Chapter 39 Energy Prices

Chapter 39Energy PricesMcGraw-Hill/Irwin© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.Chapter OutlineHISTORICAL VIEWOPECWHY PRICES CHANGE SO FASTWHAT WILL THE FUTURE HOLDElectricity PricesHistorical Events Relating to Oil and Gas Prices1972 Arab-Israeli WarUS 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 RevolutionIran’s Islamic revolution led to instability in the Persian Gulf. This led to a significant increase in crude oil prices.1980’sRapid increases in profits led to significant discoveries of oil in Mexico and the North Sea1980-1988 Iran-Iraq WarThe 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.World Oil ReservesGroupBillions of Barrels in ReservePercentage of World ReservesPersian Gulf66463%Non-Persian Gulf OPEC13413%Rest of the World23824%OPECThe Organization of Petroleum Exporting Countries (OPEC) Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates, and VenezuelaOPEC began as a cartel. A cartel is an organization of individual competitors that join to form as a single monopolist.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.The Cartel ModelOne Country’s OilMCATCPQMRPcartelMR’QcartelPQDS=MCMarket for OilQPCPPCMRQPCQquotaProfitQcheatProfitWhy Oil and Gas Prices Change So FastBecause expected price is a determinant of supply and demand a world event that causes people to expect a price increase willIncrease 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.ElectricityResidential 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.Types of MonopoliesSimple Monopoly: a monopoly in which marginal costs of production are rising.Natural Monopoly: a monopoly in which marginal costs of production are falling.Monopoly in the Market for Residential ElectricityThe 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.An Unregulated Simple MonopolyPQMCMonopolyDMRQmonopolyPmonopolyAn Unregulated Natural MonopolyPQMCMonopolyDMRQmonopolyPmonopolyATCAn Regulated Simple MonopolyPQMCMonopolyDMRQmonopolyPmonopolyPregulatedQregulatedAn Regulated Natural MonopolyPQMCMonopolyDMRQmonopolyPmonopolyATCPregulatedQregulatedThe California ExperienceCalifornia produces electricity with natural gas.California “deregulated” byHaving its utilities sell their productive capacity to a variety of competitive producing firmsHaving them buy electricity from these producersLetting the market price for wholesale electricity float.Continuing to fix residential electricity prices.Natural gas prices increased dramaticallyThe 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.