Making Markets Work:
The Special Case of Electricity
John Kwoka is the Neal F.
Finnegan Distinguished Professor of
Economics at Northeastern
University. His areas of
specialization are industrial
organization, regulation, and
antitrust economics. His research
covers a range of topics, but most
recently has focused on the effects of
various restructuring policies in the
electricity industry. He is also a
Research Fellow of the American
Antitrust Institute and a member of
the Board of Directors of the
Industrial Organization Society, and
has previously served at the Federal
Trade Commission, the Federal
Communications Commission, and
the Antitrust Division of the Justice
Department. He can be contacted at
j.kwoka@neu.edu
Kamen Madjarov is a Ph.D.
student at Northeastern University.
He received his undergraduate degree
in Economics from Adelphi
University and is currently writing
his dissertation on topics that include
restructuring in the electricity
industry.
24 1040-6190/$see front matter # 2007 Elsevier Inc. All rights reserved., doi:/10.1016/j.tej.2007.10.008
In many ways electricity markets resemble markets
generally, but they also have some distinctive features that
make pure reliance on market processes problematic. Thus,
prescriptions for deregulation and restructuring that
might succeed in other markets cannot be relied upon to
have the same effect in electricity. At worst, the result of
unthinking reform can be a perfect storm of forces
leading to serious problems in market operation.
John Kwoka and Kamen Madjarov
I. Introduction and overall performance in
particular industries. Where
Economics looks to competitive market problems arise, policy
markets for its performance prescriptions are usually based on
benchmark. Economic theory, a return to the preconditions of
empirical evidence, and competition.
experience all demonstrate that The benefits of competitive
competitive markets generally markets have been realized
result in least-cost production, through deregulation of many
appropriate quantity and quality industries or, where full
of product, optimal pricing to deregulation is not feasible, by
consumers, and strong incentives introducing competition more
for innovation. As a result, selectively.1 Electricity is the last
regulatory and antitrust policies of the major industries to be
are generally guided by the restructured and deregulated for
competitive model in assessing the simple reason that it has some
market structure, firm conduct, problematic features that make
The Electricity Journal
 conventional competition
unlikely and competition in any
form quite possibly fragile.
These problematic features
have drawn renewed attention as
it has become clear that
restructuring to date has
failed to deliver the promised
benefits.2 Here we take a closer
look at the question of the
problematic, and perhaps unique,
features of electricity markets.
I n what follows, we first review
the preconditions for
competition together with some
variations in assumptions and
implications of the competitive
model. Then we discuss the
factors often noted as
distinctive and problematic
about electric power markets
and propose a framework
for understanding which factors
are most responsible for the
difficulty of creating
well-functioning electricity
markets.
II. Competitive Markets
A conventional list of
preconditions for competitive
markets includes the following
assumptions:
(1) Large numbers of buyers
and sellers, none dominant.
Large numbers of relatively small
firms are usually necessary to
ensure against pricing power. The
degree of market concentration is
typically measured by the
Herfindahl index.3
(2) Free entry and exit. Cheap
and easy entry constrains the
pricing discretion of existing
November 2007, Vol. 20, Issue 9 1040-6190/$see front matter # 2007 Elsevier Inc. All rights reserved., doi:/10.1016/j.tej.2007.10.008
firms. This condition is less easily
measured than concentration, but
equally important.4
(3) Homogeneous product.
Homogenous products are
in more direct competition
with each other, while
differentiated products face
weaker competitive constraints.
Product heterogeneity is often
measured indirectly, as with
advertising intensity for
consumer goods.5
This is in its own
way a truly remarkable
proposition, and can
provide a benchmark
against which to
measure the operation
of actual markets.
(4) Perfect information about
current and future market condi-
tions. Rational choice requires full
information about alternatives
available to consumers as well as
about future market conditions.
The absence of perfect informa-
tion can have a variety of adverse
effects.6
(5) The absence of transaction
costs. Perfect competition
assumes that there are no costs to
the act of exchanging of goods and
services. The frictions associated
with market operation can sub-
stantially affect market equilibria.7
(6) The absence of externalities.
Good market operation requires
that all agents behave on the basis
of the full social costs of their
activity. Otherwise, even what
appears to be market equilibrium
will reflect only private costs and
benefits, not their full economic
valuation.
If all of these conditions hold, a
fundamental theorem of
economics demonstrates that total
surplus in the market is
maximized. That is, the maximum
total of consumer and producer
benefit is created, given the cost of
inputs, consumer preferences, etc.
