1. Energy Economics and Policy Spring 2012 Instructors: Chu Xiaodong, Zhang Wen Email ： chuxd@sdu.edu.cn, zhangwen@sdu.edu.cn chuxd@sdu.edu.cn zhangwen@sdu.edu.cn Office Tel.: 81696127

2. Statistics on Quiz I Results Correct answers: 1. D 2. B 3. C 4. C 5. B (Using the midpoint formula, the elasticity is calculated as (22 – 18) / 20 ÷ (10 – 8) / 9 = 0.9)

3. Statistics on Quiz I Results The quiz is on Economics of Energy Supply and Economics of Energy Supply There were 33 answer sheets submitted Correctness of answers is as the following

4. Term Projects Each group should choose a project title from the total 16 ones A coordination is maybe needed to ensure that each group has one unique project, no duplication The projects should be finished before May 14th Each group will be graded by the quality of report and presentation – The working language can be English or Chinese, no preference – Any form of cheating, plagiarism, or fraud is seriously forbidden

5. Overview Market Failures in Competitive Markets Public Goods Externalities Government’s Role in the Economy Externalities in Energy Production and Consumption

6. Market Failures in Competitive Markets Do properly functioning markets efficiently allocate resources? – In most cases the answer is yes, but in some cases the markets are not properly allocating resources efficiently – Economists refer to market failure as a situation whereby the market fails to allocate the right amounts of resources to the production of economically desirable goods In some situations they may not be produced at all In other cases they may be overproduced or underproduced

7. Market Failures in Competitive Markets Market failures sometimes happen in competitive markets We want to explore how and why this sometimes happens and the correct response from government (if one exists) Market failures tend to fall into two categories – Demand-side market failures – Supply-side market failures

8. Market Failures in Competitive Markets Demand-side market failures – Arise because it is impossible to charge consumers what they are willing to pay for the product or service – Some people can enjoy the benefits without paying An example: fireworks displays

9. Market Failures in Competitive Markets Supply-side market failures – These occur when a firm does not pay the full cost of producing its output – External costs of producing the good are not reflected in the cost of the good or service incurred by the producer An example: a coal burning power plant

10. Market Failures in Competitive Markets How competitive markets achieve economic efficiency? – Demand curves must reflect the consumers full willingness to pay – Supply curves must reflect all the costs of production When this condition exists, benefits are at least equal to costs and benefits surpluses will be maximized and shared between producers and consumers

11. Market Failures in Competitive Markets Consumer surplus – The benefit surplus received by a consumer is called consumer surplus – It is defined as the difference between what a consumer is willing to pay for a good and what the consumer actually pays – The maximum amount a person is willing to pay depends on the person’s opportunity cost in terms of other goods A person willing and able to pay a higher price than the market equilibrium price is receiving a bargain

12. Market Failures in Competitive Markets Price Quantity D Q1Q1 P1P1 Consumer Surplus Equilibrium Price

13. Market Failures in Competitive Markets Producer surplus – The producer surplus is the difference between the actual price a producer receives and the minimum price they would accept to make a particular unit of output available – The producer’s minimum acceptable price will equal the marginal cost of producing that unit The sum of the rent, wages, interest, and profit paid to obtain the resources needed to produce it

14. Market Failures in Competitive Markets Price Quantity S Q1Q1 P1P1 Equilibrium price Producer surplus

15. Market Failures in Competitive Markets Economic efficiency revisited – Productive efficiency is achieved because competition forces producers to use the best technologies and combinations of resources available, thus minimizing the cost per unit of output – Allocative efficiency is achieved because the correct quantity of the good is produced relative to other goods and services

16. Market Failures in Competitive Markets Price Quantity S Q1Q1 P1P1 D Consumer surplus Producer surplus

17. Market Failures in Competitive Markets Efficiency losses – At each level of output, the price corresponding to the demand curve represents the marginal benefit of that unit while the price corresponding to the supply curve represents the marginal cost of that unit – Quantities produced above or below the optimal amount represent efficiency losses

18. Market Failures in Competitive Markets Quantity Price c S Q1Q1 Q2Q2 D b d a e Efficiency loss from underproduction

19. Market Failures in Competitive Markets c S Q1Q1 Q3Q3 D b f a g Quantity Price Efficiency loss from overproduction

20. Public Goods In situations where efficiency losses occur from underproduction of some goods, economists assume the market has failed – These efficiency losses are most pronounced in the case of public goods – Markets may underproduce or even fail to produce a public good because its demand curve may reflect none of the consumers’ willingness to pay

21. Public Goods Private goods include most goods that are produced in the market by firms and offered for sale Important characteristics of private goods include – Rivalry in consumption – when one person buys and consumes a product, it is not available to another consumer to purchase and consume it – Excludability – sellers can prevent consumers who do not pay for a product from obtaining its benefits Competitive markets ensure private goods will be available and allocate resources efficiently to particular products

22. Public Goods Public goods have the opposite characteristics of private goods Public goods are characterized by – Non-rivalry in consumption – one person’s consumption of a good does not preclude another person from consuming it – Non-excludability – there is no effective way of excluding individuals from the benefits of the good once it comes into existence

23. Public Goods Non-rivalry and non-excludability create a free-rider problem – Once a producer has produced a public good, everyone, including non-payers, can obtain the benefits of the good – Since most people don’t offer to pay for something they can get for free, most people become free riders and their willingness to pay is not expressed in the market Free-riders effectively reduce demand – Since producers cannot produce the good profitably they have no incentive to produce it at all – Public goods tend to be provided by governments, paid for with tax collections

