Grant McDermott: Hydro Power. Market Might

A central tenet of economic theory is that market power induces deadweight loss. This claim rests on an assumption that is difficult to verify empirically. Namely, that dominant firms produce less than the social optimum. I provide evidence of such restrictive behaviour using a rich dataset of Norwegian hydropower firms. The research design exploits exogenous variation in market power, arising from transmission bottlenecks and the formation of localized electricity markets. The unique production traits of hydropower production further helps to avoid empirical complications associated with marginal cost estimation and endogenous variation in the supply mix. This allows me to identify the causal impact of market power on firm behavior in a reduced-form setting that requires minimal assumptions. I show that gaining pivotal status can cause firms to withhold production by as much as a two to five percent. My results suggest that even nominally competitive markets are susceptible to strategic manipulation and welfare losses.