Output is produced in an efficient
manner and allocated to those
consumers who value that output
most highly. This theorem forms
the basis for the preference for
competitive markets. It states that
certain preconditions, together
with surplus maximizing
behavior by consumers and
producers, will by themselves
result in the most efficient market
outcome. No other output or price
or production method can
improve on this outcome in terms
of an unambiguous surplus
increase (though many may
redistribute surplus between
groups).8
T his is in its own way a truly
remarkable proposition.
When interpreted and used
properly, it provides a benchmark
against which to measure the
operation of actual markets.
Where market operation is
deficient, it also provides
guidance for examining the
reasons for market failures. In
these respects, this proposition is
enormously useful. But it is also
important to note several
important qualifications about
25
 this proposition and the
assumptions that underlie it.
First, while this theorem
explains how maximum
efficiency can be achieved,
competitive markets do not
necessarily achieve other possible
societal objectives, such as equity
and technological progress.9 It
should be noted that competitive
markets are not necessarily
inconsistent with these objectives,
but there is nothing in the market
mechanism that ensures these
other objectives are satisfied. The
proposition described above
focuses exclusively on economic
efficiency, as measured by total
surplus.
Second, some of these
conditions are necessary as stated,
whereas the essential purpose of
others can be realized in
alternative ways. The most
important example of the latter
possibility involves the first two
assumptions above, those
concerning large numbers of
participants and ease of entry.
These assumptions jointly ensure
that no single seller has pricing
discretion, but that result can also
be achieved even when seller
numbers are small so long as
entry is instantaneous, costless,
and fully and costlessly
reversible. In that case termed a
contestable market any possible
effort by an incumbent firm to
raise price is immediately
undercut by entry before the
incumbent can benefit.10 This
proposition is of some theoretical
interest, but its requirements are
not met in any real-world market.
We note this here to illustrate the
26 1040-6190/$see front matter # 2007 Elsevier Inc. All rights reserved., doi:/10.1016/j.tej.2007.10.008
case in which the ultimate
implications of an assumption
might in principle be satisfied in
some alternative manner.
Third, in contrast to the above,
the implications of some
assumptions may be extremely
sensitive to minor variations in
whether those assumptions hold.
For example, Stiglitz shows that
even slight information
imperfections can cause sudden
and complete reversal of the usual
Competitive markets
do not necessarily
achieve other possible
societal objectives,
such as equity and
technological
progress.
conclusions with respect to
competitive markets, instead of a
smooth and continuous decline
from maximum benefits as
information is increasingly
imperfect.11 He notes, for example,
that in the presence of imperfect
information, markets can be
characterized by demand
exceeding supply, or by supply
exceeding demand. Similarly, the
implication that price will be
constant per unit of output or that
profit goes to zero with entry can
be shown not to hold under
conditions of imperfect
information. Such facts make it
important to analyze each
deviation in assumptions for its
particular effects, rather than
assuming that nearly satisfying an
assumption means nearly
achieving perfectly working
markets.
F inally, some observers have
focused on assumptions
which can be slightly violated
without reversing the competitive
implications of the model, and
offered lists of somewhat weaker,
but supposedly more realistic,
conditions. The resulting list of
conditions defines what was
originally termed workable
competition by Clark.12 While
different authors suggest slightly
different lists, one authoritative
source has suggested the
following:13
Structural criteria:
 Number of traders is as large
as scale economies permit.
 No artificial impediments to
mobility or entry.
 Moderate, price-sensitive
quality differentials among the
products.
Conduct criteria:
 Some uncertainty by rivals as
to whether price initiatives will be
followed.
 Firms strive to attain goals
independently.
 No unfair, exclusionary, pre-
datory, or coercive tactics.
 Inefficient suppliers should
not be shielded permanently.
 Sales promotion should be
informative, not misleading.
 No persistent harmful price
discrimination.
Markets satisfying these criteria
will likely produce satisfactory,
though less than perfect,
performance results.
The Electricity Journal
 III. Markets and
Electricity
With the prior discussion as
background, we now turn to
electricity to evaluate the reasons
why well-functioning markets
may be difficult to achieve for this
sector. A number of observers
have offered lengthy lists of
characteristics of electricity
markets that supposedly create
difficulties.14 These lists include
such factors as the non-storability
of electricity, low demand
elasticity, and high capital
intensity. The problem with all
these lists is that, while the factors
on them may well hold for the
case of electricity, the same factors
are equally true for other markets
that function reasonably well. But
if these factors are neither unique
to electricity nor necessarily
associated with market failures
elsewhere, they cannot logically
represent the true source of any
problems with electricity markets.
T he analysis to follow focuses
on this question: the precise
reason or reasons for the difficulty
in making electricity markets
work reasonably well. By
reasonably well, we mean
something like workably
competitive, with performance
that may fall short of perfection
but nonetheless is recognized as
satisfactory, especially by
comparison with alternatives. We
argue that there is not one single
truly unique factor responsible for
problems in electricity markets.
