Matt Woerman  “Market Size and Market Power: Evidence from the Texas Electricity Market” (December 2018) | WP-298

Economic theory tells us that market structure is the primary determinant of a firm’s ability to exercise market power. However, it is challenging to empirically estimate the causal effect of market structure on market power because a firm rarely experiences exogenous variation in its market’s structure. In this paper, I exploit a novel source of exogenous variation in market size within the Texas electricity market — congestion of electricity transmission lines due to ambient temperature shocks — to estimate the causal effect of market size on the exercise of market power. When transmission lines congest, this statewide market splits into smaller localized markets. I find that a 10% reduction in market size causes firms to more than double markups. The direction of this effect is consistent with a model of oligopoly competition in which firms set markups in response to residual demand, which is less elastic in a smaller market. My results imply that the markups induced by transmission congestion at high temperatures generate $7.1– 21.5 million of deadweight loss annually. These markups also create large transfers — $2.1 billion per year — from consumers to producers, which raise important equity concerns.