A Powerful Competition Policy - 4. Market power and its effects

4. Market power and its effects

4.1 What is market power?

When competition is restricted one or several enterprises have the opportunity to act in contravention of the interests of consumers without entailing large losses of market shares. Enterprises in such a position are said to possess market power. Normally the notion is connected to the opportunity to withhold production in order to maintain high prices, even though market power also may have other effects.

In the absence of market power, price will equal marginal costs when production is organised as efficiently as possible. Enterprises with market power will take into account that higher volumes result in reduced prices, and will therefore be more reluctant to increase volumes. An enterprise has significant market power if it can profitably maintain prices that are significantly higher than the lowest possible marginal production costs.

The exertion of market power only becomes an abuse of market power if the firm is dominant. That is, if a firm is able to increase its price above marginal costs due to a competitive advantage, the firm has at least some degree of market power. However, the positive price-cost margin does not necessarily reflect abuse of market power.

The exertion of market power is an integral part of a well functioning competitive market. Superior products or technologies can result in market power. Firms try to obtain market power in order to maximise profit. However, the market power possessed by a dominant firm allows it to profitably raise prices without being superior. The abuse of a dominant position is prohibited in the Nordic countries (and in the EU). It is important for the competition authorities to recognise the difference between the two.

Market power also encompasses a buyer's ability to determine its own purchase prices. Such buyer power may under certain circumstances have negative effects on efficiency similar to those associated with the market power of suppliers.

Market power may be exerted unilaterally by a single enterprise (unilateral market power), or collectively by a limited number of enterprises (collective market power or tacit collusion).

4.2 Unilateral market power

Unilateral market power means that an enterprise can exert market power without entailing co-ordinated responses from competitors. An enterprise having a monopoly, especially one which is not threatened by new entry, will have such market power.

A market dominant enterprise may also have the opportunity to exert unilateral market power. Generally the incentives to increase price will increase with the market shares of the enterprise. The reason is that the gains from price increases become large compared to the losses entailed by reduced volumes.

4.2.1 The residual demand

The residual demand curve facing an individual producer determines what quantity and what price will be most profitable. The residual demand is given by total market demand less the supply of the other producers at each price level. It shows the relationship between the price the producer chooses and the quantity the producer sells.

Formally [20], the residual demand facing producer I, q_i, can be expressed as

where p is the market price, D(p) is the market demand and S_j(p) is the supply of the other producers.

The ability to exert market power will depend on the elasticity of the residual demand, i.e. the percentage change of quantity relative to the percentage change of price. The elasticity of the residual demand is:

If the elasticity is low the producer will lose little demand by increasing prices. The more inelastic the residual demand, the larger the increase in price as a result of reduced production, and the larger the market power of the producer.

Taking the derivative of the residual demand with respect to the market price, and making use of the expression for the elasticity of the residual demand, we get:

where ε_D is the elasticity of market demand and ε_{s_j} is the elasticity of the rest supply (the supply of the other producers).

If competition is perfect the elasticity of the residual demand curve is infinite: The producer will lose all market share by setting a higher price. If the residual demand curve is perfectly inelastic, i.e. non of the competitors will increase their production if the price increases and consumption remains unchanged, the producer can, in theory, increase its price infinitely without losing market share. Under the likely presumption that the derivative of the market demand with respect to price is negative ( ε_D < 0) and the derivative of the rest supply with respect to market demand is strictly non-negative ( ε_{s_j}> 0), the elasticity of the residual demand is negative ( ε_i < 0).

The residual demand will be more elastic the more elastic the market demand, the more elastic the rest supply, and the smaller the market share of the producer (q_i is small). If a price increase results in a large proportion of customers leaving the market ( ε_D is large), the price increase will be less likely to be profitable. The price increase is also likely to be unprofitable if it results in a large increase of supply by the other producers ( ε_{s_j} is large). Finally, the price increase is less likely to be profitable if the producer is small (q_i is small), because the resulting loss of supply will represent a larger proportion of supply for the producer. All else equal, a small producer has a weaker incentive to raise prices than a large producer.