Much does depend upon one
unusual, but not entirely unique,
factor. Moreover, the effects of
November 2007, Vol. 20, Issue 9 1040-6190/$see front matter # 2007 Elsevier Inc. All rights reserved., doi:/10.1016/j.tej.2007.10.008
that factor are not necessarily
decisively adverse except for
being magnified by other
characteristics in the case of
electricity. The result of this
combination of forces is poor
market operation, but to repeat,
the causal mechanism is not
captured by a simple listing of the
sort found in standard sources.
W e shall set out this
economic argument,
beginning with the key factor,
There are a few other
markets with some
similar properties say,
telecom services, with
an obvious and
important time
dimension.
then followed by the various
contributing forces. This
represents an economically sound
framework for understanding the
challenges of operating a well-
functioning market for electricity.
possible example, since
A. The key characteristics
We begin by setting out and
discussing the key feature that
distinguishes the market for
electricity from most other
markets. That feature is the length
and scope of the market interval,
that is, the time and space over
which physical supply and
physical demand manifest
themselves, and the time and
space over which the market must
clear.15 In the case of electricity,
the market interval is essentially
determined by technology,
specifically, by the need for near-
instantaneous electrical balance at
all points on the electrical grid.
That is, physical supply from
generators and physical demand
from consumers must equilibrate
at all points on the electrical grid
and at all points in time, with
essentially zero tolerance.
Electricity delivered to the grid
must be taken off the grid, and
electricity demanded must be
satisfied by electricity from the
grid, with each of these strictly
time- and location-dependent.
There are a few other markets
with some similar properties. The
market for telecom services has
similarities, including an obvious
and important time dimension.
Yet not all possible transactions
need to be consummated. Excess
call volume is simply truncated
by blocking calls, essentially
rationing available capacity, and
so the market does not need to
clear in the sense of satisfying all
demand (or supply) that appears.
The stock market is another
transactions there are generally
consummated in each moment.
But both demand and supply can
and often do shift between
moments, allowing for smoother
market clearing.16 The airline
industry illustrates the case where
supply expires at the moment
when the plane departs. Yet as
with the stock market, air travel
demand shifts between moments
of time, and as with telecom
27
 excess demand can be truncated.
Thus, despite some similarities,
these other markets differ from
electricity in significant ways.
If the consequences of the
failure to maintain balance in time
and space in electricity markets
were small or limited in scope,
they might be tolerated and
internalized. In contrast to the
telephone, stock, and airline
markets, however, in electricity
disruption of electrical frequency
is likely to have several significant
adverse effects. These include the
following:17
 Equipment may be damaged.
 Product quality delivered to
consumers can be degraded
(flickering, etc.).
 Transmission lines may
become overloaded.
 The power system could
collapse.
Some of these effects are
modest in magnitude and largely
internal to consumerse.g., home
computer damage. Such effects
do not pose threats to market
operation, since the consequences
can be resolved by contractual
penalties and damage claims by
adversely affected parties. Other
effects may be much more
substantial in physical magnitude
and economic cost, as with
shutdown of commercial office
buildings or of major production
processes dependent upon
power. Even these potential
outcomes, however, do not
necessarily represent
insurmountable problems to
satisfactory market operation.
Certain other effects, however,
may involve important
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externalities that are much less
amenable to market resolution.
Blackouts, for example, can be
viewed as externalities over both
space and time. At any point in
time they may cover substantial
geographic regions having
nothing to do with the triggering
event. This externality is a
consequence of the electrical grid,
which creates the opportunity for
negative (as well as positive)
effects over a wide territory. In
The implication
of these
considerations is
that there really
is not a meaningful
market for
electricity.
addition, system failures and
blackouts at any one point in time
affect operations in the next
period, since blackouts are not
necessarily easily reversed. Hours
or even days may be required to
bring the system back up,
illustrating the interdependency
of markets over time.
System overload and blackouts
are sufficiently serious and costly
that they are viewed as requiring
avoidance at a very high level of
probability and at
correspondingly high cost. The
desired degree of reliability is a
public good due to the
externalities over time and space
created by blackouts, and the
impracticality for consumers to
write contracts that ensure against
such outcomes.
T he implication of these
considerations is that there
really is not a meaningful market
for electricity. Rather than a
single market that clears in
isolation, there is a complex web
of interacting momentary
markets. These markets must
clear in a physical sense
instantaneously and at all nodes.
Failure to do so can affect
operations more widely in space
and across time, creating external
costs to third parties. This
characteristic forms the basis for
the further analysis to follow.
