve
Generator’s costs
Costs of unsatisfied demand
Demand
Satisfied demand
22
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
Price
Demand curve
Market equilibrium
Consumer’s
surplus
Equilibium
price
Generator’s
surplus
Supply curve
Generator’s costs
Costs of unsatisfied demand
Demand
Satisfied demand
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.
23
Market optimization
Economic efficiency (1)
• Economic efficiency is attained when the welfare of society as a
whole 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
24
Market optimization
Economic efficiency (2)
Price
Demand curve
Consumer’s surplus = Total
utility− Purchase cost
Consumer’s
surplus
Equilibrium price
Generator’s surplus = Total
income − Production cost
Generator’s
surplus
Supply curve
Generator costs
Utility of
unsatisfied
demand
Demand
Satisfied demand
economic efficiency = net social benefit (NSB),
calculated as the sum of the consumer’s and the
generator’s surplus.
25
Market optimization
Summary
• 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.
26
The market price and production cost
Marginal cost versus average cost (1)
Price
MC
π
Super-normal profit
MCe = Average cost = Total cost / q
marginal cost (MC):
additional cost of producing
one more unit
Output
q*
average cost (MCe) – total
cost divided by total output for
each level of production
27
The market price and production cost
Marginal cost versus average cost (2)
Price
MC
π
MCe = Average cost = Total cost / q
Losses
Output
q*
28
The market price and production cost
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 shortterm 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.
29
The market price and production cost
Perfect market equilibrium dynamics at the break-even
point
Price
MC
Super-normal
profit
Price
Demand
MCe
New
entrants
ST price
LT price
q*
Loss
LT price
Output
Price
MCe
Market
exit
ST price
q*
Final supply
Final equilibrium
Output
MC
Price
Initial supply
Output
Demand
Final supply
Initial supply
Final equilibrium
Output
30
The market price and production cost
Break-even point
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.
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.
31
The market price and production cost
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.
32
The market price and production cost
Development of ‘economies of scale’
33
The electricity market
Variables affecting final price
Fuel markets
Generation
Networks
Supply
Domestic
resources
Number of
companies
Existence of
price subsidies
Importdependency
Import
competition
Level of
utilisation (unit
cost)
Price volatility
Ownership
Regulatory
regime
Social tariffs
Tax policy
34
Outline
• Market functioning – the basics
• Perfect markets
• Imperfect markets
36
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).
37
Market imperfections
Efficient and distorted markets
EFFICIENT MARKET
DISTORTED MARKET
Many players in the market
One 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)
38
Market imperfections
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
2.00 euro
2.00 euro
Price of
FIRM Y
A
Profit:
10 each
C
1.80 euro
Profit:
12 for Y
5 for X
1.80 euro
B
Profit:
5 for Y
12 for X
D
Profit:
8 each
Oligopoly
Price
The kinked demand curve under oligopoly
Our price increases will not be
followed by our competitors
and therefore we loose sales
Typical for
oligopoly:
price stability
Our price cuts will be
followed by price cuts
of our competitors
and therefore we gain
only little extra sales
Quantity
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?
Explanation for price spikes?
€/kwh
• Inelastic demand
• Non-storability
• Concentration
Hours of the day
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!
45
Market power in electricity markets
How does market power work?
Price
(EUR/MWh)
Price
(EUR/MWh)
Load
Load
Market price
Market price
Quantity (MW)
Quantity (MW)
46
Market power in electricity markets
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
47
Market power in electricity markets
Measuring market power (2)
• 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
48
49
Market power in electricity markets
Measuring market power (3)
• 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).
50
Market power in electricity markets
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
51
Market power in electricity markets
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
52
Market power in electricity markets
Mitigating market power (2)
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
53
Thanks for your attention!
Rudi Hakvoort
D-Cision B.V.
+31 88 18 000 81
[email protected]
www.d-cision.com
54