An examination of vertical economies in the electric utility industry

The electric utility industry has been characterized by vertically integrated regulated monopolies. Over the last 20 years, Federal regulation has allowed for independent, non-integrated generation facilities to compete with these regulated monopolies in the production of electricity. In 1995 the Federal Energy Regulatory Commission mandated that transmission owners must provide service for competitors at a price no greater than the cost of providing that service. This ruling effectively introduced competition to the generation stage of production.; Unfortunately, there are physical properties of the transmission and distribution systems—capacity constraints and high fixed costs—that may prohibit meaningful competition in these stages. Further, the market power that incumbent owners of these systems have may allow them to curtail competitive forces in retail sales. In an effort to prohibit a vertically integrated firm from using its monopoly position in one stage to gain market power in another stage, many regulators are advocating the divestiture of large vertically integrated firms.; Economic theory suggests that a firm be vertically integrated as a means of reducing the transaction costs of inter-market transfers. In this situation vertical economies exist that make it less costly to produce multiple stages of a productive process versus contracting across stages. This dissertation analyzes the relevance of these vertical economies in the electric utility industry.; Using a multistage quadratic cost function parameter estimates are obtained. From these estimates the economies of vertical integration and multistage economies of scale are calculated. Economies of vertical integration were found to exist at large levels of output and economies of multistage economies of scale are found to exist for firms that are highly integrated.; In order to verify and strengthen these results a simultaneous equations model is developed that uses cost, output, and price as endogenous variables. The parameter estimates from the cost function are again used to calculate the degree of vertical economies. The results of this model are consistent with those from the single equation cost function.; These results provide strong evidence that firms in the electric utility industry are vertically integrated, at least in part, as the result of cost savings from this type of structure.