Stochastic modeling of imperfect markets

Abstract

Stochastic optimization approaches ignore that the decisions of different actors in markets typically do not lead to a system-wide optimal solution. Suppliers in markets with entrance barriers or other aspects that hinder competition, can use their dominant positions to exert market power and drive up market prices. To represent such gaming behavior, a different modeling approach is needed. Equilibrium models can represent varying market structures, including perfect competition and oligopoly. This chapter presents a multi-stage stochastic equilibrium model for a general commodity market wherein suppliers, transportation agents and storage agents make capacity investment decisions while facing uncertainty in future market circumstances and production and sales decisions in later stages when the uncertainty has been revealed. An illustrative example for the natural gas market is used to show how market power may affect decisions and expected profits, and discuss the value of the stochastic solution for the different agents in our gaming setting.