THE UNIVERSITY OF OKLAHOMA

FINAL REPORT
ECE 5973 - POWER SYSTEMS AND MARKET OPERATIONS DR. JOHN JIANG

Cournot & Perfect Competition application and comparison in Electricity Market

Osman Bayindir Diego Rodrguez

Contents
1. 2. Introduction ......................................................................................................................................... 3 Cournot and Perfect Market Description ......................................................................................... 4 a. b. c. 3. Perfect Competition ..................................................................................................................... 4 Cournot .......................................................................................................................................... 5 Comparison between Perfect Market and Cournot ................................................................. 9

Electricity Market Study ................................................................................................................... 10 a. b. c. Model............................................................................................................................................ 10 Perfect Competition Case .......................................................................................................... 14 Cournot Model Case ................................................................................................................... 15

4. 5. 6. 7.

Result Analysis .................................................................................................................................. 17 Conclusions ........................................................................................................................................ 19 References ......................................................................................................................................... 20 Appendix ............................................................................................................................................ 21

1. Introduction

Many years ago since Adam Smith formulated the idea of how economy works; the conduct of the markets was based on the concept of perfect competition. That was a model which made strong assumptions for the dynamical behavior of the society. This model looked to maximize consumer and producer surplus and at the same time the social welfare. However, the model of perfect competency cannot apply in all the scenarios where the number of competitors is small. In that case, a more precise model who reflects the real dynamics in the market [1, 2, 3] is necessary. Some of the proposed solutions to represent those cases are Cournot, Stackelberg, etc. game theory models.

In this document we compare the perfect competency and Cournots model. To achieve this goal the structure of the document is divided in four sections. First, the paper makes the definition for perfect competency and Cournots model. Second, we apply each model to a simple power system of three competitors. Third, analysis results for that power system case are made. And finally conclusions are presented.

2. Cournot and Perfect Market Description

Game theory and behavioral economics are elements that daily accompany the market agents. In the given circumstances, a lot of alternatives are shown up; one of them being the oligopolies, whose popularity in the free market economics appears to be more common as the years pass. The oligopolies are described by a diversity of models among which three models are prominent, Cournot, Stackelberg and Bertrand. In this document the first one is studied. This will be described later and represented by an example. Simultaneously the definition, implications, characteristics and situations of the real life will be analyzed in a perfect competition dynamic which has narrow links with the development in productive processes aimed to be worked out in high efficiency environments. a. Perfect Competition

To point out this document will start with the ideal case or the case of perfect competition where the market requires a series of conditions which are only achievable with mass consumer products. Those conditions are:

An elevated number of agents which demand and offer that act exclusively as price takers, this means that there is no space for speculation. No input or output barriers. High mobility of goods and factors The information is free, public and priceless. No asymmetry. Market whose center is a homogeneous product. There are no transactions or intermediation costs.

Under these conditions, the dealers cannot impose a price with the goal of maximizing their benefits since their portion of the market is atomistic. In this sense if a company wishes to impose a superior price than the markets, it will be taken out of the competition or it must adjust its price to the newly given. In the last case, all the other competitors will keep their market prices which are inferior to the wanted price by that company. On a different side if the company wishes to use a lower price than the
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market with the idea of reducing the number of competitors, it will end losing again. Because as its good is produced by a great number of companies the new price will not have an impact at its competitors. As a result if the price is smaller than the market price the costs will be superior than its benefits leading to a new adjust at the selling price in the market. In a second matter the fact of free information obtaining (in the consumers and the producers sides) does not create extra cost, resulting in the knowledge of rentable opportunities to raise their prices, reduce their prices, substitute a product, etc. On the other hand, the fact that there are no input barriers creates an automatic regulation in the market. As an example if in a given moment the public sees exorbitant returns in an activity that does not require a huge amount of capital, they will tend to invest in this activity. The substantial raise in the number of competitors will reduce the market price, with more competitors there will be more competition making the price to be lowered and stabilized. In this manner there cannot only be observed the result in the freedom of barriers but also the regulation of the prices and the market efficiency. It is said that this type of markets is efficient when the production of goods is made at the lowest possible cost, in a space where there are only demanders that accept to pay the cost and the production at appropriated quantities. This fact makes that both the producer and the consumer reach their maximum happiness. This fact results in the social welfare maximization, which will be used in the next chapter to compare the final result of having a market with perfect competition and one with the Cournot model.

b. Cournot

In first place, the basic characteristics of an oligopoly model will be mentioned, where unlike the perfect competition model- the corporative decisions circle around the behavior given by the rival companies. This behavior creates markets where the entrance barriers are significant. As part of this oligopolistic model the Cournots model is found, it can be identified by particular characteristics, which are: The inversion decisions and the production of the companies that are part of the market segment depend on what it is done or not by their competitors. As a

result, the unattended demand left by the last named will be seen as a chance and will be immediately satisfied. As mentioned previously, there are entrance barriers which difficult the participation of a higher number of participants in the offer side. Despite that the decision of rising or reducing the production depends on the behavior of the companies that take part of the competence, the final production decision is independent. (i.e. not incentivized by the government) Market power from small number players. They decide the number of items to produce which will affect the final selling price in the market. The price is supported by the markets demand to the product, in the case of the electric market, it only would have to take into account the price in the spot that eliminates every excess of offer or demand. In the case of the forward contracts price which in general is the most, a common agreement between the two entities is dealt.