B. Complicating factors
The above discussion has noted
that most other markets allow for
demand truncation or
intertemporal shifting of supply
or demand to moderate the effects
of otherwise short market
intervals with externalities. Here
we argue that in the case of
electricity, no such helpful factors
exist. Instead of helpful factors,
electricity exhibits two important
factors that further complicate
market operation. The first factor
is inelastic short-run supply at
capacity, the second is inelastic
demand.
That short-run supply at
capacity is inelastic is not in
dispute. Figure 1 illustrates this
phenomenon from actual
operating data for all thermal
generating plants in Califormia in
three months in 1998 and 2000.
Marginal costs follow fuel costs
The Electricity Journal

Figure 1: Rising Cost of Incremental Supply as Capacity is Approached.
fairly closely until capacity is
approached. Near capacity, and
even more so at capacity, supply
costs rise sharply and elasticity
falls correspondingly. Similar
supply curves and elasticities are
commonplace for electricity
markets.
F rom the underlying
economics of electricity, we
can identify three sources of very
low elasticity of supply at capacity:
 The production technology,
which makes generation capacity
a nearly fixed parameter. Genera-
tion plants have rated capacities
that cannot be increased by the
application of other inputs. This
creates a hard capacity con-
straint, that is, output past some
amount simply cannot be obtained
from existing plant.
 Substantial sunk costs in pro-
duction, which prevent getting
additional output from new
Table 1: Time and Cost Factors for Minimum Efficient Scale of Generation Plants
Technology
Scrubbed coal
Advanced gas/oil combined cycle
Advanced nuclear
Source: EIA Annual Energy Outlook, Electricity Market Module, Table 39, April 2007.
November 2007, Vol. 20, Issue 9 1040-6190/$see front matter # 2007 Elsevier Inc. All rights reserved., doi:/10.1016/j.tej.2007.10.008
producers except in the very long
run. As summarized in Table 1,
an efficient coal-fired plant takes
about four years and $775 million
to construct. Combined-cycle gas
plants are considerably less
expensive but still require as
much as three years to bring
online. Both involve additional
time for licensing and approval.
Based on recent experience in
other countries, nuclear plants
can be expected to take six years
to construct and cost nearly $3
billion in construction costs.
Other estimates suggest another
five to six years are required for
licensing approval.18 None of
these alternatives represent rela-
tively quick and cheap sources of
new supply.
 The virtual inability to store
output, which precludes shifting
output between periods. This
prevents inventorying output in
Lead time (years) Scale (new) Capital Costs ($M)
4 600 775
3 400 238
6 1350 2800
periods of low demand in order to
make it available in periods of
high supply. Hydroelectric
pumped storage is an exception to
this statement, but its impact is
generally minor.
Collectively, these three
underlying forces cause the costs
of incremental supply to rise very
sharply at capacity, as shown in
Figure 1. But it should not be
concluded that low supply
elasticity by itself creates any
adverse effects on, say, price.
Consider, for example, Figure 2,
with inelastic supply as
previously shown and demand
that shifts between high and low
periods.19 It is evident that
instantaneous market clearing is
now still possible with only
moderate price variation, as P1
(which is at or near marginal cost)
is similar to P2. Thus under
certain conditions, supply
inelasticity at capacity need not
jeopardize relatively smooth
market operation.
T he cause of a more serious
problem is a combination of
very inelastic demand and very
inelastic supply. This case is
illustrated in Figure 3 where D3
and D4 denote inelastic demands
in the low- and high-demand
periods, respectively. Whereas
inelasticity makes only a modest
difference during the low-
demand period (P3 here is not too
different from P1 in Figure 2), in
combination with inelastic peak
supply, a shift of demands result
in proportionally far larger
changes in equilibrium market
price when demand is already
strong. This is illustrated by the
29

Figure 2: Effect of Time Shifting on Market Clearing Prices.
Figure 3: Effect of Very Inelastic Demand and Very Inelastic Supply.
contrast between P4 in Figure 3
and P2 in Figure 2.
A s an empirical matter,
demand in electricity
markets is quite inelastic,
reflecting the largely non-
deferrable nature of consumption
in the short term. A considerable
amount of econometric evidence,
summarized in Table 2, suggests
that short-run demand elasticity
is about 0.35. This value implies
that every 10 percentage point
increase in price reduces
consumption by only about 3.5
percent, considerably less than
the demand responsiveness of
Table 2: Demand Elasticity
Short Run
Low 0.20
Medium 0.35
High 0.60
Source: Chris S. King and Sanjoy Chatterjee, Predict-
ing California Demand Response, Public Utilities Fort-
nightly, July 1, 2003.
