Date of Award

2021

Degree Type

Dissertation

Degree Name

Doctor of Philosophy (PhD)

Graduate Group

Applied Economics

First Advisor

Arthur van Benthem

Abstract

This paper evaluates the effects of market power on capacity investment when firms are increasing electricity generation capacity. Chapter 1 develops a model of capacity investments in the electricity market and analyzes how investment incentives are affected by market power. Incentives for capacity investment depend on the distribution of demand. Each level of demand affects overall incentives differently depending on market power. Higher demand hours generate scarcity rent and significantly contribute to the overall incentive for investment. However, this incentive is lower for firms with a higher share of preexisting capacity. During demand levels when firms are not producing at capacity, additional capacity can increase or decrease profits. Under certain scenarios, when profits decrease from additional capacity, this decrease is stronger for competitive firms relative to firms with market power. Electricity markets can introduce price caps and capacity payments as measures to mitigate market power and provide adequate investment incentives. However, under these mechanisms, firms with market power can behave strategically either to increase capacity payments or to limit entry. Chapter 2 presents an empirical analysis of capacity investment and market power using data from ERCOT. I solve for investment costs using techniques developed by Bajari, Benkard, and Levin (2007). I then test investment levels under different market power scenarios. When firms are investing strategically, market power in the electricity generation market does not significantly affect capacity investment. This is because the incentive for capacity investment comes primarily from the scarcity rent during extreme-peak hours when electricity prices exceed \$500 per MWh. During these hours, firms will produce at capacity regardless of market power. During non-extreme-peak hours, firms with market power are able to stabilize prices more effectively when capacity increases. This means that price decreases from capacity investments during non-extreme-peak hours are less harmful to firms with market power. This may result in firms from the competitive market investing at a slightly lower level relative to firms with market power. Results from both chapters show that total welfare increases as the investment level increases.

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