4.2.2 Factors influencing the elasticity of the residual demand

The following factors make the residual demand of a producer less price elastic [21]:

inelastic market demand,
lack of flexible production technologies,
production capacity of competitors is constrained,
bottlenecks (capacity constraints in the grids),
weak competition between the producers.

The first of these factors concerns the elasticity of market demand. The other factors concern the elasticity of the supply of the other suppliers.

Market demand
The price sensitivity of the market demand for electric power is low in the short term (on an hourly basis). This is partly due to consumers not being informed of or charged for short-term price variations, and partly due to the fact that substitution possibilities are limited and that it is costly to fine-tune consumption hour by hour for most consumers. Only when prices are much higher than today's price level, some industrial firms may find it profitable to decrease their demand. Also in the intermediate run – during a season or some months – price sensitivity is limited. In the long run demand is more elastic, since households and industries can invest in energy conservation equipment or switch to other types of energy.

It is to be expected that demand will be more elastic in the future. Firstly, the deregulation has had the effect that consumers more often are faced with price variations reflecting actual variations of demand and supply and congestions in the electricity grid. An example is the reduced consumption last winter as a response to the high prices due to the exceptional low reservoirs filling. Secondly, technological development will result in cheaper and better metering equipment, making it cheaper and easier for consumers to respond to short term price changes.

Flexible production technology
As described in chapter 1 there are different production technologies in the Nordic electricity sector. These technologies have different properties with regard to their flexibility in increasing or decreasing production in the short run.

Production plants with flexible production technology are hydropower plants mainly situated in Norway and Sweden and condensing power stations mainly situated in Denmark and Finland (and to some degree in Sweden). These technologies will under free competition follow the load of the system from hour to hour. Therefore, it is the response of plants with these technologies that in most situations determine the elasticity of the rest supply.

The more concentrated the production based on flexible production technologies is, the more likely it is that it will be profitable for a producer to withhold production in order to increase price, since the short run response from other producers will be limited.

HHI will be a misleading guide to the degree of market power in markets in which some of the firms are are constrained due to inflexible production. Biggar (2002) [22] shows that the average Lerner index in such a market is

where

N_u is the number of unconstrained firms and s is the total market share of the constrained firms. Note that is a weighted average of the marginal costs of the unconstrained firms, meaning that the average Lerner index ( ) is a weighted average of the Lerner index of the unconstrained firms.

Consider a market with 10 equally sized firms. Eight of the firms have inflexible production technologies, for instance wind power plants and combined heat and power plants: s = 80. The two remaining producers have flexible production technologies, for instance hydropower plants with reservoirs and coal or gas condense plants: N_u = 2. Suppose the two firms with flexible production technologies merge.

The unadjusted HHI would increase from 1000 to 1200. The adjusted HHI would before the merger also be 1000: 10(10 + 80/2) + 10(10 + 80/2) = 1000. After the merger HHI^adj = 20(20 + 80/1) = 2000.

Suppose that the absolute value of the short-run elasticity of demand is 0.4. The unadjusted Lerner index increases from 0.1/0.4 = 0.25 to 0.12/0.4 = 0.3, representing a price increase of 7.1% (supposing constant marginal costs). The adjusted Lerner index increases from 0.25 to 0.2/0.4 = 0.5, representing a price increase of 50%.

Thus, taking into account that the competitors have inflexible production technology the merger will have more negative effects on competition

Consider a merger between one producer with flexible and one with inflexible production technology. Again the unadjusted HHI increases from 1000 to 1200. The adjusted HHI on the other hand increases form 1000 to 1550.

Note that after the merger there will be 7 firms with an inflexible technology and 2 firms with flexible technology, one of them with a market share of 20%, the other with a market share of 10%: s = 70, m = 2. Thus, we have:

HHI^adj = 10(10 + 70/2) + 20(20 + 70/2) = 450 + 1100 = 1550.

The negative effects on competition of such a merger are considerably less than the one between the two firms with flexible production. One might wonder why there are any anticompetitive effects at all, since the merged firm has not gained any increased control over the flexible production capacity. The reason is that the size of the merged firm (measured by qi) has grown, making the residual demand less elastic.

