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Economics of Energy We have met the enemy and he is us ~ Pogo CHAPTER 15 One of the most fundamental questions of our time is the rate at which we should consume our fossil resources and how this decision impacts our economic well-being at present and for decades into the future. Technologically, we currently have the necessary tools to exploit both the exhaustible fossil and nuclear fuels and the renewable hydro, wind, solar, and biomass resources. Other technologies such as fusion and yet unknown resources may also become available within the next few decades. In previous chapters, we covered technological issues related to the use of these resources and their effects on our environment. In this chapter we will discuss the economical issues of energy and their impact on our technological society. The economics of the environment will be covered in the next chapter. Overview The economic dilemma every human faces is how to satisfy unlimited wants with limited resources. The resource limitations could be technological know-how, sufficient purchasing-power, time, or materials and energy. This is why we choose (or are forced) to give up or postpone some desires to get others which are seemingly more important to us. Because of limited income, we must prioritize our desires, for example by buying a used instead of new car or by postponing the purchase of a home until we have graduated from college. At other times we give up what we already have for the sake of our children and grandchildren. The same is true with other resources at our disposal. For example, we only have limited fossil resources, and they cannot last to meet all our energy needs for a very long time. Because we are endowed with all the resources, we have the choices of using energy more efficiently, practicing conservation, and seeking alternative sources of energy; alternatively, we may continue consuming energy with no restraints and leave future generations to resolve their own energy shortages. Because energy plays a crucial role in the economic health of all nations, understanding concepts and fundamental laws in economics is essential and is the subject of this chapter. Competition Perfect Competition: Efficient Market A perfect or efficient market is a competitive market in which economic forces operate unimpeded. For a market to be perfect, the following conditions must exist: a. There are numerous buyers and sellers. The output of the goods from each firm is small compared to the total supply of those goods so none of them are able to influence the price of the goods on their own. b. There are no barriers to the entry of new competitions and competitors. Barriers can be legal, such as in patents and regulations; technological, such as with technologies that are too costly or available only to certain industries; or social, such as when loans or grants are available to only certain groups of people and not others. c. There are many other firms with products that are available and practically indistinguishable from the goods of interest. Buyers could easily substitute another product if there were shortages. d. A firm’s only goal is to maximize its profits; in other words, firms have no interests (political, social, etc.) other than their economical interest. e. All consumers and producers face the same price; alternatively, information about prices is freely available so that buyers and sellers are price takers. In actuality, markets are not perfect and many technical, financial, and legal barriers can influence them. In a real market there are only a limited number of buyers and sellers, so it is possible that a few firms collude to dominate the industry. Because the number of buyers is finite, there is a limit to how much of a product firms can sell, no matter how low the price. Monopolies, cartels, and subsidized firms that provide specialized services, sell novelty items, or offer products protected by patents and government regulations violate one or more of the conditions set above and are therefore not considered to be perfect or efficient markets. It should be noted that although most barriers to a perfect market (control of resources, predatory and retaliatory pricing, and excess capacity) are socially harmful, there are some advantages for a non-perfect market. For example, the economics of scale may reduce capital requirements and reduce costs to the consumers. To a certain degree patents and copy rights will foster entrepreneurship and promote innovation. Finally, non-perfect markets allow product differentiation which brings variety that spices up our daily lives. Supply and Demand To understand the many ramifications of modern economics, it is instructive to start with the concept of supply and demand and to explain how it determines an efficient price and quantity of a given good sold in a competitive market. In general, the theory claims that the quantity 376 Chapter 15 - Economics of Energy demanded for products increases as prices fall, ceteris paribus.1 At the same time, sellers will be willing to offer more goods at higher prices. It is therefore reasonable to expect a demand curve to exhibit a downward slope,2 whereas a supply curve has an upward trend as the quantity of goods offered increases. The point where these curves intersect is the equilibrium point (Figure 15-1). At the equilibrium point, both buyers and sellers are satisfied with the transaction and therefore there is little impetus to change. In other words, at the equilibrium, everybody is better off from the trade.3 If the price is set too high or if supply increases, then there will not be sufficient buyers, resulting in a surplus. In this instance, suppliers will attempt to reduce their inventories by cutting prices, and producers, seeing the lower price, will cut production. As price falls more customers are likely to enter the market and the price and volume will increase, approaching the equilibrium. If the price is set too low or if demand increases, then quantity demanded exceeds the quantity supplied, resulting in a shortage. In this case buyers are willing to pay more (and possibly develop a black market). Seeing prices rise, more sellers enter the market, suppliers increase their production, and again we approach equilibrium. Many factors besides price affect demand and supply. Factors that affect demand are changes in income, changes in the cost of living, personal preferences, and customers’ expectations. Factors that affect supply are changes in the costs of production (such as the cost of raw materials and labor), changes in technology, and changes in the amount of taxes and subsidies. It should be emphasized here that change in a quantity demanded does not mean a change in demand. There are two ways that demand can change: a change in price or a change in overall demand. For a given market, a change in the price results in changes in quantity demanded (movement along the demand curve); the higher the price, the lower the demand, and vice versa. For example, when the price of natural gas rises, buyers move away from natural gas and use substitutes such as heating oil, kerosene, or wood. When price drops, consumers switch back to natural gas again. Demand can also change because of changes in market conditions. For example, when there is a shift in median income, people tend to buy a different quantity of a product for the same price. Since a demand curve represents the quantity demanded at different prices, a change in demand requires a shift in the demand curve. For example the demand for natural C eteris paribus, t he Latin phrase meaning “other things remaining constant.” It should be stressed here that, although the demand curve for the market as a whole has a downward slope, individual firms sell their product at a given price. The demand curve is a flat l ine for individual firms. 3 By “better off” we only mean in terms of overall economical advantage. If the increase in a country’s income comes with the destruction of cultural values, environmental degradation, a nd other adverse non-quantifiable social implications, then an average person might actually be “worse off” as the result of the trade. 1 2 D0 Surplus S0 Price Shortage Quantity Figure 15-1 Supply and Demand. At equilibrium Q* units of the product is offered at a price of P*. When there is an imbalance between supply and demand, either a shortage or surplus results. 377 I FYI ... Shortage and Hoarding n 1973, following the Arab oil embargo, there was a gasoline shortage; long lines of cars formed at gas stations waiting hours to fill up their gas tanks. To prevent price gouging and black market profiteering, the government instituted a price control. Fearing increasing shortages, the average gas tank that was previously only one-quarter full was now being kept three-quarters full. With about 100 million cars on the American roads, and assuming the tanks had 20 gallon capacity, the hoarding resulted in a shortage of about one billion gallons in the first two weeks of the price control, causing a sudden increase in demand that actually exacerbated the shortage. gas heaters increases during a cold winter. Unless supplies change, buyers are willing to pay a higher price than they would be during a mild winter, so the demand curve shifts upward and prices rise (Figure 15-2). The opposite will be true when winters turn out to be milder than expected. Supply curves can also change depending on cost. For example, as technologies improve, the cost of production of solar cells decreases, so cell manufacturers are willing to supply more cells for a given price -- the supply curve shifts to the right (Figure 15-3). Example 15-1: Depending on their incomes and needs, different customers are willing to pay different prices for gasoline, as is shown in demand curve D0 in Exhibit 15-1. Gasoline availability is also a function of the price customers are willing to pay, as it is shown in the supply curve denoted S0. a. What is the equilibrium price of gasoline and the quantity supplied to the market? b. If everything else remains the same (ceteris paribus), how would customers’ behavior be affected if the price of gasoline drops 10 cents to $3.90 a gallon? c. How much would the price of gasoline rise during summer if demand rose by 20%? Assume that the government does not interfere in controlling supply and demand. d. Now assume that the government mandates a price freeze setting a price ceiling of $4.00 per gallon. How would customers react to the change in demand during the summer? e. How will the market react if it anticipates future shortages as a result of a 20% cutback in production by OPEC? Solution: a. The market equilibrium is at point A in graph a, where 100 million gallons of gasoline are supplied by the oil companies at a price of $4.00 a gallon. b. In this case, the demand curve is not affected. This does not mean the quantity demanded is the same. In fact as gasoline prices drop the quantity demanded will be greater (people tend to drive more or buy bigger cars), although the demand is still the same. The movement is along the demand curve to point B and 110 million gallons are sold. c. As daily demand for gasoline climbs, the demand curve shifts to D1, and customers are willing to buy 120 million gallons at the co ld wi nt no rm $ al nt er s Number of heaters r wa m er s s wi nt wi er Figure 15-2 Demand shift. $ Figure 15-3 Supply shift. 