Re: Bitten by NIMBY, CA power system goes socialist...

Date: Mon Jan 15 2001 - 11:26:06 MST

One comment on what Chris wrote:
> Reason Magazin has a couple of articles highlighting all the non-market
> aspects of the so-called deregulation.
> [...]
> markets, in which the highest price paid all day
> is charged for all contracts that day

This pricing rule sounds stupid, but I want to defend it, or at least
explain why it is not as absurd as it sounds.

First, one of the Berkeley papers I pointed to earlier makes the point
that it is entirely common in commodity markets to pay the same price
for all supplies of the commodity. This happens even when it costs more
to supply some of the commodity than others. For example, with pork
bellies the transportation costs will vary depending on where the pork
comes from. But you don't pay one price for the lot from California and
a different price for the lot from New York. One price is paid for all.
This policy simplifies the bidding process and futures contracts.

If we accept this general principle, then in the case of the electricity
market there remain two questions. First, is it reasonable to use the
same price for all the electricity delivered during the day, given that
supply and demand fluctuate during the day? And second, if we are going
to do this, should we use the highest-price rule (also called first-price
auction rules).

I think the justification for using the same price all day is twofold.
First, given how the market works, demand is almost completely insensitive
to price. Inter-day price variations aren't passed on to customers,
so they do not adjust their demand in response. Therefore there is less
advantage than in some markets to adjusting the price on an hour by hour
basis since it will not affect demand.

Secondly, this might actually reduce some of the opportunities for
"gaming" the system (using strategies to achieve higher than competitive
rates). If they actually got their hour-by-hour prices, companies which
knew that electricity was going to be worth more in the afternoon than
in the morning would hold their electricity off the market until then.
If you were selling a product that would be worth three times more at 4
PM than at 10 AM, wouldn't you do the same? By giving the sellers the
same price all day it eliminates this kind of manipulation.

Now we come to the question of first-price auctioning, that is, using
the highest price rather than the average price or some other rule.
The justification for first-price auctions is, again, that it tends to
reduce some forms of gaming and manipulation. Without this kind of rule
companies have to second-guess what other suppliers are going to ask.
They want to set their price as high as possible, but not substantially
higher than everyone else. This involves guessing and invites collusion.
With a simple auction rule like first-price auctioning there is less of
this kind of gamesmanship.

Besides, if we changed the rules it would not necessarily save money.
The prices we are paying ultimately are due to the fact that demand is
coming up against the limits of supply. Changes to the market rules
won't change this fundamental fact.

Imagine that eBay, the online auctioner, adopted a rule to "save money
to buyers". Whatever price an auction closed at, the buyer only had to
pay HALF that price to the seller. So if an item sold for $100, the
buyer would only have to pay $50. It should be clear that this would
not actually save any significant amount to buyers. Items would simply
sell for twice what they do now, so that the actual amount paid would be
the same. The real prices are set by supply and demand and the auction
rules have a relatively minor effect.

Similarly, suppose we changed from a highest-price rule to an
average-price rule. We think this will save money for the buyers by
making the sellers accept less. But this won't necessarily happen.
Instead, average prices will go up because sellers know that they
aren't going to get their afternoon prices. They have to charge more
in the morning to compensate. This price adjustment will undercut the
hoped-for effects in changing the rule.

I'm not saying market rules have no effects, but rather that the effects
are more subtle than may appear at first glance. Superficial changes
which are supposed to lower prices may not have that result. You have
to look at the details of how markets work in order to choose the best
rules. And in many cases rules like first-price auctions work as well
as any others.


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