~ps 13cs POLICY RESEARCH WORKING PAPER 1343 Trhis Stackelberg game Strategic Interdependence provides a framework for in the East-West Gas Trade analyzing te strategicmoves of three players in tie- Eas- Hi.rarchical S.ackelbeg :West gas trade -a Western A Hierarchical Stackelberg Game--.- :-: - -- G m Importer, a transiter, and a: Approach Russian- supplier as the game .eader and gaining insights into their freictablty.. Wafik Grais Kangbin Zheng. The World Bank Europe and Central Asia, Country Department IV Country Operations Division 2 - August 1994 I POLICY RESEARCH WORKING PAPER 1343 Summary findings The current and potential benefits of the East-West gas would improve but the importer's welfare would trade are enormous for all participants. Realizing those detcriorate. The supplier and transitcer would have benefits requires significant upfront investments. But the leeway to strategicaNy raise their price and transit fee, new, more complcx structure of thc gas transit system respectively, while gaining market share. But the that has emerged following changes in Eastern Europe importer yould face rising costs for gas imports and and the former Soviet Union has created uncertainties would lose welfare. that bear on the expected benefits from investrments. - An increase in the scope for the importer to Grais and Zheng argue for rhe existence of stable substitute between alternative sources of gas improves contracts that would create an environment more welfare for all three players. The perception by the conducive to investments and allow all participants to supplier and transiter of increased threat of competition benefit from expansion of the gas trade. Ieads to a preemptive move not to lose market share. The As a guidc to formulating incentive-compatible, transiter and supplier reduce the transit fee and supply transparent, flexible contracts, they propose a frampwork price, respectively, allcwing the importer to face a lower based on a Stackelberg game, with three players (a gas price. Import demand expands and welfare improves. supplier, a transiter, and an importer) under Russia's The expanded trade more than compensates for the leadership. They use this franework to analyze the reduction in the transit fee and supply price and allows contract modifications that would ensue from changes larger payoffs for transiter and supplier. affecting the gas trade. They conclude that: * The perceprion of increased reliability of Russian a Increased competitiveness of the transiter and gas supplies expands demand for Russian gas and leads supplier through cost reductions would improve the to the expansion of trade. The supplier and transiter can payoffs to all players (the transiter s and supplier's profits raise their respective charges with expanded volume, and the Westem importer's welfare). Strategic behavior improving their payoffs. The importer's welfare on the part of the supplier and transiter would ultimately deteriorates as the cost of importing gas rises reduce the price to the importer, enlarging gas demand The predictability of the players reactions to changes and reducing costs. If increased competitiveness is the in the environment would build confidence in the outcome of more costly gas from sources other than reliability of gas trade and allow its expansion, Russia, both the supplier's and the transiter's payoffs benefiting all participants. This paper - a product of Europe and Central Asia, Country Department IV, Country Operations Division 2- is part of a larger effort in the region to address the issues in the energy sector raised by the collapse of the fomer Soviet Union and the transiion to market economies. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Kangbin Zheng, room H2-092, extension 36974 (22 pages). August 1994- The Poliy Resarch Wcrking Paper Series disseminates the findngs of work in proess to encourage the cxhange of ideas about deuilo penssue An objecrtioef sbeseries istoge th dfindig out quicky. een if the presetatonsare less than fMlpolishei The papers carry the names of the authors and sbould be used and citd accordingly. The findings, interprtations. and condusions are the authors'own and should not be attributed to the Wodd Bank, itsExecutive Board of Dtrectors, crany of is mmber wonties. Produced by the Policy Research Dissemination Center STRATEGIC INTERDEPENDENCE IN EAST-WEST GAS TRADE A Hierarchical Stackelberg Game Approach Wafik Grais and Kangbin Zheng Europe and Central Asia Regio The World Bank Washington D.C. 20433 (202) 473-6974 * The authors axe grateful to Dale Gay, Ricardo Martin, F. Desmond McCarthy, and James Falk for helpful discussions and suggestions. We ourselves are fMlly responsible for the opinions expressed herein, which do not necessarily reflect the -views of the World Bank. A GAMS program for numerical solutions of the hierarchical Stackelberg game can be obtained from the second author. STRATEGIC INTERDEPENDENCE IN THE EAST-WEST GAS TRADE A Hierarchical Stackelberg Game Approach Wafik Grais and Kangbin Zheng Table of Contents Summary I. Introduction: The Need for Stable Contracts ..................... 1 IL The Changing Structure of the East-Xest Gas Trade ................. 2 UL A Game Theoretical Approach to the East-West Gas Trade .... ....... 3 A. Players .........3....................... 3 B. Decision Variable of Each Player .......................... 3 C. The Players' Pay-off Functions ............................ 4 D. Interacdons between Players ..... 5 E. A Summary Presentation of the Game ..... 6 IV. Contract Modifications In Response to Exogenous Changes ... .. 8 A. The Importer's Environment ..... 8 B. The Supplier's and Transiter's Environment ..... 12 V. Conclusions and Policy .Iplications ....... 15 Annex: Model Derivation and Calibtion List of Tables 1. The System of Equations of Strategic Interdependence among Players ..... 7 2. Strategic Interdependence with a Nested CES Welfare Function for the Importer .................................... 9 3 Directions of Variations of Endogenous Variables with respect to Fluctuations of Exogenous Variables. 11 4. Sensitivity Analysis in the Equilbrium Neighborhood .14 Summary The current and potential benefits of the East West gas trade are enormous for all participants. The realization of these benefits require significant upfront investments. The new, and more complex, structure of the gas transit system that has emerged following the changes in Eastern Europe and the Former Soviet Union has created uncertainties however that bear on the expected benefits of the investments. This paper argues for the existence of stable contracts that would create an environment more conducive to the investments and allow all participants to benefit from the expansion of the gas trade. A framework based on a Stackelberg game with three players (a supplier, a transiter and an importer) under Russia's leadership is proposed as a guide to the formulation of incentive compatible, transparent and flexible contracts. The framework is used to analyze the contract modifications that would ensuie from changes in the environment bearing on the gas trade. Three main conclusions can be drawn. An increased competitiveness of the transiter and supplier through cost reductions woulF improve the pay-offs of all players in the game. The transiter's and supplier's profits as well as the western importer's welfare would improve. Basically it would induce a strategic behavior on the part of the supplier and transiter that would lead to a decline in the price faced by the importer, enlarging gas demand and reducing costs. If the increased competitiveness is the outcome