Essays on commodity cycles based on expanded Cobweb experiments of electricity markets
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This thesis studies cycles in commodity markets. Such fluctuations have significant adverse effects on consumers and producers. The properties of commodity price fluctuations are well known. However, there is considerable disagreement about the underlying causes of market fluctuations. Understanding such cycles is essential for policy analysis. We analyze the case of recently deregulated electricity markets, where several authors have expressed a concern that capacity cycles may emerge. The potential occurrence of cycles represents a major threat to electricity security, since there could be periods with insufficient capacity to satisfy demand followed by periods with excess capacity and unsustainably low prices. Traditional economic literature argues that oscillations are caused by external shocks. We explore an alternative explanation that comes from the internal structure of the system. The method is laboratory experiments. To link to the existing literature we start by investigating the simplest economic model of cycles (the Cobweb model) with standard conditions, linear demand, and constant costs. Step by step, we add complexity (and realism) to the simple model. We introduce long lifetimes of production capacity and then we introduce a two period investment lag in addition to long lifetimes. Consistent with previous experiments and the rational expectations hypothesis, we find no evidence of cycles in the basic design and in the capacity lifetime treatment. Average prices are close to Cournot Nash equilibrium with a bias towards competitive prices. In the investment lag treatment, however, variance and autocorrelation analysis indicate cyclical tendencies. In a follow up experiment we introduce a constant price elasticity with dynamic demand adjustment. The experiment gives rise to larger and asymmetric fluctuations similar to observed commodity prices (e.g. sugar and coffee prices). In a third experiment, we increase the frequency of decisions. We observe oscillatory behaviour in investment activity and prices. The cyclical tendency is stronger than in the previous experiments, and the results corroborate assumptions made in previous simulation studies of electricity markets. In a fourth paper, we look at empirical evidence of fluctuations in some electricity markets in South America. While the time-series are not long enough to conclude that there are systematic fluctuations, we observe that both Brazil and Chile have experienced very small reserve margins, electricity supply crises, and considerable shortages of electricity. The likely cause is lack of investments in new generation capacity. Argentina and Colombia have high reserve margins and very low spot prices, largely because of the deep recessions in their respective economies. The thesis contributes to a better understanding of endogenous causes of market fluctuations. This should call for an increased interest in market models that include supply and demand side dynamics. Also, the findings should serve as a motivation to search for alternative stabilising policies in existing markets, particularly in markets where deregulation is considered.
Paper I: Arango, Santiago, 2006, Cyclical behaviour, a function of market complexity? Expanding the cobweb experiment. Draft version.Paper II: Arango, Santiago, 2006, Asymmetric commodity cycles: Evidence from an experimental market. Draft version.Paper III: Arango, Santiago, 2006, Cyclical Behaviour in Electricity markets: An Experimental study. Draft version.Paper IV: Utilities Policy 14(3), Arango, Santiago; Larsen, E. R. & Isaac Dyner, Lessons from deregulation: Understanding electricity markets in South America, pp. 196-207. Copyright 2006 Elsevier Ltd. Reproduced with permission. Published version. The published version is also available at: http://dx.doi.org/10.1016/j.jup.2006.02.001