On the Inefficiency of Forward Markets in Leader-Follower Competition

TL;DR

This paper analyzes how forward markets affect leader-follower competition with capacity constraints and different production times, revealing that forward contracting can sometimes increase market power and lead to inefficiencies.

Contribution

It provides an explicit characterization of equilibrium outcomes in leader-follower markets with forward contracts, highlighting conditions where forward markets are inefficient.

Findings

Forward markets can either mitigate or enhance market power.

Heterogeneous production lead times create complex equilibrium dynamics.

Symmetric equilibria may not exist due to market power asymmetries.

Abstract

Motivated by electricity markets, this paper studies the impact of forward contracting in situations where firms have capacity constraints and heterogeneous production lead times. We consider a model with two types of firms - leaders and followers - that choose production at two different times. Followers choose productions in the second stage but can sell forward contracts in the first stage. Our main result is an explicit characterization of the equilibrium outcomes. Classic results on forward contracting suggest that it can mitigate market power in simple settings; however the results in this paper show that the impact of forward markets in this setting is delicate - forward contracting can enhance or mitigate market power. In particular, our results show that leader-follower interactions created by heterogeneous production lead times may cause forward markets to be inefficient, even when there are a large number of followers. In fact, symmetric equilibria do not necessarily exist due to differences in market power among the leaders and followers.