In this, the second lecture, I focus on electricity markets. I’ll divide the summary of that lecture into two parts.

Until the 1980s electricity markets around the world operated as regulated monopolists. Generation (power plants) and distribution (the wires) were combined into a single entity. Beginning with Chile, a variety of Latin American countries started to privatize their electricity markets. So, imagine you were a bright young thing in the early 1980s, freshly baptised in the waters of Lake Michigan off Hyde Park. The General approaches you and says I want a free market in electricity, make it so (Quiero un mercado libre de la electricidad, que asiĀ­ sea.) What would you reccomend?

Obviously, privatize the generators by selling them off, perhaps at auction (or given one’s pedigree, allocate them at random and allow the owners to trade among themeselves). What about the wire’s that carry electricity from one place to another. Tricky. Owner of the wire will have monopoly power, unless there are multiple parrallell wires. However, that would lead to inefficient duplication of resources. As a first pass, lets leave the wires in Government hands. Not obviously wrong. We do that with the road network. The Government owns and mainatins it and for a fee grants access to all.

So, competition to supply power but central control of the wires. Assuming an indifferent and benign authority controlling the wires, what will the market for generation look like? To fix ideas, consider a simple case. Two generators ${\{1, 2\}}$ and a customer ${3}$.

Generator has unlimited supply and a constant marginal cost of production of \$20 a unit. Generator 2 has an unlimited supply and a constant marginal cost of production of \$40 a unit. Customer 3 has a constant marginal value of ${V}$ upto 1500 units and zero thereafter. Assume ${U}$ to be sufficiently large to make all subsequent statements true. Initially there are only two wires, one from generator 1 to customer 3 and the other from generator 2 to customer 3. Suppose ${\{1,2,3\}}$ are all price takers. Then, the Walrasian price for this economy will be \$20. For customer 3 this clearly a better outcome than unregulated monopoly, where the price would be ${U}$. What if the price taking assumption is not valid? An alternative model would be Bertrand competition between 1 and 2. So, the outcome would be a `hairs breadth’ below \$40. Worse than the Walrasian outcome but still better than unregulated monopoly. It would seem that deregulation would be a good idea and as the analysis above suggest, there is no necessity for a market to be designed. There is a catch. Is unregulated monopolist the right benchmark? Surely, a regulated monopolist would be better. Its not clear that one does better than the regulated monopolist.

Now lets add a wrinkle. Suppose the wire between 1 and 3 has capacity 600 units. There are two ways to think of this capacity constraint. The first is a capacity constraint on generator 1 that we have chosen to model as a constraint on the wire ${(1,3)}$. The second is that it is indeed a constraint on the wire ${(1,3)}$. The difference is not cosmetic as we shall see in a moment.

Suppose its a constraint on generator 1’s capacity. Then, under the price taking assumption, the Walrasian price in this economy will be \$40. An alternative model of competition would be Bertrand-Edgeworth. In general equilibria are mixed, but whatever the mixture, the expected price per unit customer 3 will pay cannot exceed \$40 a unit. In both cases, the outcome is better for customer 3 than unregulated monopolist.

Assume now the capacity constraint is on the wire instead. Under the price taking assumption, at a price of \$20 unit, generator 1 is indifferent between supplying any non-negative amount. Generator 3’s supply correspondence is the empty set. However there is no way for supply to meet demand. Why is this? In the usal Walrasian set up each agent reports their supply and demand correspondence based on posted prices and their own information only. To obtain a sensible answer in this case, generator 1 must be aware of the capacity of the network into which its supply will be injected. As the next scenario we consider shows, this is not easy when it comes to electricity.

Suppose there is now a link joining generator 1 and 2 with no capacity constraint. There is still a 600 unit capacity constraint on the link between 1 and 3. One might think, that in this scenario, customer 3 can receive all its demand from generator 1. It turns out that this is not possible because of the way electricity flows in networks.