378 ye ste r Number of cells da y's cu tec rre hn nt olo tec gy hn fut olo ure gy tec hn olo gy Chapter 15 - Economics of Energy price of $4.00 (point C in graph b). In the short run, the market reacts and eliminates the initial shortage by driving prices up to point E at which 120 million gallons are sold at $4.20 a gallon. In the long run, as prices rise, drivers will cut their driving (for example by vacationing shorter distances or by carpooling) and equilibrium moves back to point D. As a result, 110 million gallons are offered at the price of $4.10 a gallon. d. With the price ceiling set at $4.00 a gallon, the oil companies are willing to sell only 100 million gallons of gasoline every day (equilibrium point A in graph c). The daily demand for gasoline, however, is 120 million gallons. To prevent shortage, customers are willing to pay more, potentially causing a black market and driving up the prices to as much as $4.20 a gallon (point E). Because there is a price ceiling, drivers cannot legally pay more than $4.00 a gallon. In the absence of a black market, they have to pay in non-monetary terms such as waiting in line. In a way, a new equilibrium is reached where 100 million gallons of gasoline are traded at $4.20, of which $4.00 is paid monetarily and $0.20 is paid in terms of waiting in line. e. In this case the supply curve shifts to S1 (graph c) while demand remains the same, and again we will face a daily shortage of 20 million gallons (AF), temporarily driving the price up to $4.20 a gallon (point E). In the long run, changes in consumers driving habits and willingness to switch to alternative fuel vehicles and to electric and hybrid cars reduce the demand for gasoline. It eventually reaches a new equilibrium point G where price drops to $4.10 again. It is clear from the above example that the market has a built-in mechanism that reacts to scarcity by raising prices and ultimately eliminating scarcity. The rise in price causes a decrease in the quantity demanded, and an increase in the quantity supplied by providing incentives to existing firms to up production, to invest in new technologies, and to enable new firms to enter the market. Total and Marginal Costs 4.60 4.40 4.20 4.00 3.80 3.60 60 80 100 120 S0 Price per gallon ($) A B D0 140 160 180 millions of gallons (a) 4.60 S0 Price per gallon ($) 4.40 4.20 4.00 3.80 3.60 60 80 100 120 E D A C Price ceiling D0 140 D1 160 180 millions of gallons (b) 4.60 4.40 4.20 S1 S0 Price per gallon ($) E G F A 4.00 3.80 3.60 60 D0 80 100 120 140 160 180 millions of gallons There are many kinds of costs associated with activities, but they can be generally divided into two types -- fixed and variable. Fixed costs exist whether or not any products are produced or services are delivered. Examples are rent, furniture, insurance, and the cost of purchasing equipment. Other costs -- called variable costs -- change as output changes. Examples are the costs of raw material and labor. The sum of the fixed and variable costs is the total private cost, or simply the total cost. All of these costs are important to a supplier, but they are not the most important costs for the firm to decide the quantity of goods to produce. That decision depends on whether the cost of producing one additional (c) EX 15-1 379 unit pays for the revenue received for that additional unit. The additional or incremental cost of producing one extra unit of product or providing one unit of additional service is called the marginal cost. The marginal cost of oil production is the minimal additional cost of producing one extra barrel of oil. Because higher production levels necessitate extraction from higher-cost fields, marginal cost increases as production rises. Similarly the marginal revenue (marginal benefit) can be defined as the additional or incremental revenue (benefit) of obtaining one extra product or receiving one unit of additional service.4 As long as the marginal benefit is higher than marginal cost, production of additional units is profitable. Said another way, the total profit of the firm is maximum when marginal cost of one additional unit produced is equal to marginal revenue resulting from its sale (the price it gets for its good). Example 15-2: An agricultural firm is selling corn in a competitive market. The firm incurs a fixed cost of $20 (let’s say for rent) and an additional cost which depends on the quantity of corn produced. The data is given in columns 2 and 3 in the table shown. Assuming that the market price offered by the competition is $14 a bushel, find the number of bushels that the firm must produce to maximize its total profit. Solution: We can calculate the total cost (column 4) by summing up values of fixed and variable costs (TC = FC + VC). Marginal cost (column 5) is calculated by taking the difference between the total costs of production where one additional bushel of corn is produced. Total revenue (column 6) is simply the product of the quantity produced and the unit price of $14. Total (column 8) and marginal (column 9) profits are calculated as the difference between total and marginal revenues and cost. (TP = TR - TC and MP = MR - MC). As the results show, the total maximum profit the firm can make is $54.88 by selling 8 or 9 bushels of corn. This is where marginal cost and marginal revenue cross and are equal to the price of one bushel of corn ($14). The firm continues to be profitable as production increases beyond 9 bushels, although marginal profit starts to drop. Beyond 12 units of production the firm loses money at an accelerated rate. The graphical representation of the results is shown in Exhibit 15-2. It should be noted that the analysis made above is valid only in the short run. In a perfect competition, as long as there are profits to be made, there is incentive for other firms to enter the market. As new competitors enter the market, supplies increase and prices fall. Those who experience a loss will necessarily exit the market and are replaced with new firms that enter to fill the gap. The process continues until There are instances when no marginal cost or benefit exists. For example, there is no marginal cost for an extra plate in an all-you-can-eat diner, and there is zero marginal benefit of an e xtra plate when you are no longer hungry. 4 60 Cost or revenue ($/Bushel) 50 40 30 20 10 0 MC MR = P 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Bushels of corn 300 Cost or revenue ($/Bushel) 250 200 150 100 50 0 1 2 3 4 5 6 7 8 loss TC TR maximum pro t loss VC FC 9 10 11 12 13 14 Bushels of corn EX 15-2 380 Chapter 15 - Economics of Energy the equilibrium is reached (P = MR = MC), at which point the firms make no profit. This is the long-run condition for perfectly competitive firms. 1 Qty Q 0 2 Fixed Cost FC 20.00 3 Variable Cost VC 0.00 4 Total Cost TC 20.00 6.32 1 20.00 6.32 26.32 3.92 2 20.00 10.24 30.24 2.48 3 20.00 12.72 32.72 2.00 4 20.00 14.72 34.72 2.48 5 20.00 17.20 37.20 3.92 6 20.00 21.12 41.12 6.32 7 20.00 27.44 47.44 9.68 8 20.00 37.12 57.12 14.00 9 20.00 51.12 71.12 19.27 10 20.00 70.40 90.40 25.52 11 20.00 95.92 115.92 32.72 12 20.00 128.64 148.64 40.88 13 20.00 169.52 189.52 50.00 14 20.00 219.52 239.52 60.08 196.00 14.00 182.00 14.00 168.00 14.00 -7.52 -34.40 154.00 14.00 19.36 -26.88 140.00 14.00 38.08 -18.72 126.00 14.00 49.60 -11.52 112.00 14.00 54.88 -5.28 98.00 14.00 54.88 0.00 84.00 14.00 50.56 4.32 70.00 14.00 42.88 7.68 56.00 14.00 32.80 10.08 42.00 14.00 21.28 11.52 28.00 14.00 9.28 12.00 14.00 14.00 -2.24 11.58 5 Marginal Cost MC 6 Total Revenue TR 0.00 14.00 10.08 7 Marginal Revenue MR = P 8 Total Profit TP 7.68 Marginal Profit MP Elasticity Marginal quantities are closely related to the elasticity of demand and supply. Elasticity of supply can be viewed as the responsiveness of the market to changes in quantity supplied as prices change. The higher the number of substitutes for a given service or product, the more elastic the supply curve. When there is an infinite number of alternative products available in response to a change in price, we call the supply curve perfectly elastic (horizontal line in Figure 15-4). When there can be no change to quantity supplied, no matter the price, the supply curve is perfectly inelastic (vertical line in Figure15-4). During a very short time, when a new product enters a market or when plant operates at full capacity, supply cannot change with a change in price; i.e the supply curve perfectly inelastic elastic P perfectly elastic Q Figure 15-4 Elasticity 381 FYI ... Price Elasticity of Gasoline and Oil D2 D1 The sudden rise in the price of gasoline brought about by the oil crisis of 1973 and the Iranian Revolution of 1979 demonstrates the inelastic nature of these commodities in the short run. Because there are essentially no substitutes for gasoline in cars, and because of the American dependence on private cars, the price of gasoline increases suddenly following any interruption in the supply of the imported oil with practically no noticeable drop in demand. The price rises from P0 to P1 and the short-term demand curve is D1 (See Shortage and Hording). Given enough time, people look for shorter and less frequent trips, switch to alternative modes of transportation such as mass transit, carpool, more economy cars, and even move their houses closer to their work, all in order to cut expenses. The long-term demand curve (D2) becomes more elastic. Price of Gasoline P1 P2 Elasticity P0 Q2 Q1 Quantity is highly inelastic. As new suppliers enter the market, the supply curve becomes more and more elastic. For a constant cost industry (such as an industry that uses inputs common to many other industries), the output is too small to affect prices of the inputs, and long run supply is perfectly elastic. Similarly, elasticity of demand is a measure of the responsiveness of demand as prices change, i.e. the percentage change in sales caused by a percentage change in price. Demand is less elastic in the short run (there is less that we can do to moderate consumption), and more elastic in the long run (we can develop substitutes, learn to live without). Externalities When two people trade, the belief is that they both mutually benefit from that trade. Unless they are required by law, buyers and sellers are unlikely to consider the effect of their trades on others. Many trades and agreements have some direct and indirect effects whose costs are not borne by the buyers and sellers, and therefore prices do not reflect true costs. These costs are called external costs or externalities and include such things as the cost of health care associated with pollution and damage done to the environment, buildings, etc. Society at large must bear both the private cost of production as well as the externalities distributed among various sectors. The sum of private and external costs is called the social cost. Depending on whether the externalities benefit or harm the society as a whole, they can be positive or negative. Pollution is a negative externality, whereas cleaning the environment and research to eliminate an infectious disease are positive externalities. The true cost of energy is not limited to the price we pay for our utilities or at the gas station, but also includes what we eventually pay in terms of degrading the quality of life by ruining the environment and our health. Additionally, the energy sector, petroleum in particular, is highly subsidized by the government in terms of various tax incentives, low-cost access to leases, mapping, R&D on oil extraction, building pipelines, highways and other infrastructures, and finally by military expenditure to protect the flow of oil. According to one estimate, in the last 30 years, the US has spent a total of $230 trillion dollars (1998 382 Chapter 15 - Economics of Energy dollars) for oil imports.5 The government additionally spends somewhere between $100 billion and $300 billion on hidden costs like health care and lost productivity and another 6 to 60 billion dollars defending oil supplies in the Middle East every year.6 If the costs associated with the current Iraq war are included, the last figure would be substantially higher. Many other environmental costs such as the destruction of natural habitats and wildlife and the loss of species diversity, which are not commercially traded, cannot be accurately measured and are not included in these figures. Question: W hat are the external costs associated with electricity generation using solar and other renewable energy sources? Answer: Although photovoltaic cells emit no pollutants during operation, their manufacture requires large quantities of hazardous materials, and their ultimate disposal could release toxic elements such as arsenic and cadmium into the environment. Other renewable energy sources incur similar costs; the external costs associated with them is however a lot less than with non-renewable sources. In a new study by the European Commission, the external costs associated with various energy technologies (fossil, nuclear, hydro, solar, and wind) for generating electricity were estimated. For non-market goods such as health care costs, noise, etc., an evaluation was made on the basis of the willingness to pay for damages or willingness to accept the risks. The external cost of material was estimated from the emission produced during its manufacture. Damages to ecosystems (acid rain, ozone depletion and global warming) as a result of fossil combustion were assessed by estimating the cost of avoidance. Because of different technologies used and material and labor costs, the cost is somewhat different from country to country and from one location to another. Table 15-1 shows the marginal external costs of electricity production in Germany.7 Data for other countries show similar trends. Table 15-1. Marginal external costs of electricity in Germany (€ cent/kWh) Coal Damage Cost Noise Health Material Crops Total Avoidance Cost Ecosystem Global Warming 5 Natural Gas Nuclear Solar (PV) Wind Hydro 0 0.73 0.015 0 0.75 0 0.34 0.007 0 0.35 0 0.17 0.002 0.0008 0.17 0 0.45 0.012 0 0.46 0.005 0.072 0.002 0.0007 0.08 0 0.051 0.001 0.0002 0.05 0.20 1.60 0.04 0.73 0.05 0.03 0.04 0.33 0.04 0.004 0.03 0.03 Greene, D. L., and Tishchishnya, N., “Costs of Oil Dependence: A 2000 Update,” Oak Ridge National Laboratory, ORNL/TM-2000/152, Oak Ridge, TN, 2000, and data updates, 2 003. 