Capacity Choice in Decentralized Grid-Bound Industries

In grid-bound industries, individual investment in production capacity constitutes a public good in the form of a delivery insurance for all market participants. We analyze the effects of entry (caused e.g. by deregulation) on capacity and output choice in these industries. To this end we employ a Cournot-model with symmetric firms and firm-specific capacity shocks. Our results reveal that the standard welfare-enhancing competition effect of an increasing number of firms, induced by lower prices and higher output quantities, is countervailed by a decrease in delivery insurance and thus by a growing probability of delivery disruptions (blackouts). Beyond a certain number of firms, the latter effect dominates. As a consequence, the socially optimal number of firms is bounded. We calibrate the model on data of the German electric power market to get a notion of this optimal number firms.