of more costly gas from other sources than Russia, both the supplier's and transiter's pay-offs would improve but the importer's welfare would deteriorate. The supplier and transiter would have leeway to strategically raise their price and transit fee respectively while gaining market share. The importer however would face rising costs of gas imports and lose welfare. An increase in the scope of substitution for the importer between gas from alternative sources improves on welfare of all three players. The perception on the part of the supplier and transiter of an enhanced threat of competition leads to a preemptive move to not lose market share. The transiter and supplier reduce the transit fee and supply price respectively allowing the importer to face a lower gas price. The latter's import demand expands and welfare improves. The expanded trade more than compensates for the reduction in the transit fee and supply price and allows for larger pay-offs for the transiter and supplier. The perception of increased reliability of supplies of gas from Russia shifts outward the demand for gas from Russia and leads to the expansion of trade. The supplier and transiter have scope to raise their respective charges with expanded volumes improving their pay-offs. The importer's welfare deteriorates as the cost of importing gas rises. The predictability of the players' reactions to changes in the environment would build confidence in the reliability of gas trade and allow its expansion benefitting all participants. The game proposed in the paper provides a framework for analyzing the strategic moves of the prayers and gaining insights on their predictability. STRATEGIC INTERDEPENDENCE IN THE EAST-WEST GAS TRADE -- A Hierarchical Stackelberg Game Approach Wafik Grais and Kangbin Zheng I. Introduction: The Need for Stable Contracts In 1992 Russia exported to Western and flexible contract rules can be analyzed. In Europe about 60 billion cubic meters (bcm) of light of the emerging strucure of the market, gas at a value of $9 billion. Russia, the Western it identifies participants and looks at their marketers (mainly Ruhrgas), and the transit sharing of rents as a non-cooperative non-zero- countries received 43%, 47% and 10% sum game. respectively of the value of the gas delivered. Ukraine's and the then Czechoslovak's shares Section II below briefly describes the amounted to $100 and $730 million respectively. structure of the market as it is emerging post the For foreign exchange strapped Russia and transit collapse of the FSU. Section m then delineates countries, gas exports are a critical source of the interdependence and interactions in the East- revenue. They are also essential for the western West gas trade as a Stackelberg non-cooperative European countries that rely for 25% of their game with Russia as the leader, and discusses gas consumption on Russian sources. The stakes the equilibrium outcome of the game in general. are even much larger if one looks at the Section IV develops a numerical application potential expansion of that trade. Europe is assuming a social welfare function for the likely to increase its reliance on gas, notably western gas importer of the nested constant- because of environmental concerns, while Russia elasticity-of-substitution (CES) type, under could generate and deliver large additional transparent assumptions and conditions supplies1. prevailing around 1993. It analyzes how exogenous changes modiy the outcome, offermg Given the up front costs involved, to an miustration of the transparency and flexibiliy develop the East-West gas market and provide of the rules. Conclusions and policy participants with the associated benefits, stability implications follow. The detailed mathematical of contracts will be essential. That will require structure of the game and the calibration of the a perception of fairness on the part of all initial conditions are presented in the Annex. involved. as well as transparency and flexibility of the rules. Some of these features partially characterized gas trade while the Soviet Union existed. However the disintegration of the latter, the "velvet divorce" of the Czech and Slovak republics, and the transition to private market economies of the countries of central Europe and the former Soviet Union (FSU) have created new conditions and expressions of specific country interests that call into question previous arrangemnents. This paper develops a framework within which fair, i.e. incentive compatible, transparent 1 Grais & Zheng Strategic Interdependence in the East-West Gas Trade I. The Changing Structure of the East-West Gas Trade The gas pipelines transit system channels transiters, forming partnerships with distributors, Russian gas from Siberian fields northeast of and gaining new clients to strengthen demand3. Moscow trough Ukraine, Slovakia and the Finally western consumers, balancing costs and Czech Republic to Germany. Some gas transits security of supplies, arc considering alternative through Belarus, while Austria and Italy also sources ranging from Nortl African, Middle receive deliveries. Eastern to Norwegian gas. - Before the collapse of the Eastern Bloc, The terms of the East-West gas trade a stable market relationship existed between a have become more complex. More participants monopoly. supplier, Gazprom of the Soviet are now involved. Each has the potential for Union, and a monopsony buyer, Ruhrgas of disrupting supplies if it perceives unfairness and Germany. Gazprom sold the gas at an agreed possible additional gains. Incentive compatible, upon price at the western border of then transparent and flexible rules that can survive Czechoslovakia and paid fees to local gas transit are needed even more now than previously. companies in Belarus, Ukraine - and Czechoslovakia. Ruhrgas distributed the gas to industrial users and consumers in Germany. Since 1989 Czechoslovakia split from toe Eastern Bloc and then went through the "velvet divorce" between its two constituting components the Czech Republic and Slovakia. Meanwhile the dissolution of the Soviet Union allowed Belarus and Ukraine to emerge as independent states. Each of these new actors gained a monopolistic control on the portion of gas pipeline running through its territory. These historical events put into question the stable monopolist-monopsonist relationship that existed previously. The transit countries, also dependent on Russia for their energy resources, sought to improve their situation by claiming a higher fee for the transit services they provide2. Meanwhile Gazprom is developing a new commercial and development strategy to maintain its dominant role in the transit system and the benefits associated with it. This strategy could-include pursuing equity participation in the transit companies of other countries to exert some control on them, promoting construction of new pipeline routes to break the monopolies of 2 - Grais & Mheng Strategic Interdependence in the East-West Gas Trade Ill. A Game Theoretical Approach to the East-West Gas Trade The following describes the East-West concerns of transit countries is the transit fee, gas trade as a three-player, non-cocperative denoted by T in local currency, to be charged. repeatable game with information asymmetry Finally the importer's essential decision is the and behavioral coordination. The economic anount G of gas to buy from Russia. Assuming rationale for these assumptions are discussed eR and eD to be the exchange rates between the below and lead into the forumlation of a set of Russian ruble and the transiter's local currency relationships whose solutions are the transit