Chapter 8. Energy

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Chapter 8. Energy
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Summary Exercises for Chapter 7

• True or False?
• The efficient allocation of depletable and
  renewable resources depends on the circumstances.
  When the resource is extracted at a constant MC,
  the efficient quantity of depletable resource
  will suddenly run out.
• Only depletable resource can be recyclable.
• Because renewable resources can be replenished,
  so we do not manage them.

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• A resource governed by a well-defined property
  rights structure will then have
• A. use value
• B. asset value
• C. environmental value
• D. Both A and B.

4

• Suppose a depletable resource can be extracted
  for N-periods. If there is no substitute for this
  resource and the marginal extraction cost is
  constant over time (say, 5). Which of the
  following statement is true given stable discount
  rate?
• The efficient quantity extracted is constant over
  time.
• The marginal user cost is constant over time.
• The efficient quantity declines over time, and
  the marginal user cost is steadily increasing
  over time.
• This resource will be unfortunately suddenly run
  out at period N-2.

5

• Which of the following resource reserves can be
  most appropriately defined as a number?
• Current reserves
• Potential reserves
• Resource endowment
• All of the above

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Introduction

• Energy is one of our most critical resources,
  which directly or indirectly comes from ______.
• Currently most industrialized countries depend on
  _____ and ____________ for most of their energy
  needs. The two resourced together supply 67 if
  all energy consumed in the U.S.

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Figure 8.1 Estimated Crude Oil Reserves for the
United States and Western Europe over Time
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Figure 8.2 Estimated Natural Gas Reserves for
the United States and Western Europe over time
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Natural Gas Price Controls

• After the invention of the automobile, rising
  demands for gasoline stimulated searches for new
  sources of crude oil which also led to
  discoveries of large quantities of natural gas.
  Natural gas then began replacing manufactured gas
  as an energy source.
• A natural gas shortage of 2 trillion cubic feet,
  or 10 percent of the marketed production,
  occurred in 1974-1975.

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Natural Gas Price ControlsHistory

• In 1938 the Natural Gas Act was passed. With this
  Act, the Federal Power Commission (FPC) became a
  federal regulatory agency 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.
• Price ceilings were imposed which prevented
  prices from reaching their normal levels.

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Figure 8.3 Increasing Marginal Extraction Cost
with Substitute Resource in the Presence of
Price Controls (a) Quantity Profile (b) Price
Profile
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Natural Gas Price Controls

• On the demand side, price ceilings, by holding
  prices at an artificially low level, led to
  overconsumption of natural gas, causing
  shortages. Over time, a price ceiling would cause
  more of the resource to be used in earlier years.
• 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. (what will
  happen when MC rises to price ceiling?)

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Natural Gas Price Controls

• Since the price controls on natural gas were
  imposed only on gas shipped across state lines,
  gas produced and sold within a given state
  received a higher price than gas sold in other
  states. Thus, the share of gas sold on the
  interstate market fell over time.
• This caused shortages to be concentrated in
  states dependent on interstate shipments of
  natural gas. Thus, the price control system
  caused more damage than would have happened
  otherwise.

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Natural Gas Price Controls

• The price controls caused a substitution bias.
  Artificially low prices of natural gas created a
  bias toward substitutes that could be blended
  with natural gas and away from substitutes that
  could not.
• For example, pipeline companies looked for
  alternative sources of supplyvery expensive
• Liquid natural gas shipped from abroad in
  pressurized ship
• Synthetic natural gas

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Natural Gas Price Controls

• Why did Congress embark such a policy?
• This inefficient policy was pursued based on
  __________________ behavior.

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Figure 8.4 The Effect of Price Controls
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Natural Gas Price Controls

• Price ceilings reduce the marginal user cost of
  natural gas since higher future prices are no
  longer possible. A lower marginal user cost
  causes the producers perceived supply curve to
  be lower.
• Current consumers are better off. Future
  consumers are worse off.
• Producers, by overproducing, are giving up the
  scarcity rent they would have received without
  the price controls. Producers, thus are worse
  off.

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Natural Gas Price Controls

• Congress may view scarcity rent as a possible
  revenue to transfer from producers to consumers.
  So Congress imposed this type of policy.
• However, in actuality, this is a transfer from
  future consumers to current consumers. Scarcity
  rents are important for efficient allocations
  over time.
• Over the long run, price controls hurt consumers.
  Price controls are politically attractive,
  however, since current consumers mean current
  votes.

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Natural Gas Price ControlsEnd of the story

• The Natural Gas Policy Act was passed on November
  9, 1978.
• Natural gas prices began to be decontrolled in
  the early 1980s causing rapid price rises.
• By 1993, no sources of natural gas were subject
  to price controls.

