Sub optimal investment in oligopolistic electricity markets

Summary : in a context of concentrated electricity industries and entry barriers, governments may worry that incumbent firms strategically under-invest in generation. Associated with the well known short-term strategy of production restriction, suboptimal investment allows firms to increase price and profits, and retain long-term market power. When these strategies include reserve capacity investment, system reliability could be altered. The paper analyses a policy response using a public firm to invest in generating capacity and produce competitively so as to restore the long-term social optimum. A dynamic three-stage game is modelled to analyse the capacity choices in a mixed oligopoly with private leaders and a public follower. The model considers two stages of investment, (the first by the private firms, the second by the public one), and a stage of production to distinguish long-term and short-term market power. It shows that short-term market power of private firms could prevent the public firm from restoring the long-term optimum. Contrary to usual result on commitment, it is the inability of private firms to commit to a given production level that allows them to get strictly positive profits. We establish that for high degree of concentration of the industry and low elastic demand, the private firms are still able to get strictly positive profits. The distance to optimal level of investment may be decreasing with respect to the number of firms .