Energy: The Transition from

Depletable to Renewable Resources

Lecture 6
(Chapter 7)

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Energy

Energy is one of our most critical resources

 Worldwide, oil and natural gas together supply 62% of all
energy consumed
 Coal remains the main source of energy in the most
developing and highly populated countries like China and
India
 According to depletable resource model, oil and natural gas would be used until
the marginal cost of further use exceeds the marginal cost of substitute
resources (renewable sources!)
 In an efficient market path, transition to these alternative sources
would be smooth and harmonious

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 Energy
Need to examine some of the major issues associated
with the allocation of energy resources over time
 Have the allocations of the last several decades been efficient or

not?
 Is the market mechanism flawed in its allocation of

depletable, nonrecyclable resources?

 If so, is the flaw fatal?

 If not, what caused the inefficient allocations?

 Is the problem correctable?

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 Natural Gas: Price Controls
Effects of ceiling price on natural gas:
 Ceiling would prevent prices from reaching its

efficient levels, reduce the incentive to conserve

 Lower prices would cause more resources to be

used/consumed in the earlier years

 On the supply side, when marginal cost rose to

meet the ceiling price, no more would be produced

in spite of high demand.
 Some of the valuable resources would remain

unexploited

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 Natural Gas: Price Controls
Effects of ceiling price on natural gas:
We will not be using all natural gas available at prices
consumers were willing to pay
 Cause a transition to the substitute before the

technology to use it were adequately developed

 Burden on the consumers: investments on the

equipments to use cheap natural gas are obsolete

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 Natural Gas: Price Controls
Why did many governments pursue this counterproductive
policy?
Could be explained by rent-seeking behavior in terms of CS
and PS (Figure in the next slide), a static analysis for a
given year:
 Ceiling price reduces marginal user cost because higher

future prices would no longer possible

 Producers perceived S curve would shift to the right due to

lower marginal user cost, produce more than the efficient

level.
 Current consumers are unambiguously better off, CS

increased by the area B+C

 Does producers also gain if area D>B?

 NO, why???
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The Effect of Price Controls
 Natural Gas: Price Controls
 Producers are overproducing and give up the scarcity
rent that could be achieved if there is no price control.
 Considering the loss in scarcity rent, producers are
unambiguously lose net benefits.
 Future consumers are also unambiguously worse off,
why???
 Resource depletion leads to higher marginal extraction
costs over time, when exceeds ceiling price, no
production will take place and some valuable resource
will remain unexploited.

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 Natural Gas: Price Controls
Rent Seeking behavior
 Politicians view scarcity rent as a source of revenue to

transfer from producers to consumers

 Scarcity rent is an opportunity concept – the protection

of future consumers
 An attempt to reduce it through price control results in

overallocation to current consumers and underallocation

to future consumers.
 Price control/rent seeking is politically attractive, why??

 But they are inefficient and unfair, why???

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 Oil: The Cartel Problem
Price controls are not the only source of inefficiencies
in energy resource allocations. Collusion in oil
markets (called cartel) has also led to inefficiencies.
 The member countries of the international cartel called

the Organization of Petroleum Exporting Countries

(OPEC) collude in order to gain monopoly power.
 A monopolist, by restricting supply, can extract more

scarcity rent from a depletable resource. Restricted

supply results in higher prices. Net benefits to society
are reduced, and there is a deadweight loss. The
transition to a substitute will occur later. Monopoly
power results in inefficient allocations.
 Draw a standard monopoly diagram

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 Oil: The Cartel Problem
Conditions that allow for successful cartelization are:
 Price inelasticity of demand for oil in both the long run

and the short run.

 High income elasticity of demand

 A small competitive fringe.

 Compatibility of member interests.

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 Oil: The Cartel Problem
Price elasticity of demand
 Determines how responsive demand is to change in

price
 When demand is inelastic, price increase leads to

increase in total revenue

 Lower the elasticity of demand for oil, larger the gains

from cartelization
It depends on:
 Scope of conservation and availability of substitutes

 Length of time to switch to alternative sources

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 Oil: The Cartel Problem
Income elasticity of demand
 Determines how responsive demand is to growth in the

world economy (business cycle)

 High income elasticity of demand support the

cartelization of oil
 A world recession in 1983 curved the OPEC profit from

cartelization.