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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 has also led to
  inefficiencies.
• The oil cartel, the Organization of Petroleum
  Exporting Countries (OPEC)
• Their website is amazing www.opec.org

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Oil The Cartel Problem

• Some information regarding oil
• Crude oil is a naturally-occurring substance
  found trapped in certain rocks below the earth's
  crust. It is a dark, sticky liquid.
• Crude oil is measured in barrels. When crude oil
  first came into large-scale commercial use in the
  United States in the 19th century, it was stored
  in wooden barrels. One barrel equals 42 US
  gallons, or 159 litres.
• World crude oil reserves are estimated at more
  than one trillion barrels, of which the 11 OPEC
  Member Countries hold more than 75 per cent.
  OPEC's Members currently produce around 27
  million to 28 million barrels per day of oil, or
  some 40 per cent of the world total output.

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Oil The Cartel Problem

• 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. The transition
  to a substitute will occur later. Monopoly power
  results in inefficient allocations.
• The member countries of the international cartel
  called the Organization of Petroleum Exporting
  Countries (OPEC) collude in order to gain
  monopoly power.

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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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Price inelasticity of demand for oil

• ___________________ measures the responsiveness
  of quantity demanded to price.
• Inelastic the price elasticity of demand is less
  than one in absolute value, price increases lead
  to increases in total revenue.
• Oil and oil products are price inelastic.
• The lower the price elasticity of demand (in
  absolute value), the larger the potential gains
  from cartelization.
• Price elasticity of demand depends in part on the
  availability of substitutes.
• Thus in the long run, price elasticity of demand
  is usually ________. The more substitutes
  available, the less power the cartel has to raise
  the price. The prices of available substitutes
  will set an upper limit on the cartel price.
  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

• _____________ measures the responsiveness of
  quantity demanded to changes in income.
• At constant prices, as income grows, oil demand
  should ________.
• High income elasticities of demand support the
  cartelization of oil and strengthen the ability
  of OPEC to raise prices.
• The higher the income elasticity of demand, the
  more sensitive demand is to the business cycle.
  So economic growth brings increased demand for
  the resource, recessions can thus put pressure on
  OPEC.

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Figure 8.5 Real Crude Oil Price (19731998)
recession
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A small competitive fringe

• OPEC currently produces approximately two-thirds
  of the worlds oil.
• Non-OPEC suppliers are called the ______________
• ______.
• A cartel will have more market power if it can
  prevent new suppliers from entering the market
  and undercutting the price.
• Few competitive fringe can unilaterally decide
  international oil prices. (Mexico?)
• OPEC must take non-OPEC members into account when
  setting prices. (why?)
• Pressure on the cartel was evident in the
  mid-1980s when production was down and prices
  fell.

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Figure 8.5 Real Crude Oil Price (19731998)
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Compatibility of member interests

• Unlike a monopoly, a cartel is dependent on
  internal cohesion.
• Cartels have strong profit incentives to
  cartelize, but also strong incentive to cheat!
  (why?)
• Because raising their own production, they can
  capture some of the profits from the higher
  prices. This behavior, however, can cause the
  collapse of the cartel.
• Enforcing the colllusive agreement is essential
  for the success of the cartel. Saudi Arabia has
  huge reserves and its influence on world
  pricesoil policeman,

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Oil and National Security

• National security is a _______ good. The market
  would generally result in an excessive dependence
  on imports.
• Reliance on foreign oil supplies puts the country
  at the risk of possible embargo.
• Risk of embargo must be considered as an
  additional implicit cost incurred by using
  foreign oil.

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Figure 8.6 The National Security Problem
Without considering security costs, ____would be
consumed. ____would be produced by
U.S. ______would be imported.
S Domestic supply (short run)
(Long run)
w/ security cost
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Figure 8.6 The National Security Problem
Considering national security costs, ____would
be consumed. ____would be produced by
U.S. ______would be imported.
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S Domestic supply (short run)
Under an embargo, ____would be consumed.
____would be produced by U.S. ______would be
imported. ______ is the price. (why?)
w/ security cost
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Under self-sufficiency, ____would be consumed.
____would be produced by U.S. ______would be
imported. ______ is the price. ______ is the
consumer surplus and _______ is the producer
surplus. Compare to the case with imports, is
self-sufficiency efficient?
G
E
P3
w/ security cost
C
D
F
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Oil National Security

• Self-sufficiency is
• less efficient than the import scenario because
  embargoes are not certain.
• myopic. Consuming domestic resources now means
  they will not be available for future
  consumption.
• How about develop a domestic stockpile of oil to
  be used during embargo?
• Strategic petroleum reserveto replace 3 million
  barrels per day (up to 1 billion barrels).