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Characterizations of long-run producer optima and the short-run approach to long-run market equilibrium: a general theory with applications to peak-load pricing

Horsley, Anthony and Wrobel, Andrew J. (2005) Characterizations of long-run producer optima and the short-run approach to long-run market equilibrium: a general theory with applications to peak-load pricing. TE, 490. Suntory and Toyota International Centres for Economics and Related Disciplines, London School of Economics and Political Science, London, UK.

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Abstract

This is a new formal framework for the theory of competitive equilibrium and its applications. Our “short-run approach” means the calculation of long-run producer optima and general equilibria from the short-run solutions to the producer’s profit maximization programme and its dual. The marginal interpretation of the dual solution means that it can be used to value the capital and other fixed inputs, whose levels are then adjusted accordingly (where possible). But short-run profit can be a nondifferentiable function of the fixed quantities, and the short-run cost is nondifferentiable whenever there is a rigid capacity constraint. Nondifferentiability of the optimal value requires the introduction of nonsmooth calculus into equilibrium analysis, and subdifferential generalizations of smooth-calculus results of microeconomics are given, including the key Wong-Viner Envelope Theorem. This resolves long-standing discrepancies between “textbook theory” and industrial experience. The other tool employed to characterise long-run producer optima is a primal-dual pair of programmes. Both marginalist and programming characterizations of producer optima are given in a taxonomy of seventeen equivalent systems of conditions. When the technology is described by production sets, the most useful system for the short-run approach is that using the short-run profit programme and its dual. This programme pair is employed to set up a formal framework for long-run general-equilibrium pricing of a range of commodities with joint costs of production. This gives a practical method that finds the short-run general equilibrium en route to the long-run equilibrium, exploiting the operating policies and plant valuations that must be determined anyway. These critical short-run solutions have relatively simple forms that can greatly ease the fixed-point problem of solving for equilibrium, as is shown on an electricity pricing example. Applicable criteria are given for the existence of the short-run solutions and for the absence of a duality gap. The general analysis is spelt out for technologies with conditionally fixed coefficients, a concept extending that of the fixed-coefficients production function to the case of multiple outputs. The short-run approach is applied to the peak-load pricing of electricity generated by thermal, hydro and pumped-storage plants. This gives, for the first time, a sound method of valuing the fixed assets–in this case, river flows and the sites suitable for reservoirs.

Item Type: Monograph (Discussion Paper)
Official URL: http://sticerd.lse.ac.uk
Additional Information: © 2005 the authors
Library of Congress subject classification: H Social Sciences > HB Economic Theory
Journal of Economic Literature Classification System: D - Microeconomics > D5 - General Equilibrium and Disequilibrium > D58 - Computable and Other Applied General Equilibrium Models
D - Microeconomics > D4 - Market Structure and Pricing > D46 - Value Theory
L - Industrial Organization > L9 - Industry Studies: Transportation and Utilities > L94 - Electric Utilities
D - Microeconomics > D2 - Production and Organizations > D24 - Production; Cost; Capital and Total Factor Productivity; Capacity
C - Mathematical and Quantitative Methods > C6 - Mathematical Methods and Programming > C61 - Optimization Techniques; Programming Models; Dynamic Analysis
Sets: Collections > Economists Online
Departments > Economics
Research centres and groups > Suntory and Toyota International Centres for Economics and Related Disciplines (STICERD)
Research centres and groups > Computational, Discrete and Applicable Mathematics@LSE (CDAM)
Rights: http://www.lse.ac.uk/library/usingTheLibrary/academicSupport/OA/depositYourResearch.aspx
Identification Number: 490
Date Deposited: 11 Jul 2008 11:44
URL: http://eprints.lse.ac.uk/19307/

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