30 1040-6190/$see front matter # 2007 Elsevier Inc. All rights reserved., doi:/10.1016/j.tej.2007.10.008
most consumer goods.20 Inelastic
demand for electricity is rooted in
business and residential
commitment (i.e., sunk costs) to
its use, in long-lived capital
equipment with fixed energy
efficiency, and in consumer
behavior toward electric power
usage that resists quick change.
B oth supply elasticity and
demand elasticity are
greater in the long run, as
consumers and producers
respond more completely to price
changes. Consumers can switch to
more energy-efficient appliances
or more fully adjust their own
behavior, while producers can
alter existing capital equipment or
bring more capacity online over
Long Run
time. Table 2 also reports the
0.60 results of a survey of long-run
0.90 electricity demand elasticity
1.20 studies. That review concludes
that long-run demand elasticity is
on the order of 0.90. This implies
that a 10 percentage point
increase in price results in a 9
percent decrease in quantity
demandedconsiderably more
than in the short run. Long-run
supply elasticity is limited only by
the timeframe one allows, since in
a sufficiently long time period
much new plant can be
constructed at constant long-run
marginal cost. The relevant time
frame for analysis, however, is not
the long run, but rather the very
short interval in which the market
must clear. During that time, both
demand and supply (at capacity)
are quite inelastic. It is the
combination of these forces that
jeopardizes a well-functioning
market.
The considerations are
illustrated in Figure 4. That
schematic illustrates the fact that
the most fundamental and
relevant characteristic of
electricity markets is their very
short market interval. It also
indicates the role of elasticities,
storability, barriers to entry, etc.,
in making good operation
difficult. Causation runs from
factors such as non-storability to
low elasticities, and then from low
elasticities to market operation
that is problematic.
C. Making matters worse
It should be stressed that, even
under the above circumstances,
markets may work in the literal
sense that supply and demand do
intersect, there is a price that
results, and the market clears. The
outcome of that process, however,
may have undesirable properties.
The Electricity Journal

Figure 4: Effect of Short Market Interval on Electricity Market.
Figure 5: Hourly Loads for Four Weeks in 2006.
This section examines various
features of the outcome,
explaining how some may arise
that are judged to be undesirable.
Figure 6: Daily Load Chart for PJM.
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(1) First, low elasticities
become more troublesome to the
degree that demand (or supply)
shifts significantly between
periods. As shown in Figure 3,
demand given by D3 results in
price P3 while D4 causes a much
different P4. The degree of price
change depends on the magni-
tude of demand variation as well
as on the supply and demand
elasticities. Demand for electricity
varies substantially over hourly,
daily, and seasonal cycles, as
illustrated in Figures 5 and 6.
Figure 5 shows hourly loads, by
day, for four different weeks in
2006 in PJM. Retail load over most
days varies by about 60 percent in
the seasonal off-peak of April, and
by about 70 percent in the July
peak period. Moreover, these
weeks differ in level, as shown in
the daily load chart for PJM in all
of 2006, shown in Figure 6. Few
other markets exhibit such enor-
mous, and inflexible, time-
dependent variations.
T his demand variation in
combination with fixed
capacity causes substantial
price volatility. This is illustrated
for PJM wholesale market prices
on an hourly basis in Figure 7
and on a daily basis in Figure 8.
Substantial price volatility is an
undesirable outcome for
residential, commercial, and
industrial consumers. There are
two reasons why volatility is
undesirable. One is adjustment
costs to consumers who are
dependent upon electricity.
Large and sudden changes
require adaptation of
consumption and use
patterns in ways that are
themselves costly.21 While
adjustment costs are rarely
addressed in economics, their
31

Figure 7: PJM Prices on an Hourly Basis.
Figure 8: PJM Prices on a Daily Basis.
practical implications may be
significant.
I n addition, such volatility
creates substantial and
seemingly arbitrary transfers of
revenues between consumers and
Figure 9: Price Changes Resulting from D1 to D2 Shift.
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producers. Figure 9 illustrates the
price change that might result
from a shift from D1 to D2. One
result of this price change would
be an enormous revenue transfer
from consumers to sellers. Under
some circumstances, this transfer
serves a straightforward
economic purpose. In a market
that is competitive, such a transfer
sends a signal that greater
capacity is required in this
market. In at least two other cases,
however, it might not be
economically justified or socially
acceptable. For one, in markets
such as electricity, the capacity
expansion just described may not
be forthcoming because the
price/revenue signal is viewed as
too transient and too arbitrary to
prompt new entrants (or their
financiers) to bet on the expensive
and lengthy process of capital
investment. If so, the revenues
constitute a simple transfer from
consumers to producers
windfall profits and the
outcome might be judged socially
unacceptable. As a second point,
the market may not be
competitive, in which case the
price increase itself might be
economically unjustified. In that
case the resulting windfall profits
cannot and will not prompt new
entry and therefore have no
justification as part of the
ordinary process of market
adjustment.
