McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 21 The Economics of Energy, The Environment, and Global Climate Change

21-2 Chapter Objectives Basics of energy supply and demand Energy sustainability Economics of conservation Economics of the environment Controlling pollution Global climate change

21-3 Basics of Energy Supply and Demand Since 1850, oil usage per person in the US has more than tripled. Since 1973, due to the energy shocks of 1973 and 1979, energy usage per person in the US has remained relatively constant. The US uses more energy per person than most other countries.

21-4 US Energy Consumption per Person

21-5 Global Energy Consumption per Person, 2005

21-6 Energy Supply The most widely used energy sources are fossil fuels, which include coal, crude oil, and natural gas. The marginal cost of extraction is the amount of money that it takes to get one more ton of coal, one more barrel of oil, or one more cubic foot of natural gas out of the ground. This cost can vary greatly, depending on where the resource is located.

21-7 Energy Supply Companies will pump oil or mine coal where the marginal cost of extraction is the lowest. Once these resources are exhausted, companies will extract energy from more expensive locations. Eventually, as the marginal cost of extraction continues to rise, we will shift out of fossil fuels to alternatives.

21-8 Energy Supply Two other main sources of energy are renewable energy and nuclear power. Renewable energy sources such as wind and solar power have low variable costs, but high fixed costs. Nuclear power also has high fixed costs, but higher variable costs than renewable energy sources.

21-9 Share of World’s Energy Supply Energy source Coal 24.4%25.1% Crude oil 46.2%35.1% Natural gas 16.0%20.7% Nuclear 0.9%6.3% Hydro 1.8%2.2% Combustible renewable 10.6%10.1% Solar, geothermal, wind, and other 0.1%0.5%

21-10 The Real Price of Gasoline

21-11 Energy Sustainability World energy is likely to continue to grow at a fast pace, driven by growth in China, India, and other developing countries. The question is whether future supplies of energy will increase enough to meet this demand. If not, sharply higher prices of energy are likely to occur, which will slow economic growth.

21-12 World Oil Reserves These is an ongoing debate among economists and geologists about the world’s crude oil reserves. The position that global production of oil may be nearing its highest point is called the peak oil argument. This implies a slowdown in oil production and is equivalent to an upward shift of the supply curve for oil.

21-13 World Crude Oil Reserves

21-14 Economics of Conservation Energy conservation is a shift in economic activities to reduce the use of energy. There are three types of energy conservation. –First, there is the normal market reaction to higher oil prices. If the supply curve for oil shifts to the left, the price of gasoline goes up, and quantity demanded and supplied goes down.

21-15 Energy Conservation in Response to a Supply Shift

21-16 Energy Conservation in Response to a Supply Shift Demand curve for gasoline Q P Supply curve for gasoline Price of gasoline Q1Q1 Quantity of gasoline supplied/bought New supply curve for gasoline P1P1 B A

21-17 Economics of Conservation –The second type of energy conservation is the result of government intervention. Examples include the fuel efficiency standards for cars (CAFÉ standards) and speed limits. These actions shift the demand curve to the left, causing price and quantity demanded and supplied to fall.

21-18 The Effect of a Speed Limit on the Gasoline Market Demand curve for gasoline Q P Demand curve for gasoline with 55 mph speed limit Price of gasoline Q1Q1 Quantity of gasoline supplied/bought Supply curve for gasoline P1P1 B A

21-19 Economics of Conservation –The third type of conservation is also the result of government intervention, but using a market-based approach. A market-based approach changes the price signals that consumers and producers face, in order to move their behavior in the desired direction. One example of a market-based approach would be raising the tax on gasoline.

21-20 Energy Conservation with a Gas Tax

21-21 Economics and the Environment The key concept in environmental economics is externalities. A negative externality is the negative side effect from an exchange that affects someone other than the buyer and seller. A plant burning coal to generate electricity produces externalities in the form of various air pollutants, such as sulfur dioxide and nitrogen dioxide.

21-22 Impact of Pollution Externalities There are several negative impacts from pollution. –First, health impacts caused by externalities include loss of life and reduction of health. –The second negative impact from pollution is material and crop damage. –The third negative impact is the harm to environmental amenities. –Finally, pollution can do ecological damage.

21-23 Measuring the Damage Done by Pollution Externalities To measure the damage done by pollution, economists use the techniques of revealed preference and stated preference. Revealed preference means that you look at the choices that people make in their daily lives to change their risk of death by a little bit. Stated preference means that you ask individuals how much they would pay to reduce their risk of death by a little bit.

21-24 Equilibrium in a Market with Externalities The competitive equilibrium occurs where price equals marginal cost. The problem is that the competitive equilibrium ignores the impact of the externality. Taking the externality into account shifts the marginal cost curve to the left, resulting in higher prices and a lower equilibrium quantity.

21-25 The Impact of Noise Externalities on Airline Passengers

21-26 Controlling Pollution There are a number of ways to regulate or control pollution: –First is the command-and-control approach. Government determines what products can’t be produced through various regulations. –For example, the Environmental Protection Agency banned the pesticide DDT and issued strict regulation on the amount of carbon monoxide produced by autos. The command-and-control approach reduces pollution, but is inflexible and forces all emitters to meet the same standard. This raises costs.

21-27 Controlling Pollution –The second approach is the market-based approach, which uses prices to create incentives to reduce pollution. One example of using a market approach to reduce the amount of pollution is to tax the product or process causing the externality. The tax raises the price of the product. Another market-based approach for reducing pollution is through tradeable pollution permits. A pollution permit gives a business the right to emit a particular amount of pollution. This is often called a cap-and-trade system.

21-28 Global Climate Change The current scientific consensus is that the build-up of greenhouse gases such as carbon dioxide will lead to a significant warming of the Earth over the next 100 years. The economic effects of global warming could be very significant, especially for the agricultural sector of the economy. The potential solution to global climate change falls into two categories: adaptation and mitigation.

21-29 Global Climate Change Adaptation is the alteration of consumer and business behavior to reduce the damage from global climate change. –This approach uses price increases and the resulting incentives to minimize the harm from global warming. –The impact on some groups in the society could be high.

21-30 Global Climate Change Mitigation includes policies to significantly reduce emissions of greenhouse gases. –This approach also prefers to use price signals to slow down the emission of greenhouse gases. –One proposed means for reducing the incentive to burn fossil fuels is a carbon tax. –The tax rate would vary for different fuels according to their carbon content. –The other proposed alternative is to use the cap-and-trade system.