Grais & Zheng Strategic Interdependence in the East-West Gas Trade

# IV. Contract Modifications in Response to Exogenous Changes

In the following, we analyze how the game regains its equilibrium solution and the players change their strategy selections, in response to external shocks. These comparative statics analyses show that gas trade contracts with incentive compatibility as presented in our game solutions possess sufficient flexibility to be modified to reflect changes in the trade environment. Each player will act on its decision variable, that is the three core variables _PR, T,_ and G. depending on the strategic interactions specified in the game. The assumption on the behavior of the importer as reflected by the specification of the welfare function plays a critical role in determining the outcome of the game. Here we ass-me a nested CES type welfare index'<sup>0</sup> , which provides a reasonable first approach while allowing for ease of calibration. Table 2 presents the set of equations of the game with the assumption of a CES welfare index, while Tables 3 and 4 identify the signs of the partial derivatives and the elasticities of endogenous variables respectively in the neighborhood of the initial equilibriumw, as calibrated on 1992 figures (see Annex). We first consider changes in the importer's environment and then in the transiter's and producer'sIn each case, we look at modifications of the players' strategy choice, the payoffs, and the distribution of trade gains.

# A. Clanggs intleTImporter's Envir ent

or the price behavior of competitors, and iii) increased competition in the gas market.

An increase of the expenditure on gas (AY >0) relaxes the importer's budget constraint, and thus contributes to the expansion of demand for gas from all sources, as a direct result of the income effect in welfare maxiuization (fables 3 and 4, collum 4). Strategic intractions in the competitive gas market force the supplier and the transiter not to raise their supply price and transit fee, respectively, in respond to a growing demand. Indeed any increase in the price of Russian gas charged to the importer would induce alternative suppliers to capture a larger share of the increased demand, compress Russia's market share, and limit the improvemen in pay-offs to both the transiter and supplier below the one which could be obtained under a no-price-change strategy Consequendy, all three players benefit from the stronger purchasing power of the importer and the enlarged volume of gas trade. Due to the homogeneity of degree one assumption of the welfare function, a one percent increase in Y leads to a one percent expansion of gas demand G, and improves the importer's welfare index by one percent. The transiter's and supplier's pay-offs improve by more than one percent each, because of the presence of fied costs in their pay-ffs<sup>t</sup> .

The importer's decision environment can be affected by: i) an increased expenditure on gas as can result from a general expansion of the western economy or inter-fuel substitution between oil and gas aue to stronger environmental concerns; ii) a shift in the western demand schedule of Russian gas either due for example to a changed perception of its reliability Finally, it is noticeable that, though its profit rises, the transiter's share in the total profit becomes marginally lower, reflecting its lower fixed costs. However, the rent and revenue share of the transiter do not change as they depend only on prices which remain unchanged when the importer's expenditure on gas increases.

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