(2) Second, an important com-
plicating factor to price volatility
is the high fixed costs of the
electricity production process. A
given level of total costs with high
fixed costs implies lower mar-
ginal costs and hence lower price
up to capacity. In high-demand
periods, however, the demand
curve intersects the marginal cost
line in the sharply increasing
segment near capacity, resulting
The Electricity Journal

Figure 10: Scenario with Modest Fixed Costs.
in a much higher price than in the
low-demand period. This case of
volatile prices is illustrated by
Figure 9. By contrast, if fixed costs
were modest, then marginal costs
would be higher and more uni-
form (indeed, if all costs were
variable, then the marginal cost
curve would be flat). Now even
with low demand elasticity and
the same demand variation, the
high-demand price would not
diverge as much from that in the
low-demand period. This latter
case is illustrated in Figure 10
where the two prices resulting
from demand D1 and D2 do not
differ anywhere near as much as
in Figure 8 where fixed costs are
higher.
E lectricity production is, of
course, characterized by
very high fixed costs. Table 3
reproduces a tabulation of capital
intensity for various prominent
industries, measured in terms of
assets per dollar of revenue.
This list is headed by investor-
owned electric utilities. Only
mining and railroads have capital
intensities anywhere close to
that for IOUs, with all other
industries trailing well behind.
This evidence confirms common
belief about electricity
production.
November 2007, Vol. 20, Issue 9 1040-6190/$see front matter # 2007 Elsevier Inc. All rights reserved., doi:/10.1016/j.tej.2007.10.008
(3) Yet another complicating
factor in the case of electricity
is the unpredictability of
demand fluctuations. Apart from
their magnitude, the unpredict-
able nature of those fluctuations
violates the competitive
assumption of perfect informa-
tion and limits consumers abil-
ity to avoid or contend with the
resulting price volatility. Of
course, certain determinants of
demand are well enough
understood to lend some pre-
dictability, but many others are
not. Residential demand for
electricity, for example, varies
with climate conditions that are
known with only modest, if any,
lead times. Seasonal demand is
more predictable than hourly
load for any particular day.
The inability to predict these
changes limits consumers
ability to protect against their
adverse effects.
Figure 11: Price Effect of Unilateral Withholding.
(4) A rather different concern
is that the electricity markets
just described are unusually vul-
nerable to the exercise of unilat-
eral market power. Unilateral
market power arises when a
single company controls suffi-
cient capacity in a market so that
shutting down some part of that
capacity causes a profitable price
rise. This phenomenon is illu-
strated in Figure 11. Suppose the
market is supplied by 10 units of
capacity, two of which are owned
by the same company. With
inelastic demand as shown, mar-
ket price is a modest P1, but the
company can take one unit offline,
causing price to rise to P2. While
there is lost profit on the deacti-
vated unit, the added profit on the
remaining unit may more than
compensate. Neither high
market concentration nor a
large market share is required
for the exercise of unilateral
market power. Under conditions
of sufficiently low demand and
supply elasticity, such as electric
power, unilateral market power
may occur in a wide range of
market structures, not requiring
conventional market power.22
(5) Yet another complicating
feature is that the geographic
extent of electricity markets can
33
 Table 3: Capital Intensity peak, and off-peak periods, which
Industry Assets per Revenue Dollar themselves differ by season.
Investor-owned electric utilities $2.26 Other analyses would further
Mining $2.07 subdivide geographic markets
Railroads $1.71 based on likely transmission
Investor-owned gas utilities and pipeline industry $1.20 constraints that effectively
Communications $0.99 isolate territories. The essential
Nondurable manufacturing industries, average $0.98 point is that electricity markets
Durable manufacturing industries, average $0.87 are constantly and unpredictably
Retail trade $0.50 being redefined, making it
Wholesale trade $0.43 difficult to sustain a normal
Source: Electric Perspectives, Edison Electric Institute, 1996. market process. It might also be
noted that transmission
congestion has proved vulnerable
to market power and other
manipulation by opportunistic
traders, so that this feature of
electricity markets can be
exploited.23

T hese considerations are

summarized in the
schematic in Figure 12. Together
with the preceding discussion
and description, it should be
apparent that the key
Figure 12: Effect of TKTK on Electricity Market. characteristic of electricity
markets the short length and
narrow scope of the market
vary continuously and unpredic- its termination may be unpre- interval becomes a more
tably as the result of transmission dictable, since congestion can substantial impediment to good
congestion. Overloaded trans- arise with little prior market operation as a result of an
mission lines result in the abrupt warning and lead to immediate unusual combination of other
termination of electricity imports loss of supply into the congestion forces.
