Providing Uncertain Quantities Efficiently : Theory and Applications to Electricity Deregulation

This paper studies situations where a single buyer with uncertain demand wishes to buy from a small number of suppliers. In this setting it is well understood that supply function bidding results in the product not being produced at the lowest cost, that is, in the loss of production efficiency. We show that not only is production efficiency obtained, but entry and cost reducing investment are also optimal if suppliers are allowed to bid both a payment contingent on the quantity supplied and a payment contingent on the realization of total demand. We discuss our scheme in the context of electricity deregulation and evaluate some of the latest reforms within the industry in the light of our results. We also show that our results can be reinterpreted in the multi-unit auction setting with random supply, a single seller and multiple buyers