Chapter 2 Energy, Markets, and Society Part A Peter Schwarz, Professor of Economics and Associate, Energy Production and Infrastructure Center (EPIC), University of North Carolina Charlotte

Chapter 2 Outline Introduction What is Different about Energy? Efficiency Social Welfare Sustainability of 14

I. Introduction (1) Economics: Allocation of scarce resources Economic Efficiency: Maximize output (size of pie) from scarce resources. Private efficiency: The best outcome for direct participants. Social efficiency: The best outcome for all affected parties. Equity: Fairness, income distribution (how the pie is sliced). Social Welfare: Maximize societal well-being, including efficiency and equity. Society welfare function (SWF) encompasses all affected parties (one big family). Cost-Benefit Analysis (CBA) a special type of SWF. Equity: $ = $, no matter who receives it. of 14

Introduction (2) Energy Markets example Hummer Private interest Bury in landfill: Society may be better off. Introduction (2) Energy Markets example Hummer Private interest Supply and demand Third parties Oil depletion Emissions Climate change Equity Who bears emissions? Environmental justice Sale to Chinese company fell through. of 14

Introduction (3) One other criterion Sustainability Effect on future generations May not be considered in today’s efficiency, equity decisions "Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs.” Bruntland Commission (1987) Our Common Future Efficiency, equity, sustainability need not coincide Ex. China Three Gorges Dam http://www.businessinsider.com/chinas-enormous-three-gorges-dam-is-turning-out-to-be-a-huge-mistake-2012-4 of 14

Introduction (4): Decision Criteria Weak Strong of 14

II. What is Different about Energy?(1) Widespread dissatisfaction with market solutions Not always based on economic considerations Running out of energy National security Environmental damage Consider government If governments fail Choose least bad alternative Ronald Coase of 14

What is Different about Energy?(2) Market failures pervasive Market power Externalities Public goods characteristics Decline of coal Carbon emissions So substitute nuclear energy? Radiation Wind and solar? Cost Intermittency North Carolina and 29 other states Renewable Portfolio Standards (RPS) European Union Feed-in Tariffs (FITs) Carbon pricing would be more efficient. of 14

III. Efficiency (1) Invisible Hand Adam Smith, Wealth of Nations (1776) Private interests coincide with social interests. As long as certain conditions hold Otherwise private and social interests may diverge Inefficiency Inequity Market Failure But can also have government failure Government cure is worse than the disease. of 14

III. (In)Efficiency (2) Invisible Hand Necessary Conditions Market Failure due to inefficiency Monopoly Natural Monopoly Economies of Scale Externalities Public Goods Imperfect Information Second-best Considerations Macroeconomic instability Inflation, Unemployment Other types of failures Inequity Unsustainability of 14

(In)Efficiency (2): Monopoly Firm = Market (Industry) OPEC Extract oil for $20 or less; sell for more (as much as $150) Economist’s objection is not higher profit, but loss in social welfare Consumers lose more $s than producers gain. Pm > Pc , Qm < Qc Consumers lose Producers gain on first Qm units, lose on Qc - Qm units Net loss (demonstrated in next chapter) Deadweight loss (DWL) of 14

Efficiency (3) Economies of scale Declining LRAC Example: Electricity Natural monopoly Example: Electricity Transmission and distribution lines Generation? of 14

(In)Efficiency (4): Externalities Also called third-party or spillover effects Usually negative. Difference between Social and Private Cost or Social and Private Benefit Example: Steel firm burns coal to heat furnace Emits sulfur (S), nitrous oxides (NOx), particulate matter (PM), mercury (Hg), carbon (C) Chooses lowest cost method of production: Uses air for free. So ignores emissions. www.nytimes.com/video/arts/television/1247468091675/excerpt-gasland.html of 14

(In)Efficiency (5): Public Goods Characteristics Extreme case of (positive) externalities Pure public good Non-rival Non-excludable Taxonomy Commons Rival, non-excludable (Pure) Public Non-rival, Private Excludable Club (Quasi, impure) Public Good) Examples: Climate change agreement Nuclear fusion R & D of 14