Once its postulates are defined, it is possible to see the implications of the model. The model establishes that in the case of having two companies (case which can be generalized to represent an oligopoly), the selling price will not be constant and will depend on the number of commodities which are produced, resulting in the next demand function1: = 300 Where Q represents the total market demand, that is denoted by Q = q + q . The 300 represents the price to the public that demands the good. Additionally, the production costs (raw matter transformation) in this case are assumed constant and equal to 30. According to this, the revenue that will be obtained can be represented as: = 30 As said previously, the first term is the demand function and allows estimating the sales (billing) of the company in a unitary scale, to this production cost is subtracted; and finally multiplied by the quantity of the produced units by the company to get the final profit for one of the companies. = 300 ( + ) 30 In the same sense the profit for the second company will be: = 300 ( + ) 30
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This is an illustrative example to show how Cournot model works. The function was taken as given.

As the objective in companies with a profit goal is to maximize the revenue2, the derivate of the pair of expressions is taken and equaled to zero:

In the case of : 300 ( + ) 30 ( ) = 0= 270 = Now in the case of : = 270 2 270 2

These new equalities are named reaction functions and represent the production of an enterprise, given the performance of its counterpart in offer terms. The behavior derived from the previous expressions is the one of a straight line with a negative slope, which indicates that as a company produces less quantity of its product, the other can cover the rest as shown in the next graph, Figure 1:

That differs from the perfect competition in which companies tend to minimize the cost, since the number of products can not affect the price. In that condition, it is said that the companies are price takers but this will be explain in the next section Perfect Competition

Figure 1 Reaction curves in Cournot model. Small oligopoly two companies

As a final result, it is generally said that industries associated with this type of model achieve high profit margins, result that is evident in the case of the financial sector and oil, not so much in the field of power generation and transmission where rates are strictly regulated for most of the population; and only allowed variations and high volatility in spot market where trading a small portion of the total contract.

c. Comparison between Perfect Market and Cournot

Market Type # Companies Structure Kind of entry Product Type Company Power Market Price Strategy Production Strategy Benefits Results Efficiency Optimization Problem

Perfect Competition Huge Free Homogeneous No No Independent Normal Good Minimize Cost

Cournot Model

Small Barrier Homogeneous Yes Interdependency Interdependency Excessive Inefficient Maximize Profit

Conduct

Table 1 Perfect Competition and Cournot Market Comparison

3. Electricity Market Study a. Model In this section we consider three different thermal power plant generators and we set an electricity market respect to their models which we define. The objective of producers in this electricity market is maximizing their profits. Essentially, this is the motivation which alters their behaviors or incentives to be able to exist in the market. As we know the profit function is the surplus remaining after total costs are deducted from total revenue. Basically, profit shows the benefit of the company after its all costs and loses. Pr ofit = Re venue Cost

Revenue:

Revenue is the total amount of money received by the company for goods sold or services provided during a certain time period. In this model total revenue is electricity price times the amount of electricity sold. Re venuei = Pe Qi

We denoted revenues of generators by Ri;

R1 = PeQ1 R2 = PeQ2 R3 = PeQ3

where Pe is the electricity price.

Electricity Price:
Electricity price is obtained by the inverse demand curve of electricity market showed in Figure 2.

Pe = (Q1 + Q2 + Q3 )
where Q1 , Q 2 , Q3 are outputs of three thermal power plant generators.

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Figure 2: Demand curve of electricity market

Cost:
In general, quadratic model has been accepted to represent cost function in electricity market [4], which describes the fuel cost as a quadratic function of the generation. We have the fuel-cost functions of three generators of thermal power plants [5], which are denoted by Ci;

C1 = a1Q12 + b1Q1 + c1
2 C2 = a2Q2 + b2Q2 + c2
2 C3 = a3Q3 + b3Q3 + c3

Marginal Cost:
Marginal cost is the increase or decrease in the total cost of a production run for making one additional unit of an item. In electricity market that means it is the additional cost which responds to one more MW electricity generation. We draw the marginal cost of each generator which is showed in Figure 3.

