McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 39 Energy Prices McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Outline HISTORICAL VIEW OPEC WHY PRICES CHANGE SO FAST WHAT WILL THE FUTURE HOLD Electricity Prices

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 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 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.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. World Oil Reserves GroupBillions of Barrels in Reserve Percentage of World Reserves Persian Gulf66463% Non-Persian Gulf OPEC 13413% Rest of the World23824%

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Cartel Model One Country’s Oil MC ATC P Q MR P cartel MR’ Q cartel P Q D S=MC Market for Oil Q PC P PC MR Q PC Q quota Profit Q cheat Profit

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. An Unregulated Simple Monopoly P Q MC Monopoly D MR Q monopoly P monopoly

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. An Unregulated Natural Monopoly P Q MC Monopoly D MR Q monopoly P monopoly ATC

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. An Regulated Simple Monopoly P Q MC Monopoly D MR Q monopoly P monopoly P regulated Q regulated

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. An Regulated Natural Monopoly P Q MC Monopoly D MR Q monopoly P monopoly ATCP regulated Q regulated

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.