Preventing Monopoly or Discouraging Competition? The Perils of Price-Cost Tests for Market Power in Electricity

Allegations of market power in wholesale electricity sales are typically tested using price-cost margins. Such tests are inherently suspect in markets - such as electricity - that are subject to capacity constraints. In such markets, prices can vary with demand while quantity, and thus cost measure, remain fixed. Erroneous conclusions are more likely when the proxy for marginal cost is the average operating cost of the marginal plant. Measured this way, Lerner indexes are consistent with competitive behavior. Using this proxy to cap wholesale prices, as the U.S. Federal Energy Regulatory Commission has proposed, would discourage entry by making it impossible for peak power suppliers to recover capital costs. The wholesale electricity sector may be susceptible to market power. But a preferable (if not unproblematic) test for market power would look not at prices but output, i.e., whether individual generators withheld energy that would have been profitable to supply at prevailing prices.