Blowin' in the Wind: Sequential Markets, Market Power, and Arbitrage

A variety of economic goods are traded through sequential markets, a set of forward and real-time markets, to improve the efficiency of the final allocation. However, in many markets, prices across sequential markets do not converge in practice. We develop a theoretical framework to characterize strategic behavior in sequential markets under imperfect competition. Our theory predicts that market power can be a key force for a systematic price premium and that dominant firms and fringe firms may have substantially different incentives to update their positions though sequential markets. We test these theoretical predictions in the Iberian electricity market, which provides unique market structures suitable for our analysis and unusually detailed micro-data on bidding strategies, production, and costs. We show that 1) the observed price differences are consistent with the exercise of market power, 2) fringe firms arbitrage, particularly using wind power, which has advantages for price arbitrage, 3) dominant firms do not arbitrage and rather withhold production in the forward market, consistent with the premium being driven by market power. Finally, we explore the welfare effects of arbitrage. Price convergence is often interpreted as a sign of efficiency. However, we show that in the presence of market power, arbitrage is not necessarily welfare enhancing, even in the absence of arbitrage costs.

Speaker: Mar Reguan, Stanford