Lecture Issues in economics today - Chapter 39

The main contents of this chapter include all of the following: Financing international trade, the balance of payments, exchange rate systems, globalization of the U.S. dollar, growing foreign ownership of american assets.

Chapter 39

Energy Prices

Chapter Outline

• HISTORICAL VIEW

• OPEC

• WHY PRICES CHANGE SO FAST

• WHAT WILL THE FUTURE HOLD

• Electricity Prices

0

0.5

1

1.5

2

2.5

19731975197719791981198319851987198919911993199519971999

year Real Gas PriceReal Domestic Crude Real Import Crude

Real Oil and Gas Prices

per gallon (1 barrel=42 gallons)

Historical Events Relating to

Oil and Gas Prices

• 1972 Arab-Israeli War

– US 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 Revolution

– Iran’s Islamic revolution led to instability in the Persian Gulf This led to a significant increase in crude oil prices.

• 1980’s

– Rapid increases in profits led to significant discoveries of oil

in Mexico and the North Sea

• 1980-1988 Iran-Iraq War

– The 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 Reserves

Non-Persian Gulf

• The Organization of Petroleum

Exporting Countries (OPEC) – Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates, and Venezuela

• OPEC began as a cartel

– A cartel is an organization of individual competitors that join to form as a single monopolist.

Was OPEC a Cartel?

10000

20000

30000

40000

50000

60000

70000

1970 1975 1980 1985 1990 1995 2000

Year

World Non-Opec Opec

Oil Production

World, Non-OPEC and OPEC

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 Model

One Country’s Oil

MC ATC

P

Q MR

P cartel

MR’

Q cartel

P

Q D

S=MC Market for Oil

Q PC

P PC

MR

Q PC

Q quota

Profit

Q cheat Profit

Why Oil and Gas Prices

Change So Fast

• Because expected price is a determinant of

supply and demand a world event that causes people to expect a price increase will

– Increase 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.

• Residential 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 Monopolies

• Simple 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 Electricity

• The 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 Monopoly

P

Q

MC Monopoly

D MR

Q monopoly

P monopoly

An Unregulated Natural Monopoly

P

Q

MC Monopoly

D

MR

Q monopoly

P monopoly

ATC

An Regulated Simple Monopoly

P

Q

MC Monopoly

D MR

Q monopoly

P monopoly

P regulated

Q regulated

An Regulated Natural Monopoly

P

Q

MC Monopoly

D

MR

Q monopoly

P monopoly

ATC

P regulated

Q regulated

The California Experience

• California produces electricity with natural

gas.

• California “deregulated” by

– Having its utilities sell their productive capacity to a variety of competitive producing firms

– Having them buy electricity from these producers – Letting the market price for wholesale electricity float.

– Continuing to fix residential electricity prices.

• Natural gas prices increased dramatically

• The 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