Deregulation, Market Power, and Prices

When deciding whether to introduce market-based prices into a regulated market, a regulator faces the following tradeoff: profit incentives may reduce costs through the more efficient allocation of resources, but the presence of market power may lead to increased markups. The paper presented in this Research Seminar uses a detailed dataset on electricity transactions to investigate the impact of market-based deregulation in the context of the U.S. electricity sector. The authors find that the increase in markups dominates despite modest efficiency gains, leading to higher prices to consumers. Deregulation does not necessarily lead to lower prices to consumers. A consumer-oriented regulator may prefer to regulate rates to be consumer friendly, rather than let prices be subject to market power.