Does Strategic Ability Affect Efficiency? Evidence from Electricity Markets
64 Pages Posted: 6 Mar 2019
Date Written: February 1, 2019
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 that increase sophistication can increase efficiency despite increasing market concentration.
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