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On the Inefficiency of Forward Markets in Leader–Follower Competition

Author

Listed:
  • Desmond Cai

    (Department of Electrical Engineering, California Institute of Technology, Pasadena, California 91125)

  • Anish Agarwal

    (Department of Computer Science, California Institute of Technology, Pasadena, California 91125)

  • Adam Wierman

    (Department of Computing and Mathematical Sciences Department, California Institute of Technology, Pasadena, California 91125)

Abstract

Motivated by electricity markets, this paper studies the impact of forward contracting in situations where firms have capacity constraints and heterogeneous production lead times. We consider a model with two types of firms—leaders and followers—that choose production at two different times. Followers choose productions in the second stage but can sell forward contracts in the first stage. Our main result is an explicit characterization of the equilibrium outcomes. Classic results on forward contracting suggest that it can mitigate market power in simple settings; however, the results in this paper show that the impact of forward markets in this setting is delicate—forward contracting can enhance or mitigate market power. In particular, our results show that leader–follower interactions created by heterogeneous production lead times may cause forward markets to be inefficient, even when there are a large number of followers. In fact, symmetric equilibria do not necessarily exist due to differences in market power among the leaders and followers.

Suggested Citation

  • Desmond Cai & Anish Agarwal & Adam Wierman, 2020. "On the Inefficiency of Forward Markets in Leader–Follower Competition," Operations Research, INFORMS, vol. 68(1), pages 35-52, January.
    • Handle: RePEc:inm:oropre:v:68:y:2020:i:1:p:35-52
    DOI: 10.1287/opre.2019.1863
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    References listed on IDEAS

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