Understanding Competitive Pricing and Market Power in Wholesale Electricity Markets

Discussions of competition in restructured electricity markets have revealed many misunderstandings about the deﬁnition, diagnosis, and implications of market power, including the common myths that it is present in all markets and that it must be present in order for ﬁrms with

Severin Borenstein is Director of the significant fixed costs to remain profitable. University of California Energy Institute and a Professor of Business Severin Borenstein Economics at U.C. Berkeley’s Haas School of Business. He has published extensively on competition in the n the brief period of time that have been exacerbated by strategic airline, oil and gasoline, and electricity the restructured California elec- behavior by some firms attempting industries. He is a member of the Board I tricity market has been operating, to manipulate market prices. The of Governors of the California Power a number of issues have arisen that debate about the appropriate treat- Exchange, a research associate of the National Bureau of Economic Research, relate to the competitiveness of the ment of reliability must-run (RMR) and an editor of the Journal of wholesale electricity market in the plants has likewise focused atten- Industrial Economics. Dr. Borenstein state. There have been lively tion on the possibility that some holds a Ph.D. in economics from the debates over the need for price producers may attempt to supply Massachusetts Institute of Technology. caps in the California Power power in ways designed to influ- He can be reached via email at Exchange (PX) day-ahead market ence market prices. The questions [email protected]. and the California Independent raised in these discussions are cen- The opinions expressed here do not System Operator’s (ISO) real-time tral to judgments about the need necessarily reflect those of the California Power Exchange, the and ancillary services markets. for intervention by the PX, ISO, or U.C. Energy Institute, or any These debates have raised the government regulatory institu- other organization. question of whether the high tions to alter the operation of the prices that have been observed at wholesale electricity market. times are a natural result of peak This article discusses what mar- demand times or whether they ket power is, how it is often con-

fused with competitive behavior— include variable costs due to fuel if transmission were available and particularly competitive peak-load and the other variable operating and no more costly than transmission pricing—how it can be distin- maintenance costs, i.e., all costs that into California, then it would not guished from competitive behav- actually vary with the quantity of be willing to offer power in Cali- ior, and the implications for whole- power that the plant produces. Costs fornia for any price less than $21/ sale electricity markets. that don’t vary with the quantity of MWh. This would not indicate power the plant produces in the market power: The firm is not rais- given time period, such as fixed ing its offer price in California in I. The Behavior of Price- costs of operating and maintaining order to raise the California market Taking Firms and Competitive the plant, are not part of the mar- price. It is simply choosing to sell Markets ginal cost and are thus irrelevant to power where the price is highest. A firm exercises market power the firm when it makes its short-run The marginal cost that a firm faces when it reduces its output or raises production decision. for selling power is the greater of the minimum price at which it is its marginal production cost and willing to sell output (its offer price) its opportunity cost. Of course, a in order to change the market price. A high price in an alternative market firm that is unable to exercise market can reflect market power in that power is known as a price taker; the A price-taking market, resulting in high prices firm makes decisions taking the firm is willing to sell that are then transmitted across price it faces for its output as given, output so long as markets by the response of com- believing that the actions it takes petitive suppliers. cannot change that price. Common the market price t is important to understand examples of price-taking firms are is above the firm’s I that a price-taking firm does wheat, rice, corn, or soybean farm- not sell its output at a price equal ers; gold, silver, or platinum mining marginal cost. to the marginal cost of each unit of companies; and natural gas produc- output it produces. It sells all of its ers. Many industry observers sug- output at the market price, which gest that producers of oil are price is set by the interaction of demand takers, while others argue that the Still, the cost of selling a unit of and all supply in the market. The Organization of Petroleum-Export- electricity can be greater than the price-taking firm is willing to sell at ing Countries (OPEC) is able, as a simple production costs if the firm that market price any output that it group, to manipulate oil prices. has an opportunity cost that is can produce at a marginal cost less OPEC has certainly tried to do this, greater than its production cost. than that market price. but frequently has had difficulty dis- An opportunity cost is the revenue In markets run as uniform-price suading its members or other non- the firm would get from putting auctions, such as the day-ahead OPEC producers from responding the power to an alternative use, market run by the PX, a price- individually to higher oil prices by such as selling it in a different loca- taking seller that wishes to maxi- increasing their production. tion. For instance, a power pro- mize its profits would bid its price-taking firm is willing to ducer in the northwestern United power into the market at its own A sell output so long as the mar- States can sell power (1) into Cali- marginal cost. That is not the price ket price (which it believes that it fornia, (2) in its own location, or (3) it would receive for its power. It cannot profitably influence) is above in some other location in the West- would receive the price that equates the firm’s marginal cost of produc- ern Systems Coordinating Council the entire supply and demand in the ing and selling the output, properly (WSCC). If the producer expects auction. It would then be awarded calculated. In the electricity industry, that it can earn $21/MWh selling sales exactly equal to the quantity of the marginal cost of production will the power in another location, and power that it could produce at a