6 Hu, P.S., “Estimates of 1996 US Military Expenditures on Defending Oil Supplies from the Middle E ast: A Literature Review,” Oak Ridge National Laboratory, Oak Ridge, TN, March 1996. 7 R eport EUR 20198, “External Costs: Research results on socio-environmental damages due to electricity and transport,” European Commission Directorate-General for Research I nformation and Communication Unit, B-1049 Brussels, Belgium, 2003. Executive Summary at Internet: . 383 As this data suggests, electricity generated by wind energy has a very low external cost. The cost can be reduced even further by eliminating external costs associated with noise by installing wind farms some distance away from population centers. Nuclear energy has no externality with respect to classical pollution costs such as health effects associated with pollutants like particulates and oxides of carbon, sulfur, and nitrogen. The cost of global warming is also minimal and limited to that associated with the construction of the nuclear plant. There are, however, other external costs associated with the nuclear power. When uranium ore is mined, left behind are tailings; spent fuel must also be stored. In addition, there is unaccounted risk from earthquakes, and accidental or deliberate sabotage or attack. The US government has spent billions of dollars to find ways to store the nuclear waste unsuccessfully. The cost of treatment and isolation of radioactive waste for thousands of years and damage from nuclear leaks is almost impossible to predict and therefore is not usually included in any external cost analysis. Because of the liability limits in the US, owners of nuclear plants cannot buy full liability insurance in case of major accidents or terrorist attack. The lack of an insurance market – a market failure – should be a clue that there are unaccounted externalities. The probability of a major nuclear accident is very low, and therefore externality averaged over all nuclear plants is relatively small. Same goes for possibility of a successful nuclear sabotage. In some countries such as Switzerland, the government pays for hardening their reactors to protect against attack. That is one way to count the external cost, the cost of avoiding the consequence of attack. In the event of an accident, however, and for those directly affected by the accident, the external cost could be extremely high and greatly exceed that of all other forms of electricity generation. Biomass has a relatively minimal impact on greenhouse gases, as the carbon dioxide emission balances with that which is used up during plant growth. The impact could, however, become more pronounced as price of biomass increases and rainforests are destroyed. Although biomass does not produce greenhouse gases, it is not clean. When burned, it still emits pollutants that are harmful to health and to the environment. The air pollution impact varies greatly depending on the type of biomass, the technology used, and the degree to which emission of pollutant gases into the atmosphere is controlled. Natural gas is relatively clean with respect to criteria pollutants. In terms of its impact on climate change, natural gas is a potent greenhouse gas. How great an impact it has, however, depends on which natural gas technologies are employed. Coal is probably the dirtiest of all fuels. Not only is coal a major producer of carbon dioxide, but it is also a major contributor to the particulates and sulfur dioxide emissions responsible for acid rain and other health effects. 384 Chapter 15 - Economics of Energy Taxes One way to internalize the external costs is to impose consumption taxes or pollution penalties. One example is waste disposal, which is taxed in the form of a lump sum fee per customer. For example, every American household is charged $10 a month for garbage collection. In some communities, these charges are included in property taxes or association fees. In either case, there are no incentives for customers to reduce waste. Unlike the US, European taxes are based on a scale starting from a low nominal value and increasing gradually as the volume of waste increases. Energy is usually taxed indirectly in the form of gasoline and emission taxes. However, this may sometimes cause unwanted consequences. For example, taxing gasoline raises its price and so more people will switch to electric cars. To charge the batteries, electricity generated mostly from dirty coal-fired power plants is used, and the overall concentration of carbon dioxide may actually increase. It is therefore more reasonable to directly tax the pollution (for example by taxing per kilogram of carbon produced) instead of placing indirect taxes on energy usage. Several states have begun imposing pollution taxes directly. Depending on what source of energy is being used, a surplus tax per kilowatt-hour of electricity produced is imposed. Imperfect Competition: Monopoly and Cartel Monopoly A monopoly is an industry with only a single seller or provider of goods and services. In a monopoly, there is no competition and therefore the seller can charge prices that are higher than they would be in a competitive market. Because the price being offered by the monopoly is usually high, the quantity demanded is smaller than in competitive enterprises. In monopoly firms, prices are set at the point where total profit is maximized. They can sell more at lower prices, or they can sell less but at higher prices. In either case a monopoly can either control the output or fix the product price. Once the price is set, market demand will determine the quantity that can be sold at that price. Conversely, given the output, market demand determines the price at which that quantity can be sold. Monopolies are characterized by a lack of viable substitute goods or the existence of high barriers against the entry of potential competitors into the market. The former could be because the monopoly controls a major resource such as raw material or a specific technology necessary to produce a product. The latter could include laws that forbid competition (exclusive control over a patent on a product or on the processes needed to produce the product), laws that effectively forbid competition (through heavy regulations and subsidy), state monopoly (such as printing money and issuing stamps), or natural monopoly where production conditions and high initial cost make a sole provider more efficient (power and 385 water distribution to private households). The term is also loosely applied to companies which have de facto control of a large share of a total market; Microsoft and AT&T (before its breakup), could, because of their shear sizes, be involved in practices that prevented others from fair competition.8 Also classified as monopolies are firms that control the entire market through many smaller, seemingly diverse companies; in the early twentieth century, Standard Oil controlled the exploration, extraction, and transportation of petroleum. Just like a competitive firm, a monopoly maximizes its profit when MR = MC; unlike a competitive firm, marginal revenue in monopolies is not equal to the price. In fact, marginal revenue is below price. Example 15-3: Consider the market for heating oil in a large metropolitan area. Data of consumer behavior from previous seasons indicate that the total quantity of fuel oil sold decreases as price increases, as more and more customers switch to electricity to meet their energy needs. The cost is also a strong function of the quantity, as additional units must be imported from farther and farther distances. The total fixed cost for all firms is $4,000. The cost of production of each additional unit and the projected demand curve are given below. W hat is the total volume of heating oil and price offered to the market assuming that: a. There are 100 firms who are competing for the same market? b. The biggest firm buys out the remaining 99 smaller firms and thus becomes the sole supplier of the heating oil? Quantity Price ($) Marginal Cost ($) 0 42.00 -100 40.00 10.00 200 38.00 8.50 300 36.00 8.00 400 34.00 8.50 500 32.00 10.00 600 30.00 12.50 700 28.00 16.00 800 26.00 19.50 900 24.00 26.00 1000 22.00 32.50 Solution: W hether a firm operates as a monopoly or competes in a competitive market, it is interested in maximizing its profit. As long as the revenue of producing one additional unit (marginal revenue) is higher than its marginal cost, the firm makes a profit. In a competitive market, there are a large number of competitors, so each firm can only charge a price equal to the marginal cost. Since for a competitive firm P = MR, its profit-maximizing output is where MC = MR = P. Attempting to charge any price above its marginal cost brings in additional profit and signals competitors to enter the market. In the example given, marginal costs are reduced initially but increase as additional units are produced. At the same time, prices continue to decline with increasing output. The price becomes equal to marginal cost ($26) when 800 barrels of heating oil are sold cumulatively among the 100 retailers, bringing a total of $7,500 in profit. Increasing production does not necessarily mean more profit. In a competitive market, each firm is only after its self-interest and tries to 8 Some argue that a monopoly can lead to higher quality - Microsoft working hard to maintain monopoly, for example, by improving its product. 386 Chapter 15 - Economics of Energy maximize its own profit, even if it does not bring maximum profit for all firms collectively. In a monopolistic firm, there is no competition so a firm can set the price as it wishes and marginal revenue need no longer be equal to the price. In this example, the monopoly’s interest is in reducing the total quantity from 800 to 600 but to sell it at a higher price of $30 a barrel (A barrel of oil is exactly 42 gallons) instead of $26, increasing total profit by $750 to $8,250. As could be expected, monopolistic enterprises lead to higher prices and lower outputs. 1 Qty Q 0 2 Price P 42 3 Total Cost TC 4,000 10.00 100 40 5,000 8.50 200 38 5,850 8.00 300 36 6,650 8.50 400 34 7,500 10.00 500 32 8,500 12.50 600 30 9,750 16 700 28 11,350 19.50 800 26 13,300 26 900 24 15,900 32.50 1000 22 19,150 22,000 21,600 4 2,850 20,800 8 5,700 19,600 12 7,500 Competitive 18,000 16 8,250 16,000 20 8,250 Monopoly 13,600 24 7,500 10,800 28 6,100 7,600 32 4,150 4,000 36 1,750 4 Marginal Cost MC 5 Total Revenue TR 0.00 40 -1,000 6 Marginal Revenue MR 7 Total Profit TP -4,000 8 Advantages and Disadvantages of Monopoly The major disadvantages of a monopoly are lower efficiency, higher prices, and somewhat poorer quality. Because they don’t have to compete in the marketplace, monopoly firms can set prices artificially high, the firm is less efficient, and innovation is restricted. As a result, the product quality compared to quality in a competitive market is poor. Some economists do not consider these actions as necessarily harmful if firms reinvest their profit into the industry to expand their internal R&D (research and development) effort, building new plants and upgrading existing equipment. According to the Wall Street Journal, Japan owes its impressive energy efficiency to big energy companies who tacitly agreed among themselves to increase the price of energy but reinvest the windfall back into energy research and development.9 9 “How Japan became so Energy Efficient” Wall Street Journal , September 10, 1990. 