Strategic Use of Forward Contracts and Capacity Constraints

Allaz and Vila (1993) argued that forward markets mitigate market power and enhance efficiency. This paper analyzes the implications of forward markets when oligopolistic firms endogenously choose capacity levels. The paper shows that the forward market that occurs after the investment decision is committed may discourage total investment and result in a Pareto-inferior outcome. However, the forward market could improve social welfare if the introduction of the forward market decreases spot market prices without negatively affecting investment levels. An increase in the number of firms decreases the likelihood that the forward market has a negative effect on social welfare. The findings have important policy implications for capital-intensive industries where capacity expansion requires long lead time.