Chapter 36 Energy Prices

Chapter Outline HISTORICAL VIEW OPEC WHY PRICES CHANGE SO FAST WHAT WILL THE FUTURE HOLD Electricity Prices

Real Oil and Gas Prices 1996 dollars Per gallon (1 barrel=42 gallons)

Historical Events Relating to Oil and Gas Prices 1972 Arab-Israeli War US support for Israel prompted an embargo by Arab oil producers against the US and Europe. This led to a significant increase in crude oil prices. 1979 Iranian Revolution Iran’s Islamic revolution led to instability in the Persian Gulf. This led to a significant increase in crude oil prices. 1980’s Rapid increases in profits led to significant discoveries of oil in Mexico and the North Sea 1980-1988 Iran-Iraq War The war led to increased production by both parties as each needed to fund their war effort. This caused a precipitous fall in crude oil prices. 2003 U.S. invasion of Iraq Prior to the war oil prices spiked at over $35 per barrel and fell under $25 per barrel during the occupation

World Oil Reserves Group Billions of Barrels in Reserve Percentage of World Reserves Persian Gulf 664 63% Non-Persian Gulf OPEC 134 13% Rest of the World 238 24%

OPEC The Organization of Petroleum Exporting Countries (OPEC) Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates, and Venezuela OPEC began as a cartel. A cartel is an organization of individual competitors that join to form as a single monopolist.

Was OPEC a Cartel? OPEC production has always been a significant part of the oil market but it has never reached the level of monopoly. The cartel model is still useful because it has been a dominant player.

Why Oil and Gas Prices Change So Fast Because expected price is a determinant of supply and demand a world event that causes people to expect a price increase will Increase current demand (as middlemen and consumers try to buy as much as possible) Decrease current supply (as middlemen and gas stations try to hold onto their current stocks) This causes an immediate increase in prices.

Is It a Conspiracy? Rapid price changes are consistent with the supply and demand model where price expectations drive current prices. It is in the economic interest of neighboring gas stations to have identical prices because if they do not, consumers will choose their competition.

Electricity Residential electric power tends to be sold by a regulated monopoly. It has been a monopoly because of significant barriers to entry. It has been regulated because prices would be much higher than is socially optimal.

Types of Monopolies Simple Monopoly: a monopoly in which marginal costs of production are rising. Natural Monopoly: a monopoly in which marginal costs of production are falling.

Monopoly in the Market for Residential Electricity The market for residential electricity is likely to be a natural monopoly for nuclear power because of the very high fixed costs (transmission lines and the power plant and diminishing marginal costs.) The market may be characterized as a simple monopoly or natural monopoly for coal or gas generated electricity.

An Unregulated Simple Monopoly MCMonopoly P Pmonopoly D MR Qmonopoly Q

An Unregulated Natural Monopoly Pmonopoly D ATC MR MCMonopoly Qmonopoly Q

An Regulated Simple Monopoly MCMonopoly P Pmonopoly Pregulated D MR Qregulated Qmonopoly Q

An Regulated Natural Monopoly Pmonopoly D Pregulated ATC MR MCMonopoly Qmonopoly Qregulated Q

The California Experience California produces electricity with natural gas. California “deregulated” by Having its utilities sell their productive capacity to a variety of competitive producing firms Having them buy electricity from these producers Letting the market price for wholesale electricity float. Continuing to fix residential electricity prices. Natural gas prices increased dramatically The utilities could not buy the power because they were selling it at regulated prices that were lower that the deregulated prices at which they were buying it.

Kick it Up a Notch: The Cartel Model Q D S=MC Market for Oil QPC One Country’s Oil MC ATC P Q Qquota Profit MR Pcartel MR’ Qcartel Qcheat Profit PPC MR QPC