Industrial organization.

• Author: Rose, Nancy L.

The NBER Program in Industrial Organization (IO), established in 1991, promotes applied economic research on a broad set of questions relating to firm behavior, the organization and operation of markets, and the economic analysis of government regulation. The last decade has provided a wealth of new, interesting, and important questions for industrial organization and regulatory economists to study. There have been substantial changes in market structure in many industries, from sources as varied as merger waves, reorganization of production and distribution, and increased international competition. Market-based institutions increasingly are replacing government regulation or ownership of firms, in industries as diverse as airlines, railroads, electricity, and telecommunications. Even where regulation has been retained, it often has been transformed to replace "command-and-control" with economic incentives and enhanced flexibility. Finally, researchers have developed a wealth of new databases and microeconometric techniques to study firm behavior, including issues such as pricing decisions in differentiated product markets, the effect of search costs on market outcomes, and the determinants of firms' contracting and internal organization decisions, that previously had been subject to only theoretical discussion.

This report describes several broad research themes analyzed by members of the Industrial Organization program. Rather than presenting an exhaustive summary of past research, I have chosen to focus on a set of major topics, and to explain critical findings in each one.

Deregulation, Restructuring, and Market Design: The Case of Electricity

In the late 1980s and the 1990s, throughout the world, basic infrastructure industries including electricity, telephone, natural gas, railroads, and even water distribution have undergone dramatic reorganizations. Government ownership or administrative regulation typically has been replaced with substantial reliance on private market: mechanisms within much or all of the restructured industry, and "natural monopoly" characterizations have given way to notions of "workable competition." NBER researchers have been active in assessing the consequences of market restructuring and exploring market design issues in a variety of settings. I focus here on the work relating to electricity markets.

The electricity generation, transmission, and distribution industry, long operated as a vertically integrated, publicly-owned or regulated natural monopoly in virtually all markets worldwide, has attracted particular research attention. Catherine Wolfram has taken advantage of a wealth of data created by the United Kingdom's electricity restructuring to test competing models of firm behavior in deregulated markets.(1) She finds that while the two dominant generating firms in the England and Wales have been able to raise the pool price for wholesale electricity above their marginal costs of generation, they appear not to exploit their potential market power fully. Wolfram argues that this may be the result of efforts to reduce the threat of competitive entry or re-regulation. Frank Wolak and Robert Patrick provide further evidence on the potential magnitude of generators' market power in their study of the real-time price sensitivity of electricity demand for a group of industrial customers in the United Kingdom.(2)

A critical issue in the restructure of these markets is how specific institutions may enhance or mitigate the exercise of market power. England and Wales, which rely on an auction mechanism to clear the wholesale power market, provide an important research laboratory for exploring the effect of particular auction rules on market outcomes. Wolfram focuses on the multi-unit character of this auction to model generating firms' incentives to raise their bid price for a given unit, as a function of the total quantity of generation they bid into the pool.(3) Because the price of all electricity traded through the pool is set by the bid price for the last unit selected to run, a generator that thinks its unit may be marginal has an incentive to increase its bid. This raises the price received on that unit and all inframarginal units it owns. Wolfram's empirical analysis finds behavior consistent with these predictions.

Wolak and Patrick focus on the pool rules that determine capacity payments at peak demand periods.(4) As a result of these rules, generator revenues can include substantial payments intended to reflect the shadow cost of capacity needed for reliable operation of the system during these high demand hours. They also document the incentive that this gives firms to strategically manipulate the amount of generating capacity made available to the power pool during peak periods, and they provide econometric evidence that suggests this behavior is an important mechanism by which the two dominant generators raise their overall profitability.

These studies of the electricity market in England and Wales are important for the information they provide about that market in particular, but they also are of more general interest. Wolak's current research focuses on the broad lessons for market design in a comparative study of restructured electricity markets that includes Australia and New Zealand, a number of Latin American countries, Norway and Sweden, as well as England and Wales. This body of work illustrates how detailed institutional characteristics of a deregulated market may affect its performance.

This research also provides substantial guidance on issues facing policymakers involved in...