into a load area or exports from a area.
generation site. While many
other markets of course face
transport difficulties with
T hese factors result in a
multiplicity of geographic
markets at any one point in time,
IV. Counter-Measures
and Further
respect to out-of-region supply, as well as a changing set of such Complications
typically these cause rising markets over time. These are
marginal costs of supply. In illustrated by filings in the Duke- All of the above factors make
electricity momentary Cinergy proposed merger, for electricity markets unusually
transmission constraints example, which defined three difficult to implement and fragile
result instead in truncation of all broad geographic markets based to operate. It should be
outside supply. Moreover, the on established transmission emphasized, however, that
amount of electricity thus con- constraints. Each of these is then measures can be taken to resolve
strained may be substantial, and subdivided into peak, shoulder in whole or part some of the

34 1040-6190/$see front matter # 2007 Elsevier Inc. All rights reserved., doi:/10.1016/j.tej.2007.10.008 The Electricity Journal
 difficulties described above.
At least the following three
should be noted:
(1) The need for physical
clearing of the momentary
market does not necessarily imply
that economic clearing must take
place in the same time frame.
Agents generally cannot take
action or respond in as short a
period of time as the market
interval for electricity, and so they
enter into contractual relation-
ships that cover a series of such
momentary markets. Contracts
help consumers contend
with imperfect information
and price volatility by
providing some certainty
and moderating any adverse
effects, though there are
explicit and implicit costs of
contracting. Clearly, contracts
(and regulation itself) have
served to ensure electricity
consumers more moderate
price fluctuations than underly-
ing conditions would have
produced.
(2) The inelasticity of
demand can be moderated by
such measures as interruptible
supply or priority use contracts
and by time of use metering.
Interruptible contracts are
typically negotiated with
large industrial users, who
agree to cessation of some
supply under conditions of
extreme network imbalance.
Time-of-use metering
confronts consumers with the
real-time cost of power, thereby
evoking some response. Both
therefore impart some elasticity to
demand.
November 2007, Vol. 20, Issue 9 1040-6190/$see front matter # 2007 Elsevier Inc. All rights reserved., doi:/10.1016/j.tej.2007.10.008
(3) The complete inelasticity of
supply at capacity can be mod-
erated by holding capacity in
reserve for unexpectedly high
demand. This strategy is an alter-
native to reliance upon outside
supply to meet peak demand.
Instead of some outside capacity
being quickly converted to pro-
duction not easily done in elec-
tricity here dedicated capacity is
simply held in readiness and then
operated only part of the time.
Typically, about 15 percent of
available capacity is held in
reserve, but this is maintained at
some significant cost to the system.
On the other hand, there are
at least two other factors that
further complicate the
introduction of markets into
electricity. These are loop flow
externalities and vertical
economies.
(1) Loop flow externalities
arise as a consequence of the fact
that electron flow over the trans-
mission grid is governed by the
laws of electrical engineering,
often resulting in flows that across
the lines of non-parties to a
transaction. The difficulty of
assigning property rights in this
context complicates the task of
orderly markets for long-distance
transmission.
(2) Vertical economies are
sacrificed as a result of the
separation of the generation,
transmission, and distribution
functions under restructuring.24
These economies derive from the
need for tight coordination
among stages, a task that the
market or institutions such as
power pools and independent
service operators find difficult to
duplicate.
V. Conclusions
In many ways electricity
markets resemble markets
generally, but they also have some
distinctive features that make
pure reliance on market processes
problematic. Foremost among
these features is the limited time
and space over which the physical
supply and physical demand
manifest themselves, and over
which the market must clear.
These characteristics make
electricity markets uniquely
vulnerable to poor operation and
even failure, especially when
other factors come into play. Low
supply and demand elasticities,
volatile and unpredictable
demand, high fixed costs and
sharp capacity limits in
production, and constraints on
transmission capacity all
compound the core problem.
T his array of forces cautions
that prescriptions for
deregulation and restructuring
35
 that might succeed in other
markets cannot be relied upon to
have the same effect in electricity.
At a minimum, the particulars of
proposed reforms in electricity
need to be carefully examined
before the market mechanism can
be trusted to produce benefits. At
worst, the result of unthinking
reform can be a perfect storm of
forces leading to serious problems
in market operation.&
Endnotes:
1. A useful account of the
deregulation movement in general
and with respect to various industries
can be found in C. Winston, Economic
Deregulation: Days of Reckoning for
Microeconomists, J. ECON. LITERATURE,
Sept. 1993.
2. J. Kwoka, Restructuring the U.S.
Electric Power Sector: A Review of Recent
Studies, American Public Power Assn.,
Nov. 2006.
