Dynamic Pricing and Learning in Electricity Markets

We analyze the price-formation process in an infinite-horizon oligopoly model where hydroelectric generators engage in dynamic price-based competition. The analysis focuses on the role of "indifference" prices, i.e., prices that equate the gains from releasing or storing water. Strategies where players bid their indifference prices and the marginal player undercuts the lowest-cost unsuccessful bidder constitute a Markov Perfect Equilibrium (MPE) under appropriate conditions. These conditions involve symmetric production capacity and nonfractional (i.e., "all or nothing") output by successful bidders. Although the MPE solution represents an equilibrium consistent with dynamic strategic behavior, it requires computational sophistication by market participants. However, a basic "learning" procedure involving indifference prices converges to an MPE.