Chapter 7

Energy: The Transition from Depletable to Renewable Resources

Objectives
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.

Introduction
Energy is one of our most critical resources, without it, life would cease. Currently, most industrialized countries depend on oil and natural gas for most of their energy needs (depletable & nonrecyclable) According to depletable resource models, 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, 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.

Natural Gas: Price Controls

A natural gas shortage of 2 trillion cubic feet, or 10 percent of the marketed production, occurred in 19741975. Under efficient allocation, shortages of this magnitude 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 crude oil

 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 extend its price control regulations to the producers.

Hastily conceived initial price ceilings remained in effect for a almost a decade

 Price ceilings were imposed which prevented prices from reaching their normal levels:
overconsumption of natural gas, causing shortages, causing more of the resource to be used in earlier years and with a sudden jump in price.

On the supply side, producers who expect price ceilings to be lifted have incentives to slow production and wait for higher prices, thus exacerbating existing shortages. Combined D-S effects would distort allocation significantly

 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 suddenly jumping to new higher levels
Discontinuous jump to a new technology

(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

 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

 Natural gas allocations not only hastened the transition 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.

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

 Scarcity rent is an opportunity cost that serves a distinct 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 future consumers to present consumers

Price controls are politically attractive: current votes Inefficient, unfair: the losses to future consumers and producers are greater than the gains to current consumers, distort allocation toward present Over lung run, harms consumers Scarcity rent plays an important role in allocation process, attempts to eliminate it can create more problems

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

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), 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.

High income elasticity of demand How sensitive oil demand is to growth in the world economy At constant prices, as income grows, oil demand should grow. The higher the income elasticity of demand, the more sensitive demand is to the business cycle.
Recessions can thus weaken OPEC and expansions are beneficial to the cartel.

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 worlds oil. OPEC must take non-OPEC members into account when setting prices. Pressure on the cartel was evident in the mid-1980s when production 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

Compatibility of Member Interest Individual cartel members have incentives to cheat on production agreements. Price elasticity of demand facing each individual member is higher than for the cartel. With higher price elasticity, lowering price maximizes profit. Enforcing the collusive agreement is essential for the success of the cartel. (and detection of cheating)

The Worlds 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.

TABLE 7.2 Carbon Content of Fuels

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 reflects increasing 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.

The National Security Problem

 To reduce the potential damage of an embargo, the U.S. has developed a stockpile called the strategic petroleum reserve. Conservation can help decrease reliance on foreign imports. A tax on energy consumption is one tool that can be used to encourage conservation. Domestic subsidies are another possible tool. A final option is the use of tariffs and quotas on imports.

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

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

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 to utilities.

The U.S. government established the Nuclear Regulatory Commission.

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 peak periods

The Efficient Level of Precaution

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.

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.

 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.