1. Economics of Electricity
J2$
Part II: Profit maximization;
pollution; and
government responses
Some of the initial material in the following slides comes from Principles of Economics by N. Gregory Mankiw

2. Production
J2$
Assume diminishing marginal products for at least some factors of production
Marginal product of labor
Amount of additional output you get from employing one additional worker for a fixed stock of capital
Slope of the production function
Marginal product of the first worker is greater than the 100th worker

3. J2$ Costs of production Fixed costs (FC)
Do not vary with the quantity of output produced
Incurred even if the firm produces nothing at all
Solar array on top of SSW; building is a sunk cost
Variable costs (VC)
A function of the level of output
Examples: wood chips at biomass facility; Gus Libby
Implicit costs
Require no outlay of money from the firm
Examples: Alternative ways for Colby to use $100M; U.S. News & World Report ranking

4. Average & Marginal Costs
J2$
Average total cost
Average fixed cost + average variable cost
ATC = TC / Q
Cost of producing a typical unit of output
Marginal cost
Change in total cost / Change in output
MC = DTC / DQ
Cost of increasing production by one additional unit
MC equals ATC at the minimum point on the ATC curve

5. J2$ Competitive Markets Three key characteristics
Many buyers and sellers
Homogenous goods and services
No barriers to entry/exit
Result: the actions of a single buyer or seller will not impact the equilibrium market price
Examples?
Foreign exchange markets; real estate; dairy/farming

6. J2$ Monopoly Barriers to entry cause monopolies
Only one seller/producer
Other firms cannot enter the market because they can’t compete with it
Three main reasons why monopolies arise:
A key resource is owned by a single firm
Government gives exclusive rights to produce a good or service
Costs of production make a single producer more efficient than a large number of producers

7. Other market structures
J2$
Oligopoly
Only a few sellers, each offering a similar product
Examples: athletic equipment; crude oil (OPEC)
Monopolistic competition
Many firms selling similar, but not identical products
Examples: e-book sellers; digital music; computer games; movies

8. J2$ Firm revenue All firms: Total revenue: TR = P × Q
Average revenue: AR = TR / Q
Marginal revenue: MR = DTR / DQ
Profit = total revenue - total cost
Firms operating in competitive markets:
P is determined by the market and does not vary with Q
A 1 unit increase in Q increases total revenue by $P
Therefore, MR = P

9. J2$ Profit maximization
Economic profit: total revenue minus all of the opportunity costs (implicit and explicit) of producing the goods and services it sells
Accounting profit: total revenue minus total cost
Profit maximization occurs when MR = MC

10. Geometry of profit maximization
J2$
MR equals the market price
AR = (P×Q)/Q = P = MR
MR > Q1 so the firm can increase profit by increasing output
MR < Q2 so the firm can increase profit by decreasing output
Profit is maximized when MC = MR at Qmax

11. Competitive Firm’s Supply Curve
J2$
The marginal cost curve illustrates the quantity supplied by the firm at any give price
Therefore, the MC curve is the competitive firm’s supply curve
For the competitive firm, the price of its output is pre-determined
Therefore, MR = $P
An increase in price (say, due to an increase in demand) causes MR > MC and the firm will respond by increasing Q to increase profit

12. Shut-down decision
J2$
The competitive firm ignores fixed costs in the decision whether or not to shut down
As long as the firm can cover its variable costs it will remain in business
Algebra:
Shut down if TR < VC or if TR/Q < VC/Q
Since TR/Q = AR = P and VC/Q = AVC
Shut down if P < AVC

13. J2$ Monopolies Government created in the public interest
Patent and copyright laws encourage investment, innovation, and creativity
Natural monopolies
One firm can supply a good or service to an entire market at a lower cost than could two or more firms
Economics of scale exist; ATC declines over the entire relevant range of production

14. Monopolies
J2$
Monopolies can control the price of its output by adjusting the quantity it supplies to its market
Competitive firms have no control over price because they are small relative to the market
The competitive firm’s demand curve is equal to the market price (perfectly elastic)
The monopolist’s demand curve is the market demand curve
Thus, market demand constrains the monopolist’s production possibilities
A monopolist can choose to produce at any point on the market demand curve

15. Marginal Revenue for the Monopolist
J2$
The monopolist’s marginal revenue is always less than the price of its output because it faces a downward sloping demand curve
To increase output, the monopolist must lower its price
Thus, the monopolist’s marginal revenue will always be less than its price
MR = DTR / DQ
When the monopolist increases output, there are two effects on DTR:
TR increases due to the increase in Q, but
TR decreases due to the decrease in P
If Q gets large enough, the negative price effect can outweigh the positive output effect causing MR to become negative

16. Profit maximization for the monopolist
J2$
Profit maximization once again occurs at the point where MR = MC
But for the monopolist, P > MR

17. Problems with monopolies
J2$
Inefficient allocation of resources
Socially efficient level of output occurs where the demand curve intersects the marginal cost curve
The value to consumers (willingness to pay) equals the cost to the monopolist
But the monopolist produces less than the socially efficient quantity of output
Result is a deadweight loss to society

18. J2$ Government responses
Antitrust Laws designed to increase competition
Regulation of prices
Unique challenge with natural monopolies
Setting P=MC means the monopolist loses money
Subsidies must be offset through higher taxes
Setting P=ATC means zero economic profit and no incentive for the monopolist to reduce costs through innovation or investments that increase productivity
Turn the private monopoly into a public corporation (e.g., municipal water & sewer; hospitals)
Do nothing

