1. Chapter 7
Depletable, Nonrecyclable Energy Resources: Oil, Gas, Coal, and Uranium

2. 7.1 Introduction Main contents:
This chapter will examine some of the major issues associated with the allocation of energy resources over time and how economic analysis can clarify our understanding of both the sources of the problems and the solutions.

3. 7.2 Natural Gas: Price Controls
There was serious shortage of natural gas in the U.S. during the winter of late 1974 and early In an efficient allocation, shortages of that magnitude would never have happened. Why did they?
The source of the problem can be traced directly to government controls over natural gas prices.

4. 7.2 Natural Gas: Price Controls
What’s the effect of price control regulation?

5. 7.2 Natural Gas: Price Controls
Effect on the demand side:
The price ceiling would prevent prices from reaching their normal levels.
Consumption levels in earlier years would be higher under price controls than without them.

6. 7.2 Natural Gas: Price Controls
Effects on the supply side:
As long as price controls are 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.

7. 7.2 Natural Gas: Price Controls
Effects of price control:
The combined impact of these demand and supply effects would be to distort the allocation significantly.
The time of transition is earlier under price controls.
The transition is abrupt, with prices suddenly jumping to new higher levels.

9. NB!
Even though the price in the first year is lower than the price ceiling, it is not equal to the efficient price. The price ceiling causes a reallocation of resources toward the present, which, in turn, affects prices in the earlier years.

10. 7.2 Natural Gas: Price Controls
Price controls may cause other problems as well.
When the ceiling is lifted, the prices could suddenly rise which would incentive producers to stop production and wait for the higher prices. This circumstance could cause severe problems for consumers.
Price control over natural gas not only hastened the time of transition to a substitute resource, it also caused a transition to an inefficient substitute.(example 8.1)

11. 7.2 Natural Gas: Price Controls
Why did government embark on such a policy?
The answer is found in rent-seeking behavior which can be explained through the use of consumer and producer surplus model.

13. 7.3 Oil: The Cartel Problem
Four factors for making cartelization possible:
The price elasticity of demand for OPEC oil in both the long run and the short run.
The income elasticity of demand for oil.
The supply responsiveness of the oil producers who are not OPEC members.
The compatibility of interests among members of OPEC.

14. 7.3.1 Price Elasticity of Demand
The elasticity of demand is an important ingredient because it determines how responsive demand is to price. In general, the lower the price elasticity of demand, the larger the gains to be derived from forming a cartel.

15. 7.3.1 Price Elasticity of Demand
The price elasticity of demand for oil depends on the opportunities for conservation, as well as on the availability of substitutes.

16. 7.3.1 Price Elasticity of Demand
The larger the set of opportunities and the smaller the cash outlays required to exploit them, the more price-elastic the demand. This suggests that the price elasticity of demand in the long run will be greater, perhaps significantly, than in the short-run.

17. 7.3.1 Price Elasticity of Demand
The availability of substitutes is important because it limits the degree to which prices can be raised by a producer cartel. Abundant quantities of substitutes available at prices not far above competitive oil prices can set an upper limit on the cartel price.

18. 7.3.2 Income Elasticity of Demand
The income elasticity of oil demand is important because it indicates how sensitive oil demand is to growth in the world economy.
At constant prices, as income grows, oil demand should grow. This continual increase in demand fortifies the ability of OPEC to raise its prices. High income elasticities of demand support the cartelization of oil.

19. 7.3.2 Income Elasticity of Demand
The income elasticity of demand is also important because it registers how sensitive demand is to the business cycle. The higher the income elasticity of demand, the more sensitive demand is.

20. 7.3.3 Non-OPEC Suppliers
Another key factor in the ability of producer nations to exercise power over a natural resource market is their ability to prevent new suppliers, not part of the cartel, from entering the market and undercutting the price.

21. 7.3.3 Non-OPEC Suppliers
Non-OPEC members have an impact on price. The cartel must take the nonmembers into account when setting prices.

22. 7.3.4 Compatibility of Member Interests
The final factor in determining the potential for cartelization of natural resource markets is the internal cohesion of the cartel.
Cartel members have a strong incentive to cheat.
Another threat to the stability of cartels is the degree to which members fail to agree on pricing and output decisions.