fee, and between the latter and the importer's the price of gas charged by Russia, and the currency respectively, the three identified amount of demand for gas by the importer. decision variables are linked in the following way A. Players eDPG-T+CRPR (1) The current East-West gas trade can be modeled as a game among three players: a where P0 is the gas price the importer would supplier (Russia), a transiter (Belarus, Ukraine, pay in local currency, and this price wo:ld Slovakia and the Czech Republic) and a directy affect the demand G. Alternatively the consumer (Western Europe). This grouping of foregoing relationship entails: participants reflects the common characteristics of interests within each group and captures the PC = P t PR, T, e, eR), (2) essential interdependence within the gas trade chain4. reflecting the direct dependence of the local price paid by the Western importer on the In a longer time perspective, more Russian supply price, PR, the transit fee, T, and participants are likely to be involved in this the relevant exchange rates. It Is not difficult to trade. Turkmenistan and Kazkhstan, Norway, verify tht5 PG will rise if Russia raises its Middle East or African countries may contribute export price, the transiter increases its transit to supplies in competition with Russia. Poland fee, or the importer's currency appreciates. is a major potential competitor to current transit countries. More Western European countries For simplicity, theforegoingformulation may want to have direct access to Russian gas. assumes that each of the three participants In addition increased private participation may concentrates on one major decision variable, or add new transit and distributor companies. alternatively each one has a one-dimensional These developments would increase the number strategy space. In fact, every player's strategy of participants in each of the three identified space can be multi-dimensional, and each is groups of players. Eventually a more likely to be able to influence a number factors. competitive market could emerge. Russia could decide inter alia on the price and volume of the gas supplied for the domestic B. Decision Variable of Each Player consumption of the transiter, the price and volume of oil deliveries, electricity exchanges One of Russia's major decisions is the and their tariffs, apart from the price to be price it would charge for the gas it exports, say charged to the final Western importer. Besides PR in rubles. Similarly one of the main the transit fee, thc adnsiter has discretion over 3 Grais & Zheng Strategic Interdependence in the East-West Gas Trade the amount of storage it can offer, and the level parameters A would include the perception of and quality of services it provides. Finally apart the reliability of supplies, among other factors from the volume of gas it imports from Russia, not specifically spelt out here. the importer would be deciding simultaneously on gas imports from other sources as well as on The transiter's pay-off is the profit it the use of alternative kinds of energy. The draws from the gas transit. lThis is defined multi-dimensionality of each player's choices is assuming that the transiter is aware of the unit very important in reality, and is a direction for gas transit cost S, the fixed pipeline cost Fl, the further research. price P, Russia charges, the behavior 'rule" of the Western importer (4), and the relationship C. The Players' Pay-off Functions (2) between prices and the transit fee. The Xy off function of the transiter is then: Each player's objective in the game is to choose its best strategy to maximize its payoff. l(PR 7) =(T-S)G[PG(PR, flJ-Fr (5) The Western imDorter's pay-off function is the welfare associated: with the volume of gas imported from Russia. Abstracting from For any given Russian supply price P., institutional complexities and from the details of the transiter selects the transit fee Tto maximize how gas contributes to welfare, one can assume its profit. The transiter is here a Stackelberg a utility function', depending on the quantity G, follower as its behavior is a reaction rule to the a vector of quantities of other goods consumed price signal set by Russia as the leader. The Z, including gas and energy imported from other maximization will lead the transiter to set the fee sources, and a vector of parameters A: at the point where the marginal revenue of an U=U(G A (3) increase in the transit fee is equal to the U = U ( G ,Z,A ) 3 marginal cost!. The outcome will be a transit fee T that depends on the Russian supply price, Based on the above utility finction, the P,, the unit transit cost S, the relevant exchange information on the prices charged for the various rates, and the market import demand for Russian goods, including P, the price index of the gas in western Europe: composite good Z, and the available total expenditure Y, the Western importer's demand T = T(Pr S, F7 eD, e, P, Y,A) (6) for Russian gas would result from utility maximization as The Russian gas supplier is assumed to G = G ( PG' P, YA) A (4) have full knowledge of the transiter's reaction function (6), of the Western importer's behavior (4) and of the relationship between the relevant Naturally utility maximization would prices (2). With C denoting the known unit cost result in a parallel demand equation for the for gas production and F. the fixed cost, the composite good Z.Under normal assumptions an Russian gas suRplier's ply-ff function is: increase in P6 would drive down G, and a decline in the price of energy from alternative sources, captured by a decrease of Pz, would shift the demand curve outward. TMe vector of 4 Grais & Zheng Strategic Interdependence in the East-West Gas Trade developments render Russia desperate for - I'(PR) a (PR - CW[EPc/Pa)] -FR,s (7) foreign exchange, its leadership role may come into question and the framework proposed here where the argument T in P.(.) has been replaced would need to be modified. by the expression in (6) reflecting the transiter's behavior. The gas supplier will select PR to The framework considered in the maximize its profit as presented in (7). The foregoing assumes an asymmetry in the price chosen will be the one at which the avail;bility of information to the players. In marginal revenue and cost of an increase in PA order to proceed with its decision-making on P, are equal, the marginal cost being the revenue the Russian supplier needs to have access to foregone ty the ensuing decline in demand. information on other players' decision The profit maximization will result in a price PR parameters (e.g., factors affecting demand in such as: European markets, Y, A, P,, i.e. the parameters entering the other players' decision rules). P.jPpjCgFRS,FpP4iY,ereA) (8) However the transiter needs ony to observe the determinasts of the Western importer's demand while the latter decides on the basis of only the price signal PG and information on his own D. Interactions between Players environment. The assumption on information asymmetry reflects the reluctance of Gazprom to Russia is assumed to have a leadership allow foreign equity participation in either gas role in the supply of gas to Western markets. It production or transit companies and its active is the largest supplier that can satisfy Western efforts to get involved in downstream activities. Europe's demand at an economic cost in the short to medium term. This position gives it an influential role in the determination of the price Before 1990, the transiters and the it can charge. The above framework captures suppliers formed a coalition. Then Russia's leadership role in the fact