Thus, from a competition point of view a merger between two producers with flexible production technologies is worse than a merger between one with flexible and one with inflexible production technologies, which again is worse than a merger between two producers with inflexible production technologies.

Production capacity constraints
The situation with inflexible production is analogous to the situation with production capacity constraints. In a market where some firms operate at their maximum capacity levels, these firms will not be able to increase quantity as a response to a quantity reduction by another firm. Again the firm will have inflexible production, not because of its production technology as described above, but because it is operating at a maximum production scale. In the power markets the number of firms that face capacity constraints will vary. As demand increases more and more firms will face such constraints.

If all competitors operate at their capacity limits, the remaining producer will in fact operate as a monopolist towards its residual demand. The closer the market is to full capacity utilisation, the less risky it is for a producer to increase price, since there are fewer suppliers with an opportunity to increase production.

An inverted L is the typical shape of the cost function of power producers. This means that the producers' production functions have constant economies to scale up to the capacity constraints, where the costs increase very rapidly

In the Nordic power market a relatively large share of the capacity belongs to so-called competitive fringe firms, i.e. producers that in practise will be too small to exert market power and therefore will act as price takers. These firms will produce at maximum capacity as long as price is above marginal costs (and, if they have available capacity, increase their production if price increases and covers the marginal costs of increased production.)

Moreover, a relatively large proportion of production capacity in the Nordic region has low variable (alternative) production costs and limited or no flexibility: wind power plants, hydropower without reservoir capacity, nuclear power. The effective production capacity of wind power plants depends on variable wind conditions. Inflow of water plays a similar role for river hydropower plants. In combined heat and power (CHP) generation (power station that generates both electricity and heat for supplying neighbouring district heating networks or industrial processes), the demand for heat determines power production. Production plants with low marginal costs will often operate at full capacity. The reason is that the marginal value of any foregone production (the price-cost margin) is high, making it costly to hold back production.

When the market is close to full capacity utilization these producers are likely to be capacity constrained. These firms will not be able to increase production as a response to price increases. Only producers having marginal costs higher than the market price will be able to increase production as a response to a price increase. If these producers have marginal costs that are high compared to the present price level, a producer with market power will be able to increase the prices up to this level without entailing increased production from other producers (since these are capacity constrained).

During the 90ties the increase in capacity has been lower than the increase in consumption in the Nordic region. The situation has been the same in all Nordic countries except Denmark. This means that there will be fewer instances of idle capacity. Considering the limited prospects for new production capacity (confer chapter 1) it is likely that demand will increase more than production capacity in the years to come.

Bottlenecks
As described in chapter 2.5 constraints in transmission capacity will reduce the number of competing actors. Thus, bottlenecks lower the elasticity of the residual demand.

When bottlenecks split the Nordic region into two or more separate relevant geographic markets market power can be exerted in two ways. [23]

Firstly, a producer in a deficit market area may find it profitable to exert market power within that area when there are constraints on imports from producers located in other areas. A producer with market power might find it profitable to hold back production in order to create a deficit area or strengthen the price effect of an already existing deficit area.

Secondly, in a surplus area where the export capacity is fully utilised prices may fall considerably below the price in neighbouring areas. A producer with market power might find it profitable to hold back production in order to push up the price level. This behaviour might in fact lead to prices being equal to prices in other price areas, meaning that a separate price area will not be created.

The second case illustrates that it might be possible to exert market power in a region, even when that region is not separated out as a price area. This possibility will not be eliminated even if the transmission capacity into the region is improved.

Generally, the larger the market is, the more competitors there are, which is also the reason why market concentration is much smaller in the Nordic area as a whole than in the national markets. However, the constellation of suppliers operating in the Nordic market and the location of their production capacity emerged before the deregulation of the national markets. To a large extent actors have the main part of their production capacities concentrated in their respective national markets.

Weak competition
Finally, the elasticity of the residual demand also depends on the strategic behaviour of the competitors. Even if competitors are able to increase production as a response to an increase in market price, they might not be willing to do so. If competitors lack incentives to compete, it will be possible to exert some degree of market power.

