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Energy: The Transition from Depletable to Renewable Resources
• Discuss the history of natural gas price regulation and illustrate the effect of price ceilings on the market for natural gas. • Discuss how OPEC colludes to gain market power and acts as a monopolist. • Show how inelasticity of demand for oil leads to large gains for the cartel. • Teach the concept of income elasticity of demand and the its potential effect on cartel pricing power.
• Show how the competitive fringe can impact prices. • Discuss national security concerns introducing concepts such as the vulnerability premium, domestic versus foreign supply and options for reducing dependence on imports. • Discuss the environmental impacts of using transition fuels such as coal and uranium. • Discuss the use of nuclear power and regulation. • Discuss utility pricing • Discuss long run alternative energy sources.
oil and natural gas would be used until the marginal cost of further use exceeded the MC of substitute resources (either more abundant depletable resources like coal. life would cease. without it.Introduction • Energy is one of our most critical resources. most industrialized countries depend on oil and natural gas for most of their energy needs (depletable & nonrecyclable) • According to depletable resource models. • Currently. or renewable resources like solar energy) • In an efficient market path-transition should be smooth • Have the allocations in the past been efficient? .
Introduction • Current energy crisis shows that the allocations have not been efficient • This chapter examines some of the issues associated with the efficient allocation of energy resources and shows how economic analysis can be used in policy making. .
occurred in 1974–1975.Natural Gas: Price Controls • A natural gas shortage of 2 trillion cubic feet. • Under efficient allocation. led to exploration of natural gas along with crude oil . • Source of problem: government controls over natural gas prices • Rise of automobile rise in demand for gasoline. or 10 percent of the marketed production. shortages of this magnitude would never happen.
• In Phillips Petroleum Co. v.. • Hastily conceived initial price ceilings remained in effect for a almost a decade . – The Federal Power Commission (FPC) was charged with maintaining “just” prices.• In 1938 the Natural Gas Act was passed. – Price controls were imposed on natural gas shipped across state lines. Wisconsin (1954). the Supreme Court forced the FPC to extend its price control regulations to the producers.
• On the supply side. producers who expect price ceilings to be lifted have incentives to slow production and wait for higher prices. causing shortages. • Combined D-S effects would distort allocation significantly . thus exacerbating existing shortages.• Price ceilings were imposed which prevented prices from reaching their normal levels: – overconsumption of natural gas. – causing more of the resource to be used in earlier years and with a sudden jump in price.
with prices suddenly jumping to new higher levels • Discontinuous jump to a new technology .• Two important aspects of the inefficient outcome: – The time of transition is earlier under price controls • Will not be using all of the gas available at prices consumers will be willing to pay – The transition is abrupt.
affects prices in the early year .(a) Increasing Marginal Extraction Cost with Substitute Resource in the Presence of Price Controls: Quantity Profile. (b) Increasing Marginal Extraction Cost with Substitute Resource in the Presence of Price Controls: Price Profile Affect behavior even if price controls are not binding Price ceiling causes a reallocation of resources toward the present. in turn. which.
• Looked at the effect of permanent price controls. may not be permanent • Prices suddenly rise when the ceiling is lifted. producers have an incentive to stop production and wait for the higher prices .
caused by government interference and not market behavior • This inefficient policy was pursued based on rent-seeking behavior.1) • Beyond the limits concerns may be valid here.• Natural gas allocations not only hastened the transition to a substitute resource. also caused a transition to inefficient substitute (substitution bias-example 7. .
The Effect of Price Controls Price ceiling would reduce MUC because higher future prices would no longer be possible Future consumers are made worse off-loss in CS of future consumers Reducing scarcity rent means over allocation to current consumers =Perceived supply Area D only covers current profits without considering scarcity rent Current production increases due to lower perceived supply .
unfair: the losses to future consumers and producers are greater than the gains to current consumers. harms consumers • Scarcity rent plays an important role in allocation process. a transfer from future consumers to present consumers • Price controls are politically attractive: current votes • Inefficient. distort allocation toward present • Over lung run. MUC falls. attempts to eliminate it can create more problems . – Result is overallocation to current consumers and an underallocation to future consumers – Transfer from producers to consumers.• Scarcity rent is an opportunity cost that serves a distinct purpose: the protection of future consumers • Through price controls.
Oil: The Cartel Problem • Second source of misallocation: The member countries of the international cartel called the Organization of Petroleum Exporting Countries (OPEC) collude in order to gain monopoly power. • Exercise control over price by restricting output • A monopolist can extract more scarcity rent from depletable resources as compared to competitive firms-slower production and higher prices • Transition to a substitute occurs _____ (later) .
Oil: The Cartel Problem • Effective cartelization needs to consider: – Price elasticity of demand for OPEC oil – Income elasticity of demand for oil – Competitiveness from non-OPEC producers – Compatibility among OPEC member countries .
