THE ECONOMICS OF REGULATION: COMPETITIVE ACTIVITIES

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1 FSR TRAINING COURSE OCTOBER 10 TH OCTOBER 14 TH 2011 THE ECONOMICS OF REGULATION: COMPETITIVE ACTIVITIES Rudi Hakvoort

2 Outline Market functioning the basics Perfect markets Imperfect markets 2

3 Outline Market functioning the basics Perfect markets Imperfect markets 3

4 Microeconomics Consumers Price Producers What is consumed? Who consumes it? Market Law of supply and demand What is produced? How is it produced? Who produces it? Types of market Market failures Natural monopolies Real markets Perfect markets Transaction costs Public goods and externalities Incomplete information Internalisation Regulated businesses Market power Economic efficiency Allocation prop. rights Direct intern. Indirect Intern.

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6 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

7 Micro-economics Type of market by number of participants Supply 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 7

8 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

9 Micro-economics Demand curve PRICE P * demand curve Q * QUANTITY 9

10 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

11 Micro-economics Supply curve PRICE supply curve P * Q * QUANTITY 11

12 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

13 The market Demand and supply PRICE supply curve P * demand curve Q * QUANTITY 13

14 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 P * Q * supply curve demand curve QUANTITY 14

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16 Outline Market functioning the basics Perfect markets Imperfect markets 16

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. 17

18 The perfect market Supply curve Price In perfect competition companies see demand as a straight horizontal line p Company f s supply curve = MC e f ( ) p = CM q f Optimal output for company f Output 18

19 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

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21 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

22 Market clearing Equilibrium between product supply and demand Price Demand curve Market equilibrium Equilibium price Consumer s surplus Generator s surplus Supply curve Generator s costs Costs of unsatisfied demand Demand Satisfied demand 22

23 Market clearing Consumer & producer surplus Equilibium price Price Consumer s surplus Generator s surplus Demand curve Generator s costs Market equilibrium Costs of unsatisfied demand Satisfied demand Supply curve Demand 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. 23

24 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

25 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 Generator costs Utility of unsatisfied demand Supply curve Demand Satisfied demand economic efficiency = net social benefit (NSB), calculated as the sum of the consumer s and the generator s surplus. 25

26 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

27 The market price and production cost Marginal cost versus average cost (1) Price π Super-normal profit MC MCe = Average cost = Total cost / q q* marginal cost (MC): additional cost of producing one more unit Output average cost (MCe) total cost divided by total output for each level of production 27

28 The market price and production cost Marginal cost versus average cost (2) Price MC π Losses MCe = Average cost = Total cost / q Output q* 28

29 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

30 The market price and production cost Perfect market equilibrium dynamics at the break-even point Price Super-normal profit MC MCe Price Demand Initial supply Final supply ST price LT price New entrants Final equilibrium q* Output Output Price Loss MC MCe Price Demand Final supply Initial supply LT price ST price Market exit Final equilibrium q* Output Output 30

31 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

32 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

33 The market price and production cost Development of economies of scale 33

34 The electricity market Variables affecting final price Fuel markets Generation Networks Supply Domestic resources Importdependency Price volatility Number of companies Import competition Ownership Level of utilisation (unit cost) Regulatory regime Existence of price subsidies Social tariffs Tax policy 34

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36 Outline Market functioning the basics Perfect markets Imperfect markets 36

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). 37

38 Market imperfections Efficient and distorted markets EFFICIENT MARKET Many players in the market Easy entry to and exit from the market (contestable market) Fully informed market participants Most of the players are private (seeking for maximum profits) DISTORTED MARKET One or few players (monopoly, oligopoly) Legal entry / exit barriers Imperfectly informed players 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

39 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.

40 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.

41 Oligopoly Prisoner's dilemma Profits (million Euro) for two firms (X and Y) at different prices Price of FIRM X 2.00 euro 1.80 euro Price of FIRM Y 2.00 euro 1.80 euro A Profit: 10 each C Profit: 12 for Y 5 for X B Profit: 5 for Y 12 for X D Profit: 8 each

42 Oligopoly The kinked demand curve under oligopoly Price Our price increases will notbe 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

43 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).

44 What is happening? Explanation for price spikes? /kwh Inelastic demand Non-storability Concentration Hours of the day

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! 45

46 Market power in electricity markets How does market power work? Price (EUR/MWh) Load Price (EUR/MWh) Load Market price Market price Quantity (MW) Quantity (MW) 46

47 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 Example: HHI = Σ i (s i ) 2 i = 1,, N firms in the relevant market s i = 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 Three companies with market shares of 40%, 40% and 20% yield HHI of =

48 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

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50 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

51 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

52 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 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

53 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

54 Thanks for your attention! Rudi Hakvoort D-Cision B.V