BILATERAL OLIGOPOLY IN POLLUTION PERMIT MARKETS: EXPERIMENTAL EVIDENCE

We experimentally investigate behavior in a bilateral oligopoly using a supply function equilibria model discussed by Klemperer and Meyer (1989), Hendricks and McAfee (2010), and Malueg and Yates (2009). We focus on the role that market size and the degree of firm heterogeneity have on the market equilibrium. Our results indicate that subjects within the experiment recognize the strategic incentives in a bilateral oligopoly, but they do not exploit these incentives to the exact magnitude predicted by theory. We find weaker support for predicted market outcomes, as market efficiency does not depend on market size, and in some cases buyers or sellers are more successful at extracting the rents from the market. (JEL L13, Q5, C9) I. INTRODUCTION Pollution permit markets have been applied to a wide variety of pollution problems. Recently, there has been quite a bit of interest in optimizing the scale of these markets (Wiliams 2003; Krysiak and Schweitzer 2010; Yates et al. 2013). When a market is optimized with respect to scale, the polluting firms are divided up into zones and firms may trade emissions only with other firms in their zone. In a given zone, there may be a small number of buyers and sellers, and if so, then all market participants in the zone, not just the buyers or just the sellers, exert market power. This market structure is called a bilateral oligopoly. In general, the strategic incentives inherent in bilateral oligopoly lead to a reduction in trade between firms relative to a competitive benchmark. For pollution permit markets, this reduction in trade has a cost (firms must expend more resources to reduce emissions) as well as a benefit (there are fewer localized damage hot spots). These effects tend to cancel out, implying that the bilateral oligopoly performs about as well overall as a competitive market (Yates et al. 2013). So a regulator need not be overly concerned if it turns out that a zone contains only a small number of firms, at least according to theory. Optimizing permit markets with respect to scale offers promise for the design of future permit markets. But regulators may be reluctant to put these insights into practice and create a zone with a small number of buyers and sellers without assurances that the resulting market will behave according to theoretical predictions. Toward that end, we conduct the first experimental test of a bilateral oligopoly utilizing a supply function equilibria market structure. Using varying market sizes and cost heterogeneity, we find that subjects within the experiment recognize the strategic incentives in a bilateral oligopoly. However, we find weaker support for predicted market outcomes as the overall market efficiency does not appear to depend on market size. Our cautious conclusion is that permit markets that are optimized for scale should generally perform as predicted. In comparison to other market structures (e.g., monopoly, monopsony, bilateral monopoly, oligopoly, or oligopsony), bilateral oligopoly has received surprisingly little attention. Virtually all of the extent literature is theoretical. Hendricks and McAfee (2010) use extensions of Klemperer and Meyer's (1989) supply function equilibria models to characterize bilateral oligopoly equilibria in a single market. Weretka (2011) uses similar techniques to analyze a general equilibrium setting. Bjornerstedt and Stennek (2001) do not use supply function equilibria, but rather analyze sequential bilateral bargaining between market participants in a network structure. Lange (2012), Malueg and Yates (2009), and Wirl (2009) have all studied bilateral oligopoly in the specific context of pollution permit markets. These papers are conceptually similar in that they all use techniques related to supply function equilibria. There are some differences in their exact structure, however, and here we focus on the model in Malueg and Yates (2009). The key feature of the Malueg and Yates (2009) model is a net-trade function, which specifies how many permits the firms are willing to buy and sell at various prices. …