On the Inefficiency of Forward Markets in Leader–Follower Competition

The role of forward contracts in mitigating market power is an important and recurring theme in oligopolistic industries, such as electricity and gas. In “On the Inefficiency of Forward Markets in Leader–Follower Competition,” D. Cai, A. Agarwal, and A. Wierman study the impact of forward contracting in situations where firms have capacity constraints and heterogeneous production lead times. The authors introduce a model that combines forward contracting and leader–follower competition and explicitly characterize the equilibrium outcomes with and without forward contracting. They show that the impact of forward markets is delicate—it may mitigate market power or create opportunities for market manipulation. In particular, leader–follower interactions due to 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 leaders and followers. 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.