In chapter 3.1.1 we have shown that competition will not be perfect in a Cournot-Nash setting, and that market power will increase with the market concentration. This is an example where weak incentives to compete might lead to unilateral market power.

Weak incentives to compete may also lead to so-called "collective market power", which is the subject matter of the next chapter.

4.3 Collective market power

4.3.1 Introduction

In markets with a limited number of enterprises collective market power may arise as a result of co-ordinated behaviour. The co-ordination can take the form of tacit or explicit collusion. We will focus on the conditions conducive to tacit collusion.

On June 6^th the European Court of First Instance (CFI) overturned the European Commission's decision to block Airtours proposed acquisition of First Choice [24]. According to the CFI, a collective dominance situation significantly impeding competition arises when each member of the dominant oligopoly considers it possible, economically rational and hence preferable, to adopt a common policy on a long-lasting basis.

The CFI outlined three conditions that need to be met to block a merger on collective dominance grounds:

The companies concerned need to have both an incentive and the ability and the opportunity to coordinate their behaviour. The market thus needs to be sufficiently transparent in order for the companies concerned to accurately monitor each other's behaviour.
It is also necessary for the companies concerned to be able to maintain co-ordination over time. There has to be an incentive not to deviate from the common strategy. There needs to be a retaliation mechanism against companies deviating from the common strategy so as to ensure that there is a long term incentive to conform to the common strategy.
The third aspect deals with the countervailing power of potential and existing competitors and consumers. Can these, as a group or individually, act in such a way that the effects of the common policy will be mitigated?

The following discussion will focus on some of the characteristics of the Nordic electricity market in the light of EC case law. The list of market characteristics is not exhaustive.

4.3.2 Incentive to co-operate

Concentration and market shares

As shown in subsection 3.2.1 the five largest companies achieve a joint market share of approximately 60 % in the Nordic market. In 3.2.3 we calculated the cross-ownership adjusted Herfindahl-Hirschman index to be 1138. Thus, the integrated Nordic market is relatively unconcentrated. Market concentration in regionally delimited relevant markets is on the other hand very high.

In EC law there has been no presumption of dominance based on achieving a specific market concentration. To determine whether collective dominance is likely in the Nordic electricity market the analysis needs to be extended further.

A large market share indicates an ability to exert market power. An oligopoly with the same market share as a single firm is generally assumed to have a lesser ability to exert market power. An oligopoly contains an inherent instability arising from the differing interests that, to some extent, always exist between the individual companies, each company striving to strengthen its own position in the market.

An oligopoly is considered more stable over time if the distribution of market shares is symmetrical. Symmetrical market shares may be an indication that the companies have similar incentives to co-operate and similar opportunities to retaliate against each other. Tacit collusion may be facilitated if the market shares within the oligopoly are evenly distributed while at the same time the other companies on the market only have small market shares.

In 3.2.1 we found that the market shares of the five largest actors on the integrated Nordic market are distributed as follows: Vattenfall 19 %, Fortum 16 %, Statkraft 12 %, Sydkraft 8 % and Elsam 4%. The distribution of markets shares between the five largest companies is not particularly symmetrical. In the long run this might contribute to the instability of the oligopoly.

The transparency of the market
The transparency of the market is important since it enables the oligopolists to monitor each other's behaviour in the market. To be able to maintain tacit collusion over time they need to be able to detect deviations quickly and accurately to determine who deviated and to what extent.

The Commission has concluded that electricity is a homogenous product [25]. With a homogenous product it is easier to compare prices since it reduces the need for comparing price with quality. This increases the transparency of the market.

In homogenous product markets price is an important decision parameter. Thus, price will be an indicator of whether a company deviates from the common strategy. Price is either determined in bilateral contract or on the power exchange, i.e. Nord Pool.

Nord Pool publishes its prices on the Internet, which enables interested parties to follow the price on an hourly basis. Nord Pool publishes both the system price and the price for the different price areas. The power exchange also provides information on certain factors influencing supply. Every participant on Nord Pool has access to the same relevant information, which is important for the functioning of the market. The price on this part of the market is transparent.

