1. Chapter 36
Energy Prices

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

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

4. 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
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

5. 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%

6. 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.

7. 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.

8. 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.

9. 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.

10. 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.

11. 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.

12. 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.

13. An Unregulated Simple Monopoly
MCMonopoly P
Pmonopoly D MR
Qmonopoly Q

14. An Unregulated Natural Monopoly
Pmonopoly D
ATC MR
MCMonopoly
Qmonopoly Q

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

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

17. 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.

18. Kick it Up a Notch: The Cartel ModelQ 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