that the Czechoslovakia, Ukraine, Belarus and Russia critical decision that deternines the game shared information, production resources and outcome is the Russian gas supplier's revenues in cooperation. The configuration of determination of the price P. Once that the transit system that emerged after 1991 has decision is made, the other players in the chain not allowed the pursuit of previous cooperation will use their decision rule to react. The transiter and is making attempts at reviving difficult. and the Western importer will determine the This feature is captured in the non-cooperative transit fee T and the demand of gas G, nature of the game framework proposed in the respectively. The further assumption of above9. behavioral coordination is based on the presumption that no player is expected to Finally the decisions made can be challenge the leadership role of the Russian undone and adjusted in response to changes in supplier in the short to medium term (entailing the environment of each participant. There is that this hierarchical decision structure is likely always the possibility of recontracting within the to last for a while) and the players' acceptability same framework which gives the game its of the sequential nature of the decision-making repeatable feature. procedure in the chain. However, if 5 Grais & Zbeng Strategic Interdependence in the East-West Ga9 Trde E. A Summary Presentation of the Game The behaviors outlined in the foregoing lead to two sets of equations. The first is composed of three relations that together determine the core variables namely the supplier's price PR. the transit fee T and the importer's demand for gas G. These three equations (8), (6) and (4) respectively are gathered in the top panel of Table- 1, and followed by relation (2) that link the price faced by the importer to that charged by the supplier and to the transit fee. The second set of equations are presented in the lower panel of Tablel1. They permit the computation of the total rent accruing to both the transiter and the supplier and their respective shares, the profit of each of them, and the welfare index of the importer. This second set of variables can be derived once the three core ones are determined. The recursivity of the set of the three core equations in the top panel of Table I reflects the Stackeliberg leadership of the supplier. Equation (8) allows the supplier to determine his price on the basis of his information on costs, market conditions and the other players' reaction functions. Once the supplier sets a price PR,, then the transiter through equation (6) determines the transit fee T. Finally the importer can decide on the level of gas imports from Russia G. 6 GnUs & Zhcng St-tegic Inteidopendance in the Iast-Woet Gas Trde Table 1 The System of Equations of Strategic Interdependence among Players Supplier's Price PR PR P,(C, FR, S. F7, Pz, Y, en, eR A) Transit Fen T T m T(PR! S, Fp el,, ep Pz Y, A) Demand for Russian Gas G G = G(PG, Pz, Y, A) Importer's Price PC T + eRPR l 7 ~~~~~~~~~~~~~Z3 Z(P,;, Pz, Y, A) Demand for Other Goods Z Importer's Welfare Index U U = U(G, Z, A) Unit Rent R R = cDPG - S - eCC Russia's Profit -iR HR - ( C)G - FR Transiter's Profit [ Hr = (T-S)G - Fr T Revenue (OF TP + = RPE T-S Transiter's Unit Rent _T + eRPZ - S - e,C Share in Mr Total Profit _ 0 = eT _ 7 Grais & Zheng Strategic Interdependence in the East-West Gas Trade IV. Contract Modifications in Response to Exogenous Changes In the following, we analyze how the or the price behavior of competitors, and iii) game regains its equilibrium solution and the increased competition in the gas market. players change their strategy selections, in response to external shocks. These comparative An increase of the expenditure on gas statics analyses show that gas trade contracts (AY >0) relaxes the importer's budget with incentive compatibility as presented in our constraint, and thus contributes to the expansion game solutions possess sufficient flexibility to be of demand for gas from all sources, as a direct modified to reflect changes in the trade result of the income effect in welfare environment. Each player will act on its maxiuization (fables 3 and 4, collum 4). decision variable, that is the three core variables Strategic intractions in the competitive gas PR, T, and G. depending on the strategic market force the supplier and the transiter not to interactions specified in the game. The raise their supply price and transit fee, assumption on the behavior of the importer as respectively, in respond to a growing demand. reflected by the specification of the welfare Indeed any increase in the price of Russian gas function plays a critical role in determining the charged to the importer would induce alternative outcome of the game. Here we ass-me a nested suppliers to capture a larger share of the CES type welfare index'0, which provides a increased demand, compress Russia's market reasonable first approach while allowing for share, and limit the improvemen in pay-offs to ease of calibration. Table 2 presents the set of both the transiter and supplier below the one equations of the game with the assumption of a which could be obtained under a no-price-change CES welfare index, while Tables 3 and 4 strategy identify the signs of the partial derivatives and the elasticities of endogenous variables Consequendy, all three players benefit respectively in the neighborhood of the initial from the stronger purchasing power of the equilibriumw, as calibrated on 1992 figures (see importer and the enlarged volume of gas trade. Annex). We first consider changes in the Due to the homogeneity of degree one importer's environment and then in the assumption of the welfare function, a one transiter's and producer's- In each case, we percent increase in Y leads to a one percent look at modifications of the players' strategy expansion of gas demand G, and improves the choice, the payoffs, and the distribution of trade importer's welfare index by one percent. The gains. transiter's and supplier's pay-offs improve by more than one percent each, because of the A. Clanggs intleTImporter's Envir ent presence of fied costs in their pay-ffst. The importer's decision environment can Finally, it is noticeable that, though its be affected by: i) an increased expenditure on profit rises, the transiter's share in the total gas as can result from a general expansion of the profit becomes marginally lower, reflecting its western economy or inter-fuel substitution lower fixed costs. However, the rent and between oil and gas aue to stronger revenue share of the transiter do not change as environmental concerns; ii) a shift in the western they depend only on prices which remain demand schedule of Russian gas either due for unchanged when the importer's expenditure on example to a changed perception of its reliability gas increases. 8 Gris & Zheng Strategic Interdependence in the East-West Gas Tmade Table 2 Strategic Interdepundence with a Nested CES Welfare Function for the Inporter Supplier's Price pit S+eRPR 7PR)-S T(PR) +eRC 7 1EPR)+eRPR 71PR)+eRPE S. pplier's P-ice R PR C T(PR)+eRPRR OaVRPR + SI a TPR) - Transit ree T T-S = [a(T+e[r RP)I I eRPR + S -1 Demand for G -G= D [ (T+eRPpl \ Russian Gas G T+e= (1, e13P0 mporer's Price PC. eD (T P e4tPR) Damand for 'Oter' Gas 0 O -F(Y-PGG) Importers U U=.CE5[G,O,a,o.