Securing investment for essential goods how to design demand functions in reservation markets?

Authors

Leopold Monjoie, Fabien Roques

Abstract

This paper studies the provision of an essential good with time-varying uncertain stochastic demand and capacity-constrained producers such as electricity. Due to price regulation, public good externalities, and market power, investments are typically under-procured by private agents. To restore efficient investment level, we analyze the design of reservation markets where producers can sell their capacity availability before the demand is known. While their direct effect on investment decisions is well known, we focus on indirect effects generated by their implementation, namely how the capacity price is allocated on the demand side and how the realized demand is accounted for in the market design. We develop a novel approach to studying the reservation market’s interdependencies and the subsequent production and retail markets for the essential good. We provide a sequential analytical model of the three markets and describe how different market design regimes can indirectly affect the equilibria in the production and retail markets in terms of prices, investment level, and welfare. In particular, we demonstrate that the ability of the reservation market to restore the social optimum, or at least to reach a second-best optimum, crucially depends on the different design regimes of the reservation market, on the assumptions of policy interventions, and the various market inefficiencies. The model results and the associated policy implication are discussed first using a general framework and then in reference to electricity markets where capacity reservation is often used to ensure adequate investment to ensure.