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

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

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

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

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

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

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

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

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

Geometry of profit maximization J2$ MR equals the market price AR = (P×Q)/Q = P = MR MR > MC1 @ Q1 so the firm can increase profit by increasing output MR < MC2 @ Q2 so the firm can increase profit by decreasing output Profit is maximized when MC = MR at Qmax

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

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

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

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

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

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

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

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

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)

J2$ Model of An Ecological Economic System Natural Capital Costanza, R., June 2001. 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

J2$ Model of An Ecological Economic System Natural Capital Costanza, R., June 2001. 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

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

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

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

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

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

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

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