387 Did You Know That ...? The Facts: The Price of Gasoline in Caifornia This is where the money we pay for each gallon of gasoline goes (May 2008): • Cost of the crude (including profit) $3.06 73% • Refining $0.28 7% • Various taxes o Federal excise tax $0.184 o State excise tax (av) $0.180 o State sales tax (av) $0.286 o Total $0.65 15% • Distribution and marketing $0.20 5% Total cost $4.19 100% Source: California Energy Commission ( Cartel When, instead of a single seller, a combination of a group of firms control the flow of a good or a service to a market, we have a cartel (also called a trust). In a cartel, a group of industries form an alliance where they can jointly decide on strategies that effectively control production and set prices. Like monopoly enterprises, cartels’ main objective is to maximize profit, except that cartels strategize to maximize collective profit of their members even when different firms have conflicting interests. In practice, one or two larger firms control cartel policies and set quota and prices. Smaller firms must exit or follow suit. OPEC is one such entity formed in 1960 by six major oil-producing countries to control production and combat falling oil prices (Figure 15-5). In the years following the 1960s, OPEC had limited success, as the price of light crude was raised modestly from $1.80 to $2.59 in 1973. The most striking success was the Arab Oil Embargo and OPEC’s cutback following the 1973 Arab-Israeli war. This resulted in a rapid rise in the price of oil to $11.65 by January 1974, which was gradually raised to $14 a barrel by 1978. The Iranian revolution in 1979 and Iran-Iraq war of the 1980s gave OPEC another opportunity to push prices to as much as $40 a barrel in 1981. Adjusted for inflation to 2007 prices, this exceeded $100 a barrel (Figure 15-6). The rapid rise in the price of petroleum forced industrial nations to consume oil more efficiently and invest heavily in alternative sources of energy such as wind and solar. Furthermore, high prices gave incentives to other nations to explore more of their own reserves and expand their production capacities. Due to these changes, along with the discovery of the North Sea and Norwegian oil deposits and the flow of Russian oil, OPEC’s role as an effective cartel was greatly reduced. Within the next few years, Saudi Arabia lost its leadership role in controlling prices, and the price of oil continued to decline – falling to $15 a barrel by February 1986. OPEC tried many times to control prices by cutting production, but the strategy remained largely ineffective, and except for a 388 Figure 15-5 OPEC Official Bulletin 100 Price per barrel of oil 80 60 40 20 0 Nominal price Adjusted price 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 Figure 15-6 Oil prices from the 1960s to present adjusted to 2007 dollars. U.S. Occupation of Iraq Iraq Invasion of Kuwait Iranian Revolution Arab Oil Embargo Chapter 15 - Economics of Energy short time during the 1991 Gulf War, prices stayed under $20. As of May 2008, various economical factors and the turmoil in Iraq resulting from the US occupation have resulted in a spike in oil prices to $130 a barrel, the highest they have ever been in OPEC history. It is important to point out that for a cartel to work efficiently, all members must agree to set aside economic differences and work in unison. In the case of OPEC, the internal economic factors and external political pressures, along with rivalry among members and emergence of nonmember powerhouses, have effectively stopped OPEC from performing efficiently as a cartel. Goods and Bads “Goods” are anything that people desire, and by extension “ bads” can be defined as all that they do not wish to have. Examples of goods are houses, cars, food, and energy. Examples of bads are pollution and noise. Garbage could be considered a good or a bad depending on whether we have to pay to get rid of our garbage, or if we are being paid by incinerator companies who burn it to produce electricity. Plastic bags can be considered to be goods when they are used to carry groceries but as bads when they no longer have any useful function and must be disposed of. The goods that can be sold in a market or traded in a barter economy in exchange for other services and products are called market goods. Nonmarket goods are goods that are available to all without charge. Examples of market goods are televisions, hamburgers, oil, electricity, and in some instances even pollution. Air and water are prime examples of non-market goods. Private and Public Goods Private goods are goods whose consumption or use by one consumer precludes its consumption or use by someone else. For example, a car sold to you is only for your own use (or your family and friends if you wish). The gasoline that you put in your car cannot be used by any other car except yours. Private goods are usually exclusionary. Watching a movie in a movie theatre or riding a train requires buying a ticket, so those who do not have tickets can be excluded from watching the movie or riding the train. Public goods are goods in common -- they can be used simultaneously by many individuals. Furthermore, once these goods are produced, they cannot be exclusionary, either by law or because of prohibitively high cost. Examples include the use of park services, police protection, roads, schools, and courts. The use of a public good by one person does not exclude others from using and benefiting from it as well. One person enjoying park facilities does not prevent others from enjoying the same 389 park. Unless it is overcrowded, the use of the university library by one student does not diminish its use to others, so there is no rivalry between students over library resources. Without exclusion, private firms have little or no incentives to provide public goods. To make a profit private firms require users to pay a fee for their products or services. For example, although TV broadcasting is a public good, cable companies can exclude non-subscribers and make a profit. For this reason, public goods are often provided by the government, which levies mandatory taxes on everyone. In certain instances, the government may hire private contractors to deliver public goods and pay them by issuing bonds or from general funds. Two problems often associated with public goods are free riding and open access. Free riding is a problem when each consumer of a public good is inclined to consume the good without sharing its cost of production – to free ride on the investment of others. Open access refers to overexploitation of natural resources to the benefit of each consumer at the expense of the community benefit. For example, consider the decision to hire a pool man to maintain the community pool. If contributions are totally voluntary, each neighbor may not contribute their fair share, hoping to free ride on the contribution of others. As a result enough funds may not be collected. In another scenario, individual homeowners may not be as careful in keeping the community pool clean as they would have if they were the only one who used the pool. One way to correct the free riding and open access problems is to impose regulations and levy fees to each member of the community who may benefit from the public good. Question: Is electricity a public or a private good? Answer: Strictly speaking, electricity is a private good as it is non-rival and exclusionary. Electricity is, however, an essential part of our daily life and as such is consumed by the public at large. It may therefore be argued by some that electricity should not be treated in the same fashion as other private goods. That’s to say, as a matter of economic justice or fairness, electricity must be regulated or subsidized (offered at lower prices) to low income customers. In the United States and many capitalist countries, however, electricity has been subjected to the general laws of supply and demand and treated similarly to other conventional private goods. Because electricity generation is capital intensive, only a few firms control the electricity market. In economic terms, a production system that is controlled by limited producers is called an oligopoly. The problem with an oligopoly is that these firms can theoretically collude to fix prices, forcing smaller firms out of competition and thus in effect, becoming a single unregulated monopoly firm. When energy was deregulated in the United States, proponents cited “deregulation” as 390 Chapter 15 - Economics of Energy a measure intended to increase competition. In reality, as we saw in Chapter 13, deregulation of electricity resulted in major collusions among big energy firms who raised prices to unprecedented levels. Because the public required the service, they had no choice but to accept the highly inflated prices. Example 15-4: In the absence of any regulatory pressure, John is dumping his garbage (a private bad) in a vacant lot adjacent to his house. Two neighbors, Sue and Bob, are particularly upset and are even willing to pay for the cost of hauling John’s garbage, which is $10 a month. Sue is willing to pay $7 toward the effort; Bob has volunteered to pay $5. Would enough money be collected to clean up John’s garbage? Solution: Not necessarily! Knowing Bob’s willingness to pay $5, Sue may conclude that $5 is all she needs to contribute toward the effort. By the same logic, Bob will volunteer to pay only $3, for a total of $8. As a result, each tries to free ride off the desperation of the other and not enough money is collected. Demand curves for public and private goods Depending on whether a good is private or public, its demand curves look different. In a market for a private good, a single price is offered, each buyer buys as many goods as desired, and total demand is simply the sum of the individual demands. For example, consider the total cigarette demand of two smokers, Mary (a regular smoker) and John (a casual smoker). Since cigarettes used by Mary cannot be used by John and vice versa, the total cigarette demand is the horizontal sum of the demand curves of John and Mary. Unlike private goods, public goods must be shared by many customers. In this case, the demand curve is the vertical sum of the demand curves of individual customers. For example, the inhabitants of two nearby cities, A and B, may be willing to pay different taxes for developing a beachfront. The residents of city A, being farther away from beach or because of their lower median income, are willing to pay less than the more affluent residents of city B, which is also closer to the beach. Demand curves for these two cities per meter of beachfront are denoted by Da and Db. If the beach is willing to accommodate both cities, then total demand is found by adding the two demands vertically. That is, if the residents of city A are willing to pay $150 in taxes for developing 3 kilometers of beachfront and residents of city B are willing to pay only $80, then the total demand for 3 kilometers of beachfront is $230. Figure 15-7 shows the total demand for private and public goods. Price Da Db D total Quality A. Private Good Price D total Db Da Quality B. Public Good Figure 15-7 Demand curves for (a) private and (b) public goods. Money Prior to the invention of money, trades were conducted by bartering – the 391 direct exchange of goods and services for other goods and services. A shoemaker could exchange his shoes with a teacher who could tutor his children, or a tailor for a pair of pants. A housewife could borrow meat from a butcher, cook it and keep some for her family while delivering the rest to feed the butcher. In a small village with a handful of artisans, bartering was highly efficient. Although bartering worked in feudal societies where only a limited number of products and services were available, it was largely ineffective in larger towns where a great variety of goods and services were needed. As societies grew and more goods and services were available, the number of exchanges became exceedingly large, and bartering became less attractive. With the invention of money, the need for direct exchange was eliminated, as individuals and businesses found a common unit of measure and value that could be exchanged for any number of products and services. Money also facilitated contracts for future activities and payments. Wealth In conventional capitalism, the quantity often cited as a measure of the economic health of a country is the gross domestic product (GDP), defined as the total market value of all goods and services produced in a country in a given calendar year.10 Another closely related indicator is the gross national product (GNP), which is calculated as the GDP plus what domestic companies earn from activities abroad, minus what foreign companies make from domestic activities in that country. In other words, GDP is the sum of all goods and services produced by labor and property located in a country irrespective of who supplies them, whereas GNP is the sum of all goods and services supplied to a country’s residents, irrespective of where they are physically produced. Some economists (commonly referred to as ecological economists) object to the GDP and GNP as true indicators of wealth, because they limit wealth to only the portion of market activities where income is generated. Functions such as charity and housework are not accounted for, whereas the costs of cleaning the environment and health care are included. Furthermore, there is no distinction between desirable and undesirable outcomes, i.e. they measure only money spent, not the value received. One million dollars spent on health care research will contribute as much to GDP and GNP as one million dollars used on building a refinery in a residential community. A better measure of human welfare may be the net national welfare (NNW), defined as the total annual output of both market and nonmarket goods and services, minus the cost of externalities, minus the cost of depreciation of natural and human-made capitals used up in production. 