The theory of bid function equilibria and its application to spot markets for electricity

This dissertation consists of two chapters. Chapter I introduces a theory of oligopoly in multi-unit auctions. Strategies are bid functions that specify offer prices for different discrete levels of output. The basic model deals with games of complete information. This model is extended to provide applications relevant to electricity markets, including demand uncertainty and multiple demand periods. Bid functions are not restricted to any conventional parametric functions and thus admit a rich domain of high dimensional strategies. In all models, there are asymmetric outcomes even when cost functions are symmetric. These outcomes result from a configuration in which one firm, the “price setter”, creates markups by pricing units out of the market while other firms bid prices that are outcome equivalent to marginal cost pricing. I define these equilibria as Bid Function Equilibria (BFE). The purpose of Chapter II is to test the implications of BFE in the British spot market for electricity. Unlike existing theories of electricity supply, BFE predicts asymmetric bidding by producers: a single firm (the “price-setter”) bids strategically while other firms (“non-price-setters”) bid closer to cost. Using data on bid functions in the British spot market for electricity between 1993 and 1995, I find strong empirical support for the theory. In addition to testing the implications of BFE in an empirical specification of (log) markups, I also use BFE to simulate market prices and price-cost margins. For the years of our sample, the price-cost margin is 20 percent, which is slightly below the 21 to 27 percent that Wolfram (1998) found for her sample. The price-cost margins obtained by using BFE to simulate market prices are approximately 22 percent. Implications for the British electricity market remain to be considered.