191 * Corresponding author. The Leone Family Department of Energy and Mineral Engineering, The Pennsylvania State University, 110 Hosler Building, University Park, PA 16802. E-mail: chiaraloprete@psu.edu. ** Department of Geography and Environmental Engineering; Environment, Energy, Sustainability and Health Institute, The Johns Hopkins University, Baltimore, USA. The Energy Journal, Vol. 36, No. 2. Copyright  2015 by the IAEE. All rights reserved. Market Power in Power Markets: An Analysis of Residual Demand Curves in California’s Day-ahead Energy Market (1998–2000) Chiara Lo Prete* and Benjamin F. Hobbs** ABSTRACT We examine the exercise of market power in California’s power market in 1998– 2000, with a focus on its day-ahead energy market and its five non-utility thermal generating companies. Our goal is to assess whether the hourly bids of market participants, together with information on thermal unit characteristics and power output, suggest that the five suppliers were behaving in line with Nash supply function competition, bidding close to their marginal costs or restraining quan- tities relative to the Nash level. The analysis of residual demand inverse elastic- ities suggests that the five thermal generators had an incentive to exercise unilat- eral market power that was not always fully exploited. A comparison of market-clearing prices, estimated marginal costs and marginal revenues finds that firm conduct was broadly consistent with Nash supply function competition or more competitive than Nash behavior in most of our sample. Keywords: Market power, California, Day-ahead electricity market, PX http://dx.doi.org/10.5547/01956574.36.2.9 1. INTRODUCTION Producer market power can be defined as the ability of a supplier “to profitably raise prices above competitive levels and maintain those prices for a significant time period” (U.S. Department of Energy, 2000). A distinction is often made between vertical and horizontal market power. The former is exercised when a firm involved in two different activities in the supply chain (e.g., power generation and transmission) uses its dominance in one area to raise prices and increase overall profits. In liberalized electricity markets, separating ownership of generation, transmission and distribution or requiring transmission owners to give nondiscriminatory access to their transmission systems addresses issues of vertical market power. However, unbundling does not exclude the possibility of horizontal market power, which occurs when a firm is able to affect prices because of concentration in a single step of the supply chain (e.g., power generation). In the case of horizontal market power in generation, a supplier could maintain high prices by reducing output below competitive levels (Werden, 1996), or by exploiting the unique charac- teristics of electric networks, for instance increasing output to create bottlenecks in the transmission system (Cardell, Cullen Hitt and Hogan, 1997). Such exercise of market power could arise as a