392 Chapter 15 - Economics of Energy Future and Present Worth In Chapter 1, we gave a few examples of how a quantity such as savings in a bank, population, or energy consumption grows exponentially. With no penalty for early withdrawal, a deposit of $100 in a 10-year CD (certificate of deposit) receiving a 10% interest, grows to 100 (1.10) = 110 after a year, 100 (1.10)2 = 121 after the end of second year, and 100(1.1)10 = 259 dollars at the maturity date. Mathematically speaking, if the present value of a quantity is P and the rate of growth is r, then the future worth of a present value after time n years have passed is (F/P) given by: F = P(1+r)n (15-1) Rearranging this equation, we can find the present value of a quantity if we know its future worth, i.e. the present worth of a future value (P/F) is: P = F(1+r)-n (15-2) For convenience, values of F/P and P/F are tabulated for various n and r values and are given in Tables 15-2 and 15-3. Table 15-2. Future Worth of a Present Value F/P=(1+r)n r/n 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 1 1.01 1.02 1.03 1.04 1.05 1.06 1.07 1.08 1.09 1.10 2 1.02 1.04 1.06 1.08 1.10 1.12 1.14 1.17 1.19 1.21 3 4 5 10 15 20 25 1.28 1.64 2.09 2.67 3.39 4.29 5.43 6.85 8.62 1.083 30 1.35 1.81 2.43 3.24 4.32 5.74 7.61 10.06 13.27 17.45 1.03 1.04 1.05 1.10 1.16 1.22 1.06 1.08 1.10 1.32 1.35 1.49 1.09 1.13 1.16 1.44 1.56 1.81 1.12 1.17 1.22 1.48 1.80 2.19 1.16 1.22 1.28 1.63 2.08 2.65 1.19 1.26 1.34 1.79 2.40 3.21 1.23 1.31 1.40 1.97 2.76 3.87 1.26 1.36 1.47 2.16 3.17 4.66 1.30 1.41 1.54 2.37 3.64 5.60 1.33 1.46 1.61 2.59 4.18 6.73 P/F=(1+r)-n r/n 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 1 0.99 0.98 0.97 0.96 0.95 0.94 0.93 0.93 0.92 0.91 2 0.98 0.96 0.94 0.92 0.91 0.89 0.87 0.86 0.84 0.83 3 4 5 10 15 20 25 0.78 0.61 0.48 0.38 0.30 0.23 0.18 0.15 0.12 0.09 30 0.74 0.55 0.41 0.31 0.23 0.17 0.13 0.10 0.08 0.06 0.97 0.96 0.95 0.91 0.86 0.82 0.94 0.92 0.91 0.82 0.74 0.67 0.92 0.89 0.86 0.74 0.64 0.55 0.89 0.85 0.82 0.68 0.56 0.46 0.86 0.82 0.78 0.61 0.48 0.38 0.84 0.79 0.75 0.56 0.42 0.31 0.82 0.76 0.71 0.51 0.36 0.26 0.79 0.74 0.68 0.46 0.32 0.21 0.77 0.71 0.65 0.42 0.27 0.18 0.75 0.68 0.62 0.39 0.24 0.15 Table 15-3. Present Worth of a Future Value 393 Example 15-5: According the US Department of Energy data, the world production of crude oil increased from 60 million barrels per day in 1981 to 74 million barrels per day in 2001. What is the average rate of increase of the world’s crude over this period? Calculate the expected volume of crude in 2020 if the rate of production continues to increase at 1% per year. Solution: We can think of the value in 2001 as the future worth of the value in 1981, i.e. F/P = 74/60 = 1.23. Consulting Table 15-2, we can see this corresponds to a rate of increase of about 1% per year over the past 20 years. The same table can be used to extrapolate future production from 2001 data. Interpolating for n = 19, we can find F/P = 1.21. The 2020 consumption of crude can be estimated as 74x1.21 = 90 million barrels. It is left to the student to verify these results by applying equations 15-1 or 15-2 instead of using tables. Example 15-6: A new substitute to Middle Eastern oil is expected to be found in the next 20 years. The cost of production of energy equivalent to one barrel of oil is estimated at $100. What should the price be of a barrel of oil sold today in a competitive market? In a market with substantial monopoly owner? Solution: Assuming the market is efficient that no cost is associated with the extraction of oil from the Middle East, and that the cost of production remains the same, the oil should be priced at a value equal to its future price discounted to present time: 100x{(P/F) n=20, r=0.05} = 100x0.38 = $38. It is very difficult to predict the cost of future technologies with certainty. Monopolies usually price their commodities at the cost of substitutes today, which could be substantially higher than $38 at today’s prices. Example 15-7: The US consumed 7.3 billion barrels of oil (bbo) in 2003, 2% more than it consumed in 2002.11 Assuming the consumption continued to increase at the same 2% per year, how much petroleum would be left in US reserves at the beginning of 2006? The total US petroleum reserves were estimated to be 100 billion barrels at the start of 2003. Solution: In 2004, we would be consuming 7.3x1.02 = 7.5 billion barrels of oil (bbo). The remaining reserves would be 92.5 bbo. In 2005, we would be consuming 7.5x1.02 = 7.6 bbo. The amount of oil that would remain at the end of 2005 is 84.9 bbo. Doubling Time Assuming a quantity grows in an exponential manner at a rate of r per year, the quantity grows after n years as given by equation 15-1. Of interest is 11 US DoT, 394 Chapter 15 - Economics of Energy the amount of time it takes for a present value to double for a given rate of growth, i.e. F/P = 2. The solution can be found by searching in the table of F/P factors for a given r values. For example, for a rate of 8% per year, the doubling time is 9 years. In general, it can be shown that doubling time is approximately calculated by dividing 72 by the percent interest rate (annual percentage growth rate). This approach is called the Rule of 72 and is expressed algebraically as: T2 = 72 R (15-3) where T2 is the doubling time in years, and R is the annual percentage growth (R = 100 r).12 Example 15-8: How long does it take for a deposit of $5,000 in a saving account to yield a total of $20,000 in principal and interest? The bank pays 6% interest. Solution: At the rate of 6% (r = 0.06), it takes 72/6 = 12 years to double the deposit. So the investment doubles to $10,000 after 12 years and doubles again to $20,000 after 24 years. Cumulative Value of a Series of Future Payments Also of interest is the cumulative value of a series of installments paid in equal intervals. For example, the total principal and interest paid on a home mortgage is the sum of all monthly payments over the course of a 30-year loan. Similarly, the cumulative value of energy consumption is the sum of energy used annually from the original reserves. The analysis presented in the previous section can be used to forecast energy consumption from the present rate of consumption assuming a certain growth rate. Of greater consequence is the amount of energy remaining at a future point in time. We calculated the remaining US oil for the years prior to 2006. That procedure can be used until the oil reserves are depleted. A better way is to find a formal relationship for the cumulative consumption is by adding all future consumption by summing up the series: C = P[1+(1+r)+(1+r)2)+(1+r)3)+….+(1+r)n-1] The mathematical series converges to give: C/P= 12 (1+r)n - 1 r (15-4) I n this example, we have assumed that the interest rate is compounded yearly. If the interest rates were compounded monthly, or even better, daily, then our money would have doubled i n a shorter time. Taken to the extreme, exponential growth would occur on a continuous basis as it does naturally in population, energy consumption, etc., further shortening the doubling time, i.e. N = N 0 e -rt (See equation 1, Appendix B). The doubling time is found by substituting N/N 0 = 2 to give: T2 = ln 2 r = 0.693 r = 70 R For the example above, the doubling time is calculated as 0.693/0.08 = 8.66 years instead of 9 years calculated with equation 15-3. 395 Equation 15-4 can also be interpreted as the future value of the stream of annual payments, accumulating interest compounded over time. The C/P factors are tabulated in Table 15-4. Table15- 4. Cumulative Value of a Series of Future Payments C/P=[(1+r)n -1]/r r/n 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.15 0.20 0.25 0.30 1 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 2 2.01 2.02 2.03 2.04 2.05 2.06 2.07 2.08 2.09 2.10 2.15 2.20 2.25 2.30 3 3.03 3.06 3.09 3.12 3.15 3.18 3.21 3.25 3.28 3.31 3.47 3.64 3.81 3.99 4 4.06 4.12 4.18 4.25 4.31 4.37 4.44 4.51 4.57 4.64 4.99 5.37 5.77 6.19 5 5.10 5.20 5.31 5.42 5.53 5.64 5.75 5.87 5.98 6.11 6.74 7.44 8.21 9.04 10 10 11 11 12 13 13 14 14 15 16 20 26 33 43 15 16 17 19 20 22 23 25 27 29 32 48 72 110 167 20 22 24 27 30 33 37 41 46 51 57 102 187 343 630 25 28 32 36 42 48 55 63 73 85 98 213 472 1,055 2,349 30 35 41 48 56 66 79 94 113 136 164 435 1,182 3,227 8,730 Example 15-9: Given the data in example 15-7, calculate how long US petroleum reserves will last. Repeat the calculation for the total world petroleum reserves. The remaining world oil reserves are estimated at approximately 2,000 billion barrels; the current rate of consumption is 30 billion barrels annually and is expected to rise at a rate of 4% per year. Solution: In this example, C is cumulative consumption equal to total US oil reserves in 2003 (C = 100 bbo) and P is the total oil consumed in 2003 (P = 7.3 bbo), so C/P = 100/7.3 = 113.7. Assuming that the annual rate of consumption continues to increase at 2% a year, we can refer to Table 15-4 to find 10 < n < 15 years. Interpolating, a better estimate will give a value of n ≈ 12.3 years. Similarly, for the world, C/P = 2,000/30 = 66.6. For r = 0.04, we can estimate we will have petroleum for another 40 years. Annuities (Net Present Value) Investors are interested in the return that their capital investment brings to them. It is also understood that the greater the risk they take, the higher their expectations for returns will be. The minimum that any investor expects as their rate of return is the interest that they could collect if they had deposited their investment into a bank or other financial institution. Depending on the perceived risk that different projects have and the tolerance of the potential investor to the loss of capital, different investors may expect different rates of return. 396 Chapter 15 - Economics of Energy Investors do not necessarily put all the capital up front. Rather, it is common that they make a series of payments as the project proceeds. To make a wise decision on the profitability of the investment, all future revenues and costs must be discounted to the present. The discount rate is commonly chosen to be the expected rate of return. The present value of a stream of annual payments or annuities, A, is calculated by summing Equation 15-2 over all future payments: P = A [1 + 1 1 1 + + ..... + ] (1+r) (1+r)2 (1+r)n The series converges to give: P/A= (1+r)n - 1 r(1+r)n (15-5) The P/A factors are calculated and summarized in Table 15-5. Example 15-10: A $10,000,000 lottery win can be awarded either over a 20 year period, by installments of $500,000 each, or as $5,000,000 in cash right away. Assuming the winner plans to deposit his money in a 20-year CD that pays 8% in interest, which option makes more sense? Solution: The present value of the annual installments is {(P/A) n=20, r=0.08} = 10.59. The present worth of all future installments is $500,000x10.59 = $5,295,000 and is somewhat better than $5,000,000 in cash paid out today. Example 15-11: The population of a large metropolitan area is expected to increase by 200,000 people within the next 5 years. To meet the future demand, a 200 MW wind farm is proposed for construction. The cost of construction is expected to be $5M in the first two years and an additional $2M for the following three years. The plant is expected to generate a net income (revenue minus maintenance costs) of $2M for 20 years after it is completed. Does this investment make economic sense? Assume an interest rate of 5%. Solution: In the first five years that the plant is under construction, $16M are spent on construction. Starting year 6, the plant will generate revenues of $2M in annual income for the next 20 years after maintenance costs are deducted. A summary of the cost and income schedule is given below: Year Cost (M) Income (M) 1 5 0 2 5 0 3 2 0 4 2 0 5 2 0 6 0 2 7 0 2 … 0 2 25 0 2 Please note that P/A factors assume that all payments are equal and 397 start from year 1. As mentioned, there is no income for the first 5 years. To correct for this we subtract the net present value of income that would be generated for 25 years and subtract from it the lack of income opportunity for the first five years. Similarly, we can break down costs as annual cost of $2M for five years, in addition to annual costs of $3M a year for the first two years. This is best understood if the timeline table is rearranged as: Year Cost (M) Cost (M) Income (M) Income (M) 1 2 3 2 -2 2 2 3 2 -2 2 -2 2 -2 2 -2 2 2 2 2 3 2 4 2 5 2 6 7 … 25 The approach is to calculate P/A factor for a series of annual payments starting in year 1. Consulting Table 15-5, the net present values of income and expenses are: NPV(income) = [2(P/A, 0.05, 25) - 2(P/A,0.05,5)] =2(14.09)–2(4.33)=9.52 M NPV (cost) = [3(P/A,0.05,2) + 2 (P/A,0.05,5)] = 3(1.86) + 2(4.33) = 14.24 M NPV (income) / NPV (costs) = 19.52/14.24 = 1.37 ; thus the investment makes sense! Capital Recovery Factor The capital recovery factor (annualized cost) represents the series of annual payments to pay off a loan. This is the reverse of the previous problem -- we know the