Ranking Supply Function and Cournot Equilibria in a Differentiated Product Duopoly with Demand Uncertainty

In this paper, we provide a welfare ranking for the equilibria of the supply function and quantity competitions in a differentiated product duopoly with demand uncertainty. We prove that the expected consumer surplus is always higher under the supply function competition, irrespective of whether the (duopolistic) products are substitutes, complements, or independent. Numerical simulations suggest that if the products are either complements or independent, or if they have an extremely low degree of substitution, then the supply function competition can always be Pareto superior to the quantity competition in terms of the producers’ and consumers’ welfares. Moreover, if the degree of product substitution is not extremely low, then the supply function competition can be Pareto superior to the quantity competition if and only if the size of the demand uncertainty is sufficiently large to exceed a critical level. We find that this critical level of demand uncertainty becomes higher when the duopolistic products are less differentiated. Additionally, this critical level is nonincreasing both in the marginal cost of producing a unit output and in the own-price sensitivity of each inverse demand curve when all other parameters are fixed. Our results imply that in electricity markets with differentiated products, the regulators should not intervene to impose the quantity competition in favor of the supply function competition unless the degree of product substitution is sufficiently high and the predicted demand fluctuations are sufficiently small.