firm’s fixed costs of operation. If it is less than the firm’s fixed costs, the firm will eventually shut down or at least scale back its operations. If the area is greater than fixed costs, this is a signal that the firm (or some competitor) might be able to profitably expand. Assuming that there are no barriers to either new entry or existing firm expan- sion, large profits among existing generators would likely lead to Figure 1: Price Can Exceed the Marginal Cost of the Last Unit Produced entry of new firms and plants that would drive down prices and dis- sipate extranormal profits. marginal cost less than or equal to Because a price-taking firm sells ome analysts of the electricity the market price. Note that this its output at the market price, and S industry have raised the con- means it would produce all power that market price is usually above cern that price-taking behavior on for which its marginal cost is less the marginal production cost of all the part of every firm is simply too than the market price, and it or almost all the output it pro- strict a standard to be used as a would not produce any power for duces, price-taking firms can still benchmark. They argue that it is which its marginal cost is greater cover their full costs of production, unrealistic to think that no market than the market price. including their going-forward power will exist, because there is If the industry marginal cost (i.e., fixed costs of operation. This is market power present in most supply) function, which is the illustrated in Figure 3 for a single markets. Though market power aggregation of all firms’ supply price-taking firm: The area above exists in many markets, there are functions, exhibits distinct steps— the firm’s marginal cost curve and also many markets in which virtu- as is often thought to be the case in below the price line is revenue that ally no market power exists—most the electricity industry—then a contributes to covering fixed costs agricultural and natural resource competitive market equilibrium of operation. It is possible that this markets, for instance. These indus- may be reached at which the price area is greater or less than the tries are notable for producing vir- exceeds the marginal cost of even the last unit of output produced, but is still less than the marginal cost of producing one more unit of output (Figure 1). Similarly, if all units of production are in use, then the intersection of supply and demand can occur at a price above the marginal production cost of any unit (Figure 2). Thus, in the absence of market power exercised by any seller in the market, price may still exceed the marginal production costs of all facilities producing output in the market at that time. Figure 2: Price Can Exceed the Marginal Cost of All Production

the equilibrium market prices rise, so that all remaining firms earn higher prices and greater contribu- tions to fixed costs. In a competitive market, this process of entry and exit occurs until, in long-run equilibrium, all generators in the market are able to cover their fixed costs and no other generator could enter and cover its fixed costs at the current market prices. There is no economic argument for the necessity of market power to ensure the viability of the industry. Figure 3: Revenues Earned above the Marginal Cost Contribute to Fixed Costs Note that this does not mean that all current capacity in an industry will be able to cover its (past) sunk tually homogenous products and difference between price and the investment costs or even its fixed selling them over a large geo- marginal cost of each unit of out- going-forward costs in a deregu- graphical area, characteristics that put makes a contribution toward lated market. Some firms or gener- bear an important similarity to the fixed costs. During very-high- ating units may have to exit the electricity industry. demand times, for instance, price market because they cannot cover A more extreme view than the spikes will occur even in competi- their total going-forward costs of inevitability of market power is the tive markets as price rises to operation. This can occur because view that market power is neces- ration demand to the available such generators are just not suffi- sary to allow firms to cover their supply. In a competitive market, ciently efficient to be viable in a total costs of operation. In the however, all output that can be competitive market, or because absence of market power, the argu- produced at a marginal cost less there is simply too much capacity ment goes, marginal cost pricing than the market price will be pro- in the market and some of it must will leave nothing to cover fixed duced, and no generator will exit in order for the market price to costs and firms will not be profit- inflate its offer bid in an attempt rise to a level that allows the able enough to survive. This view to raise the market price.1 remaining firms to break even as an represents an unfortunate confu- f the net revenue earned (after outcome of the competitive supply/ sion about the economics of com- I covering variable operating demand process. The numerical petitive markets. Price-taking costs) is more than is necessary to illustration in the inset on p. 53 behavior, a precondition for com- cover the fixed costs for some type provides an example of