24. Public Goods There are only two practical ways for public goods to be provided: private philanthropy or government provision Since there are no markets in which one can buy public goods like national defense, once government decides to provide a public good the question arises of how to determine the optimal amount to be produced? – Government has to try to estimate the demand for public goods through surveys or public votes

25. Public Goods $6 5 4 3 2 1 0 P Q 12345 $6 5 4 3 2 1 0 P Q 12345 Adams Benson D1D1 D2D2 Adams’ Demand Benson’s Demand $3 for 2 Items $4 for 2 Items $1 for 4 Items $2 for 4 Items $9 7 5 3 1 0 P Q 12345 DCDC S Collective Demand $7 for 2 Items $3 for 4 Items Connect the Dots Optimal Quantity Collective Willingness To Pay How much of this good should government actually provide?

26. Public Goods How does the government estimate the amount of the public good to provide? By comparing marginal cost and marginal benefit to society of producing the good Cost–Benefit Analysis is the comparison of marginal benefits to marginal costs – Marginal cost Resources will be diverted from private good production Opportunity cost of private goods that will not be produced – Marginal benefit The extra satisfaction from the output of more public goods

27. Public Goods Quasi-public goods – Quasi-public goods are goods that could be provided through the market system in a way that exclusion would be possible – Because of positive externalities, the government often provides them to avoid the underallocation of resources that might otherwise occur – Examples: education, libraries and museums

28. Public Goods How are resources reallocated from production of private goods to production of public or quasi-public goods? If the economy is fully employed, government must free up resources by – Taxing individuals and businesses – Taxation releases resources from the production of private consumer goods and private investment goods – Government can then shift those resources to the production of public and quasi-public goods

29. Externalities In addition to providing public goods, government can improve the allocation of resources by correcting for market failures caused by externalities An externality is a cost or benefit accruing to a third party external to a market transaction – Positive externalities Too little is produced, leading to demand-side market failures – Negative externalities Too much is produced, leading to supply side market failures

30. Externalities (a) Negative externalities (b) Positive externalities 0 D S StSt Overallocation Negative Externalities StSt Underallocation Positive Externalities QoQo QoQo QeQe QeQe P P 0 QQ D DtDt a c z x b y The failure to account for all production costs results in the firms supply curve being to far to the right With positive externalities, the demand curve is to the left of the socially optimal output The presence of externalities results in efficiency losses

31. Government’s Role in the Economy Government intervention (policy instruments) may be called upon to achieve economic efficiency when externalities affect large numbers of people – Correct negative externalities Direct controls Specific taxes – Correct positive externalities Subsidies Government provision

32. Government’s Role in the Economy (a) Negative Externalities D S StSt Overallocation Negative Externalities QoQo QeQe P 0 Q a c b (b) Correct externality with tax D S StSt QoQo QeQe P 0 Q a T Direct controls and taxes both raise the cost of production and shift the firm’s supply curve to the left, raising price and lowering output to socially optimal levels

33. Government’s Role in the Economy (a) Positive Externalities 0 StSt Underallocation Positive Externalities QoQo QeQe D DtDt z x y (b) Correcting via a subsidy to consumers 0 StSt QoQo QeQe D DtDt (c) Correcting via a subsidy to producers 0 S' t QoQo QeQe D Subsidy StSt U Positive externalities are most often promoted through subsidies to buyers or sellers or by direct government provision

34. Government’s Role in the Economy 0 Society’s Marginal Benefit and Marginal Cost of Pollution Abatement (Dollars) Q1Q1 MB MC Socially Optimal Amount Of Pollution Abatement

35. Government’s Role in the Economy Market failures are the justification for government taking an active role in correcting externalities But problems involved in doing so include: – Officials not being able to correctly identify the existence and cause and find a reasonable solution – Finding a reasonable solution usually has to be done in the context of politics This can result in overregulation in some cases and underregulation in others Pork barrel projects

36. Externalities in Energy Production and Consumption External social and environmental costs of energy production and consumption are largely ignored, e.g., – Coal mining – Electricity generation – Oil extraction and refining – Gasoline use in automobiles Ways should be found to address the negative externalities associated with energy use, i.e., to internalise externalities

37. Quantity of Coal Mined D S=MPC QmQm PmPm S=MPC + MSC Q o PoPo Example 9.1: External Costs of Extracting Coal Price per Quantity of Coal

38. Quantity of Electricity D S=MPC QmQm PmPm S=MPC + MSC QoQo PoPo Price per Quantity of Electricity Example 9.2: External Costs of Electricity Generation

39. Externalities in Energy Production and Consumption Including social and environmental externalities in energy prices is, in principle, an elegant way to address many issues of sustainability But in the real world it proves difficult, for practical and political reasons – Finding ways to figure externalities into energy prices is problematic because there is no consensus on how to measure their costs

40. Externalities in Energy Production and Consumption The policy instruments applied to internalise externalities should encourage end-use efficiency for all energy users and reflect the wider range of adverse social and environmental impacts implied by different forms of energy Various countries have introduced policies aimed at integrating externalities into energy prices – For example, several European countries have introduced taxes on carbon emissions of fossil fuels

41. Next Lecture The main topic will be Energy Policy Instruments – A quiz will be given on Models of Market Structure Please read in advance Chapters 17 and 33 of [Evans & Hunt, 2009]