Prior to 1996, roughly 70% of electricity service in California was provided by investor owned utilities (IOUs). The IOUs operated as monopolies in their respective service territories, performing all of the functions necessary to generate and deliver electricity to the consumer. In exchange for service, the IOUs were paid a regulated rate which was designed to recover their cost of providing the service plus a reasonable return on their investment. In 1996, California changed the way electric service was provided in order to make it more competitive. Among the changes, utilities would procure their supplies at market prices in an auction or spot market; residential customers could choose their electric supplier; and residential rates were frozen at 10% below their June 1996 levels. The rate freeze was to remain in effect until the later of March 31, 2002, or the date the IOUs fully recovered certain expenses that were still on their books (i.e., stranded costs). The restructured market commenced operations on March 31, 1998. During the summer of 2000, California experienced record increases in wholesale prices and supply shortages that ultimately resulted in a number of rolling blackouts. Most of California?s residential customers were unaffected by the increased wholesale prices because their rates remained frozen. Regulators and others who have studied what went wrong during the summer of 2000 in California agree that the increase in wholesale prices was due to a combination of factors, one of which was the residential rate freeze. This thesis proposes to show how fixing the price of electricity resulted in excess demand and to quantify the size of the excess. This thesis also shows how much of a price increase would have been needed to prevent the shortages. / Master of Arts

This dissertation is a theoretical exploration of commonly used policy tools meant to improve market performance. The first chapter examines the use of prizes and grants as instruments for encouraging research and development. The second chapter investigates the welfare impact of price caps in oligopoly markets with endogenous entry. The third chapter studies the relationship between deposit insurance and bank risk taking, when a banker is motivated by reciprocity. The first chapter explores the use of grants and prizes as tools for encouraging research activity and innovation. Grants and prizes are commonly used by public and private research funders, and encourage R&D activity in different ways. Grants encourage innovation by subsidizing research inputs, while prizes reward research output. A common rationale for prizes is moral hazard; if a funder cannot observe all relevant research inputs then prizes create a strong incentive for R&D activity. In this chapter, it is shown that grants are a more efficient means of funding when a researcher's ability is unknown to the funder (adverse selection). When both adverse selection and moral hazard problems exist, a grant may emerge as an optimal funding mechanism, provided the moral hazard problem is relatively weak. In settings where the moral hazard problem is sufficiently strong, a grant emerges as part of an optimal funding mechanism, in conjunction with a prize. These results are useful for understanding different funding mechanisms used by both public and private entities. The second chapter, which is based on joint work with Stan Reynolds, examines the impact of price caps in oligopoly markets with endogenous entry. In the case of deterministic demand, reducing a price cap yields increased total output, consumer welfare, and total welfare. This result falls in line with classic results on price caps in monopoly markets, and with results for oligopoly markets with a fixed number of firms. These comparative static results for price caps need not hold when demand is stochastic and the number of firms is fixed, but recent results in the literature show that a welfare improving price cap does exist. We show that a welfare-improving cap need not exist in the case where demand is stochastic and entry is endogenous. In addition, we provide restrictions on the demand function such that a welfare-improving price cap exists under endogenous entry and stochastic demand. The third chapter, which is based on a joint project with Martin Dufwenberg, investigates the relationship between deposit insurance, risk taking, and insolvency. Empirical evidence suggests that the introduction of deposit insurance increases risk taking by banks and results in a greater chance of insolvency. The common rationale for this connection is that deposit insurance decreases the incentive for customers to monitor their banks, and invites excessive risk taking. In this chapter, it is argued that this classic explanation is somewhat puzzling. If customers can monitor their bank's behavior, certainly the insurance provider (FDIC) has this same ability. If this is the case, appropriate mechanisms could limit the moral hazard problem. We put forth an alternative explanation, and demonstrate that deposit insurance invites excessive risk taking when a banker is motivated by reciprocity.