this. petitive markets, means simply of generation, then in a competi- that a firm is producing every unit tive market with no barriers to II. The Behavior of a Firm of output that it can produce at a entry, new generation of that type with Market Power marginal cost below the market will enter the market. If the net price and is not producing any revenue is less than is necessary to In contrast to price-taking firms, output for which its marginal cost cover the fixed costs for some type a firm that exercises market power is greater than the market price. of generation, then some genera- sets its production quantities and/ Thus, most or all output produced tors of that type are likely to exit. or the prices at which it is willing is produced at a marginal cost When exit occurs, the supply curve to sell output in order to influence below the market price, and the in the industry shifts to the left and the market price. It influences the

is $15. If that firm could influence A Numerical Illustration of Competitive Peak-Load Pricing price by reducing its output to 9 onsider a market in which there are two types of electricity generating units—causing price to rise either to C plants: those with high fixed costs but low marginal costs (MC), and the point that total demand is those with low fixed costs but high marginal costs. To be concrete, assume reduced by one unit or some other that each of the 50 low-MC plants in the market has a monthly fixed cost of seller is induced to increase its pro- $926,400, a marginal production cost of $15/MWh, and a capacity of 80 MW. Assume that each of the 100 high-MC plants has a monthly fixed cost of duction by one unit to compensate, $288,000, a marginal production cost of $25/MWh, and a capacity of 60 MW. or some combination of these two Finally, assume that each plant is owned by a different firm and all firms effects—then it would compare the behave as price takers. profit from selling 10 units at $15 On the demand side, assume that there are two levels of demand: 300 with selling 9 units at some higher high-demand (peak) hours each month, when demand is Q ϭ 50,000 Ϫ 1,000 и price. In the latter case, the firm ϭ P and 420 low-demand (off-peak) periods each month, when demand is Q would also save money by having 30,000 Ϫ 1,000 и P. During peak periods, all generators will be running, total to produce only 9 units instead of consumption will be 10,000 MW, and the market clearing price will be P ϭ 40. 10. If reducing its output to 9 caused During off-peak periods, all of the low-MC plants will be running and some of price to rise to $17, then the firm’s the high-MC plants will be running. Total consumption will be 5,000 MW and P ϭ 25. Note that during off-peak periods, the high-MC plants are indifferent total revenue would rise (from $150 between running or not, since price is exactly equal to their marginal cost. to $153) causing its profits to rise Now we can calculate the operating profits of each type of plant—total even before accounting for its cost revenue minus variable costs—and see how they compare to the fixed saving from having to produce only costs of the plant. The low-MC plants earn operating profit equal to 9 units of output instead of 10. и Ϫ и ϩ и Ϫ и ϭ [300 (40 15) 80] [420 (25 15) 80] 936,000. The high-MC plants earn he same effect occurs if the firm и Ϫ и ϩ и Ϫ и ϭ [300 (40 25) 60] [X (25 25) 60] 270,000. X is the number of hours doesn’t necessarily reduce its the particular high-MC plant runs during off-peak periods. Note that X has T output, but instead offers to sell its no effect on the profit of these plants since price just covers their variable 10th unit of output for some higher costs during the off-peak. It appears that the low-MC plants are making money ($9,600 per month), more than covering their fixed costs of opera- price, some price above $15. If the tion, while the high-MC plants are losing money ($18,000 per month). firm offers that unit for $17, then That is not the end of the story, however. In a competitive market with- either that offer is accepted and the out barriers to entry, new low-MC plants will enter because there are positive market price is increased to $17, or profits to be made and some of the existing high-MC plants will leave the that offer is not accepted. If that market, because they are losing money. One can solve simultaneously for the offer is not accepted, it is because number of low-MC and high-MC generators who could exist in the market in either demand adjusts by demand- equilibrium. In this case, the solution is that in the long-run competitive equi- ing less total output or the supply of librium the peak price is $41, the off-peak price is $24, there are 75 of the low- other producers adjusts by offering MC generators and 50 of the high-MC generators. (While calculating this is rather tedious, it is straightforward to verify that all the generators, both those to supply more at some price less with high MC and those with low MC, are just covering their fixed costs.) than $17, or some combination of these adjustments. In either of these cases, the market price must still market price by withholding out- power is that in a market where all rise to some extent in order to equal- put at the margin or raising the output is sold at (or nearly at) the ize supply and demand after this price at which it is willing to sell same price, a firm that can influence firm has raised the offer price of its this marginal output. By taking price in the market will do so in 10th output unit. such actions, the firm risks selling order to raise the price for all the When is it profitable for a firm to less, but it raises the price it will production it sells. Consider, for behave this way, restricting its out- get for all output that it does sell. instance, a firm that is selling 10 put or raising its offer price in order The central idea behind market units of output and the market price to affect the market price? It is profit-