• Oil and oil products are price inelastic.Price inelasticity of demand for oil in both the long run and the short run • PED depends on the opportunities for conservation as well as the availability of substitutes • The lower the price elasticity of demand (in absolute value). • Price elasticity of demand depends in part on the availability of substitutes (set an upper limit on the cartel price. the larger the potential gains from cartelization. price elasticity of demand is usually larger. . – Substitutes for oil are expensive and transition times are long – Solar energy sets a long-run upper limit on the ability of OPEC to raise prices.) Thus in the long run.
• The higher the income elasticity of demand. as income grows. . oil demand should grow. – Recessions can thus weaken OPEC and expansions are beneficial to the cartel. the more sensitive demand is to the business cycle.High income elasticity of demand • How sensitive oil demand is to growth in the world economy • At constant prices.
• Pressure on the cartel was evident in the mid-1980s when production was down and prices fell. Force competitive fringe to produce more in the earlier periods . • OPEC currently produces approximately two-thirds of the world’s oil. • OPEC must take non-OPEC members into account when setting prices.Non-OPEC Suppliers • A cartel will have more market power if it can prevent new suppliers from entering the market and undercutting the price. OPEC would set the initial price somewhat lower than the pure monopoly price and allow price to rise more rapidly. • Salant (1976) model of monopoly pricing in the presence of a “competitive fringe.” • With a competitive fringe.
Compatibility of Member Interest • Individual cartel members have incentives to cheat on production agreements. (and detection of cheating) . With higher price elasticity. lowering price maximizes profit. • Enforcing the collusive agreement is essential for the success of the cartel. • Price elasticity of demand facing each individual member is higher than for the cartel.
The World’s Largest Oil Reserves .
.Fossil Fuels: National Security and Climate Considerations Climate Dimension • Carbon dioxide is a contributor to climate change. • Climate considerations affect energy policy: – Level of energy consumption mix matters – The mix of energy sources matters • Market-based energy choices imposes externality to energy users.
2 Carbon Content of Fuels .TABLE 7.
The market consumes too much oil and domestic production is too small.National Security Dimension • National security is a public good. . • Using the graph to show that the efficient allocation including national security costs is less than the market outcome. The market would generally result in an excessive dependence on imports. • The long run domestic supply curve of oil reflects increasing availability of domestic oil at higher prices.
The National Security Problem .
• To reduce the potential damage of an embargo. A tax on energy consumption is one tool that can be used to encourage conservation. has developed a stockpile called the strategic petroleum reserve. • A final option is the use of tariffs and quotas on imports. the U. • Domestic subsidies are another possible tool.S. . • Conservation can help decrease reliance on foreign imports.
Coal and Nuclear • Unconventional Oil Sources – Sources that are typically more difficult and expensive to extract – Concerns on their environmental impact • Using more energy to extract the resource • Emission of air pollutants .The Other Depletable Sources: Unconventional Oil.
mercury and carbon dioxide emissions • Current technological progress on carbon sequestration • Implementation of technologies calls for policy support .Coal • An abundant energy source • Air pollution: sulfur dioxide. particulate.
Uranium • Safety is the major concern. • The U. government established the Nuclear Regulatory Commission. • The U. government has underwritten liability since the passage of the Price-Anderson Act in 1957. – Price-Anderson Act reduces the expected cost of nuclear power to utilities.S. . – Sources of concern: nuclear accidents and storage of radioactive waste • The market will not make the correct choice for nuclear power.S.
• Peak-load pricing is a pricing structure where consumers using power during peak periods are charged higher rates during the peak periods . The resulting rate will be lower than the true marginal cost of power and thus is inefficient.Electricity • Average cost pricing entails averaging high cost sources with lower-cost sources.
The Efficient Level of Precaution .
• While new technologies emerge. the level of energy efficiency chosen by the market is low.Energy Efficiency • Improving energy efficiency reduces greenhouse gases emissions and dependence on foreign oil. .
Transitioning to Renewables • Hydroelectric Power – Clean energy source – Helpful with national security concerns – Having impact on ecosystem • Wind – Cost effective in favorable sites – Environmental effects have triggered debates • Photovoltaics – Direct conversion of solar energy into electricity – Attractive in developing countries .
• Active and Passive Solar Energy for heating – Input energy is costless while transformation and distribution requires capital investment. • Biomass Fuels – Have the potential to reduce greenhouse gases and imports on oil – Both the type of fuel produced and the type of biomass used to produce it matter. – Construction costs are high. . • Ocean Tidal Power – The plant has impact on coastal ecosystem.
– Using government subsidies has impact on promoting the renewable energy resources. the payback periods vary from 2-10 years.• Geothermal Energy – Derived from the earth’s heat – Initial cost is high. and the infrastructure is undeveloped. . • Hydrogen – Technologies of using hydrogen is expensive.