QUESTION

1) Assume that the cost of building a clean (environment-friendly) power

plant on a remote island where no other power source is available is 140
Euro per kW. The rate of discount is 10 percent and the power plant is
infinitely durable. For simplicity, we assume the year has 350 days rather
than 365, and that each day can be divided into three equally long
periods, each with constant demand for electricity that is the same all 350
days. One of these periods is the peak period, when (inverse) demand is
given by

P = 0.16 – 0.0008Q

and the other two are off-peak periods with (inverse) demand

P = 0.16 – 0.0016Q

where Q is the number of kW power consumption during the period and P

is the price for consuming 1 kW during one of the periods. (To be more
precise, assume that all users have constant demand for electricity during
the period. Then we can think of Q as the number of 8 kWh and P as the
price per 8 kWh.)

a. Assume that the installed capacity is 120 kW (and that it cannot be

changed). Find the socially optimal prices during the three periods.
Calculate the power company’s profit.

b. Assume instead that we can choose capacity freely. (There is no

preinstalled capacity.) What is the socially optimal capacity? Find
the corresponding optimal peak and off-peak prices. And what is the
profit?

c. Assume now that peak and off-peak demand is given by

P = 0.05 – 0.0008Q

and

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 P = 0.05 – 0.0016Q

respectively. Assume again that the installed capacity is 120 kW and

that new capacity cannot be added. Find the socially optimal prices
during the three periods. What is the profit?

d. Assume demand as given in c) but that capacity is again to be

freely chosen. Find the socially optimal capacity and the optimal
peak and off-peak prices. What is the profit?

HINT FOR THE QUESTION

Think of the situation as a regular demand curve and do not assume that
Q=1. Instead, in subquestion a), the quantity is fixed at 120, because that's
the capacity. The regulator's task is to set a price so that all available capacity
is used. (However, we may not want to bring price down below zero, so you
need to think what's optimal if that were to happen!) To be specific, there are
no marginal costs of production, since the plant is already built.

In b), the task is to find the socially optimal quantity. Now, first calculate
the marginal cost of adding one more kW capacity. The marginal cost is
constant and is the per-day interest cost corresponding to the investment per
kW. This is to be compared with the marginal benefit of additional capacity,
which in turn is determined as the sum of three marginal benefits. Remember
that each capacity unit can be used by three users: a peak user (an afternoon
user, say) and two off-peak users (one in the morning and one during the
night). At the social optimum, the marginal cost is equal to the total marginal
benefit.

In c and d, the above questions are repeated again, but since the demand
curves are different, the results will be different. They will not only be
quantitatively different, they will be qualitatively different in this case.

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