In most economics textbooks, market power is defined as the ability of a firm or group of firms to affect market prices. Oligopolies (markets where firms possess some level of price-setting ability) are often compared against perfectly competitive markets in terms of the impacts of this price-setting ability on consumer welfare and firm profits.
The textbook model of perfect competition is just that - a model. Virtually no market is as competitive as the textbook models would suggest. In most markets, firms have some ability to manipulate prices, although in markets that are more competitive this ability will not last long (because other firms will respond, or new firms will enter the market). In assessing the competitiveness of electricity markets in particular, the Federal Energy Regulatory Commission (FERC) has recognized this and has its own definition of market power, being the ability to profitably raise prices for sustained periods of time. While these terms are not all defined very concretely, the intent is reasonably clear. If a firm is able to take actions that increase LMP in an electricity market in a single hour, then FERC generally does not equate that with the exercise of market power. If a firm is able to increase LMP consistently over the course of many hours, then FERC would recognize that firm having market power.
Moreover, the concept of market power in electricity markets can be interpreted one of two ways:
- Structural market power refers to the ability of a firm to profitably raise the price in an electricity market, whether or not it actually takes actions to raise the price.
- Behavioral market power refers to the actions taken by firms in attempts to raise the price.
In this lesson, we'll actually look at behavioral models of market power first and then turn to ways in which structural market power is measured in electricity markets. There are two broad strategies that power generators can use to try to artificially increase electricity market prices. They can remove capacity from the market ("physical withholding," which was rampant during the California power crisis) or they can submit inflated supply offers that reflect monopoly or oligopoly power.