present worth of all future payments (i.e. the loan principal). The result is: A/P= r(1+r)n (1+r)n -1 (15-6) A/P factors are tabulated in Table 15-6. Example 15-12: W hat is the annual payment required to pay a $250,000 loan at 7% over 15 years? Solution: Annual cost = loan amount x [(A/P)r=0.07, n=15] = ($250,000) x 0.11 = $27,500 Internal Rate of Return A convenient way to evaluate the economic benefit of a project is to calculate the effective rate of return of all future transactions. Since payments and revenues take place at different times, a proper method of evaluation is to discount them to present value. The internal rate of return is computed simply by equating the NPVs for all future costs and incomes. NPV (cost) = NPV (income) 398 Chapter 15 - Economics of Energy Table 15-5. Net Present Value of a Series of Future Installments (Annuities) P/A=[(1+r)n-1]/[r(1+r)n] r/n 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.15 0.20 0.25 1 0.99 0.98 0.97 0.96 0.95 0.94 0.93 0.93 0.92 0.91 0.87 0.83 0.80 2 1.97 1.94 1.91 1.89 1.86 1.83 1.81 1.78 1.76 1.74 1.63 1.53 1.44 3 2.94 2.88 2.83 2.78 2.72 2.67 2.62 2.58 2.53 2.49 2.28 2.11 1.95 4 5 10 9.47 8.98 8.53 8.11 7.72 7.36 7.02 6.71 6.42 6.14 5.02 4.19 3.57 15 20 25 22.02 19.52 17.41 15.62 14.09 12.78 11.65 10.67 9.82 9.08 6.46 4.95 3.98 30 25.81 22.40 19.60 17.29 15.37 13.76 12.41 11.26 10.27 9.43 6.57 4.98 4.00 3.90 4.85 3.81 4.71 3.72 4.58 3.63 4.45 3.55 4.33 3.47 4.21 3.39 4.10 3.31 3.99 3.24 3.89 3.17 3.79 2.85 3.35 2.59 2.99 2.36 2.69 13.87 18.05 12.85 16.35 11.94 11.12 9.71 9.11 8.56 8.06 7.61 5.85 4.68 3.86 14.88 13.59 11.47 10.59 9.82 9.13 8.51 6.26 4.87 3.95 10.38 12.46 Table 15-6. Capital recovery factor A/P=[r(1+r)n]/[(1+r)n-1] r/n 1 2 3 0.340 0.347 0.353 0.360 0.368 0.375 0.382 0.388 0.395 0.402 0.439 0.474 0.513 0.549 4 0.256 0.262 0.269 0.275 0.282 0.288 0.295 0.302 0.309 0.315 0.351 0.386 0.424 0.461 5 0.206 0.212 0.218 0.225 0.231 0.238 0.244 0.251 0.257 0.264 0.299 0.334 0.372 0.410 10 0.111 0.117 15 0.078 0.084 20 0.055 0.061 0.067 0.074 0.080 0.087 0.094 0.102 0.110 0.118 0.160 0.205 0.253 0.301 25 0.045 0.051 0.990 0.064 0.071 0.078 0.086 0.094 0.102 0.110 0.155 0.202 0.251 0.300 30 0.039 0.045 0.051 0.058 0.065 0.073 0.081 0.089 0.097 0.106 0.152 0.201 0.250 0.300 0.01 1.01 0.508 0.02 1.02 0.515 0.03 1.03 0.524 0.04 1.04 0.529 0.05 1.05 0.538 0.06 1.06 0.546 0.07 1.08 0.552 0.08 1.08 0.562 0.09 1.09 0.568 0.10 1.10 0.575 0.15 1.15 0.613 0.20 1.20 0.654 0.25 1.25 0.694 0.30 1.30 0.735 0.106 0.072 0.123 0.090 0.130 0.096 0.136 0.103 0.142 0.149 0.110 0.117 0.156 0.124 0.163 0.131 0.199 0.171 0.239 0.214 0.280 0.259 0.324 0.306 Example 15-13: An investor is considering investing in the wind farm project described above. The investor also has an opportunity to purchase a government bond which is expected to earn a 10% return. W hich option would be advantageous? Solution: To have a fair basis for comparison, the investor should compare the internal rate of return for the project and the rate of return from the bond. The internal rate of return can be calculated by equating the NPVs for income and cost. NPV (income) = NPV (cost) 399 2(P/A, r, 25) - 2(P/A, r, 5) = 3(P/A, r, 2) + 2(P/A, r, 5), or D (NPV) = 2(P/A, r, 25)-4(P/A, r, 5) -3(P/A, r, 2) = 0 The problem must be solved by trial and error. Assume a rate of return and evaluate the equation above until it converges. r 0.07 0.08 0.09 D (NPV) 2(11.65) -4(4.10) -3(1.81) = 1.47 2(10.67) -4(3.99) -3(1.78) = 0.04 2(9.82) -4(3.89) -3(1.76) = -1.20 The effective rate of return for investing in the wind farm project is about 8%, which is less than the 10% that the bond would earn. Although the investment in the bond is a better choice financially, an environmentally contentious investor may still consider the investment in the wind farm. Cost of Living Adjustment (COLA) How can we compare the cost of acquiring a good or service at two different times? Our salary today is probably higher than it was 10 years ago, but does that mean that we are richer today? The answer depends on whether we can buy less or more with the money we earn today than with our income of 10 years ago. This means our salaries today must be discounted to account for inflation. Table 15-7. The 2008 CPI Conversion Factor Year 1810 1820 1830 1840 1850 1860 1870 1880 1890 1900 1905 1910 1915 1920 1925 1930 CF 0.066 0.063 0.05 0.047 0.042 0.045 0.07 0.055 0.049 0.046 0.048 0.051 0.052 0.103 0.106 0.096 Year 1935 1940 1945 1950 1955 1960 1965 1970 1971 1972 1973 1974 1975 1976 1977 1978 CF 0.067 0.068 0.087 0.117 0.131 0.144 0.153 0.189 0.196 0.203 0.216 0.239 0.261 0.276 0.301 0.326 Year 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 CF 0.352 0.400 0.441 0.469 0.484 0.504 0.522 0.532 0.551 0.575 0.602 0.635 0.661 0.681 0.701 0.720 Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 CF 0.740 0.762 0.779 0.792 0.808 0.836 0.860 0.873 0.893 0.917 0.939 0.957 0.978 1.000 To convert dollars of any year to 2008 dollars, divide the dollar value of that year by its conversion factor. For example, $1,000 in 1950 dollars is equivalent to 1,000/0.117=$8,547 in 2008 dollars. 400 Chapter 15 - Economics of Energy The Consumer Price Index (CPI) was designed in 1983 to measure the average cost of living of average consumers. CPI calculated the cost for a basket of products and services (food, housing, transportation, clothing, health, etc.). Although CPI was a good indicator of inflationary pressure for a few years, its value became less and less indicative of the cost of living. The main reason is because CPI was based on a fixed set of commodities and ignored behavioral changes as technologies matured and peoples’ taste for goods and services changed. Furthermore, CPI ignored the impact of consumption on declines in the price of goods. In 1983, an average person traveled fewer miles and paid less for gasoline. The cost of a computer was much higher, however. As prices of some commodities rose sharply, consumers found other alternatives. As a result, the consumer behavior today is widely different from that of twenty years ago, and the “basket” of goods and services used in 1983 does not give a true representation of the change in purchasing power of the average consumer. The price of any item in dollar-values of year X can be calculated in terms of dollar-value of the price of any item in dollar-values of year Y from the equation below: Dollar value in year X = CF in year X . (Dollar value in year Y) CF in year Y Example 15-14: Following the Iran-Iraq war in 1981, the price of Middle Eastern oil reached an all-time high of $40 a barrel. What was the price in 2005 dollars? Adjusting for inflation, are we paying more or less for gasoline today compared to 1981 prices? Solution: Using the CPI indicator (Table 15-7) to adjust for inflation gives us a conversion factor of 0.47; every 2005 dollar was worth only 47 cents in 1981. The price of 1981 gasoline in 2005 dollars can be calculated by dividing the 1981 price by 0.47 (40/0.47 = $85 in 2005 dollars). Compared to the $55 price of gasoline today, we are buying oil at a relatively cheaper price than in 1981. Example 15-15: The average of price of gasoline in the US was $2.60 a gallon at the gas pump in 2004. What was the price in 1950 dollars? Solution: Consulting Table 15-7 for CF values, the price of gasoline in 1950 dollars can be calculated as: 0.125/0.977 x $2.60 = $0.33. International Trade International trade has always been a key component of relations among nations and is critical for the economical development of all nations. As we discussed earlier, trades take place because both sides are better off as a result of the transaction. International trade is particularly important because different countries have different resources and therefore, different opportunity costs. In other words, some resources have a comparative advantage over other resources; different countries may be 401 better off putting their resources towards production of one product than another and using trade as a means to acquire their needs—in the process both countries benefit. To make any trade possible, there are middlemen or entrepreneurs that facilitate the transactions, generating profits and at the same time allowing both countries to benefit economically. Example 15-16: Saudi Arabia is a large supplier of oil, but its desert climate is not particularly suitable for agricultural products such as wheat. It costs the Saudi government $5 for every barrel of oil it produces and $50 for a ton of wheat. The United States, on the other hand, does not have large oil resources, but has a high opportunity cost of producing oil ($25 a barrel). US temperate climate and fertile soil is ideal for growing wheat and can produce it at relatively lower cost ($15 per ton). Assuming each country’s production satisfies its own national needs, is there anything gained from trades between the two? Solution: The volumes of production for oil and wheat and the total cost of production are given in column A for each country. For Saudi Arabia, the cost of production of one ton of wheat is higher than for one barrel of oil. It therefore makes sense for Saudi Arabia to dedicate its resources to the production of additional oil; it can invest all its resources to increase production of oil to 3,000 barrels and buy wheat from the US (Column B), keeping its total production cost the same. By the same token, it makes sense for the US to divert its resources to production of wheat, increasing its volume to 1,250 tons, and to import its oil from Saudi Arabia. Now Saudis can export 150 barrels of their oil to the United States and keep 2,850 barrels for domestic use or sell them to other countries. Without trades it would have cost Saudis $24,250 to produce this amount of these two products (Column C), resulting in a net savings of $9,250 directly resulting from the trade. The United States, on the other hand, buys 150 barrels of oil while selling 200 tons of its wheat to Saudi Arabia, meeting its domestic oil needs and keeping 50 tons of wheat in excess of what it would have without these trades, saving $750. It is clear that both countries have benefited from this trade. Saudi Arabia A Production, oil (barrels) Production, wheat (tons) Total production cost ($) Net saving ($) 1,000 200 B 3,000 0 C 2,850 200 9,250 A 150 1,000 US B 0 1,250 C 150 1,050 750 15,000 15,000 24,250 18,750 18,750 19,500 The example above shows that both countries benefited from free trade with a net benefit that is spread across the society. Free trade, however, is not free of cost. For example, US oil workers may be laid off or must switch to farm work. The reverse is true for Saudi Arabian nationals. As a result, some sectors of the society will be unsatisfied. To counteract the 402 Chapter 15 - Economics of Energy adverse effects of free trade, these groups, through their trade unions, hire lobbyists encouraging lawmakers to enact trade barriers, organize strikes, or boycott a particular good imported from a foreign country. Usually, the cost incurred to these individuals is small compared to the benefit gained by the populace at large, however. Question: The European Union places a high tariff on food imported from non-EU countries. What would the effect on EU population be? Answer: Although some jobs are saved as a result of lower imports, the general public will suffer from higher prices of food in EU member countries. With no restrictions on free trades, the EU food prices drop and everybody benefits. The farmers, through political campaigning and advertisement, will try to inform the public of the costs, not the benefits, of free trade. One approach to neutralize the opposition to free trade is by passing on some of the benefits to farmers and those who are directly affected and still making the whole population better off overall through free trade. Sources and Types of Barriers and their Impacts There are several reasons that countries impose trade barriers. The most common ones are: a) learning by doing, b) economics of scale, and c) national security.13 a. Learning by doing – Trade barriers are imposed when the government believes that they can make a particular good more internationally competitive only if an infant industry is given enough time to gain experience to improve the product and reduce manufacturing costs. For example, a country may restrict the import of plastics to give local manufacturers time to improve their inferior product and eventually compete with a superior foreign product. b. Economics of scale – Trade barriers are intended to allow a higher output of a certain good by local manufacturers. This reduces the cost per unit, making the good more attractive to foreign competition. For example, a country may be able to produce cotton at below international market price only if the volume of production exceeds a certain level. c. National security – Trades are restricted by a country on the grounds that their national security may be threatened. This restriction may be imposed on both imports and exports. For example, a country may put a restriction on volume of imported oil because they don’t want to be dependent in a time of war. At the same time, the export of certain military equipment or specific chemicals may be banned to assure they do not fall into unfriendly hands. Trades may also be restricted by a country as a means of putting pressure on or punishing another country to achieve a certain political goal. For example, the 13 Colander, D. C., M acroeconomics, 3rd Ed., Irwin McGraw-Hill, 1998, pp. 489. 