Deinonychus antirrhopus

The Wolak Model

In several posts below (sorry I'm too lazy to link to them) there were several references to Frank Wolak's simple model for what happened during the energy crisis. It really is a brilliant model, IMO, given its simplicity. Here is the simple form of the model.

There are three generators that bid in electricity. Each of the three generators can produce 500 MW each. The demand is forecasted to be 1,300 MW. No two generators can meet all the demand. Further lets assume that bidding is sequential and the bidding rules are structured so that whatever the highest bid is to clear the market each market participant recieves that bid price.

Now with this set up there is clearly no disadvantage to being a first mover (if anything it is advantage to move first). So the first firm bids in 500 MW, and so does the second. Total demand bid into the system at this point is 1,000 MW, 300 MW short of the maximum necessary. At this point the final generator has tremendous market power and can basically set whatever price he wants. Now some might think that the generator can charge whatever price he wants. This is not quite the case. The generator would be constrained by the demand curve. If the price is $1,000,000/MW clearly nobody will purchase any electricity.

So why does Frank Wolak just set demand in his model to some number (in this case 1,300)? There are institutional factors here. These factors basically created a complete disconnect between the retail market and the wholesale market. The two main institutional factors are,

1. The retail rate freeze.
2. The regulatory requirment that the utilities must serve.

The first one completely protected retail customers from the price volatility in the whole sale market. For example, prior to the electricity crisis in CA, the typical residential customer faced an average rate of $.13/kWh, and would pretty much pay that rate no matter what the cost was in the wholesale market. This means demand for electricity in the wholesale market was perfectly inelastic (i.e. unresponsive to price changes).

The second one means that no matter how much it cost to buy the power retail customers demanded the utilities had to buy it. Even if it cost $100,000,000 a day, they had to spend that much money (and recover only pennies on the dollar).

This in effect removed almost all constraints from the price of electricity save for the price caps. Of course, in December, those price caps were effectively removed when FERC put into place the $150/MW soft cap. This is when you saw prices going as high as $1,500/MW in some hours. Just to put this in some perspective, the utilities back when they were vertically integrated charged around $30/MW.