Externalities in a Capacity Auction

Abstract

This paper examines a Cournot game where capacity constraints are determined in an auction prior to the market interaction. Traditional auctions may not generate a profit-maximizing allocation of capacity in this case, a failure that is traced to the presence of externalities in the valuations. The modification of Ausubel & Milgrom (2002)'s generalized ascending proxy auction developed in Ranger (2004) is shown to lead to an efficient allocation. It is efficient and strategically simple for the bidding firms. Furthermore, the auction is designed to allow the explicit inclusion of auctioneer preferences in calculating the final allocation. Unlike in standard auctions, consumer surplus considerations can thus be incorporated in a straightforward manner.

Keywords: Auctions, Externalities, Cournot, Oligopoly

JEL Classification: D44, D45, D63, D23