403 US restricts trades with Cuba and North Korea to pressure these governments to change their policies on immigration or developing certain nuclear technology. Trade barriers can also be imposed to protect against transmission of insects, or to protect human health. Depending on the impact they are intended to make, many kinds of trade barriers may be imposed. These include tariffs, quotas, embargos, regulatory trade restrictions, and nationalistic appeals. Tariffs or custom duties are taxes imposed by governments on imported goods. They are mainly to increase revenues and encourage consumption of domestically produced goods. Quotas refer to quantitative limitations placed on imports. An embargo is a total restriction on the import or export of a good. Regulatory trade restrictions are designed by governments to set certain standards and requirements to limit imports. Nationalistic appeal refers to a direct pleading to citizens to buy domestic products rather than products manufactured and imported from other countries. No matter which type is used, trade barriers can only work if the affected country does not retaliate in kind or by other means. This is highly unlikely and, except in rare circumstances, trade barriers will not work in the long run. As trades become more and more global in nature, countries find other means to counteract by imposing their own barriers or finding alternative markets in which to sell and buy their necessities. Mixed (Dual) Economies The free market economy is practiced in developed countries and international trades and is based on established laws of supply and demand. Many problems inherent in developing countries, however, hinder the full implementation of this system. These include political instability, corruption, overpopulation, and lack of financial infrastructure. Political instability results from social inequality, excessive poverty, lack of political freedom, and arbitrary decisions by authoritarian regimes. As a result, the transition of government is unlikely to be orderly and is often associated with coups, bloodshed, and political apathy among the people. Political instability discourages foreign and internal investment and encourages the flight of qualified engineers and technocrats. Because there are no checks and balances on government leaders, citizens have a deep mistrust of their government, and corruption is usually rampant and a way of life in many developing nations. Generally, low-income developing countries have a dual economy, one being the traditional, often non-market economy, and the other a westernstyle free market economy. The traditional economy sector financing is limited, and trades are largely in local currency and in cash, even at times by bartering. These systems do not have an institutional apparatus to collect taxes. Even if such a system is in place, it is often rigged with fraud and bribery. The free market economy sector is used in large financial 404 Chapter 15 - Economics of Energy transactions and when the government or private enterprise engages in international trading. Financing is usually possible and often the norm. Globalization Globalization, in the broadest terms, refers to the integration of world economies through increased trade and knowledge and the free movement of material, labor, and capital across international borders in search of new markets and investment opportunities. Although globalization is not new and existed at some level centuries ago, the technological advances of the past few decades have made it easier and quicker to complete transactions and the trend toward globalization has accelerated. Whether globalization benefits or harms a particular country has been the topic of many debates. Some consider globalization and free market economy to be the keys to future world economic development. They foster competition and improve efficiency by making the flow of technological innovations, skilled labor, and free flow of capital easier. They also help developing and underdeveloped countries make progress towards democracy and a cleaner environment as their living standards rise. Critics of globalization argue that markets do not necessarily ensure that the benefits of increased efficiency are shared by all. Furthermore, these policies, written primarily by large corporations and western governments, require such agencies as the International Monetary Fund (IMF), the World Bank, and the World Trade Organization (WTO) to oversee trade and investment agreements negotiated between member states. These organizations often impose regulations that put industrialized nations at an unfair advantage and at the same time increase their access to natural resources of the developing countries. According to these rules, all resources, no matter where they lie, must be available for sale to the highest bidder, but the technologies used to discover, extract, and process these resources are regarded as proprietary, or “intellectual property” of the developers. The role of energy is particularly important in shaping this debate. Certain types of energy such as wind and solar are inherently decentralized. Others, such as fossil and especially nuclear, are controlled by large corporations and governments; therefore the control over these resources and supply routes brings about economic as well as political power. As we have seen by now, the world is divided into two groups: those who have vast fossil resources and those who have not. The countries that are endowed with these resources are mainly developing countries, mostly in the Middle East. Western and other industrialized countries are by far the greatest consumers of energy. To secure the flow of petroleum and other natural resources to industrialized countries, through a twin strategy of military intervention and economic globalization, governments are required to open their borders to international trade and investment without the imposition of taxes, tariffs, and other regulatory barriers. 405 So far, the result of globalization has been mixed as best. Rich countries have in large benefited from international trades, although many of their citizens (especially those hired in low-tech industries such as textile, agriculture, and some electronic products) have suffered from losing jobs to lower-paid foreign workers. During the past century, the average per capita GDP of many industrial countries increased by as much as six-fold, although the income gap between rich and poor countries has been widening.14 In the last three decades, some developing countries, especially in Asia, have been able to benefit from globalization by increasing their share of world trade. Other countries, notably in Africa and in South America, have not been able to integrate with the world economy and their per capita income has actually declined. What is clear is that globalization is here to stay and if they are to benefit, individual countries must embrace globalization on their own terms, taking into account their own history, culture, and traditions. The two most populous countries in the world, China and India, are growing rapidly to become world’s new economic powerhouses. This means that not only their demand for energy and fossil fuel will accelerate, but also their ecological footprints, the strain on natural resources, release of carbon into the atmosphere, and higher level of environmental pollution. Unless drastic effort in finding new alternative resources and implementing innovative conservational measures are made, the competition for control of these resources and potential for additional regional conflicts will increase.15 Summary Higher energy prices have direct and dramatic effects on the global economy. Because fossil fuels, especially petroleum, comprise the majority of our energy consumption, rises in oil prices have correlated closely with inflationary pressures. Though the US has successfully reduced its dependence on imported oil in the last decade (measured as energy consumption per dollar of the GDP), other countries have not been able to follow suit. Moreover, over half of the US total oil consumption is now imported, and this number continues to increase steadily into the future. As the price of oil climbs, other commodity prices will also increase, likely affecting prices of non-energy exported and imported goods, which in turn affects the global economy and may result in political instability in developing countries. In the United States, government and business focus on the shortterm profit motives and quarterly earnings and not much on long-term interests. Banks and other sources of funding will seek to receive a return on their investments in as early as a 3-5 year period, rarely exceeding 10 14 15 “ World Economic Outlook,” International Monetary Fund, Washington D.C., May 2000, ( Stiglitz, J.E., Globalization and its Discontent , Norton Publishers, New York, 2002. 406 Chapter 15 - Economics of Energy years. As a result, in many instances lack of clear immediate revenues will stifle innovation or give it away easily to foreign competitors. For example, during the 1970s when energy sufficiency and environment became a national security issue, the US spent a tremendous amount of resources to support research and development of renewable energy technologies such as solar photovoltaic, solar thermal power, and wind. In the 1980s, soon after the energy crisis subsided and oil prices dropped, so did the support for alternative sources of energy and environmental protection. The Reagan administration reversed the energy independence policy of the former Carter administration by slashing the federal research funds from $150 M to zero and much of their tax credits and subsidies as well. At the time, the United States was the leading manufacturer of solar cells and wind turbines. Japan and much of Europe capitalized on these inventions by buying American companies and at the same time developed longterm energy policies that reduced the imports of foreign oil and instead relied on the development of cleaner technologies and alternative sources of energy. Today, Japan is the leading producer of solar cells and fuel cells, and over one-half of all hybrid and electric vehicles sold in the United States. Germany is the largest manufacturer of wind turbines. Spain and several other European countries are developing the next generation of solar thermal power plants. Unless the United States reverses its “cheap oil policy,” not only will its reliance on Persian Gulf oil increase, but much of its engineering ingenuity and know-how will be relegated to foreign competitors. Additional Information Books 1. Colander, D. C., Economics, 3rd E., Irwin-McGraw-Hill, 1998. 2. Bosselman, F., Energy, Economics and the Environment, Second Edition, Foundation Press, 2005. Periodicals 1. Energy Economics, Science Direct Elsevier Publishing Company. Publishes research papers concerned with the economic and econometric modeling and analysis of energy systems and issues. Non-Government Organizations and Websites 1. United States Association for Energy Economics (http://www.usaee. org). 2. International Monetary Fund ( 3. The World Bank ( 407 Exercises I. Problems: 1. The worldwide consumption of petroleum was 150.8 quads in 2002. Assuming the consumption continues to increase at 2% per year, what will the world consumption of petroleum be in 2025? 2. A bacterial colony in a jar grows at the rate of 10% every hour. Find: a. Doubling time b. If the jar were initially 1/8 full, how long would it take before the jar is completely full? c. Assume that a person is accidentally infected with only one bacterium. What is the bacterial population after one week? 3. If an employer were to offer you a) $10,000 a year in initial salary and a $2,000 raise every year thereafter, or b) $1 a year in initial salary, but would double it every year for the next twenty years, which one would you choose? Why? Assume that the prevailing interest rate remains at around 5% for the 20 year period. 