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case of strategic interaction (PEQ,4

, 4 firm oligopoly and PEQ,2

duopoly). In order to make

the differences more visible, in the figure we focus on prices in the interval [0, 350]. We find that for the parameter configuration we chose, observed prices are somewhere in between the first best scenario and strategic interaction of firms.

Notice that the relatively low level of observed prices (as compared to the strategic scenario) may well be due to the fact that currently firms have more capacity installed than they would have chosen in a liberalized regime.35 Our theoretical analysis implies that the current prices do not yield sufficient investment incentives to sustain the current investment level. Strategic investment would affect the price distribution, as comparison of the curves for the cases F B and EQ illustrates. We can conclude that there seems to be considerable potential for the exercise of market power in the long run when taking firms investment decisions into account.



In this article we analyze firms investment incentives in liberalized electricity markets. Since electricity is economically non storable, it is optimal for firms to invest in a differentiated portfolio of technologies in order to serve strongly fluctuating demand. In the absence of strategic interaction, for a single firm, optimal investment and pricing decisions have been thoroughly analyzed in the so called peak load pricing literature. Those findings were widely used to model investment decisions in electricity markets prior to liberalization, when electricity was supplied by regulated monopolies.

Liberalization of electricity markets which started in the 1990’s throughout Europe has changed this picture dramatically. In many countries electricity generation has been opened to competition and regulated monopolistic generators have been replaced by com- peting firms. All the results obtained in the peak load pricing literature, however, are not applicable in case firms do not behave perfectly competitively, but interact strategically when making their investment decisions. Since electricity markets especially in Europe are thought to be subject to the exercise of market power, however, the formerly used frame- work of the peak load pricing literature now has only limited use when predicting firms investment decisions in those markets.

It has been the aim of the present article to derive equilibrium investment choice in

35In the pre-liberalization period, generators where subject to a rate of return regulation that imposed excessive investment incentives.


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