23. 7.4 Oil: National Security Problem
From an economic point of view, vulnerable strategic imports have an added cost which is not reflected in the marketplace. The added cost is the national security costs.

25. 7.4 Oil: National Security Problem
Notice that when national security is an issue, the market in general tends to consume too much oil and domestic production is too small. Both of these factors raise vulnerable imports above their efficient level.

26. 7.4 Oil: National Security Problem
What would happen during an embargo?
The amount consumed would be Q1 and the price would be P2. The loss in consumer surplus during an embargo can be very large indeed.
How can importing nations react to this inefficiency?

27. 7.4 Oil: National Security Problem
How can importing nations react to this inefficiency?
The importing nations may self-sufficiency, yet this is not the optimum because the net benefit from self-sufficiency (the allocation in which consumption is Q3 and imports are zero ) is lower than the net benefits from the efficient allocation(Q4)

28. 7.4 Oil: National Security Problem
Why is self-sufficiency so inefficient when embargo obviously impose so much damage?
The simple answer is that the vulnerability premium is lower than the cost of becoming self-sufficient. Why?

29. 7.4 Oil: National Security Problem
Embargos are not certain events---they may never occur.
Domestic steps can be taken to reduce vulnerability of the remaining imports.
Accelerating domestic production would incur a user cost by lowering the amounts available to future users.

30. 7.4 Oil: National Security Problem
Some of the policy choices to reduce the vulnerability of imports:
Energy conservation by means of a tax on energy consumption
Subsidization of domestic supply
A tariff on imports equal to the vertical distance between Sfo and Sf1 or a quota on imports equal to Q4-Q2

31. 7.4 Oil: National Security Problem
Some redistributive consequences by using tariffs or quotas:
If a tariff were imposed on imports equal to P1-P0, the area ABCD would then represent tariff revenue collected by the government.
If a quota system were used and the quotas were simply given to importers, area ABCD would represent the value of those quotas to the importers.
The effect of either system on domestic producer surplus should also be noticed. Producers of domestic oil would be better off with a tariff or quota on imported oil than without it

32. 7.5 Transition Fuels: Environmental Problems
The fuels receiving the most attention as transition fuels are coal and uranium.
The main issue defining the role for these two fuels involves their environmental impact.

33. 7.5 Transition Fuels: Environmental Problems
Coal’s main drawback is its contribution to air pollution: acid-rain problem, greenhouse
Note: if those who burn coal fail to consider these environmental costs, the market will foster an excessive reliance on coal.
The limitation of uranium is safety.
Nuclear accidents
The storage of radioactive waste

34. 7.5 Transition Fuels: Environmental Problems
Can we expect the market to make the correct choice with respect to nuclear power?
The answer is no because of externalities.
Would the utility have an incentive to choose the efficient level of precaution?

35. 7.5 Transition Fuels: Environmental Problems
If the utility had to compensate fully for all the damages caused, then the answer would be yes.
The efficient level of precaution is the one minimizing the sum of the costs of precaution and the costs of the unabated damage.

37. 7.5 Transition Fuels: Environmental Problems
Will a private utility choose q*?
Presumably it would, if the curves it actually faces are MCa and MCd.

38. 7.5 Transition Fuels: Environmental Problems
Both the operating safety and the nuclear waste storage issue can be viewed as a problem of determining appropriate compensation.
The compensation approach could also help resolve the current political controversy over the location of nuclear waste disposal sites.

39. 7.5 Transition Fuels: Environmental Problems
Under a compensation scheme, those consuming nuclear power should be taxed to compensate those who live in the areas of the disposal site.
If the compensation is adequate to induce them to accept the site, then nuclear power is a viable option and the costs of disposal are ultimately borne by the consumers.
If taxes to obtain a sufficient number of disposal sites are so high that nuclear energy becomes noncompetitive, then nuclear energy is not an efficient source.

40. Objectives & Requirements:
Understand the effects of price control on natural gas
Understand the cartel problem of oil
Understand the national security problem of oil
Understand the environmental problems of transition fuels