Working Paper: NBER ID: w23526
Authors: Ali Hortasu; Fernando Luco; Steven L. Puller; Dongni Zhu
Abstract: Oligopoly models of price competition predict that strategic firms exercise market power and generate inefficiencies. However, heterogeneity in firms’ strategic ability also generates inefficiencies. We study the Texas electricity market where firms exhibit significant heterogeneity in how they deviate from Nash equilibrium bidding. These deviations, in turn, increase the cost of production. To explain this heterogeneity, we embed a Cognitive Hierarchy model into a structural model of bidding and estimate firms’ strategic sophistication. We find that firm size and manager education affect sophistication. Using the model, we show that mergers that increase sophistication can increase efficiency despite increasing market concentration.
Keywords: Electricity Markets; Strategic Ability; Market Efficiency; Cognitive Hierarchy
JEL Codes: D03; D22; L1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| larger firm sizes (L25) | higher strategic sophistication (L15) |
| higher strategic sophistication (L15) | improved market efficiency (G14) |
| increasing strategic sophistication of lower-type firms (L19) | enhanced market efficiency (G14) |
| lower strategic sophistication (L15) | higher production costs (D24) |
| higher production costs (D24) | inefficient market outcomes (D61) |
| mergers involving high-type firms (G34) | efficiency gains (D61) |
| increased sophistication from mergers (G34) | offset losses in economic efficiency (D61) |
| strategic sophistication (D80) | market outcomes (P42) |