=(a G 0+(I-a)O Welfare Index [ Unit Rent R R = eDPG - S - eRC Russia's Profit if' = (PR - C)G FR Transiter's Profit _fr I = (T-S)G - FT T Revenue ~~~~~~T+ eRPR Sham of R "3R T+ eP- S -eRC Transiter - FH+ eRlIt 9 Grais & Zheng Strategic Interdependence in the East-West Gas Trade An outward shift in the demand schedule 4, col. 5.). The increase in a will result in the for Russian gas can result, for instance, from a perception by both the supplier and the transiter perception of increased supply reliability, which of a weakening of their negotiation power and leads to an exogenous increase in Russia's lead to a reduction of the supply price P, and market share (Ao>O) (Tables 3 and 4, col. 6), the transit fee T, to attain their maximal profits. or from a rising price of competitors (AP0>O) The importer now faces a lower price P. and (Tables 3 and 4, col. 7). These developments demands more Russian gas. Gas from other will reduce, relatively, the competitiveness of sources is crowded out, but not as much as the non-Russian gas suppliers, and strengthen the incremental Russian gas supply. negotiating power of the transiter and supplier. Therefore, they are provided with some leeway One of the most important messages here to increase their fee and price respectively, while is that stronger market competition benefits all continuing to benefit from a larger volume of agents in the market. The overall East-West gas trade. The importer has to rely more on the gas trade expands. The average import cost from Russia. For a given expenditure on gas declines. All three players harvest larger pay- imports, demand for gas from other sources is offs. The importer consumes more gas thanks compressed to the extent more than the increased to that competition beats down prices. The demand for Russian gas (i.e. &O+AG<0). The transiter's and supplier's profits also improve, average import cost is raised. Accordingly, the because the expansion in gas trade (+ 1.32) is total consumption of gas declines. relatively more important than the decline in the unit rent (-.63). As a result, Russia's and the transiter's pay-offs are improved, while the welfare index Nevertheless, the transiter's bargaining of the importer is worsened. Naurally the power shrinks more than that of the supplier, revenue, rent and profits of the supplier and when the western European gas market becomes transiter expand. more competitive, due mainly to its position in this chain game as a Stackelberg follower. The distribution pattern of the trade gain Hence, its shares in revenues, rents and profits changes mainly in response to the variations of deteriorate, leaving relatively more to the the revenue-cost ratios. Because the percentage supplier. The larger decline in the transit fee (- increase in transit fee is larger than that in the .66) than in the supplier's price (-0.1) drives supplier's price, the transiter's share in revenue down the transiter's share in revenues. improves. However, both the supplier's variable Similarly, the transiter gets a smaller share in and fixed costs are larger than those of the thetotalrent(downby-.25)andthetotalprofit transiter. Therefore, the unit rent and profit of (down by -.32). the supplier expand more than those of the transiter, whose shares in them deteriorate slightly. The gas market in Western Europe may become mnore competitive. One reason, among others, can be a rise in the scope of substitutability for the importer between gas from alternative sources (Aor>0) (rables 3 and 10 Table 3 Directions of Variations of Endogenous Variables with Respect to Fluctuations of Exogenous Variables (In the Neighborhood of the Initial Equilibrium Outcome) Exchange Rates Endogenous Variables Importer's Parameters in Transiter's Gas Transit Gas Supply and Parameters _ _ _ Currency Cost Cost Expendi- Substitu- Russia' Price of DM Rbl Unit Fixed Unit Fixed Variables ture on tion Market "Other" (eD) (eR) (S) (FT) (C) (FR) Variables ~~~~~~Foreign Gas Elasticity Share Gas l ~ ~ ~ ~ ~~Y o p ____ Supplier's Price PR 0 + + + - _ 0 + 0 Transit Fee T 0 + + + = + 0 = 0 Demand for Russian Gas G I + + + + 0 - 0 Importer's Price PG 0 + + + + 0 + 0 Demand for "Other" Gas 0 I - _ + + 0 + 0 Importer's Welfare Index U I + _ + _0 0 Unit Rent R 0 + ± + _ 0 0 Russia's Profit nf - + + + + + 0 Transiter's Profit flT+ + + + + - . O Revenue xp 0 + + + + 0 0 Transiter's-- - - :TSahnare eirnS Unit Rent z 0 + + 0 + 0 Total Profilt u I - + + . + + Grais & Zheng Strategic Interdependence in the East-West Gas Trade B. Changes In the Environment of the significantly less than the increase in the unit Transiter and SuoDlier rent measured in the transiter's local currency (by 1.41). In the determination of their strategic moves, the transiter and supplier are affected by The depreciation of the transiter's changes in their costs. The current framework currency vis a vis that of the supplier reduces allows us to analyze the effects of the following the competitiveness of Russian gas on Western elements of costs: i) depreciations in the markets and worsens the pay-offs of the three exchange rates of the transiter vis a vis both the players. Assuming the transiter buys the gas at importer's and supplier's currencies; ii) changes the Rassian border and resells it at its Western in the variable and fixed costs of both the border, the cost of the main input has increased, traniiter and the supplier. putting upward pressure on the price to the Western importer. Were the one percent The depreciations" of the transiter's depreciation to be passed through to the currency vis a vis that of the western importer importer, the price P0 would also increase by as and the supplier have opposite effects. In the much. That would entail a significant switch first case, the depreciation increases the away from Russian gas and loss of welfare. The competitiveness of the cransiter's activity and supplier and transiter contain that effect by improves the pay-offs of all participants. A one reducing both the transit fee and the supply percent devaluation reduces by half a percentage pnce, limiting the final increase in the importer point the price paid by the importer in local price to less than half a percentage point, and currency. Had there not been a strategic the loss of market share. The average import response by the supplier and transiter to increase cost increases, while the importer consumes less their charges, the importer would have faced a foreign gas. price lower by also a one percentage point. But the devaluation provides leeway for both the With a larger marginal profit, Russia is transiter and supplier to raise their charges while affected more negatively than the transiter by a still leaving the Russian gas more competitive on shrinking of the trade volume. Hence, the the importer's market As a result of the lower Russia's profit declines (by -5.15) more than price Raid and the ensuing expansion of denand, that of the transiter (by 3.00), resulting in a the importer's welfare improves. The expansion relative improvement for the transiter's share in of demand, together with the larger transit fee the total profit. Meanwhile, the transit fee is and supplier's price, contributes to the improved pressed less (by -0.09) than the unit share (by - pay-offs of both. The relative position of the 0.36), leading the transiter gains a larger share transiter- improves in terms of revenue in the unit rent, though its marginal transit profit collection, since the transit fee rises (by 0-86) shrinks. However, since the transiter's currency more than the Russian supply price (by 0.40). becomes less valuable against that of the However, its shares in the total profit declines, suppliers, its share in the total sales revenue mainly because Russia enlarges its profit (by declines. 