4. A loan agency has offered a customer to pay off his $ 100,000 existing loans using one of the following three options: a. By paying balance immediately in cash b. By paying 10 equal payments of $11,000 each annually. c. By paying $50,000 now and a balloon payment of $60,000 in 10 years. W hich option makes more sense to the customer? Assume annual interest rate of 5%. 5. The national average price of regular gasoline in the United States is given by the DoE Energy Information Energy (all data are for August) as following: 1992 $1.03 a gallon 1994 $1.13 “ 1996 $1.17 “ 1998 $1.00 “ 2000 $1.45 “ 2002 $1.36 “ 2004 $1.85 “ 2006 $3.00 “ 408 a. Adjust the prices for inflation, which year offered the cheapest gasoline? most expensive gasoline? b. What is the price of gasoline in today’s dollar? in 2000’s dollar? In 1950’s dollar? In 1900’s dollar? II. Multiple Choice Questions 1. In an efficient market a. There are numerous buyers and sellers b. There are no barriers to entry c. There are numerous products that are essentially indistinguishable from the good of interest d. Firms’ only goal is to maximize their profits e. All of the above 2. The supply curve is upward sloping because a. As prices increase, so do costs b. As prices increase, demand for a product declines c. As prices increase, demand for a product also rises d. As prices increase, suppliers are willing to produce more e. As prices increase, suppliers are willing to produce less 3. As the cost of production of cell phones falls, a. The demand curve for cell phones shifts to the left b. The demand curve for cell phones shifts to the right c. The supply curve for cell phones shifts to the left d. The supply curve for cell phones shifts to the right e. Neither the supply curve nor the demand curve shift 4. In a perfectly efficient market, a firm’s long-term profit will be maximized when a. Price equals fixed cost b. Price equals total cost c. Fixed cost equals total revenue d. Total cost equals total revenue e. Marginal cost equals marginal revenue Chapter 15 - Economics of Energy 5. Which of the following is not consistent with the existence of a perfect competitive market? a. Absence of low transaction costs b. Limited competitors c. Significant barriers for entry into the market d. Absence of a sufficient number of indistinguishable substitutes e. All of the above 6. When a newer technology replaces an older technology a. Both demand and supply curves shift to the right b. Both demand and supply curves shift to the left c. Demand curve does not change, but the supply curve shifts to the right d. Supply curve does not change, but the demand curve shifts to the right e. Neither the demand curve, nor the supply curve are affected 7. When median income increases, a. Both demand and supply curves shift to the right b. Both demand and supply curves shift to the left c. Demand curve does not change, but the supply curve shifts upward d. Supply curve does not change, but the demand curve shifts upward e. Neither the demand curve, nor the supply curve are affected 8. Which of the following is considered to be a positive externality? a. A power plant emits pollution into the air thus reducing its cleanup cost. b. A man blasts his music and gives his neighbor a headache. c. A little girl buys a pretty doll from a toy store. d. A power plant switches from coal to natural gas. e. None of the above. 9. As a result of higher demand for a product a. The demand curve does not change, but price rises The demand curve does not change, but price falls The demand curve shifts to the right, but price rises The demand curve shifts to the right, but price falls Both price and quantity supplied increase b. c. d. e. 10. As a result of a rise in the cost of living, we expect a. Both price and quantity of goods to rise b. Price increases as quantity of goods falls c. Price does not change as quantity of goods falls d. Quantity of goods does not change as price increases e. Both price and quantity of goods increase 11. Exponential growth may be characterized by a. The absolute amount of growth every year remaining constant b. The percentage growth every year being constant c. The percentage growth every year being exponential d. The growth rate doubling every year e. None of the above 12. Linear growth may be characterized by a. The absolute amount of growth every year being constant b. The percentage growth every year being constant c. The percentage growth every year being exponential d. The growth rate doubling every year e. None of the above 13. According to the latest (2000) census results, Nevada showed the fastest population growth (5.4%) in the United States. In what year would the population of Nevada double? a. 2005 b. 2013 c. 2018 d. There is not enough information to predict the year. 409 e. None of the above. 14. In the US, the doubling time of our exponentially growing electricity consumption rate was 10 years from 1900 to 1970. How did the electricity consumption from 1960 to 1970 compare to all US electricity consumption prior to 1960? a. It was twice as much. b. It was half as much. c. It was an equal amount. d. It was 1/6 as much. e. It cannot be determined from given information. 15. Since the 2000 census, the US population has grown at a rate of 1.2% per year. In what year will the US population double? a. 2058 b. 2083 c. 2120 d. There is not enough information to predict the year. e. None of the above. 16. In 75 years, a small community of 10,000 people that enjoys a constant 2.8% annual growth rate will attain a population of about a. 28,000 b. 30,000 c. 80,000 d. 2,100,000 e. None of the above 17. An employer guarantees a salary increase of 7.2% a year for all employees. If a particular employee is hired at an initial annual salary of $30,000, how long would it take for their salary to reach $60,000? a. About 7 years b. A bit sooner than 10 years c. 10 years d. A bit longer than 10 years e. About 14 years 18. Statistics show that for the last few decades, the US consumption of petroleum has doubled every decade. The corresponding annual percent growth 410 rate is a. 2% b. 7% c. 10% d. 13% e. None of the above 19. $200 invested at 5% compound interest will grow to $800 in about a. 4 years b. 28 years c. 40 years d. 42 years e. 56 years 20. What is the present worth of $1,000 payable in 5 years assuming an average discount rate of 4%? a. $ 820 b. $ 850 c. $ 1,000 d. $ 1,170 e. $ 1,220 21. How much interest does $1,000 placed in a 5-year CD paying 4% accumulate? a. $ 2,220 b. $ 1,220 c. $ 820 d. $ 220 e. None of the above 22. If a sin tax is imposed on tobacco and alcohol a. The demand curve shifts to the left b. The demand curve shifts to the right c. The supply curve shifts to the left d. The supply curve shifts to the right e. Neither the supply curve nor the demand curve shift 23. What happens to the price of air travel when the price of travel by rail increases? a. The demand curve shifts to the left. b. The demand curve shifts to the right. c. The supply curve shifts to the left. d. The supply curve shifts to the right. e. Neither the supply curve nor the demand curve shifts. Chapter 15 - Economics of Energy 24. The social cost of a product or activity is the sum of a. Fixed and variable costs b. Private and variable costs c. Private and fixed costs d. Private and external costs e. Private and public costs 25. Firms often collude to form a cartel because a. They can function like a monopoly b. It allows them to spend more money on innovation c. It furthers competition and increases their market shares d. Cartels are more efficient e. All of the above 26. Net National Welfare (NNW) is defined as a. The total value of all goods and services produced in a country in a given calendar year b. The sum of all goods and services produced by labor and property located in a country irrespective of who supplies them c. The sum of all goods and services supplied by a country’s residents irrespective of where they are physically produced d. The total annual output of both market and non-market goods and services, and minus the cost of externalities and depreciation of natural and human-made capitals used up in production e. The total money spent on welfare agencies 27. The United States has a GDP in the order of a. 10 billion dollars b. 100 billion dollars c. 1 trillion dollars d. 10 trillion dollars e. 100 trillion dollars 28. The Gross National product (GNP) is defined as a. The total value of all goods and services produced in a country in a given calendar year b. GDP plus what domestic companies earn from activities abroad plus what foreign companies make from domestic activities in that country c. The sum of all market and non-market goods and services supplied by a country’s residents d. The sum of all goods and services produced by labor and property located in a country irrespective of who supplies them e. Another name for Gross Domestic Product 29. One example of an objection raised against globalization and free-trade is a. Richer countries can use their economic muscles to force poorer countries to accept their wastes b. Resource depletion is accelerated because richer countries can have unrestrained access to natural resources of poorer countries c. Richer countries can impose regulations that put them at an unfair advantage over underdeveloped and developing nations d. All of the above e. None of the above 30. The quantitative limitation placed by a government on an import is called a(n) a. Quota b. Tariff c. Embargo d. Import tax e. Excise tax III. True or False 1. There are two ways that demand can change: in price or in overall demand. 2. As price increases due to a shift in the demand curve, suppliers respond by reducing the supply. 3. As the cost of production of a product goes down, the price declines, causing the demand curve to shift to the right. 4. As the price of gasoline rises, the demand for automobiles shifts to the right 5. Along a standard demand curve, price and quantity are inversely related—when price rises, quantity demanded decreases and vice versa. 6. When there can be no change to quantity supplied 411 no matter the price, the supply curve is perfectly elastic. 7. When the price of air travel rises, the price of travel by rail increases also. This is because airline and rail travel are substitutes. 8. Externalities arise when private costs and social costs or benefits do not match. 9. Depending on their implications, some goods could have both positive and negative externalities. 10. Police protection is a prime example of a private good. 11. In the long run, no profit can be extracted in a perfectly competitive market. 12. When MB= MC, total net benefits are maximized. 13. The social benefit of a trade is the sum of the private benefit to buyer and seller and the external benefit to all other members of society. 14. International trade facilitates the transfer of technology from industrial to developing nations. 15. During off-tourist seasons there will be an increase in equilibrium price along with a decrease in quantity sold. IV. Fill in the Blanks 1. As the cost of production of a product goes down, the price to the customer declines, making it more affordable. This results in a shift along the ___________ curve. 2. __________ is the money that must be paid to buy a product. _________, on the other hand, refers to the foregone value of resources that are used to make a product. 3. When a price ceiling is imposed below the equilibrium price, a ____________ results. 4. In a competitive market, surplus occurs if the price is set __________ the equilibrium price. 5. A monopoly is inherently _________ efficient than a competitive market. V. Project - Power Plant Finances It is estimated that a nuclear power plant will cost $3 billion to build. The utility needs to raise $2.4 B for the plant construction and equipment. The money is needed over a 5 year period ($480 M each year for 5 years) which is how long it takes the plant to be built. There are three options available: a. Borrow the total sum at the beginning of year 1 at a rate of 8%. The excess money, will be invested in the stock market, where an historic average of 5% has been returned. b. Borrow money from the bank as needed, i.e. $480 million at the beginning of year 1, 2, 3, 4, and 5. The bank charges 7% per year interest. c. Borrow the money monthly at the prime rate, i.e. borrow $8 M for 60 months. The prime rate at the beginning of the year 1 is 4%, but is expected to raise by 1.5% every year for the next 5 years. At the end of year 5, the plant is operational and the utility will be able to make a monthly payment of $5 million until all of the loan is paid off. Find: 1. What is the net present worth of the three options proposed above? Which option is economically more viable? 2. What is the effective interest rate of all future payments? 3. Redo the problem if a 3% cost of living adjustment is considered. 4. How many months does it take for all loans to be paid off? 5. What is the cumulative value of all payments for the option considered? 412