Forward Markets Increase Competition And Benefit Consumers

In industries like oil, gas and electricity, the introduction of forward markets – which allow buyers and sellers to ''lock in'' a price in advance of the transaction being completed – can significantly increase competition and benefit consumers. That is the central conclusion of new research by Paul Pezanis-Christou and colleagues, published in the January 2008 issue of The Economic Journal.

Controlling and managing monopoly power is one of the basic problems that regulators have to deal with. Besides new entry or the splitting of companies, a possible way to address this problem is to allow for forward contracts between producers and traders or to set up a forward market such as those in the oil, gas, and electricity industries.

The authors provide experimental evidence to support the theoretical prediction that the existence of a forward market increases competition, which in turn benefits consumers. This is in addition to the benefits that forward markets bring in limiting exposure to future price swings.

The original rationale for forward markets relates to attempting to manage the risk of uncertain future demand. Another reason for introducing such a market is that it changes the producers'' strategic incentives in a way that enhances competition and efficiency.

Indeed, selling decisions on the forward market involve a dilemma for firms: if just one firm sells forward it benefits from moving first, but if all firms pre-commit by selling forward, then they are all worse off than if none of them had sold forward.

The study reports on a series of laboratory experiments that specifically test this strategic motivation and that compare the effect of adding a contract market to the introduction of an additional competitor.

The experiments were designed to reproduce the main features of the electricity industry. This usually involves a small number of firms who operate plants with different unit-costs of production and who compete with each other by submitting selling-price bids for each unit of production they propose to supply the market with.

The results suggest that, as predicted, the introduction of a forward market in an industry with three firms significantly lowers the prices, although not as much as if there are four firms and no forward market. It also appears that the presence of a forward market in an industry with three firms leads to higher efficiency levels than if there are only three or four firms.

Although these experiments leave aside the demand uncertainty feature inherent to electricity markets in order to focus on the strategic effect of forward trading, they provide supportive evidence that allowing firms to sell forward leads indeed to higher efficiency and to lower price levels, which is beneficial to society in general and consumers in particular.

''Competition with Forward Contracts'' by Jordi Brandts, Paul Pezanis-Christou and Arthur Schram is published in the January 2008 issue of The Economic Journal.