5.71) more than the transiter (by 4.48), taking advantage of its larger marginal profit and bigger fixed cost. Similarly, the transiter's share in the unit rent also deteriorates, becaue the increase in the transit fee (by 0.86 is 12 Gmis & Zheng Strategic Interdependence in the East-West Gas Trade An increase in the variable cost of ffie contained by the supplier's price behavior. The supolier or the transiter also reduces the importer still pays a higher price however, competitiveness of Russian gas on Western switches away from Russian gas and sees a markets and worsens the pay-offs of all three deterioration in welfare. Both the supplier and players. transiter have also reduced pay-offs. The transiter's share in revenue improves as the An increase in the supplier's variable transit fee increases while the supplier's price cost affects negatively the pay-offs of all three declines. The gains in rent and profits share are players but improves the position of the transiter minor also. relatively to that of the supplier. The rise in the variable cost of the supplier reduces its rent and The supplier and the transiter absorb throws itself off the profit maximization increases in their own fixed costs and experience equilibrium. In seeking a new one, the supplier a deterioration in their own profits. Their raises the price to the point where the marginal respective shares in aggregate profits respond revenue is equal to the marginal cost correspondingly. A variation in fixed costs does incorporating into this decision, because of its not affect marginal revenue or cost at the leadership position, the expected reactions of the prevailing prices; it does not lead hence to a importer and the transiter. The importer reduces modification of the volume of trade and demand in response to the price increase and consequently of the existing equilibrium in hence the transiter's marginal revenue. In strategy selections. response the transiter reduces its transit fee. A one percent increase in the supplier's variable cost leads to a contraction of gas demand by more than 2-5 percent and an increase in the importer's price by almost half a percentage point. The latter's welfare index deteriorates. The supplier's pay-off contracts by almost 4 percent in spite of the marginal gain of slightly more than half a percentage point in the price charged. The contraction of the volume of gas traded pulls down also the transiter's profit by 3 percent, almost a percentage point less than that of the supplier. As a result of a rising supplier's price and a failing transit fee, the transiter's share in the total revenue declines. However, its share in the unit rent and the total profit improve. A one percent increase in the unit transit cost will lead to an increase in the transit fee by about a quarter of one percentage point to the point where the marginal revenue is again set to be equal to the marginal cost. The ensuing upward pressure on the importer's price is 13 Table 4 SENSITIVITY ANALYSIS IN TIlE EQUILIBRIUM NElGIIBORIIOOD Witlh a Nested CES Welfare Function for the Imiporter Exchange Rates Importer's Parameters in Transiter's Gas Transil Gas Supply Cost Elasticities of the Endogenous . Currency Cost Variables with respect to Initial I% change in Values Expendi- Substilu- Russia's Price of the Exogenous Variables ture on lion Mfarket "Other" DhI Rbl Unit Fixed Unit Fixcd Foreign Elasticity Share Gas (en) (er) (S) (FT) (C) (FR) ._______________________ ._________ G as (Y) (°) (a) (PO) Benchmark Value $20.6 bn 7.25 25.0% $86/tcm 1.0 1.0 $5/tcm S100n $SSO/lcm S2OOm m - _. - Supplier's Price Pft $65.9/tem 0.00 .0.10 +0,08 +0.40 +0.40 -0.38 -0.01 0.00 +0.62 0.00 Transit Fee T $20.1 /tem 0.00 -0.66 +0.18 +0.86 +0.86 -0.09 +0.24 0.00 -.09 0.00 Demand for Russian Gas G 60 bcm +1.00 + 1.32 +0.39 +1.79 +2.81 -2.55 -0.26 0.00 -2.55 0.00 Importer's Price P. $86.0/tcrn 0.00 -0.23 +0.11 +0.51 -0.49 +0.45 +0.05 0.00 +0.45 0.00 Demand for 'Other' Gas 0 180 bcm +1.00 -0.36 -0.16 -1.75 -0.77 +0.70 +0.07 0.00 +0.70 0.00 Importer's Welfare Index U 100.0 +1.00 +0.06 -0.03 -0.87 +0.12 -0.11 -0.01 0.00 -0.11 0.00 Unit Rent R $3 1.0/tem 0.00 -0.63 +0.30 +1.41 +1.41 -0.36 -0.04 0.00 -0.36 0.00 Russia's Profit lilt + 1.27 +1.15 +0.93 +4.40 +5,71 -5.15 -0.40 * 0.00 -3.93 -0.27 Transiter's Profit IT + 1.12 +0.48 +0.71 +3.33 +4.48 -3.00 -0.30 -0.12 -3.00 0.00 Revenue w . 23.4% 0.00 -0.43 +0.08 +0.35 +0.35 -0.54 +0.19 0.00 -0.54 0.00 Transiter'. Share in Unit Rent wit 0.00 -0.25 -0.05 -0.26 -0.26 +0.23 +0.02 0.00 +0.23 0.00 Total Profit wll. 0.07 -0.32 -0.11 -0.50 4-.56 + 1.08 +0.05 -0.06 +0.47 +0.13 Grais & Zheng Strategic Interdependence in the East-West Gas Trade V. Conclusions The current and potential benefits of would face rising costs of gas imports and loose the East West gas trade are enormous for all wclfare. participants. The realization of these benefits require significant upfront investments. The An increase in the scope of substitution new, and more complex, structure of the gas for the importer between gas from alternative transit system that has emerged following the sources improves on welfare of all three players. changes in Eastern Europe and the Former The perception oni the part of the supplier and Soviet Union has created uncertainties however transiter of an enhanced threat of competition that bear on the expected benefits of the leads to a preemptive move to not loose market investments. This paper argues for the existence share. The transiter and supplier reduce the of stable contracts that would create an transit fee and supply price respectively allowing environment more conducive to the investnents the importer to face a lower gas price. The and allow all participants to benefit from the latter's import demand expands and welfare expansion of the gas trade. A framework based improve. The expanded trade more than on a Stackelberg game with three players (a compensates for the reduction in the transit fee supplier, a transiter and an importer) under and supply price and allows for larger pay-offs Russia's leadership is proposed as a guide to the for the transiter and supplier. formulation of incentive compatible, transparent and flexible contracts. The framework is used The perception of increased reliability of to analyze the contract modifications that would supplies of gas from Russia shifts outward the ensue from changes in the enviroment bearing demand for gas from Russia and leads to the on the gas trade. Three main conclusions can be expansion of trade. The supplier and transiter drawn. have scope to raise their respective charges with expanded volumes improving their pay-offs. An increased competitiveless of the The importer's welfare deteriorates as the cost of transiter and supplier through cost reductions importing gas rises. would improve the pay-offs of all players in the game. The transiter's and supplier's profits as The predictability of the players' well as the western importer's welfare would reactions to changes in the environment would improve. Basically it would induce a strategic build confidence in the reliability of gas trade behavior on the part of the supplier and transiter and allow its expansion benefitfing all that would lead to a decline in the price faced by participants. The game proposed in the paper the importer, enlarging gas demand and reducing provides a framework for analyzing the strategic costs. If the increased competitiveness is the moves of the players and gaining insights on outcome of more costly gas from other sources their predictability. than Russia, both the supplier's and transiter's pay-offs would improve but the importer's welfare would deteriorate. The supplier and transiter would have leeway to strategically raise their price and transit fee respectively while gaining