able so long as the gain in profit by ginal units in order to raise the in a market, then if it were to selling all the output it still sells after market price. If the firm reduce output in order to raise the market price increases is greater attempted to do this, then even a profits, it would run into two prob- than the loss it faces by selling fewer small increase in the market price, lems. First, demand would not units, if that occurs. Calculation of maybe to $15.01, would bring have to adjust very much to absorb the change in profits takes into forth additional supply from the loss of part of the firm’s produc- account both the change in the other producers that would tion (remember that this strategy firm’s revenues and the change in its replace the unit of supply that the only makes sense if the firm still production costs if it ends up pro- firm has decided not to offer or to has some output left in the market ducing fewer units of output. offer at only a higher price. The that it can sell at the new higher wo factors are critical in deter- small increase in price would then price), so price would not have to Tmining the extent to which not be sufficient to make up for rise very much. such behavior is likely to be profit- the firm’s reduction of sales from Second, with 99 percent of the able for the firm: the sensitivity of output produced by other compa- demand to price changes and the nies, these other companies proba- sensitivity of the supply of other bly could expand their output by producers to price changes. If the small amount necessary to demand must adjust to having one There is no economic replace the firm’s reduced produc- less unit to consume, then the price argument for the tion without driving up their own must rise to reduce demand necessity of market costs appreciably. So, even a slight accordingly. If demand is very sen- increase in price would probably sitive to price—i.e., in economic ter- power to ensure bring forth a replacement of the minology, if demand has a high the viability of reduced supply, undermining the price elasticity—then it won’t require firm’s intent when it reduced its much of a price rise to reduce the the industry. supply. In other words, a firm with quantity demanded by one. If that a very small market share is more is the case, then restricting output is likely to see demand as relatively less likely to be profitable: in the price-elastic, and the supply of extreme, the firm might end up sell- 10 to 9, so the firm would not find other firms as relatively price- ing 9 units for $15.01 each, probably it profitable to reduce its output or elastic, over the range of output less profitable than selling 10 units its offer price on the marginal that it might contemplate remov- for $15.00 each. In contrast, if the unit. Again, if the supply of other ing from the market or offering to demand has a low price elasticity, firms instead has a low price sell only at a high price. then a large price increase would elasticity—i.e., if others would n contrast, a firm with a large be necessary before quantity not increase output unless price I share of the market is more demanded would be scaled back increased by a large amount or if likely to be able to lower its out- by one unit. In that case, the reduc- they were unable to increase output, or raise the offer price on part tion of sales to 9 units is much put at all—then the strategy of of its output, in a way that is diffi- more likely to be profitable. reducing output or raising the cult for demand to adjust to Similarly, if the supply that offer price on marginal units is because the firm’s action consti- other firms are willing to offer is more likely to be profitable. tutes a significant share of the very sensitive to price—i.e., if The ability to exercise market entire market production. Like- supply has a high price elasticity— power is correlated, albeit imper- wise, other companies may find it then any one firm is unlikely to fectly, with a producer’s market much more difficult to replace the find it profitable to reduce its out- share. If, for instance, a firm sup- output reduction of a large firm put or raise its offer price on mar- plies 1 percent of the total output without themselves running into

production constraints that would be stored (so that inventories are some markets, firms may try to col- drive up their own costs. not available as an alternative lude to jointly exercise market The connection between market supply source if a firm tries to power. The idea behind collusion is share and market power, how- exercise market power). For this for each firm to recognize that ever, can be overstated. In some reason, electricity markets are, all when it expands its output, it may situations, a firm with even a rela- else equal, more vulnerable to the raise its own profits, but it pushes tively small market share might exercise of market power than are down the market price and reduces find it profitable to restrict its out- other energy markets, such as the profits of other producers. Like- put or raise its offer price on mar- gasoline markets. wise, when a firm reduces its out- ginal output. Think about a situa- hen a firm does exercise put (or raises its offer prices), it may tion in which demand is not at all Wmarket power, all firms in harm its own profits, but it raises price elastic—in the extreme, a sit- the market benefit. In fact other the market price and the profits of uation in which buyers don’t even firms may benefit more than the other producers. Recognizing this know the price at the time they interdependence, firms may try to are buying. Then add to that a sit- reach an agreement to restrict their uation in which other factors, output or raise their offer prices in such as a very hot day, have order to jointly raise profits. OPEC driven up the quantity that buyers Electricity markets tries to do exactly this. But OPEC want to consume to the extent that are, all else equal, more