Theoretical and empirical analyses of the long-run evolution of energy markets rely on the concept of a backstop energy source: a hypothetical source of unlimited quantities of energy, available at a constant cost. In this paper we first develop a model which determines the socially optimal rate of investment in backstop capacity, and simultaneously, the optimal rates of production of depletable and backstop energy, under the assumption that the costs of creating backstop capacity increase with the rate of investment. Using this model, it is shown that it is optimal to expand backstop capacity before depletion of conventional energy and keep it idle while conventional energy is cheap.
In the second part of the paper we formulate and study a two-player Stackelberg game model describing the market interaction between the conventional energy cartel and a competitive backstop sector. In this game the cartel, which is the price leader, seeks a dynamic limit-pricing strategy against the backstop sector depicted as a follower possessing perfect foresight. Numerical examples show that the leader’s strategy consists of an initial phase of low production and high prices, followed by a phase where price equals operating cost and backstop capacity is idle.