market share. The importer however 15 Gmis & 2heng Strategic Interdependence in the East-West Gas Tmde Rderence Alt, James E. and Barry Eichengreen, 1989, Parallel and Overlapping Games: Theory and an Application to the European Gas Trade, Economics and Politics 1(2): 119-44 Arthur, D.L., 1992, Prospects for Russian Gas Sales to Europe, Banks, Ferdinand E., 1983, European Reliance on Soviet Gas Exports, Energy Journal 4(3): 95-96 Boucher, Jacqueline and Smeers, Yves, 1985, Gas Trade in the European Community during the 1970s, Energy Economics 7(2):102-16 Gray, Dale, 1993, Changing Structure of East-West Gas Trade and the Role of the Gas Transit Countries, The World Bank Report Greer, B. 1. and Russell, Jeremy L., 1982, European Reliance on Soviet Gas Exports: The Yamburg-Urengoi Natural Gas Project, Energy Journal; 3(3): 15-37 Hufbauer, Gary Clyde and Schott, Jeffrey J., 1985, The Soviet-European GaM Pipeline: A Case of Failed Sanction, in Moran, Theodore H., ed. Multinational Corporations: The Political Economy of Foreign Direct Investment Lexington, Mass., and Tomnto: Heath, Lexington, pages 21945 Jeoland, AlP. and S.M. Shugan, 1983, Managing Channel Profits, Marketing Science 2:239-272 Julius, DeAnne and Mashayekhi, Afsaneh, 1990, The Economics of Natural Gas: Pricing, Planning and Policy, Oxford University Press Kaser. Michael, 1986. Soviet Gas Supplies, in Stevens, Paul, ed. International Gas: Price, Prospects and Trends. New York: St. Martin's Press, pages 71-88 Martin, R. and S. van Wijnbergen, 1988, Efficient Pricing of Natural Gas: A Case Study of Egypt, Journal of Public Economics, 36:177-196 Price, Robert S., 1986, Govermment Policy and International Natural Gas Trade, Journal of Energy and Development 11(2): 189-211 SternL. and A 1. El-Ansary, 1988, Marketing Channels, New Jersey: Prentice-Hall Wirl, Franz, 1991, hnpact of the Political and Econonic Restrucuring in Eastern Europe on the Availability of Net Energy - An Empirical Framework, Economics of Planning 24(3): 181-202 16 Gfais & Zheng Strategic Intcrdependence in the East-West Gas Trade Notes: 1. An additional amount of about 30 bcm could be supplied with limited investments in the order of $325 million. Expansion of supplies by additional 60 bcm could be made with further investments at still a reasonable rate of retum. Beyond these amounts transport costs rise significandy. Moreover, energy efficiency improvement in Russia through structural adjustment and appropriate energy pricing policies can also be expected to contribute to energy conservation in the domiestic market and thus generate additional exportable gas. 2. In addition each transit country has its own privatization and coxporatization objectives that bear on the fate of the companies managing the transit services and the commercial policies these would follow. 3- All of these policies seem to be pursued by Gazprom. For instance, in the fall of 1990 Gazprom joined Wintershall/BASF in a new partnership. 4. Considering individual countries as idependent players can be done at some cost but would not add insights. 5. From (1) we have aP 0 e a=-o, - = c0e afa eD aT eD OtR 6D ijDn -C 6. In fact one would take the utility funcdon of a epresentative consumer and the size of the populaton. Here we abstract from that to simplify the presentation without loss of generality. 7. The first order condition for the transit revenue ma on can be written as MxR'= & =CT- S)(- a)_ MCT 8. The first order condition for Russia's gas exports can be wrten as AMRR = GG = +RC(aG aT PR C) aGYa -a; -= MC"I 9. Cooperation here is understood in the game theory terminology, i.e. sharing of information, of resources and pay-offs. Players would cooperate if they ex ante agree 17 Griis & Zheng Strategic Interdependence in the East-West GJas Trade to share. The recent joint venture between Gazprom and BASF/Wintershall is a cooperative feature, however it does not necessarily allow the latter to have full access to the information environment of Gazprom. 10. The annex specifies the welfare index and derives the demand equation. The CES form incorporates the assumption of strong separability between the demand for gas from alternative sources and the demand of other commodities. The elasticity of substitution between the sources of gas is independent of relative price changes of other goods. 11. One can calculate, in the reighborhood of the initial equilibrium, possible outcomes of the game generated from different price reactions from the supplier and the transiter. For instance, when Y increases by one percent, a one percent increase in the price of Russian gas would lead to about 5 % loss in the sales volume and about 3 % loss in the sales revenue, instead of any financial gains from the price hike. 12. Basically profits are not homogeneous of degree one with respect to demand, or alternatively the marginal profit is larger han the average. More specifically, one can derive that AHR/ Pj-C R > 1 anld IHR <. T-S > AGIG P-C-FR AGIG Fr G for FR > 0, and FT> 0. I3. -No benefits from arbitrage are assumed here as the model is calibrated in US dollars, to be coherent with our classification of players into groups. The exchange rate parity holds here, e.g., DMI$ = (K/$)/(KIDM). 18 Annex: Model Derivation and Calibration This annex specifies the hierarchical goods and services consumed, in order to Stackelberg game as established in the main text capture both income and substitution effects due of the paper. An equilibrium is attained when to the price fluctuations and other extemal no player has any incentive to furither its own perturbations. We derive the gas demand interest by unilaterally changing its strategy function, which serves as the importer's strategy selection, given other players' behavioral selection rule in response to other players' choices. The equilibrium outcome of the game strategy choices, and calculate the (indirect) is characterized by individual rationale in terms social welfare index at the equilibrium that each player has maximized its own payoff in neighborhood. For presentational simplicity, an environment of strategic interdependence, and we concentrate on the sub-branch containing by collective coherence in terms that each player only the imported gas from two different foreign views the equilibrium outcome as acceptable and sources, Russia and the other area. The better than any results otherwise. assumption on an MLN-CES utility finction helps conceptalize complementariness and The mathematical structure of the game substitution linkages between energy is presented here in three steps. First, the consumption and consumption of other goods at players' decision problems are analyzed first, and then inter-thel substitutions within the sequentially. This interactive optimization energy bundle. The important point here is tat procedure guarantees the Pareto optimality of the price changes of non-foreign gas are translated equilibrium outcome of the game. Second, the across the branches in the utility tree into an behavioral consistency of strategy choices is income change for decisions on gas importing. checked to attain the Stackelberg equilibrium Hence, the expenditure on importing foreign gas solution of this hierarchical game. Six can rise not only when the overall national endogenous variables, - the gas supply price, income increases, but also the relative prices the transit fee, and the import volume in fIt move in directions favorable to consumption of strategy bundle, and the gas supply profit, the imported gas. Meanwhile, a rise in foreign gas gas transit profit, and the resultant social welfare prices will induce reallocation