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Does Strategic Ability Affect Efficiency? Evidence from Electricity Markets

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  • Ali Hortaçsu
  • Fernando Luco
  • Steven L. Puller
  • Dongni Zhu

Abstract

Oligopoly models of price competition predict that strategic firms exercise market power and generate inefficiencies. However, heterogeneity in firms' strategic ability also generates inefficiencies. We study the Texas electricity market where firms exhibit significant heterogeneity in how they deviate from Nash equilibrium bidding. These deviations, in turn, increase the cost of production. To explain this heterogeneity, we embed a cognitive hierarchy model into a structural model of bidding and estimate firms' strategic sophistication. We find that firm size and manager education affect sophistication. Using the model, we show that mergers which increase sophistication can increase efficiency despite increasing market concentration.

Suggested Citation

  • Ali Hortaçsu & Fernando Luco & Steven L. Puller & Dongni Zhu, 2019. "Does Strategic Ability Affect Efficiency? Evidence from Electricity Markets," American Economic Review, American Economic Association, vol. 109(12), pages 4302-4342, December.
    • Handle: RePEc:aea:aecrev:v:109:y:2019:i:12:p:4302-42
    Note: DOI: 10.1257/aer.20172015
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    More about this item

    JEL classification:

    • D24 - Microeconomics - - Production and Organizations - - - Production; Cost; Capital; Capital, Total Factor, and Multifactor Productivity; Capacity
    • D43 - Microeconomics - - Market Structure, Pricing, and Design - - - Oligopoly and Other Forms of Market Imperfection
    • G34 - Financial Economics - - Corporate Finance and Governance - - - Mergers; Acquisitions; Restructuring; Corporate Governance
    • L13 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Oligopoly and Other Imperfect Markets
    • L25 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Firm Performance
    • L94 - Industrial Organization - - Industry Studies: Transportation and Utilities - - - Electric Utilities

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