The trade on Nord Pool encompasses about 1/3 of total trade on the Nordic electricity market. The other part is sold through bilateral contracts. In most of these contracts it is up to the buyer and seller to determine the price. When determining price in a bilateral contract the spot price is one of the variables that will be considered. The actual contracted price is confidential and there is no obligation on the parties to publicly report this price. Nevertheless a certain transparency can be assumed in this market too, since the prices are determined with an eye on the transparent prices on the Nord Pool power exchange.

Price elasticity
For households price elasticity is assumed to be inelastic considering the preference for heating and light. Looking at industrial buyers it is reasonable to assume that they to some extent have more options. As a consequence the elasticity for industrial buyers can be considered higher than for household customers. Kwoka [26] has found that the elasticity is -0.12 for households and -0.84 for industry in the U.S. The Commission found in VEBA/VIAG that the electricity market was signified by low price elasticity. Statistics Norway (Statistisk Sentralbyrå) considers that short-run price elasticity of demand for households normally is - 0.05, in the longer run between - 0,20 and - 0.25.

Low price elasticity means that the customers are unlikely to switch suppliers or products when prices go up. Thus, if acting collectively producers would be able to exert market power both with regard to household customers and industrial customers.

Cost structure
The cost structure of a company influences its strategic choices. Differing cost structures may indicate an inclination to make different strategic choices. Symmetrical cost structures may facilitate tacit collusion since the companies would be more inclined to make the same kind of strategic choices.

As described in subsection 1.2.2 there are differences in production technology between the different companies. It follows that the five largest producers in the Nordic region may have differing incentives based on their choice of production technology since each production technology has its own cost structure.

A symmetrical structure would make it easier for the companies to gain insights into each others cost structures and likely choices. To some extent this effect will exist on the Nordic market even though the companies have different production technologies, since there are considerable overlaps. An example is Vattenfall, which is involved in a wide range of production technologies giving it a better understanding of the different choices and opportunities belonging to different technologies.

Opportunities to interact
The meetings of the companies will, over time, provide them with opportunities to achieve an informed opinion about the way their competitors are likely to act in the market. One important meeting place is Nord Pool.

Another aspect to consider is the asymmetry in information between larger and smaller companies. Larger companies tend to have more information about the market, e.g. concerning the cost of production, the premises for production, residual demand, the supply offered on Nord Pool, the bilateral contracts. The information published by Nord Pool partly mitigates this asymmetry. However, this information is to a large extent internal company information, which indicates that a certain information advantage will be unavoidable.

Another important meeting place enabling an exchange of information is the joint ownership of various assets. As described in subsection 1.4.2, the Swedish nuclear power companies are owned jointly by Vattenfall, Sydkraft and Fortum, together with some smaller companies. To our knowledge the same goes for Finnish nuclear plants. Many Norwegian hydropower plants are also owned jointly by hydropower producers. In order to operate a jointly owned production facility the owners need to agree on how to run the facility including how much to produce and when. Exchanging information about operating costs, planned sales and so on will enhance the transparency on the market, particularly since the joint ownership of production facilities usually means continuous contacts over a longer period of time. After a time the companies will have amassed a historical knowledge of probable behaviour which will help them in forecasting the behaviour of their competitors.

Conclusion
The comparatively concentrated market is an indication that there might be an incentive to collude, while the relative uneven spread of market shares can be seen as an indication that the companies may have differing views regarding most profitable behaviour. The market is transparent. Price changes are easily monitored and it would be relatively easy to follow other market developments. Most of the five major companies enjoy repeated opportunities to interact in a number of different situations. It is also reasonable to assume that the producers are able to exert at least some market power.

4.3.3 Retaliation Mechanisms

The CFI emphasised the need for a retaliation mechanism in the Airtours-judgement. If tacit collusion is to be profitable it needs to be of a certain duration, which means that an incentive not to deviate from the common behaviour is needed. It is only if all members of the dominating oligopoly comply with the parallel behaviour that they can benefit. It is thus necessary that there are sufficient deterrents to ensure a long-term incentive not to deviate from the common strategy.