3. For discussion of these and other
concentration measures, see J. Kwoka,
The Herfindahl Index in Theory and
Practice, ANTITRUST BULLETIN, 1985.
4. For discussion, see JOE BAIN,
BARRIERS TO NEW COMPETITION
(Cambridge, MA: Harvard Univ.
Press, 1956); W.G. SHEPHERD,
THE ECONOMICS OF INDUSTRIAL
ORGANIZATION (Englewood Cliffs, NJ:
Prentice-Hall, 1997), Ch. 9; and
Douglas Needham, Potential Entry into
Oligopoly, in READINGS IN
MICROECONOMICS, W. Breit and H.
Hochman, Eds., 2d edition (NY: Holt,
Rinehart: 1971).
5. F.M. SCHERER AND D. ROSS, INDUSTRIAL
MARKET STRUCTURE AND ECONOMIC
PERFORMANCE 3rd ed. (Boston:
Houghton Mifflin, 1990).
6. J. STIGLITZ, WHITHER SOCIALISM
(Cambridge, MA: MIT Press, 1994),
Ch. 3.
7. P. Joskow, Transmission Policy in the
United States, UTIL. POLICY, 2005.
36 1040-6190/$see front matter # 2007 Elsevier Inc. All rights reserved., doi:/10.1016/j.tej.2007.10.008
8. J. CHURCH AND R. WARE, INDUSTRIAL
ORGANIZATION: A STRATEGIC APPROACH,
2000, Ch. 2.
9. Scherer and Ross, supra note 5, Ch.
2, 18.
10. Strictly, the incumbent suffers
losses as a result of the further
assumption that its response time is
slower than that of entrants. For
further discussion, see J. Church and
R. Ware, op. cit, pp. 50713.
transaction must be consummated in a
11. J. Stiglitz, supra note 6, at 1067.
Related to this point, Stiglitz criticizes
the typical simple listing of
assumptions found in many sources,
noting that too often they contain
important hidden assumptions, for
example, embedded in definitions
rather than made explicit.
12. J. M. Clark, Toward a Theory of
Workable Competition, AMER. ECON. REV.,
1940.
13. This list is taken from Scherer and
Ross, supra note 5, at 525.
14. See for example S. Borenstein, The
Trouble with Electricity Markets:
Understanding Californias Restructuring
Disaster, J. ECON. PERSPECTIVES, Winter
2002. Also P. Joskow, The Difficult
Transition to Competitive Electricity
Markets, in ELECTRICITY DEREGULATION:
CHOICES AND CHALLENGES, Eds. J. Griffin
and S. Puller (Chicago: Univ. of
Chicago Press, 2005).
15. For discussion of market clearing
issues, including timing, see D.
CARLTON AND PERLOFF, MODERN
INDUSTRIAL ORGANIZATION, 3rd Ed.,
Ch. 17.
16. Where supply and demand do not
shift sufficiently smoothly over time,
as in panics, the stock market more
closely resembles electricity. Yet even
in that case, the stock market has
instituted blocks on transactions that
threaten disruption. These so-called
circuit breakers work since there is
no technological reason why the
single moment.
17. This discussion borrows heavily
from B. Kirby, J. Dyer, C. Martinez,
R. Shoureshi, R. Guttromson and J.
Dagle, Frequency Control Concerns in the
North American Electric Power System,
Oak Ridge National Laboratory, Dec.
2002.
18. M.S. Blanton, Challenges to the
Licensing, Construction, and
Operation of a New Nuclear Fleet, M.
Sanford Blanton, Balch & Bingham,
downloaded presentation dated April
18, 2007.
19. These might designate night vs.
day, weekend vs. weekday, or
summer vs. winter (or vice versa, in
some climates.)
20. C. King and S. Chatterjee,
Predicting California Demand Response,
PUB. UTIL. FORTNIGHTLY, 2003. See also
D. BOHI, ANALYZING DEMAND BEHAVIOR
(Baltimore: Johns Hopkins Univ.
Press, 1982), Ch. 2.
21. Residential consumer demand is
usually insulated from the price
volatility that characterizes wholesale.
22. Some conditions for the exercise
of unilateral market power are
developed in J. Kwoka, Unilateral
Withholding: Market Power and
Californias Electricity Crisis, George
Washington Univ. Economics Dept.
Working Paper, May 2001.
23. J. Weaver, Can Energy Markets Be
Trusted? The Effect of the Rise and Fall of
Enron on Energy Markets, HOUSTON BUS.
& TAX LAW J., 2004.
24. J. Kwoka, Vertical Economies in
Electric Power: Evidence on Integration
and Its Alternatives, INTL. J. INDL. ORG.,
2002.
The Electricity Journal