Using Experiments to Inform the Privatization/deregulation Movement in Electricity

By Rassenti, Stephen J.; Smith, Vernon L. et al. | The Cato Journal, Winter 2002 | Go to article overview

Using Experiments to Inform the Privatization/deregulation Movement in Electricity


Rassenti, Stephen J., Smith, Vernon L., Wilson, Bart J., The Cato Journal


At the University of Arizona, electronic trading (now commonly known as e-commerce) in the experimental laboratory began in 1976 when Arlington Williams conducted the initial experiments testing the first electronic "double-auction" trading system, which he had programmed on the Plato operating system. The term "double auction" refers to the oral bid-ask sequential trading system used since the 19th century in stock and commodity trading on the organized exchanges. This system of trading has been used in economics experiments since the 1950s, and is extremely robust in yielding convergence to competitive equilibrium outcomes (Smith 1962, 1982a). Since information on what buyers are willing to pay, and sellers are willing to accept, is dispersed and strictly private in these experiments, the convergence results have been interpreted (Smith 1982b) as supporting F.A. Hayek's thesis "that the most significant fact about this (price) system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action" (Hayek 1945: 526-27).

As with all first efforts at automation, the software developed by Williams allowed double-auction trading experiments that previously had kept manual records of oral bids, asks and trades, to be computerized. (1) That is, it facilitated real-time public display of participant messages, recording of data, and greater experimental control of a process defined by preexisting technology. It did not modify that technology in fundamental ways. This event unleashed a discovery process commonplace in the history of institutional change: the joining of a new technology to an incumbent institution causes entirely new, heretofore unimaginable institutions to be created spontaneously, as individuals are motivated to initiate procedural changes in the light of the new technology. Electronic exchange made it possible to vastly reduce transactions cost--the time and search costs required to match buyers and sellers, to negotiate trades, including agreements to supply transportation and other support services. More subtly it enabled this matching to occur on vastly more complicated message spaces, and allowed optimization and other processing algorithms to be applied to messages, facilitating efficient trades among agents that had been too costly to be consummated with older technologies. Moreover, resource allocation problems thought to require hierarchical command and control forms of coordination, as in regulated pipeline and electric power networks, became easily susceptible to self-regulation by entirely new decentralized pricing and property right regimes. Coordination economies in complex networks could be achieved at low transactions cost by independent agents, with dispersed information, integrated by a computerized market mechanism. This realization then laid the basis for a new class of experiments in which the laboratory is used to test-bed proposed new market mechanisms to enable a better understanding of how such mechanisms might function in the field, and to create a demonstration and training tool for potential participants and practitioners who become part of the "proving" process. Of course, once adopted, this modification and proving process continues in light of field experience.

We provide a short history of the application of the conception of smart computer assisted markets to the design of electricity markets here and abroad.

The Privatization/Deregulation Movement in Electricity

We use the term "privatization" to describe generically the process of reform of foreign government command forms of organization of the electric industry. In all cases major components of the industry have not had their ownership transferred from public to private entities. Reform has focused on the use of decentralized spot and futures markets to provide price signals to improve the short and longer term management of the industry.

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