NORTHWESTERN UNIVERSITY Essays on Spatial Price Dispersion a DISSERTATION SUBMITTED to the GRADUATE SCHOOL in PARTIAL FULFILLMEN
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NORTHWESTERN UNIVERSITY Essays on Spatial Price Dispersion A DISSERTATION SUBMITTED TO THE GRADUATE SCHOOL IN PARTIAL FULFILLMENT OF THE REQUIREMENTS for the degree DOCTOR OF PHILOSOPHY Field of Economics By Viswanath Pingali EVANSTON, ILLINOIS December 2007 2 © Copyright by Viswanath Pingali 2007 All Rights Reserved. 3 ABSTRACT Essays on Spatial Price Dispersion Viswanath Pingali This dissertation explores price differences observed in the market. While some differences are necessitated by market conditions, the others are strategic. I illustrate the former in a study of electricity spot markets in Italy and the latter for the video rental industry. The first project examines the welfare gains from eliminating price differences in the Italian electricity spot market. The market is divided into two geographic zones – North and South – with limited interzonal transmission capacity that often results in congestion. Congestion leads to different market clearing prices in the two zones, thereby creating potential market imperfections. We employ current market data to characterize the present market structure with limited interzonal transmission. We then simulate a scenario with no transmission congestion and measure the gains from market integration. Our empirical results indicate that easing transmission bottlenecks reduces spot market expenditure 4 substantially by almost four percent. We further find that that the major firm in the market does not exercise its full market power and benefits from improved transmission. In the second project, I examine the effect of competition on prices in a market where the product is offered at different quality levels, in the context of the video rental industry. Videos can be classified into DVD and VHS. Firms can also be categorized as branded stores that belong to a major chain and unbranded stores that do not belong to any major national chain. As competition increases, prices of both DVD and VHS should decrease, but from the theory it is not clear which one will decrease more. Moreover, branded and unbranded stores may respond differently to the change in competition. Using a difference-in-difference approach I estimate the effect of competition on the price difference between DVD and VHS. I use an instrumental variables approach to address price-competition endogeneity. My empirical results indicate that the effect of competition on price difference varies according to the type of store and the type of competition faced. 5 Acknowledgements I am grateful to Robert Porter for all his guidance and encouragement during my PhD career at Northwestern University. Rob has been a great mentor in the past four years and I learnt a lot about research in economics from several interactions I have had with him during the course of this dissertation. His patience in meeting with me on regular intervals and editing several versions of my papers has been unbounded. I am also thankful to my dissertation committee members: Shane Greenstein, Andrew Sweeting, and Michael Mazzeo. Independent study under Shane during my second year was one of the chief reasons for fostering my interest in empirical industrial organization. I am indebted to Andrew for several insightful discussions on electricity markets. I am also grateful to Jim Dana for several suggestions. I owe special thanks to several batch mates at Northwestern. Federico Boffa, who worked with me on an empirical project included in this dissertation, introduced me to the economics of electricity markets. Fan Zhang and Dan Liu have come up with invaluable suggestions during our weekly meetings. Michael Coates always came up with appropriate advice whenever I was stuck on a problem. Advice from Maria Salgado and Pablo Guerron are also gratefully acknowledged. Piotr was a great help with all my software needs. Above all, these people remain good friends. 6 For all their love and inspiration, I am grateful to my parents, Padmavathy and Partha Sarathy. Their support has been invaluable during the course of this PhD. My brother, Bharadwaja (Tammu), has always encouraged me through his personal example. He was always there whenever I needed someone to talk to. I would also like to acknowledge the support from my fiancée, Haritha, during the final stages of this dissertation. They have always believed in me even when things were not going right and provided me with much needed moral support. I am also grateful to Bhagawan Sri Satya Sai Baba for His guidance. Lot of friends contributed towards making living in Evanston a nice experience. My roommates: Arijit, Ketan, Tapas, and Ankush deserve special thanks for tolerating me at different points over the past six years and making my stay more homely. Their warm personality and culinary skills deserve special mention. It would be a remiss not to thank several other friends in Evanston including Sourav (Goti) and Tumpa for many a gastronomically delightful evenings at their place, my jogging partners: Agila and Monika, Amar and Payal, and Soma. Memories of times I spent with these people would remain with me for a long, long time and ensure that Evanston remains a beautiful chapter in my life. Counseling and Psychological Services (CAPS) at Northwestern has been instrumental in providing me with invaluable support. Finally, financial support from the Graduate School, Center for the Study of Industrial Organization (CSIO) and the Transportation Center at Northwestern University are gratefully acknowledged. 