D. ECONOMIC FOUNDATIONS OF THE GERMAN ELECTRICITY MARKET
I. F UNDAMENTALS OF ECONOMIC MARKETS
3. Economics of concentration
Perfectly competitive markets are rare in the world outside economic textbooks.
Therefore, economic theory did early on develop models of markets that fail to produce the socially optimal output. The contents of this subsection is limited to the case of market power, which is the only market failure relevant to the analysis of price manipulation at the energy market. First, the extreme case of only one supplier in the market (monop-oly)144 is introduced to provide a basis for the understanding of the related case of oligop-oly.
a) Pricing behavior and social welfare in monopolized markets
Other than in competitive markets, a monopoly firm does not have to act like a price taker. On the contrary, its decisions on output have influence on the price for the good.
The reason is that customers have no chance to substitute the product of the monopolist for a cheaper one offered by an alternative producer since by definition there are no other producers in the monopolized market.145 Of course, the monopolist´s power to choose the price is not unlimited, but constrained by the demand behavior of the customers.146 How-ever, the following analysis will reveal that the profit-maximizing monopolist chooses a price that differs from the one observed in competitive markets.
The monopolist faces, other than firms in a competitive environment, the complete market demand curve.147 This is best expressed by an inverse demand function p(x), where the price (p) depends on the quantity of output (x). Furthermore, the monopolist incurs some cost of production also depending on the quantity x: c(x). The resulting revenue function takes therefore the shape
R(x) = p(x) . x,
expressing that the revenue results from the quantity of units sold (x) times the price per unit (p(x)).
144 Hal R. Varian, Intermediate Microeconomics (New York: W.W. Norton & Company, 2006), 423.
145 Ibid, 444.
146 Ibid, 423.
147 Competitive firms face a demand curve in the shape of a horizontal line because they can sell an unlimited quantity of the product at the given market price. For this case and the different one of monopoly firms see: N.
Gregory Mankiw, Principles of Economics (Mason: South-Western Cengage Learning, 2008), 315.
Consequently, the maximization problem refers to the corresponding profit function, where profit results from the subtraction of cost of production from the revenue from the sale of the product:
∏(x) = R(x) – c(x).
Insertion of the above defined variables for R(x) results in
∏(x) = p(x) . x – c(x).
As introduced above, the first-order condition for a profit maximum is found by deriving
∏ with regard to x and equating the term to zero:
dπ dx = dp
dx ∙ x + p(x) - dc dx = 0
Rearranging terms yields the profit-maximizing condition for monopoly output:
dp
dxx + p(x) = dc dx .148
This term shows that the monopolist maximizes profit by choosing an output level where marginal revenue from the sale of an additional unit equals marginal cost of the production of this unit.149 Having said this, the conclusion for the price level under monopoly is straightforward: While price equals marginal cost in competitive markets, price exceeds marginal cost in a monopoly market.150 The magnitude of the price difference depends most notably on the elasticity of demand: The price-cost margin increases with a lower elasticity of demand and vice versa.151
This finding has considerable consequences for social welfare. In detail, there are three main inefficiencies stemming from monopoly pricing:
▪ Allocative inefficiencies,
▪ productive inefficiencies, and
▪ dynamic inefficiencies.
148 A similar derivation of the monopoly pricing rationale can be found in: Hal R. Varian, Intermediate Microe-conomics (New York: W.W. Norton & Company, 2006), 424.
149 Paul A. Samuelson and William D. Nordhaus, Economics (Singapore: McGraw-Hill, 2005), 155.
150 N. Gregory Mankiw, Principles of Economics (Mason: South-Western Cengage Learning, 2008), 320.
151 Massimo Motta, Competition Policy. Theory and Practice (New York: Cambridge University Press, 2004), 43.
Allocative inefficiency can be derived by a comparison of social welfare produced in the benchmark model of perfectly competitive markets with the social welfare under monop-oly. From the law of demand we know that an increase of the market price causes the quantity demanded to decrease.152 In other words: Customers with a willingness to pay for the product higher than the cost of production are not served in the monopoly case, whereas they would be in a competitive market environment; economic surplus de-creases.153 This loss of social welfare is best illustrated in the following graphic, where the loss of economic surplus from both losses of consumers´ surplus and producers´ surplus is depicted.
Figure 6: Welfare loss from monopoly
From figure 6 it is well to be seen that the monopolist´s pricing rationale increases the price, such that output decreases simultaneously. As a result, consumer surplus shrinks in favor of a gain of producer surplus. This event constitutes a pure transfer of wealth from the consumers to the producers.154 Yet, beyond this transfer, there is a true welfare loss from the inefficiently low quantity of output. This decrease of value from the lower output level due to monopoly pricing is called “deadweight loss”.155
A second aspect of allocative inefficiency with regard to monopoly has first been discussed in Gordon Tullocks 1967 article on the cost of monopolies156: He suggested, that the fo-cusing of the economic science on the deadweight loss was completely ignoring a much bigger allocative problem of monopoly, which is what was later named the “rent seeking
152 See paragraph D.I.1.a) of this chapter.
153 N. Gregory Mankiw, Principles of Economics (Mason: South-Western Cengage Learning, 2008), 323.
154 Ibid, 325.
155 Hal R. Varian, Intermediate Microeconomics (New York: W.W. Norton & Company, 2006), 433.
156 Gordon Tullock, “The Welfare Costs of Tariffs, Monopolies, and Theft”, Western Economic Journal Vol. 5, no.
3 (1967), 224-232.
