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Chapter 7
Energy: The Transition from
Depletable to Renewable
Resources
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Objectives
Discuss the history of natural gas priceregulation and illustrate the effect of priceceilings on the market for natural gas.
Discuss how OPEC colludes to gain marketpower and acts as a monopolist.
Show how inelasticity of demand for oil leadsto large gains for the cartel.
Teach the concept of income elasticity ofdemand and the its potential effect on cartelpricing power.
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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.
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Introduction
Energy is one of our most critical resources, without it, life would
cease.
Currently, most industrialized countries depend on oil and naturalgas for most of their energy needs (depletable & nonrecyclable)
According to depletable resource models, oil and natural gas wouldbe used until the marginal cost of further use exceeded the MC ofsubstitute resources (either more abundant depletable resourceslike coal, or renewable resources like solar energy)
In an efficient market path-transition should be smooth
Have the allocations in the past been efficient?
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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.
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Natural Gas: Price Controls
A natural gas shortage of 2 trillion cubic feet, or10 percent of the marketed production, occurredin 19741975.
Under efficient allocation, shortages of thismagnitude would never happen.
Source of problem: government controls over
natural gas prices
Rise of automobile rise in demand for gasoline,led to exploration of natural gas along with crudeoil
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In 1938 the Natural Gas Act was passed. The Federal Power Commission (FPC) was charged
with maintaining just prices. Price controls were imposed on natural gas
shipped across state lines.
In Phillips Petroleum Co., v. Wisconsin (1954),the Supreme Court forced the FPC to extendits price control regulations to the producers.
Hastily conceived initial price ceilingsremained in effect for a almost a decade
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Price ceilings were imposed which preventedprices from reaching their normal levels:
overconsumption of natural gas, causingshortages,
causing more of the resource to be used in earlieryears and with a sudden jump in price.
On the supply side, producers who expectprice ceilings to be lifted have incentives toslow production and wait for higher prices,
thus exacerbating existing shortages. Combined D-S effects would distort allocation
significantly
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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, with prices suddenlyjumping to new higher levels
Discontinuous jump to a new technology
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(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, which, in
turn, affects prices in the early year
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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
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Natural gas allocations not only hastened thetransition to a substitute resource, also
caused a transition to inefficient substitute
(substitution bias-example 7.1) Beyond the limits concerns may be valid
here, caused by government interference and
not market behavior
This inefficient policy was pursued based on
rent-seeking behavior.
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The Effect of Price Controls
Price ceiling would
reduce MUC
because higher
future prices would
no longer be
possible
=Perceived supply
Current production
increases due to lower
perceived supply
Area D only coverscurrent profits without
considering scarcity
rent
Future consumers
are made worseoff-loss in CS of
future consumers
Reducing scarcity
rent means over
allocation to
current consumers
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Scarcity rent is an opportunity cost that serves adistinct purpose: the protection of future consumers
Through price controls, MUC falls. Result is overallocation to current consumers and an
underallocation to future consumers
Transfer from producers to consumers, a transfer from futureconsumers to present consumers
Price controls are politically attractive: current votes
Inefficient, unfair: the losses to future consumersand producers are greater than the gains to currentconsumers, distort allocation toward present
Over lung run, harms consumers
Scarcity rent plays an important role in allocationprocess, attempts to eliminate it can create more
problems
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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 competitivefirms-slower production and higher prices
Transition to a substitute occurs _____ (later)
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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
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Price inelasticity of demand for oil in both the long run and
the short run
PED depends on the opportunities for conservation as wellas the availability of substitutes
The lower the price elasticity of demand (in absolute
value), the larger the potential gains from cartelization.
Oil and oil products are price inelastic.
Price elasticity of demand depends in part on the
availability of substitutes (set an upper limit on the cartel
price.) Thus in the long run, 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.
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High income elasticity of demand
How sensitive oil demand is to growth in theworld economy
At constant prices, as income grows, oildemand should grow.
The higher the income elasticity of demand,the more sensitive demand is to the businesscycle.
Recessions can thus weaken OPEC and expansionsare beneficial to the cartel.
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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 currently produces approximately two-thirds of the worldsoil.
OPEC must take non-OPEC members into account when setting
prices.
Pressure on the cartel was evident in the mid-1980s whenproduction was down and prices fell.
Salant (1976) model of monopoly pricing in the presence of a
competitive fringe.
With a competitive fringe, OPEC would set the initial price
somewhat lower than the pure monopoly price and allow price
to rise more rapidly. Force competitive fringe to produce more in
the earlier periods
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Compatibility of Member Interest
Individual cartel members have incentives tocheat on production agreements.
Price elasticity of demand facing each
individual member is higher than for thecartel. With higher price elasticity, lowering
price maximizes profit.
Enforcing the collusive agreement is essential
for the success of the cartel. (and detection of
cheating)
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The Worlds Largest Oil Reserves
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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.
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TABLE 7.2 Carbon Content of Fuels
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National Security Dimension
National security is a public good. The market would
generally result in an excessive dependence on imports.
The long run domestic supply curve of oil reflectsincreasing availability of domestic oil at higher prices.
Using the graph to show that the efficient allocation
including national security costs is less than the market
outcome. The market consumes too much oil and domestic
production is too small.
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The National Security Problem
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To reduce the potential damage of anembargo, the U.S. has developed a stockpilecalled the strategic petroleum reserve.
Conservation can help decrease reliance onforeign imports. A tax on energy consumptionis one tool that can be used to encourageconservation.
Domestic subsidies are another possible tool. A final option is the use of tariffs and quotas
on imports.
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The Other Depletable Sources: Unconventional Oil, 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
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Coal
An abundant energy source
Air pollution: sulfur dioxide, particulate,mercury and carbon dioxide emissions
Current technological progress on carbon
sequestration
Implementation of technologies calls for
policy support
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Uranium
Safety is the major concern.
Sources of concern: nuclear accidents and storage of radioactive waste
The market will not make the correct choice for nuclear
power. The U.S. government has underwritten liability since the
passage of the Price-Anderson Act in 1957.
Price-Anderson Act reduces the expected cost of nuclear power toutilities.
The U.S. government established the Nuclear RegulatoryCommission.
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Electricity
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.
Peak-load pricing is a pricing structure where
consumers using power during peak periods
are charged higher rates during the peakperiods
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The Efficient Level of Precaution
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Energy Efficiency
Improving energy efficiency reduces
greenhouse gases emissions and dependence
on foreign oil. While new technologies emerge, the level of
energy efficiency chosen by the market is
low.
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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
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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.
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Geothermal Energy
Derived from the earths heat
Initial cost is high, the payback periods vary from
2-10 years.
Hydrogen
Technologies of using hydrogen is expensive, and
the infrastructure is undeveloped.
Using government subsidies has impact on
promoting the renewable energy resources.
