Media Briefings

Forward Markets Increase Competition And Benefit Consumers

  • Published Date: January 2008


In industries like oil, gas and electricity, the introduction of forward markets – which
allow buyers and sellers to ‘lock in’ a price in advance of the transaction being
completed – can significantly increase competition and benefit consumers. That is
the central conclusion of new research by Paul Pezanis-Christou and colleagues,
published in the January 2008 issue of The Economic Journal.
Controlling and managing monopoly power is one of the basic problems that
regulators have to deal with. Besides new entry or the splitting of companies, a
possible way to address this problem is to allow for forward contracts between
producers and traders or to set up a forward market such as those in the oil, gas,
and electricity industries.
The authors provide experimental evidence to support the theoretical prediction that
the existence of a forward market increases competition, which in turn benefits
consumers. This is in addition to the benefits that forward markets bring in limiting
exposure to future price swings.
The original rationale for forward markets relates to attempting to manage the risk of
uncertain future demand. Another reason for introducing such a market is that it
changes the producers’ strategic incentives in a way that enhances competition
and efficiency.
Indeed, selling decisions on the forward market involve a dilemma for firms: if just
one firm sells forward it benefits from moving first, but if all firms pre-commit by
selling forward, then they are all worse off than if none of them had sold forward.
The study reports on a series of laboratory experiments that specifically test this
strategic motivation and that compare the effect of adding a contract market to the
introduction of an additional competitor.
The experiments were designed to reproduce the main features of the electricity
industry. This usually involves a small number of firms who operate plants with
different unit-costs of production and who compete with each other by submitting
selling-price bids for each unit of production they propose to supply the market with.
The results suggest that, as predicted, the introduction of a forward market in an
industry with three firms significantly lowers the prices, although not as much as if
there are four firms and no forward market. It also appears that the presence of a
forward market in an industry with three firms leads to higher efficiency levels than if
there are only three or four firms.
Although these experiments leave aside the demand uncertainty feature inherent to
electricity markets in order to focus on the strategic effect of forward trading, they
provide supportive evidence that allowing firms to sell forward leads indeed to higher
efficiency and to lower price levels, which is beneficial to society in general and
consumers in particular.
ENDS
Notes for editors: ‘Competition with Forward Contracts’ by Jordi Brandts, Paul
Pezanis-Christou and Arthur Schram is published in the January 2008 issue of The
Economic Journal
.
Jordi Brandts is at the Institute for Economic Analysis (CSIC) in Barcelona. Paul
Pezanis-Christou is at the University of Louis Pasteur in Strasbourg. Arthur Schram
is at the University of Amsterdam.
For further information: contact Jordi Brandts on +34 935 806 612 (email:
jordi.brandts@uab.es); Paul Pezanis-Christou on +33 390 242 075 (email:
ppc@cournot.u-strasbg.fr); Arthur Schram on +31 205 254 293 (email:
Schram@uva.nl); or Romesh Vaitilingam on 07768 661095 (email:
romesh@compuserve.com).