Strategic investment decisions in an oligopoly with a competitive fringe: An equilibrium problem with equilibrium constraints approach

Abstract

Modern wholesale electricity markets often have producers who exercise market power. The standard way to model market power in an oligopoly with a competitive fringe is by using Mixed Complementarity Problems (MCPs) and conjectural variations. However, such models can lead to myopic (sub-optimal) behaviour for oligopolists. We first build on existing literature to show that an oligopoly with a competitive fringe where all firms have investment decisions will also lead to myopic behaviour when modelled using MCPs with conjectural variations. To overcome this issue, we develop an Equilibrium Problem with Equilibrium Constraints (EPEC) to model such an electricity market structure. The EPEC models two types of players: price-making firms, who have market power, and price-taking firms, who do not. Our model is the first in the literature to consider an oligopoly with a competitive fringe where all firms have investment decisions. Our results indicate that an EPEC can model investment decisions in an oligopoly with a competitive fringe more credibly and thus overcome the myopic behaviour observed in MCPs. The EPEC found multiple equilibria for investment decisions and firms’ profits. Despite this, market prices and consumer costs were found to remain relatively constant across the equilibria. A further contribution of the modelling approach is that it shows how it may be optimal for price-making firms to accept losses in some time periods in order to disincentivize price-taking firms from investing further into the market. We conclude our paper with a discussion of the computational limitations of our approach.