faces the problem that any set of virtually every company is oper- vulnerable to the colluding firms face: Each firm ating at its absolute production would individually like to raise its limit. That is, the price elasticity of exercise of market output while its collusive partners supply from other producers is power than are other reduce theirs. very low because they are at their Attempts by companies in the capacity constraints. In that case, energy markets. United States to reach such agree- a firm with even a small share of ments to jointly raise price or lower the market might be able profit- output are illegal under Section 1 of ably to reduce output or raise its the Sherman Antitrust Act. In con- offer price. Because consumers company that is exercising market trast, the antitrust laws in the would react little to an increase in power. This is because the com- United States do not forbid unilat- price and other producers would pany that is exercising market eral exercise of market power. A not be in a position to fill in out- power reduces its sales quantity, or firm is free to unilaterally restrict its put that the firm threatens to risks doing so, in order to raise the output or raise its offer price in withdraw from the market, even a market price. Other firms do not order to increase its profits.2 slight reduction of output (or very have to reduce their output—in fact high offer price on that output) they may even increase output— III. Distinguishing could raise the market price sub- but still benefit from receiving the Competitive Behavior stantially and, thus, make such higher market price. Thus, even a from Market Power behavior profitable. small price-taking firm in a market This situation is particularly rel- is likely to have a strong incentive The previous two sections have evant to markets in which to resist attempts to detect or explained how prices are deter- demand is highly variable (so that undermine the exercise of market mined in competitive markets and there are times when virtually all power by other firms. in markets in which some firms production capacity is necessary Thus far, only situations in which exercise market power. In both to meet contemporaneous a firm unilaterally exercises market cases, prices can end up being demand) and the output cannot power have been discussed. In higher than the marginal costs of

all generating units in the market. wealthy corporations, small and efficient dispatch of generating In analyzing electricity markets, it large, that are making very high resources. This happens because a is critical to be able to distinguish rates of return. Likewise on the firm exercises market power by between competitive market pric- buying side, some of the partici- taking some of its generation off ing and pricing that results from pants affected are individual con- the market (or risks doing so by the exercise of market power. Two sumers who are struggling to pay raising its offer price). Given that indicators clearly distinguish these their electricity bills; but the demand is fairly inelastic, this two possible market results: impact of market power also falls means that some other firm must 1. In a competitive market, no on wealthy individuals, the fill in that production with output firm takes an action, including out- investor-owned utilities, and other from a generator that is less effi- put decisions or offer prices, with corporations that are quite sound cient. Smaller price-taking firms the intent of affecting the price in financially. For these reasons, it is are likely to be producing from a market. difficult to make definitive state- every generator that has a mar- 2. In a competitive market, a ginal cost less than the market firm is always willing to sell a unit price, while firms with market of output so long as its marginal power are likely to idle some gen- cost of selling that unit is less than erators with cost below the market the price it receives for that unit. It is critical to be able to price. Every firm is individually In a uniform-price auction market distinguish between still producing its output in the for electricity such as the PX, a competitive market least-cost way given its resources, competitive firm’s offer price will but the total production of power be equal to its marginal cost, pricing and pricing is not distributed efficiently among which will be the greater of its that results from the firms.3 In general, efficiency would marginal production cost or its be improved if the highest-cost opportunity cost of selling the exercise of market power. generation from firms with less (or power elsewhere. no) market power were reduced and additional power were gener- ated from lower-cost generators IV. Efficiency and Equity ments about the effect of market that firms with market power Concerns with Market Power power on wealth distribution have idled when they reduced In the media and public policy without a much more detailed their output (usually by bidding discussions, market power is usu- analysis of how the gains from higher offer prices). ally raised as an issue of equity: market power are distributed In addition, futures markets are Market power is said to allow among the sellers and how the less likely to be successful and sellers to “unfairly” extract reve- losses are distributed among the stable in the presence of market nues from buyers. These sorts of buyers. It is clear, however, that the power. This is because transac- equity judgments are often diffi- very poor are likely to be harmed if tions in futures markets are effec- cult to justify because there are the exercise of market power leads tively bets about what the spot individuals and corporations of to high wholesale prices that are price of a good will be at a spe- varying degrees of wealth on both then passed along in retail electric- cific future point in time. They sides of the market. Some of the ity rates. are used, in general, to mitigate sellers who benefit from market t is much less difficult to reach price risk or to speculate on price power, even if they cannot exercise I unambiguous conclusions changes that a participant antici- it themselves, are small entrepre- about the impact of market power pates will occur. If, however, a neurs who are struggling to keep on the efficiency of the market. participant in the futures market their companies afloat. Others are Market power interferes with the also has market power in produc-

