Does Strategic Ability Affect Productive Efficiency? Evidence from Electricity Markets

Standard oligopoly models of short-run price competition in oligopoly settings predict that large firms can exercise market power and generate inefficiencies. However, productive inefficiency can also arise from other sources as well, such as in the presence of heterogeneity is strategic sophistication. This paper studies such a setting in the Texas electricity market, in which bidding behavior of some firms persistently and significantly deviates from Nash-equilibrium bidding. We leverage a unique dataset that contains information on bids and valuations to identify and estimate levels of strategic sophistication. We embed a Cognitive Hierarchy model into a structural model of bidding behavior. (Preliminary) results show that larger firms have higher levels of strategic sophistication than smaller firms, though there is significant heterogeneity across firms. We then use the estimated distribution of types of strategic sophistication to perform counterfactual calculations about market efficiency under different scenarios that increase strategic sophistication of low-type firms either exogenously or through mergers with more sophisticated firms. We find that exogenously increasing sophistication of small firms increases productive efficiency. Furthermore, mergers that do not generate cost synergies and increase concentration may also increase efficiency.

Speaker: Steve Puller, Texas A&M

Wells Fargo Room