19. J2$ Pollution An externality “Load” a.k.a. emissions
Absorptive capacity: a measure of damage/externalities
Stock pollutants: little or no absorptive capacity in the environment (e.g., non-biodegradable trash, PCBs)
Fund pollutants: emissions < absorptive capacity = no accumulation (e.g., C02)
Zone of influence relative to the point source: horizontal (local, regional, global) vs vertical (ground-level concentrations vs upper-atmosphere)

20. J2$ Model of An Ecological Economic System Natural Capital
Costanza, R., June Bioscience, Vol. 51, No. 6
Model of An Ecological Economic System
J2$
Positive Impacts on Human Capital Capacity
Well Being
(Individual & Community)
Ecological Services / Amenities
Solar Energy
Complex Property Rights Regimes
Consu mption
(Based on Changing, Adapting Preferences)
Individual | Common | Public
Natural Capital
Human Capital
Social Capital
Manufactured Capital
Limited Substitutability Between Capital Forms
Restoration,
Conservation
Wastes
Evolving Cultural Norms & Policy
Education, Training, Research
Economic Production Process
Goods & Services
GNP
Institutional Rules, Norms, etc.
Building
Inves tment
Negative Impacts on All Forms of Capital
Decisions about taxes, community spending, education, science and technology, etc., based on complex property rights regimes
Waste Heat

21. J2$ Model of An Ecological Economic System Natural Capital
Costanza, R., June Bioscience, Vol. 51, No. 6
Model of An Ecological Economic System
J2$
Positive Impacts on Human Capital Capacity
Well Being
(Individual & Community)
Ecological Services / Amenities
Solar Energy
Complex Property Rights Regimes
Consu mption
(Based on Changing, Adapting Preferences)
Individual | Common | Public
Natural Capital
Human Capital
Social Capital
Manufactured Capital
Limited Substitutability Between Capital Forms
Restoration,
Conservation
Wastes
Evolving Cultural Norms & Policy
Education, Training, Research
Economic Production Process
Goods & Services
GNP
Institutional Rules, Norms, etc.
Building
Inves tment
Negative Impacts on All Forms of Capital
Decisions about taxes, community spending, education, science and technology, etc., based on complex property rights regimes

22. Efficient allocation of pollution
J2$
Stock pollutants (persistence)
Maximize benefit - cost: benefit from consumption at any point in time minus the damage caused by the pollutant
Efficient quantity declines over time as the marginal cost of the damage rises
Price of the good rises over time as the amount of resources committed to pollution control rise
Steady state: additions to the stock pollutant stop as additional emissions are ‘controlled’ (e.g., recycling)
Price and quantity consumed remain constant, but the damage persists (e.g., mercury contamination)
Technology can alter the efficient allocation
Much of the following material is adapted from Chapter 14 of Environmental & Natural Resource Economics by Tietenberg and Lewis

23. Efficient allocation of pollution
J2$
Fund pollutants (assimilation)
Static versus dynamic analysis
Low-levels of emissions: no link between current and future emissions/damages
Small amounts of pollution are more easily diluted in the environment
Marginal costs of mitigation increase with the amount controlled
Note: Q* ≠ 0

24. Efficient allocation of pollution
J2$
For some pollutants Q* might equal 0 (or close to it) [e.g., plutonium]
Upward shift of the marginal damage curve
Equivalently for ‘environmentally-sensitive’ areas
Alternatively, low population density areas may see a downward shift of the marginal damage curve and Q* would be larger

25. Marginal Abatement Costs
J2$
Consider two firms
Total emissions = 30 units
Each emits 15 units
Goal: reduce emissions to 15 units
Uniformly mixed fund pollutants
Relative point sources are less important
Find the cost-effective allocation of control responsibility
[Variable] cost of control for firm 1 is A
Cost of control for firm 2 is B

26. Marginal Abatement Costs
J2$
Minimized when the marginal costs of control are equalized for all point sources
How can we achieve the optimal solution?
Emissions standards: set a global standard and apply it evenly (e.g., each firm must reduce emissions by 7.5 units); inefficient since firm 1 has lower MC of abatement
Cap-and-Trade: each firm faces a limit on how much pollution they can emit and are allocated ‘allowances’ to pollute; exactly enough emissions are allocated necessary to meet the target reduction; allowances are tradeable; ‘dirty’ firms can buy allowances; ‘clean’ firms sell

27. Marginal Abatement Costs
J2$
Firm 1 is emitting 15 tons and suppose it is allocated permits in the amount of 7 tons, i.e., it must clean up 8 tons of emissions
Firm 2 is also emitting 15 tons and suppose it is allocated permits for 8 tons, i.e., it must reduce emissions by 7 tons (at a cost of C)
C is a lot higher than the MC for firm 1 (A) so both firms are better off by trading
Firm 2 buys two units from firm 1 so it only has to clean up 5 units and firm 1 sells 2 units so it now reduces emissions by 10 units
Efficient outcome

28. Regional Greenhouse Gas Initiative (RGGI)
J2$
January 2009 a new approach was implement among 10 states in the northeastern US
Rather than ‘gifting’ CO2 emissions allowances they were auctioned off in a sealed-bid auction with the revenue given to the states
Most states used the money for energy efficiency incentive programs
Result: lower abatement costs due to reduction in energy usage (less carbon emitted) and because of reduced energy demand