activities” of monopoly firms.157 This is, firms start spending money to gain political influ-ence and lobby in order to keep or increase their monopoly power158 - instead of investing the money in more productive uses. This waste of resources enlarges the cost associated with monopoly.159
The second drawback monopolized markets cause is productive inefficiencies. This term describes the monopolies´ tendency to face higher cost of production than firms operating in competitive markets.160 The additional welfare loss from the utilization of inefficient production technology is mainly due to the lack of competitive pressure, which would force the firm to use the best available technologies in order to keep the costs at a competitive level.161 Apart from that, productive inefficiency stems from managerial shirking. Monopoly power is said to bring about managerial inefficiency because of lacking incentives for the managers to exhaust the whole of the firm´s scope in view of safe monopoly profits.162
Eventually, dynamic inefficiencies contribute to welfare losses from monopoly. Economic models of competition and innovation show that monopoly firms have less incentives to invest in research and development (R&D).163 Innovation is materially triggered by the expectation to recover the investments made in R&D. The expectation of market power, therefore, exhibits a strong incentive to innovate. By contrast, monopoly firms already exercising market power have weaker inducement to invest considerable amounts of money in research projects with uncertain returns.164
All aspects considered there is serious evidence that monopolized industries harm social welfare and, as a result, are subject to various government regulation efforts. Oligopolized markets like the German energy industry treated in this work face similar regulatory prob-lems. The next subsection therefore presents the case in between the two extremes of perfectly competitive markets and monopoly: Market structures named oligopoly with a limited number of suppliers bigger than one, but small enough to leave individual firms some room to exert influence on the market price.165
157 Massimo Motta, Competition Policy. Theory and Practice (New York: Cambridge University Press, 2004), 44.
158 Gordon Tullock, “The Welfare Costs of Tariffs, Monopolies, and Theft”, Western Economic Journal Vol. 5, no.
3 (1967), 228.
159 Massimo Motta, Competition Policy. Theory and Practice (New York: Cambridge University Press, 2004), 44.
160 Ibid, 45.
161 This is somehow a Darwinian selection argument, since in the presence of competition, only efficient firms survive. For a more in-depth analysis and empirical evidence see ibid, 46.
162 This argument is best understood in the context of corporate governance theory and the so-called princi-pal-agent models that highlight the conflict between manager and shareholder interests. See ibid, 47.
163 Ibid, 58.
164 Ibid, 55.
165 Hal R. Varian, Intermediate Microeconomics (New York: W.W. Norton & Company, 2006), 480.
b) Pricing behavior and social welfare in oligopoly markets
Also in oligopoly markets, prices tend to exceed the costs of production, resulting in welfare losses for the economy.166 Whether and how much prices deviate from the com-petitive benchmark depends not only on the elasticity of demand as discussed for the monopoly case167, but also on how successful firms are in maintaining a collusive pricing strategy.168 This is due to the fact that in an oligopoly, the market price and as a conse-quence the firm´s profit does not only depend on the production decision of a single firm, but also of the other firms in the market.169 This constellation requires strategic interac-tions between the firms in the market.170
From a profit maximizing point of view, the oligopoly firms would prefer to act the same way a monopolist does and produce the monopoly output in order to share it between the colluding companies.171 Yet, oligopoly firms face some obstacles in trying to achieve a collusive agreement to act like a monopoly, the most important of which are
▪ the cost of detection, since collusion is illegal in most legislations, and
▪ the incentive to cheat on the agreement among oligopolists in order to make an extra profit by undercutting the oligopoly price.172
Without going into the details, some of the factors favoring collusion shall be named here.
Those ones being of further importance to the manipulations in the energy market will be discussed in-depth in the chapters devoted to the analysis of the industrial organization of the German electricity market and the considerations on antitrust regulation opportuni-ties.173 For the purpose of a first overview, important structural factors facilitating collusive agreements are as follows:174
▪ Highly concentrated markets175,
166 Massimo Motta, Competition Policy. Theory and Practice (New York: Cambridge University Press, 2004), 138.
167 See section D.I.3.a) of this chapter.
168 Paul A. Samuelson and William D. Nordhaus, Economics (Singapore: McGraw-Hill, 2005), 188.
169 N. Gregory Mankiw, Principles of Economics (Mason: South-Western Cengage Learning, 2008), 366.
170 Hal R. Varian, Intermediate Microeconomics (New York: W.W. Norton & Company, 2006), 480.
171 Paul A. Samuelson and William D. Nordhaus, Economics (Singapore: McGraw-Hill, 2005), 187.
172 Ibid, 188.
173 Issues of industrial organization in the electricity market are discussed in the second chapter in section D.
For the regulatory measures, please refer to the fourth chapter of this work.
174 The structural factors are based on the enumeration in Massimo Motta, Competition Policy. Theory and Practice (New York: Cambridge University Press, 2004), 142-149.
175 A common measure of market concentration is the Herfindahl-Hirschmann Index. In competition analysis, values exceeding 1,800 indicate highly concentrated markets. See Paul A. Samuelson and William D.
Nordhaus, Economics, 18th ed. (Singapore: McGraw-Hill, 2005), 185.
▪ high barriers of entry,
▪ cross-ownership and other links among competitors,
▪ regularity and frequency of orders,
▪ the lack of buyer power on the demand side,
▪ a sudden massive increase of demand,
▪ product homogeneity,
▪ symmetry between firms,
▪ firms meeting in more than one market (multi-market contracts), and
▪ inventories and excess capacities.
In conclusion, oligopoly may mean as much of a threat to social welfare as monopoly does.
However, firms face significantly more obstacles in achieving and maintaining collusive prices than a monopolist does. Yet, market structures with oligopolistic characteristics are much more common in real markets and in consequence much more relevant for industry analyses176. As the next section will show, this is also true for the German electricity mar-ket.