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 Oil: The Cartel Problem
Non-OPEC suppliers (competitive fringe)
 Successful cartelization depends on OPEC’s ability to

prevent new suppliers from entering into the market and

undercutting the price
 If competitive fringe were able to expand production

significantly, in response to high cartel price, could

capture OPEC’s market share and reduce price
 World oil allocation would approach to competitive or

efficient allocation
But how likely is this scenario??

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 Oil: The Cartel Problem
Compatibility of Member Interests
 Cartel members have a strong incentive to cheat

 An individual cheater can reduce price a little and sell

more, causing sales reduction for others

 Another important threat is the degree to which

members fail to agree on pricing and output decisions

 Saudi Arabia is a problem maker for others (rent

seeking again!)

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 Oil: National Security Problem
National Security is a Public Good. The market outcome
would result typically in an excessive dependence on
imports.
 Figure 7.2 illustrates the national security problem.

 The vulnerability premium of an embargo can also be

illustrated with Figure 7.2. The vulnerability premium is

lower, however, than the cost of being self sufficient.

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FIGURE 7.2: The National Security
Problem
Transition Fuels: Environmental
Problems
The environmental impact of the intermediate period
occurs prior to the transition to renewable energy
sources. Coal and uranium - intermediate transition
fuels.
Coals:
 Coal markets are not efficient because of subsidies

 The main environmental drawbacks to coal use are

sulfur dioxide emissions, particulate emissions and

carbon dioxide.
 Sulfur dioxide causes acid rain and contributes to

respiratory disease. Carbon dioxide, a greenhouse gas,

contributes to potential climate change.
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Transition Fuels: Environmental
Problems
Nuclear Energy:
 Concerns with uranium are nuclear accidents and the

storage of nuclear waste.

 Markets are not likely to make correct decisions in the

presence of these externalities.

 The risk of nuclear accidents is exemplified by the

Chernobyl plant accident in 1986 when a serious core

meltdown occurred.
 The market will not make the correct choice for nuclear

power, why??

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Conservation and Load Management
One partial solution to the transition issues is conservation. Peak period
pricing is another partial solution. This section examines the role of
conservation and the inefficiencies built into many utility pricing
schemes.
 A significant role for conservation is a utility’s ability to defer capacity

expansion. New facilities are hugely expensive and typically require

large rate increases.
 Most utilities price electricity inefficiently. Average cost pricing is a

common method.
 Average cost pricing entails averaging high cost sources with lower-

cost sources. The resulting rate will be lower than the true marginal
cost of power and thus is inefficient. Lower rates will result in a less
than efficient amount of conservation.
 One economic load-management method is called peak-load pricing.

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Conservation and Load Management
 Peak-load pricing is a pricing structure where consumers
using power during peak periods are charged higher rates
during the peak periods. Peak rates should reflect the higher
marginal cost of supplying power during peak periods. The
higher prices during peak periods should encourage
conservation during those periods and forestall capacity
expansion.
 Studies indicate that peak-load pricing works.
 Example 8.3 explores Texas’s experience with tradable
energy certificate
 Tradable Energy Certificates are designed to facilitate the
transition renewable power by easing the obstacles of large
capital investment requirement and competition.

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 The Long-Run Perspective:Transition to
Renewables
The final section in this chapter examines renewable energy
sources and economic incentives for transition to cleaner
sources.
 Global climate change is an argument for the transition

away from fossil fuels.

Renewable energy sources discussed in this chapter
include:
 Solar energy

 Hydropower

 Photovoltaics

 Windpower

 Hydrogen fuel
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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.
 Ocean Tidal Power
 The plant has impact on coastal ecosystem.
 Construction costs are high.
 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.
 The Long-Run Perspective:Transition to
Renewables
 Subsidizing renewable energy purchases through tax
credits could allow markets to become large enough to
achieve economies of scale.
 Removing inefficient subsidies, and internalizing
externalities could also help reduce the cost
disadvantage for sustainable energy sources.
 Myers and Kent (2001) estimate the global subsidies to
fossil fuels and nuclear energy at $131 billion per year
and the uninternalized externalities from these sources at
$200 billion per year.
 Low oil prices have also led to slow transitions to
renewable sources.
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