Supply function equilibria with capacity constraints and pivotal suppliers

The concept of a supply function equilibrium (SFE) has been widely used to model generators’ bidding behavior and market power issues in wholesale electricity markets. Observers of electricity markets have noted how generation capacity constraints may contribute to market power of generation firms. If a generation firm’s rivals are capacity constrained then the firm may be pivotal; that is, the firm could substantially raise the market price by unilaterally withholding output. However the SFE literature has not properly analyzed the impact of capacity constraints nor has it considered the impact of pivotal firms on equilibrium predictions. We characterize the set of symmetric supply function equilibria when firms are capacity constrained and show that this set is increasing as capacity per firm rises. We also provide conditions under which asymmetric equilibria exist and characterize these equilibria.