Strategic Pricing, Market Entry and Competition: Evidence from German Electricity Submarkets

German electricity submarkets for residential customers have been liberalized by the end of the 1990s. Since then a large number of new providers has entered former monopolistic markets, which are first and foremost retail markets. However, only a low share of households in Germany has switched to a competitive contract. Following the Monitoringbericht 2008 of the German energy regulator Bundesnetzagentur about 60 percent of households have not switched to an alternative contract, even ten years after the liberalization. These households are served with incumbents’ standard contracts, the so-called "Grundversorgungsverträge". Usually, standard contracts are offered at significantly higher prices than competitive contracts due to high customers’ switching costs. In this paper we follow the question how the standard contract price or the price-cost markup for this contract could be used to influence market structure.

Following the Limit Pricing theory, we show that retail competition in terms of the number of competitors depends on the standard contract price and that the provider of this contract type might use the price as an instrument to affect competition in its home market ceteris paribus. By reducing the standard contract price customers’ net benefits of switching to an alternative contract could be reduced. Thus, market entry might be not profitable for less efficient supplier. We would then expect a lower number of electricity suppliers in markets with lower standard contract prices. Whether the low-price strategy is profit-increasing for the incumbent depends on the behavior of the customers: With a lower standard contract price also the price-cost markup is lower. On the other hand, lower numbers of customers are willing to switch to competitive contracts.

We analyze the limit pricing idea using a simultaneous equations approach and employ data for all geographically separated German retail electricity submarkets. We control for alternative regional impact characteristics such as customer concentration, purchasing power, grid characteristics as well as the distribution charge, which providers have to pay for electricity provision in a market. Our estimation results show a significant effect of the standard contract price (or price-cost markup) on the number of offered contracts and number of the competitors offering contracts to low consumption customers (one-person households) in a distinct market. However, the number of the competitors offering contracts to households with higher consumption is not affected by the standard contract price but by the distribution charge, which is in line with the theoretical literature. Contracts per provider instead show that providers in a market with a lower number of competitors offer more contracts given the price-cost markup. Thus, our results show that, besides the distribution charge, incumbents can also affect competition due to customers’ high relative switching costs.

Nikogosian, Vigen and Tobias Veith (2011), Strategic Pricing, Market Entry and Competition: Evidence from German Electricity Submarkets, ZEW Discussion Paper No. 11-068, Mannheim.