tion of the good, it can, through time figuring out the best prices, would never exceed the marginal cost of its production decision, affect the technologies, or levels of invest- the highest marginal cost producer, but that producer would also be receiving profitability of its position in the ment in an industry. Regulators revenues in the reserve market in return futures market. Recognizing this, also are susceptible to the influ- for standing ready to produce when others become hesitant to use the ences of private parties who demand peaks. The California electricity market has this “stand-by payment” futures market. They realize that encourage them to take actions structure for spinning, nonspinning, and they are likely to end up betting that do not benefit the general replacement reserves, as well as regula- against someone who can actu- public. And, of course, it is very tion energy. When the technology is developed and deployed for consumers ally determine, or influence sig- difficult for regulators to limit the to respond in real time to energy price nificantly, the outcome upon returns that firms can earn with- changes, the need for these reserve mar- which they are betting. As a out dampening their incentives kets will diminish, since demand reduction will provide such “reserves.” result, market power in the pro- for efficiency and innovation. 2. Even if firms do not explicitly collude, it duction of a good can undermine Thus, it is clear that some degree is possible that firms that interact fre- the viability of any futures mar- of market power in an industry is quently will gradually come to an “under- kets for that good. preferable to heavy-handed regu- standing” of cooperative behavior, known as “tacit collusion” in the antitrust and eco- lation, with all of the inefficiencies nomics literature. For instance, through its behavior, a firm might make it clear that it V. Conclusion: Market Power that accompany such regulation. None of these concerns, how- will restrict its output only if another firm in the Long Run and does the same, but it will punish if the Government Intervention ever, lessens the importance of other firm overproduces by increasing its analyzing and estimating the own output dramatically and driving The diagnosis and measurement degree of market power in an prices very low. It is widely acknowledged of market power is just one step in that such tacit collusion is easiest to carry industry. They simply mean that a out when firms interact repeatedly, and is the process of developing sound finding of market power is just one always difficult to detect. Tacit collusion is public policy in a market. When part of a public policy debate a gray area of the U.S. antitrust laws. Few market power is found to be about government intervention cases have been prosecuted successfully against tacit collusion, but the government present, the logical next step is to in an industry. The important continues to argue that it can and will pur- examine the likely persistence of public policy question is what sue evidence of such behavior. that market power. In markets with amount of market power is 3. In addition, there is the standard eco- low barriers to entry, market power acceptable, and which, if any, nomic inefficiency (or “deadweight loss”) government policies are likely to when price is above the marginal cost of is likely to be quite transitory. The producing one more unit: some product ᭿ profits from market power will do more good than harm. is not consumed (or produced) even attract new entrants into the market though the consumer values the output Endnotes: more than it would cost the producer to or encourage incumbents to expand make it. A deal that would make both the in order to gain market share.4 In 1. Some analysts have argued that this buyer and seller better off (ignoring the that case, the best government pol- standard economic analysis cannot be effect it would have on the price the seller applied to electricity markets because gets for its other units) fails to occur. icy would probably be to let these demand is effectively completely price- 4. Actually, market power may not lead forces do their work undermining inelastic (vertical) at any point in time. to extranormal profits, at least as 5 They argue that price will never exceed the existing market power. On the reported by the firm. Such excess profits the marginal cost of the highest-cost gen- may be dissipated in high compensation other hand, if entry is likely to be erator, so that generator will never be able to managers, high worker wages, organi- slow, due to institutional, regula- to recover its fixed costs. However, it is zational slack, or investments in other because of the short-run price inelasticity tory, or other barriers, more active projects with low expected returns. of demand that wholesale electricity public policy may be wise. markets have reserve markets, essentially 5. It is worth noting, however, that new overnment intervention, insurance markets that pay generators to entry itself can be inefficient if it means however, has its own formi- stand by, ready to produce in case they duplicating construction of existing G are needed. In a competitive electricity facilities—facilities that are being used at dable costs. History teaches us market with completely inelastic less than their full potential by an owner that regulators have a difficult demand, the price of energy indeed that possesses market power.