7 Table of Contents ABSTRACT 3 Acknowledgements 5 List of Tables 9 List of Figures 11 Chapter 1. Introduction 13 1.1 The Italian Electricity Spot Market 14 1.2 The Video Rental Industry 21 Chapter 2. Modeling the Current Italian Electricity Spot Market 28 2.1 The Current Italian Electricity Market Setup 28 2.2 The Model 33 2.3 Data 42 Chapter 3. Simulate Vs. Actual Italian Electricity Spot Market 52 3.1 Evaluating the Counterfactual 52 8 3.2 Results 54 3.3 Conclusion 61 Chapter 4. Brand Effect and Price Discrimination in the Video Rental Industry 64 4.1 Testable Hypotheses 64 4.2 Industry Structure and Data 74 4.3 Empirical Specification and Results 83 4.4 Conclusion 92 Tables 93 Graphs and Figures 122 References 147 Appendix A. Details of the Empirical Strategy 152 Appendix B. Mails from Blockbuster Video and Hollywood Video 157 Appendix C. Vita 159 9 List of Tables Table 2-1: Generation Capacity 93 Table 2-2: Sample Characteristics 94 Table 2-3: Fringe’s Production 95 Table 2-4: Liquidity Statistics 96 Table 3-1: OLS Regression Results for Fringe’s Supply Function 97 Table 3-2: Fixed Effects Regression – Fringe’s Supply Function 98 Table 3-3: Characteristics of Alpha 99 Table 3-4: Gains from Interconnection 100 Table 4-1: Division of Stores 101 Table 4-2: Market Shares of Major Players 102 Table 4-3: Average Prices of Various Products 103 Table 4-4: Price Differentials for Different Types of Stores 104 Table 4-5: Break-up of Stores across Cities 105 Table 4-6: Income and Population Details of Census Tract 108 10 Table 4-7: Distribution of Stores in Various Tracts 109 Table 4-8: Details of Competition Faced by Stores 110 Table 4-9: OLS Regression Results 111 Table 4-10: GLS Regression Results 112 Table 4-11: IV Regression Results 113 Table 4-12: IV Regression – DVD Prices in Branded Stores 114 Table 4-13: IV Regression – VHS Prices in Branded Stores 115 Table 4-14: IV Regression – DVD Prices in Unbranded Stores 116 Table 4-15: IV Regression – VHS Prices in Unbranded Stores 117 Table 4-16 (a): Influence of Competition on Price Differences 118 Table 4-16 (b): Influence of Competition on Price Differences 119 Table 4-17 (a): First Stage Regressions 120 Table 4-17 (b): First Stage Regressions 121 11 List of Figures Figure 2-1: Generation Capacities by Generation Types 122 Figure 2-2: Zonal Structure 123 Figure 2-3: Illustration of Residual Demand Function for Enel 124 Figure 2-4: Supply Function Equilibrium in a Monopoly 125 Figure 2-5: Enel’s Demand with Transfers 126 Figure 2-6: Hourly Price Difference 127 Figure 2-7: Hourly Average Prices and Quantities 128 Figure 2-8: Firm’s Capacity in Entire Italy 129 Figure 2-9: Firms’ Capacity in North Italy 130 Figure 2-10: Firms’ Capacity in South Italy 131 Figure 2-11: Maximum and Minimum Realized Prices 132 Figure 2-12: Marginal Cost as a Step Functios 133 Figure 2-13: Observed Marginal Cost 134 12 Figure 2-14: Hourly Liquidity 135 Figure 3-1: Calculating Fringe Supply Function in the Integrated Market 136 Figure 3-2: Enel’s Demand Function in the Integrated Market 137 Figure 3-3: Regression Results 138 Figure 3-4: Hourly Average Alpha 139 Figure 3-5: Illustrating the Iterative Procedure 140 Figure 3-6: Simulated Vs. Actual Prices 141 Figure 3-7: Simulated Vs. Actual Quantities 142 Figure 3-8: Average Hourly Gains 143 Figure 4-1: Histogram of Prices: Old DVD and Old VHS 144 Figure 4-2: Histogram of Prices: New DVD and New VHS 145 Figure 4-3: Illustration of Instrumental Variables 146 13 CHAPTER 1 Introduction In this dissertation, I explore various aspects of price differences for identical products across different geographical regions. One can observe such spatial price differences in several industries: airlines, 1 gasoline, 2 fast food chains, 3 etc. In this dissertation, I analyze the spatial price difference observed in the cases of the Italian electricity spot market and the video rental industry in Cook County, IL. There are several reasons why an identical product is sold at different prices at different places. Some spatial price differences are due to infrastructural shortcomings. These shortcomings, such as a lack of adequate transportation (or transmission) capacity, impede the smooth flow of the product, thereby making it expensive in certain areas.