The ability to retaliate swiftly
A retaliation mechanism is more effective if retaliatory measures can be used swiftly. The production technology most suitable for quick adaptation is hydropower with water reservoirs. A relatively small increase in production would cause a large price cut due to the low price elasticity of demand. In Sweden, Vattenfall is the company with the largest capacity in hydropower, though Sydkraft and Fortum also own hydropower plants. In Norway the dominating production technology is hydropower, which means that all the Norwegian producers have access to this technology. The Danish producers do not use any significant hydropower.

The means of retaliation
Even when a theoretical opportunity to retaliate exists it cannot automatically be assumed that such an opportunity would be used. Every retaliatory measure comes at a price. On the Nordic electricity market it is likely that the price for effective retaliation would be high. It could be discussed whether it is likely that the companies in the present situation would be inclined to make use of a theoretical opportunity to retaliate.

Conclusion
The most common way to retaliate against deviating companies is to initiate a price war. The cost of such behaviour would be high and it would affect all the companies concerned. A more detailed study of the actual costs involved would be of interest to better be able to judge the actual costs that would be incurred by this choice of action.

4.3.4 Countervailing power

The buyers mainly consist of industry, electricity retailers and other producers/sellers of electricity. Some of these buyers are large and financially strong companies in their own right. However, when buying electricity these companies do not have such a position on the market that they can exert the kind of countervailing power that would mitigate the effects of tacit collusion.

High barriers to entry are held to facilitate tacit collusion. The barriers would discourage potential competitors from entering the market and make it less likely that a new entrant will disrupt the benefits gained, e.g. through offering lower prices. The production of electricity is capital intensive with a large proportion of sunk costs when the plant cannot be sold to another producer. The lead times for building new production capacity are fairly long.

Conclusion
There is no real countervailing power from buyers and potential competitors in the short and medium range. In the long range there may be other options for some of the buyers but this is not of sufficient importance to act as a countervailing power today.

4.4 How to Exert Market Power

It is useful to split the analysis in two parts. Firstly, when the domestic Elspot area is a potential high price area the net flow of electricity goes into that area (import). Secondly, when the domestic Elspot area is a potential low price area the net flow goes out of the area (export). In both cases the incentive of a dominant generator (a generator with market power) is to hold back production.

In the import-scenario (that is when the domestic price area is a potential high-price area), the domestic generator has an incentive to reduce generation in order to create a bottleneck on the transmission line. The generator can set the price at a level above it's marginal costs depending on the degree of market power. In the extreme, there is no upper limit to the price in this scenario.

Considering the export scenario (that is when the domestic price area is a potential low-price area), the domestic generator still has the incentive to reduce production but now in order not to congest the transmission line. Thereby the generator can sell all it's production at the high price set in the other area. There is an upper limit to the price in this scenario, though. The generator cannot increase its price above the (higher) price in the neighbouring area.

In normal and wet years, electricity has historically flown from areas with predominantly hydropower plants to areas with primarily thermal power plants. The flow is expected to be reversed in normal years as the Nordic energy balance tightens. Production of electricity in Finland, Denmark West (DK1) and Denmark East (DK2) are primarily based on thermal power, while production in Norway and partly in Sweden are based on hydropower.

Every time a thermal production plant is activated real start-up costs are paid. These start-up costs typically amounts to approximately DKK 150000 (cold start), which makes it costly to exert market power in the form of short-term up-scaling and down-scaling of production. However, the up- or down-scaling of generation can be highly profitably for a thermal generator if it possesses market power. Scaling down production might cause future start-up costs, but the price increase can easily outweigh this.

The lower the price-cost mark-up is, the less valuable is the loss of a marginal decrease of supply. Therefore, the cost of exerting market power by reducing supply to increase price is lower when the mark-up is low. Thus, all else being equal a producer with low marginal costs has a lower incentive to exert market power than a producer with high marginal costs. A nuclear power producer has lower incentives than a producer of condensing power based on coal.

