Ch 7

1. Ch 7 Energy: The Transition from Depletable to Renewable Resources

2. Energy is one of our most critical resources • Currently, many industrialized countries depend on oil and natural gas for the majority of their energy needs. According to the International Energy Agency (IEA), these resources together supply 59 percent of all primary energy consumed world- wide. • Adding coal, another fossil fuel resource, increases the share to 86 percent of the total.

3. Fossil fuels are depletable, non-recyclable sources of energy. Crude oil proven reserves peaked during the 1970s and natural gas peaked in the 1980s in the United States and Europe, and since that time, the amount extracted has exceeded additions to reserves.

4. Even if we cannot precisely determine when the fuels on which we currently depend so heavily will run out, we still need to think about the process of transition to new energy sources..... Why? • According to depletable resource models, oil and natural gas would be used until the marginal cost of further use exceeded the marginal cost of substitute resources—either more abundant depletable resources such as coal, or renewable sources such as solar energy

5. Read Ex 7.1 p.141 • In this chapter we shall examine some of the major issues associated with the allocation of energy resources over time and explore how economic analysis can clarify our understanding of both the sources of the problems and their solutions.

6. Natural Gas: Price Controls • In the United States, during the winter of 1974 and early 1975, serious shortages of natural gas developed. Customers who had contracted for and were willing to pay for natural gas were unable to get as much as they wanted. • The shortage amounted to two trillion cubic feet of natural gas in 1974–1975, which represented roughly 10% of the marketed production in 1975. • In an efficient allocation, shortages of that magnitude would never have materialized. What happened?

7. The source of the problem: Government controls over natural gas prices. • The increasing importance of the automobile for transportation created a rising demand for gasoline, which in turn stimulated a search for new sources of crude oil. • This exploration activity uncovered large quantities of natural gas (known as associated gas), in addition to large quantities of crude oil • As natural gas was discovered, it replaced manufactured gas in the geographic areas where it was found. natural gas became an important source of energy for the United States.

8. The regulation of natural gas began in 1938 with the passage of the Natural Gas Act and it extend price control regulations to the producer... Price Ceiling • What was the effect of this regulation? • The P ceiling would prevent prices from reaching their normal levels. • Since price increases are the source of the incentive to conserve, the lower prices would cause more of the resource to be used in earlier years. • Consumption levels in those years would be higher under price controls than without them.

9. Effects on the supply side are also significant. Producers would produce the resource only when they could do so profitably. • Once the MC rose to meet the price ceiling, no more would be produced, in spite of the large demand for the resource at that price. • Thus, as long as price controls were permanent, less of the resource would be produced with controls than without. • Furthermore, more of what would be produced would be used in the earlier years.

10. The combined impact of these demand-and-supply effects would be to distort the allocation significantly • While a number of aspects differentiate this allocation from an efficient one, several are of particular importance: (1) more of the resource is left in the ground, (2) the rate of consumption is too high, (3) the time of transition is earlier, and (4) the transition is sudden, with prices suddenly jumping to new, higher levels

11. The first effect means we would not be using all of the natural gas available at prices consumers were willing to pay. • Because price controls would cause prices to be lower than efficient, the resource would be depleted too fast. • These two effects would cause an earlier and abrupt transition to the substitute possibly before the technologies to use it were adequately developed.

12. The discontinuous jump to a new technology, which results from price controls, can place quite a burden on consumers. • Attracted by artificially low prices, consumers would invest in equipment to use natural gas, only to discover—after the transition—that natural gas was no longer available.

13. Price controls may cause other problems as well. • Price controls are permanent; they can change unpredictably at the whim of the political process. • The fact that prices could suddenly rise when the ceiling is lifted also creates unfortunate incentives. • If producers expect a large price increase in the near future, they have an incentive to stop production and wait for the higher prices. This could cause severe problems for consumers.

14. in Figure 7.2: An efficient market allocation would result in Q* supplied at P *. • The net benefits received by the country would be represented by areas A and B. • Of these net benefits, area A would be received by consumers as consumer surplus and B would be received by producers as a producer surplus.

15. P S0 A P* B Q Q*

16. Suppose now that a price ceiling were established. This ceiling would reduce the marginal user cost because higher future prices would no longer be possible. • This has the effect for current producers of lowering the perceived supply curve, due to the lower marginal user cost. • As a result of this shift in the perceived supply curve, current production would expand to Qc and price would fall to Pc. • Current consumers would unambiguously be better off, since consumer surplus would be area A + B + C instead of area A. They would have gained a net benefit equal to B + C.

17. What about the producer? • It may appear that producers could also gain if D > B, but that is not correct because this diagram does not take into account the effects on other time periods. • Since producers would be overproducing, they would be giving up the scarcity rent they could have gotten without price controls. • Area D measures current profits only without considering scarcity rent. When the loss in scarcity rent is considered, producers unambiguously lose net benefits.

18. Future consumers are also worse off. As the resource was depleted, the supply curve for each subsequent year would shift up, thereby reflecting the higher marginal extraction costs for the remaining endowment of the resource. • When the marginal extraction cost ultimately reached the level of the price control, the amount supplied would drop to zero. • Extracting more would make no sense to suppliers because their cost would exceed the controlled price.

19. Since the demand would not be zero at that price, a shortage would develop. • Although consumers would be willing to pay higher prices and suppliers would be happy to supply more of the resource at those higher prices (if they were not prevented from doing so by the price control), the price ceiling would keep those resources in the ground.

20. Over the long run, price controls end up harming consumers rather than helping them. • Scarcity rent plays an important role in the allocation process, and attempts to eliminate it can create more problems than solutions. • Scarcity Rent: The marginal OC imposed on future generations by extracting one more unit of a resource today. Scarcity rent is one of two costs the extraction of a finite resource imposes on society. The other is marginal extraction cost--the OC of resources employed in the extraction activity. Scarcity rent is the cost of "using up" a finite resource because benefits of the extracted resource are unavailable to future generations. Efficiency is achieved when the resource price--the benefit society is willing to pay for the resource today--is equal to the sum of marginal extraction cost and scarcity rent.

21. P S0 A P* Si B C PC D Q Q* QC