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Identification and Estimation of Cost Functions Using Observed Bid Data: An Application to Electricity Markets

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  • Frank A. Wolak

Abstract

This paper presents several techniques for recovering cost function estimates for electricity generation from a model of optimal bidding behavior in a competitive electricity market. Two techniques are developed based on different models of the price-setting process in a competitive electricity market. The first assumes that the firm is able to choose the price that maximizes its realized profits given the bids of its competitors and the realization of market demand. This procedure is straightforward to apply, but does not impose all of the market rules on the assumed price-setting process. The second procedure uses the assumption that the firm bids to maximize its expected profits. This procedure is considerably more complex, but can yield more insights about the nature of the firm's variable costs, because it allows the researcher to recover generation unit-level variable cost functions. These techniques are applied to bid, market outcomes and financial hedge contract data obtained from the first three months of operation of the National Electricity Market (NEM1) in Australia. The empirical analysis illustrates the usefulness of these techniques in measuring actual market power and the ability to exercise market power possessed by generation unit owners in competitive electricity markets.

Suggested Citation

  • Frank A. Wolak, 2001. "Identification and Estimation of Cost Functions Using Observed Bid Data: An Application to Electricity Markets," NBER Working Papers 8191, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:8191
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    Cited by:

    1. Evans, Lewis & Counsell, Kevin & Guthrie, Graeme, 2006. "Options Provided by Storage can Explain High Electricity Prices," Working Paper Series 3943, Victoria University of Wellington, The New Zealand Institute for the Study of Competition and Regulation.
    2. Asad Ahmed & Osman Hasan & Falah Awwad & Nabil Bastaki, 2020. "Formalization of Cost and Utility in Microeconomics," Energies, MDPI, vol. 13(3), pages 1-19, February.
    3. Ciro Eduardo Bazán Navarro, 2004. "Análisis de la competencia en un mercado mayorista de electricidad: el caso de España," Documentos de trabajo conjunto ULL-ULPGC 2004-04, Facultad de Ciencias Económicas de la ULPGC.
    4. Holmberg, Pär & Newbery, David & Ralph, Daniel, 2013. "Supply function equilibria: Step functions and continuous representations," Journal of Economic Theory, Elsevier, vol. 148(4), pages 1509-1551.
    5. Evans, Lewis & Counsell, Kevin & Guthrie, Graeme, 2006. "Options Provided by Storage can Explain High Electricity Prices," Working Paper Series 19042, Victoria University of Wellington, The New Zealand Institute for the Study of Competition and Regulation.
    6. Crawford, Gregory S. & Crespo, Joseph & Tauchen, Helen, 2007. "Bidding asymmetries in multi-unit auctions: Implications of bid function equilibria in the British spot market for electricity," International Journal of Industrial Organization, Elsevier, vol. 25(6), pages 1233-1268, December.
    7. Di Cosmo, Valeria & Malaguzzi Valeri, Laura, 2014. "The incentive to invest in thermal plants in the presence of wind generation," Energy Economics, Elsevier, vol. 43(C), pages 306-315.
    8. Tunç Durmaz, 2017. "Optimal storage under uncertainty: investigating the implications of frugality and prudence," Economics Bulletin, AccessEcon, vol. 37(3), pages 1624-1629.
    9. Lange, Sebastian & Sokolowski, Peter & Yu, Xinghuo, 2022. "An efficient, open-bid procurement auction for small-scale electricity markets," Applied Energy, Elsevier, vol. 314(C).
    10. Lewis Evans & Graeme Guthrie, 2009. "How Options Provided by Storage Affect Electricity Prices," Southern Economic Journal, John Wiley & Sons, vol. 75(3), pages 681-702, January.
    11. repec:vuw:vuwscr:19042 is not listed on IDEAS

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    More about this item

    JEL classification:

    • L9 - Industrial Organization - - Industry Studies: Transportation and Utilities
    • L1 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance

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