Hydropower plants have low production costs. However, since the supply of water is limited, it is the alternative value of the water that is the relevant production cost. One unit of water produced today means that there will be one unit of water that cannot be produced tomorrow. By producing today the producer will "lose" the income that this unit would have generated tomorrow. Therefore, the alternative value of hydropower plants will often be close to the market price.

Hydropower production differs from thermal production in the sense that a reduction of production in one period of time necessitates an increase in production in another time period, provided that no water is to be wasted. A reduction of production will reduce the usage of water in the electricity production, filling up water reservoirs. It is possible to spill water by allowing magazines to overflow, but this may be more costly for the producer than to produce at low prices, since the alternative value of the water is lost. In contrast, the alternative value of inputs held back from thermal production is not lost. Therefore, hydropower producers have a reduced incentive to deliberately spill water, although this possibility cannot altogether be ruled out. By exerting market power through withholding production, the probability of spilling water increases.

However, the hydropower producers do not need to forsake production (i.e. deliberately let the water spill) in order to utilise market power. In the power market, price differences between different periods of the day and year will frequently occur, since demand and supply conditions vary. If there is competition, the companies will wish to produce as much as possible in the high-price periods and as little as possible in the low-price periods. As long as the producers anticipate price differences, production will be moved from periods with low price to periods with high price. This means that prices will have a tendency to be evened out between periods, which will bring an increase in economic efficiency.

A producer with market power may find it profitable to utilise the fact that the elasticity of the residual demand curve varies between periods. In a period without binding bottlenecks the residual demand is more elastic than in periods where bottlenecks bind. The residual demand is also more elastic in periods with low consumption (low load periods) than in periods with high consumption (high load periods). This means that the price increase induced by reduced production in high load periods is higher than the price reduction induced by the (corresponding) increased production in a low load period. Hence, a producer with market power will reduce production in periods with low price elasticity and increase production in periods with a high elasticity, meaning that price variances increase.

Thus, utilisation of market power means excess price variations compared to market prices under free competition.

4.5 Efficiency Effects

A supplier with market power has the opportunity to influence the market price by changing his own behaviour. Utilisation of market power will partly increase the general price level and partly enhance price differences where such price differences would otherwise not have existed. Higher prices and larger price differences lead to economic loss.

When prices are higher than marginal costs the customers are willing to pay more for the production increase than the costs of the increased production. A loss of economic efficiency occurs because the quantity produced is too small. This loss is called a "dead-weight loss" because production that is beneficial for the society is not realised. The loss of economic efficiency is aggravated if the lack of competition means that the enterprises are not encouraged to innovate or produce at the lowest cost possible.

Market power may also result in a loss of production efficiency. Under competition, available production technology is utilised in the most efficient way possible at every point of time. In chapter 1.2.3, the industrial marginal cost curve is described. Production costs will be minimised when price is determined by the intersection of this supply curve and the demand curve. This will not necessarily be the result if the actors utilise market power. Utilisation of market power means that some capacity is withdrawn resulting in increased prices. The price increase might entail that more expensive production technologies are brought into production. A loss in production efficiency will arise if the withdrawn capacity is cheaper than the most expensive capacity that is utilised in production. The loss will be greater the larger the difference between the marginal costs of the two production technologies.

In the long run market power will influence price expectations and therefore long term market behaviour.

The costs of investing in the network grids should be based on the gains in form of reduced price differences between the price areas. If market power is exerted, price differences may be both increased and reduced (confer chapter 4.2 "bottlenecks"). Thus, the prices will not provide the correct investment signals from an economic point of view.

Market power will not give the right signals about bottlenecks, meaning that new production capacity may not be located where the gains to society are largest.

When high power prices are expected, decisions on the demand side will also be affected. For instance, concerns about high prices and market power will contribute to greater risk for the closure of businesses, reduced amounts of new investments or investments in other types of technology than would otherwise have been the case. High prices will also change behaviour in other demand sectors with respect to investments in power consuming equipment, investments in energy saving equipment, investments in heating technology and in the choice of fuel etc.

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