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Figure 3: Marginal cost for three different generators

Supply Curve & Demand Curve:

According to our equations we set a supply and demand curve of this electricity market which is showed in Figure 4. Demand curve shows the inverse relation between electricity price and total output of generators. That means when the price goes up the total quantity goes down and vice versa. Supply curve has the same direction with quantities. We draw supply curve by adding up all marginal cost of generators horizontally (Appendix). It has been seen from Figure 4 supply curve is ascending with price. There are three different slopes on the curve because we have three different marginal cost functions.

Equilibrium:
The profits are maximized at the equilibrium where the marginal cost of each generator group equals to its marginal revenue. In Figure 4 we have equilibrium at the point in which the total demand is 10333 MW which is also equal to total supply and the electricity price is 44.61$.
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MCi = MRi i = {1,2,3}

Figure 4: Market Equilibrium

Consumer Surplus:
Consumer surplus is a measure of the economic welfare enjoyed by consumers. Basically, it shows the amount of consumers who are happy. Consumer surplus is the area between equilibrium price and demand curve.

Producer Surplus:
Producer Surplus is a measure of the economic welfare enjoyed by firms or producers. Basically, it shows the amount of the happiness of producers. Producer surplus is the area between equilibrium price and supply curve.
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Social Welfare:
In our study we define social welfare as the amount of happiness of consumers and producers. We show it by summation of consumer surplus and producer surplus. Social welfare is the area between demand curve and supply curve.
Social Welfare = Consumer Surplus + Producer Surplus

b. Perfect Competition Case In the perfect competition marginal cost is equal to price which is also equal to marginal revenue.

MCi = MRi = Pe i = {1, 2,3}

Pe = (Q1 + Q2 + Q3 )
We get three equations with three unknowns;

2a1Q1 + b1 = (Q1 + Q2 + Q3 ) 2a2Q2 + b2 = (Q1 + Q2 + Q3 ) 2a3Q3 + b3 = (Q1 + Q2 + Q3 )

After solving this problem we get Q1 = 4913.241 MW Q2 = 3258.827 MW

Q3 = 2155.885 MW
The total amount of outputs is Q1 + Q 2 + Q 3 = 10328 MW .

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Figure 4 represents the perfect equilibrium. It has been seen the total of the optimum outputs of generators, which are calculated above, are same with the total outputs in Figure 4. The electricity price, which is corresponding to our total output, is $44.61. According to Figure 3 we can get consumer surplus, producer surplus and also social welfare in the case of perfect competition. Consumer Surplus 389677 Producer Surplus Social welfare 203061 592738

c. Cournot Model Case In oligopolistic Cournot model each firms behave respect to other competitors behaviors. Each power plant chooses its optimal outputs to maximize its profit. Cost functions of generators are defined which depend on fuel cost. In case of any changes in their total cost according to fuel price they must keep their profits maximized. In case of any change of the equilibrium, in which each marginal cost is equal to marginal revenue, generators will keep this equality constant.

max profit = Re venue Cost 1 1 Q1 profit = Re venue2 Cost2 max Q 2 profit = Re venue3 Cost3 max Q3

This is a multi-objective optimization problem; generators maximize their profits simultaneously. We solve this optimization problem by using first order condition. After taking derivatives of these three equations we get three equations with three unknowns.
MCi = MRi i = {1,2,3}
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2a1Q1 + b1 = Q1 + (Q1 + Q2 + Q3 ) 2a2Q2 + b2 = Q2 + (Q1 + Q2 + Q3 ) 2a3Q3 + b3 = Q3 + (Q1 + Q2 + Q3 )

After solving this problem we get optimum values.
Q1 =3503.477 MW Q 2 =2767.005 MW

Q3 =2098.940 MW
The total amount of outputs is Q1 + Q2 + Q3 = 8370

MW

The electricity price, which is corresponding to our total output, is 58.9$ showed in Figure 5. According to Cournot equilibrium showed in Figure 5 we can get consumer surplus, producer surplus and also social welfare. Consumer Surplus 255703 Producer Surplus Social welfare 315215 570918

Figure 5: Consumer surplus, producer surplus and social welfare in Cournots model
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4. Result Analysis

It has been seen from perfect competition and Cournot case analysis; the total output of perfect competition case is larger than the total output of Cournot case showed in Figure 6. As a result of these optimum outputs different market equilibrium points is obtained for the perfect case and the Cournot case that are shown in Figure 4 and Figure 5 respectively. According to these equilibrium points, consumer surplus, producer surplus and social welfare results are demonstrated in Figure 7. Consequently, consumer surplus and total social welfare in perfect competition case are bigger than that in the Cournot model case. But, producer surplus in perfect competition case is smaller than that in Cournot model case.
Comparison of generator outputs between Cournot & Perfect
6000 5000 4000 3000 2000 1000 0 Output of Generator Output of Generator Output of Generator 1 (Q1) 2 (Q2) 3 (Q3) 4913.241

