Topics in the industrial organization of electricity markets

Abstract: This dissertation consists of four essays, all related to the field of Industrial Organization of electricity markets, in one way or another. It is far from being a concise overview of the field, but rather eclectic bits and peaces of a greater puzzle that’s being solved by a large group of people.The first three essays deal with issues concerning retail markets for electricity and similar goods. The first one is an empirical study and the other two apply game theory. The fourth essay is different in many respects, primarily methodologically, as it reports a laboratory experiment on a classical theme in Industrial Organization: price competition with capacity precommitment.  Even though this final essay is more general then the rest, it is still relevant for electricity markets as it concerns the validity of models often used to analyze competition of electricity market. Chapter 1The first essay tries to explain the coexistence of three characteristics of the Swedish retail electricity market: It concerns a homogenous product, while price dispersion is high and consumers are reluctant to switch from incumbent suppliers to rivals. Consumers’ reluctance to switch, as in this case, is usually explained either by search costs or switching costs, or even both. The purpose of the paper is to evaluate the relative importance of these two factors and study their interplay. The sequential choice problem facing consumers, a) whether to become an active searcher for the best deals in electricity contracts, and b) switch suppliers is modelled as two consecutive discrete choice problems and estimated using probit model on Swedish data. I find that switching costs are, on average, larger than search costs. Yet, search costs are important, for it appears that users of electricity must become active consumer before they respond to changes in switching costs to any degree. Various forms of passive information such as direct marketing and word-of-mouth, encourage active searching.Chapter 2Essay 2 develops a simple model of a asymmetric price duopoly, where one firm is an incumbent with an established relationship to all consumers, while the other firm is a new entrant in the market. Consumers have different consumption levels and can face a switching cost or a search cost. Retail electricity markets are the prime example. Given conditions on the distribution of these costs, an asymmetric equilibrium in prices exists. In equilibrium, the rate of switching can be a bad measure of market performance. A decrease in switching costs affects prices, but for the benefit of all consumers and not only those who choose to switch. A decrease in search costs is likely to be primarily in the interest of those consumers that do not wish to search. This suggests that consumers may be facing a free-rider problem, discouraging search as well as switching.Chapter 3Niclas Damsgaard and I consider a vertically integrated electricity company operating active regulated local network services as well as deregulated but imperfectly competitive retail market, in the third essay. The firms total costs are known, both to the regulator and its competitor, while the distribution between the two services is private knowledge of the incumbent. The firm has a natural incentive to overstate its costs for the network services to receive a higher regulated price. However, since total of both operations is known a claim of high network costs signals low retail costs. But since the firms compete in prices, which are strategic compliments, the integrated firm would like its competitor to belief its retail costs are high as well. The regulator, through a combination of price incentives and monitoring, can utilize this trade-off and induce an information-revealing separating equilibrium in which the incumbent claims its true type. The optimal combination of price incentives and monitoring and the conditions under which such a separating equilibrium is preferred to a pooling equilibrium are derived.Chapter 4The fourth essay, co-authored by Chloé Le Coq, investigates why subjects in laboratory experiments on capacity constrained price competition, seem to consistently choose capacity above the Cournot level - the subgame-perfect equilibrium. We argue that this puzzling regularity may be attributed to players' perceptions about their opponents’ skill or level of rationality. In our experimental design we used the level of experience (number of periods played) as a proxy for the level of rationality and matched subjects with different levels of experience. We found evidence of capacity choices being decreasing and prices increasing with opponent's experience. This suggests that if subjects have a tendency to underestimate the rationality of their opponents or that rationality is actually limited for a large proportion of subjects, the observed regularity need not be a puzzle after all.