Relaxing Competition Through Speculation: Committing to a Negative Supply Slope

Abstract

We demonstrate how suppliers can take strategic speculative positions in derivatives markets to soften competition in the spot market. In our game, suppliers _rst choose a portfolio of call options and then compete with supply functions. In equilibrium _rms sell forward contracts and buy call options to commit to downward sloping supply functions. Although this strategy is risky, it reduces the elasticity of the residual demand of competitors, who increase their markups in response. We show that this type of strategic speculation increases the level and volatility of commodity prices and decreases welfare.

Strategic advance sales, demand uncertainty and overcommitment

“…A striking feature of Theorem 1 is that the only assumption we have made regarding F (a) is that it is continuous and differentiable, no other restriction on F (a) is required. This is in contrast with the findings of Popescu and Seshadri [25] or Hölmberg and Willems [13], who obtain closely related uniqueness results by requiring the distribution of shocks to have an increasing hazard rate. However Popescu and Seshadri consider the wide support case only, while Holmberg and Willems impose costless production in the context of supply function competition, which is equivalent to require a wide support as we discussed above.…”

“…It is realized at the beginning of period two and observed by all agents at that time. The support of F (a) is the interval [a L ; a H ] ⊆ R + , which is assumed to allow production and sales to be always potentially profitable, in the sense that if demand where known, some production would take place: 13 c ≤ a L ≤ a H ≤ +∞.…”

“…The importance of the demand support on the nature of equilibrium, as well as the consequences of the shape of the density of shocks on the existence of an individual best response, are not analyzed. In a model of supply function competition with costless production, Hölmberg and Willems [13] show that forward contracts in the form of an infinite series of options can be used by duopolists in equilibrium to commit their supply function on the spot market to have a negative slope, that is to commit to reduce competition. They establish this result in a costless production model, assuming that the hazard rate of the distribution of demand shocks either increases or is not too decreasing.…”

Supply Function Equilibrium with Taxed Benefits

“…In this case we select the least competitive SFE, following Newbery (1998). The least competitive SFE is Pareto optimal, in that it yields the highest profit for each firm, as discussed in Holmberg and Willems (2015).…”

Forward Trading and Collusion in Supply Functions

“…Brandts et al (2008) show supporting evidence from laboratory experiments. Holmberg and Willems (2015) consider supply functions and the strategic use of option contracts. None of these contributions however addresses the possibility of collusion.…”