3503.477

3258.827 2767.005 2155.885 2098.94

Cournot Perfect

Figure 6: Comparison between Cournot and Perfect Competition. Output power at each generator

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Comparison of CS,PS and SW between Cournot & Perfect

700000 600000 500000 400000 300000 200000 100000 0 Consumer Surplus Producer Surplus Social Welfare 389389 315215 255703 203061 Cournet Perfect 592738 570918

Figure 7: Comparison between Cournot and Perfect Competition. Consumer surplus, producer surplus and social welfare In order to understand why this is so, it is necessary to understand what perfect competition is. In economic theory, perfect competition describes markets such that firms do not have that much power to be able to change or set the price of the product. Because of the condition for perfect competition firms have to keep their marginal costs equal to market price that has been already fixed. Participants control only their costs to reach maximum profit. Basically perfect competition is an approximation which serves as a benchmark against which to measure real-life and imperfectly competitive markets. On the contrary, in the case of the Cournot model participants are able to set the price of homogeneous product by changing their outputs. Firms compete on the amount of output they will produce, which they decide at the same time. Producers obtain profit in Cournot case more than that in perfect competition case. Therefore it is obvious Cournot model case is provide with more benefits to producers, but it reduces the number of happy consumers in the electricity market. On the other hand, the increasing amount of producer surplus is less than the decreasing amount of consumer surplus. Because of this, social welfare of Cournot model case is less than that in perfect competition case. This difference is defined as social welfare loss in market. It is shown by red color in Figure 5.

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5. Conclusions After applying Cournot model and perfect competition model on electricity market in which there are three power plant generators, we compared the results of these two cases and we obtain: 1. The total output of three generators in Cournot model case is less than that in the perfect competition case. Therefore electricity price in Cournot model is higher than the price in perfect competition case. 2. The consumer surplus in Cournot model case is less than in perfect competition case. 3. The producer surplus in Cournot model case is larger than that in perfect competition case. 4. The amount of increase of producer surplus is less than the amount of decrease of consumer surplus in Cournot model case. Thus social welfare in Cournot model case is smaller than that in perfect competition case. 5. Perfectly competitive market is a benchmark which helps to understand the behaviors and responds in Cournot model.

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6. References

[1] Ryan, S.M.; Downward, A.; Philpott, A.B.; Zakeri, G.; , "Welfare Effects of Expansions in Equilibrium Models of an Electricity Market With Fuel Network," Power Systems, IEEE Transactions on , vol.25, no.3, pp.1337-1349, Aug. 2010 [2] Cunningham, L.B.; Baldick, R.; Baughman, M.L.; , "An empirical study of applied game theory: transmission constrained Cournot behavior," Power Systems, IEEE Transactions on , vol.17, no.1, pp.166-172, Feb 2002 [3] Valenzuela, J.; Mazumdar, M.; , "Cournot Prices Considering Generator Availability and Demand Uncertainty," Power Systems, IEEE Transactions on , vol.22, no.1, pp.116-125, Feb. 2007 [4] Yoshikawa, M.; Toshida, N.; Nakajima, H.; Harada, Y.; Tsurugai, M.; Nakata, Y.; , "On-line economic load dispatch based on fuel cost dynamics," Power Systems, IEEE Transactions on , vol.12, no.1, pp.315-320, Feb 1997 [5] Hadi Saadat. Power System Analysis. Shaniwar Peth, India, 2009

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7. Appendix
MATLAB CODE a1=input('enter first slope offset = '); a2=input('enter second slope offset = '); a3=input('enter third slope offset = '); b1=input('enter first constant offset = '); b2=input('enter second constant offset = '); b3=input('enter third constant offset = '); q1=input('enter first gen. max offset = '); q2=input('enter second gen. max offset = '); q3=input('enter third gen. max offset = '); Q1=[0:q1]; Q2=[0:q2]; Q3=[0:q3]; MC1=a1*Q1+b1; MC2=a2*Q2+b2; MC3=a3*Q3+b3; f_t=[MC1 MC2 MC3]; sft=sort(f_t); figure; plot(sft) hold on xlabel('Total output(MW)') ylabel('Price ($/MWh)') title('Supply Curve & Inverse Demand Curve') q=120; p=0.0073; Pe=q-p*(Q1+Q2+Q3); plot((Q1+Q2+Q3),Pe) figure plot(Q1,MC1) xlabel('Output(MW)') ylabel('Price ($/MWh)') title('Marginal Cost Function of First Generator') axis([0 2000 0 40]) figure plot(Q2,MC2) xlabel('Output(MW)') ylabel('Price ($/MWh)') title('Marginal Cost Function of Second Generator') axis([0 2000 0 40]) figure plot(Q3,MC3) xlabel('Output(MW)') ylabel('Price ($/MWh)') title('Marginal Cost Function of Third Generator')

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