of money for level of the importing country in thLe ff increasing consumption of other goods, and will bundle, - are explicitly linked to exogenous reshape the market shares of gas imported from variables, including the importer's aggregate different sources. Specifically, we assume expenditure on gas, availability and substitutability of altenative gas supplies in the importer's market, the gas production cost, the U = CES(G, 0 a, a] gas transit cost, and the prevailing exchange t 1 ! . (1) rates. Finally, parameters in the game are _ (s -i calibrated using relevant statistics best available. A. The Importeres Decision where U the utility level geneated from The importer maximizes its utility on consumption of foreign gas behalf of final gas consumers in the Western G consumption of Russian gas, European market, subject to its budget 0 a composite commodity, composed of constraint We choose a utility function with a gas from all other sources, structure of multi-level nested constnt a Russia's share at the bencha case, elasticities of substitutions (MLN-CES) bdween a subsdtution elasticity between G and 0. i Oaiis and Zheng Strategic Interdependence in the East-West Gas Trade Given prices Pfor G and PO for 0, the following budget constraint applies, GY =1 (7) PoG + POOCY ('2) The price elasticity of demand is where Y is the total income allocated for gas consumption. Maximizing the utility in (1) P0mG subject to the constraint in (2) leads to the =, GP( following expenditure function 1 (3)P/J (uy tPG E(PG,P- u)[pl-s+(l }Pl-vl" r ( X\ I Po) Y and the indirect utility function This is the Slutsky equation, in which (,4) the first term on the right hand side represents (4) 1 \}income effect and the second term represents the V(PcsPc,Y) = [Pc +(j-M)Po ] Y substitution effect due own price changes. As expected, a larger or or a will generate a larger Fubstitution effect in gas demand. The demand function for Russian gas is then r I- rC (P l r 5)3 - -B. The Transites Decision G(P0P0pY)= a (P | Thetransiter maximizes its transkprofit a } G wbychoosing a unit transit fee, T, for each given supply price set by the gas supplier and takng which exhibits homogeneity of degree one in into consideration market reactions from the prices and income. The share of expenditure on importer's side. Namely, Russian gas is Mar U IL = (T-S)G - FT (9) P0G |j~ + (1 (.l PG)] (6) °I where S is the unit transit cost, and FT is the fixed cost for the gas transit systemn. For any Hence, if the competition in the German given Russian gas supply price, P., the unit market of foreign gas initially equalizes P0 and transit fee can be expressed as P., then ac will be the share for Russian gas. In the case o=-1, i.e., a Cobb-Douglas utility T = ceP0 -RPR (AD) function for the gas importer, the market share will not change with the reladve price and thus where eD and eR are exchange rates of the remain constant, though the demand quantity transiter's local currency against that of the will decline when its own price rises. The importer and supplier, respectively. The first income elasticity of demand is order condition for the profit maximizaon is .. Grals and Zhong Sstrgic nrdependnce in the Emt-Wast Ou Tmde profit-marginal cost ratio; and (c) the transiter's -( _T-S-- i;a (I1) current profitabflity reflected from the pric-cost aP0 8ar ratio. If thi transiter foresees that a big decline in gas demand may occur due to a price rise, It The transiter equalizes the marginal may be willing to reduce its transit fee to rotain revenue and the marginal cost of raising its the quantity at the level which maximizes its transit fee. When the supply price is fixed, a transit profit. higher transit fee is passed through to a higher import price, which depresses the demand for gas. Ihis first order condition can be C. The Supplier's Decision rearranged into Knowing how both the importer and the - T-S T(dOG p0v ai'o T 1' transiter adjust their strategies, the gas supplier -r G p0lJ (12) as the Stackelberg leader detennines a supply apR a price, PR, to maximize its profit. That is This clearly states tiatthe mark-up ratio Max II - (P`x)G - Fx (15) of the transiter is determined as the inverse of p the product of the price elasticity of gas demand and the elasticity of the gas price with respect to where C is the unit production cost and F, is the the transit fee. The transiter's optimal reaction fixed supply cost. The first order condition is function is thus implicitly defined by: ap T S=ST a |_] - +1 alpx aT ap) e,P,+S ei[i-4 e4) where the reaction of T with respect to change The left hand is the transiter's ratio of of P1 is determined through the transiter's best marginal profit and marginal cost, an index of reaction fiuntion (10). This first order condition the transiter's negotiation power. The right can be rewritten as hand side is the market condition in terms of relative prices, expenditure shares and the aG dPG dP T adjustments with respect to changes in the PR-C. Pc; supply price can be thus derived as P5 aP0 aP1 AT aPx OT eRfT+e,P5T+eP, 'Po p. P, aT = ex +eRP+t + PR 1 (14) aPp a [ CeP1,+S T-S J Hence, the profit margin of the gas supplier is determined through both direct and Hence, whether the transiter follows the indirect effects of price changes. Raising the supplier's price movement depends crucially on supply price will not only push up direcdy the (a) the market reactions reflected from the final sales price in the importing country, but elasticity of substitution, (b) the transiter's also provoke the transiter tooptinally adjust its negotiation power reflected from the marginal transit fee setting. The decision rule is iii : I Grais and Zheng Stategic Interdependence in the East-West Gas Tmde imbedded in the following implicit function, and transiter's share in the total revenue. 1t + ar) B. Calibration of the Parameters e 7 1 1 +11 Eight parameters in the game model T+eRC (P,C)-p /-a o need to be determined to calibrate our bench op, mark case. = T - S (1) Expenditure on gas , Y: About 25% of etPe+S gas consumption in the Western Europe comes (18) from Russia, which was 60 b'lion cubic meters valued at $9 billion in 1992. Hence, the total Substituting the transiter's optimal gas consumption should be 240 billion cubic reaction into the above equation, we have meters. The suppliers and transiters in the East- West gas trade shared 57% of the total sales S+CePRt - S TTe C 1 = revenue, i.e. $5.16 billion in 1992. Assuming T+ e,PR PR-C T+exP,t eA that gas from other sources are equally costly, (19) we get Y = $20.52 billion. -T+e PR T+exPR a ejtPtPR+S T-S (2) Price of Gas from Other Sources, PO: The gas from Russia was priced on the German board at $86 per thousand cubic meters in 1992 D. The Stackewberg Equilibrium Solution ($5.16 billionl60 bcm). We take this as a price proxy for gas from other sources. Hence, PO-= An equilibrium in this game can be $861tcm. This leads to et = 25. defined as a strategy profile (PR' , Gs), where the superscript S indicates a Stackelberg (3) The fixed gas transit cost F7 and the solution-, which satisfies the following fixed gas supply cost FR do not affect players' sequential optimization procedure: decisions. However, they affect the distribution of the total profit. Our best rough estimates for (1) IR (PSR, v, GS) : I' (TR, r, ) and theseanmulizedfixedcostsareFT =$100 million P1, > C, for (1', G) as determined in and F, =$200 million, respectively. (li) and (M); (il) For any given PR. , EuP,, Ti, G0) > (4) The variable gas transit cost S is IW(P,,, T, GS) and V6>S, for Ge as estimated to be $5. 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