Lecture Issues in economics today - Chapter 39

Chapter 39
Energy Prices

 

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Chapter Outline
•
•
•
•
•

 

HISTORICAL VIEW
OPEC
WHY PRICES CHANGE SO FAST
WHAT WILL THE FUTURE HOLD
Electricity Prices

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Real Oil and Ga

per gallon (1 barrel=42
2.5
2

$

1.5
1
0.5
0
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
year

Real Gas Price
Real Domestic
RealCrude
Import C

 

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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.

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World Oil Reserves
Group

Billions of Barrels Percentage of
in Reserve
World Reserves

Persian Gulf

664

63%

Non-Persian Gulf
OPEC

134

13%

Rest of the World

238

24%

 

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OPEC
• 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.
 

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th o u s a n d b a r e ls a d

Was OPEC a Cartel?

Oil Production
World, Non-OPEC and

70000
60000
World
50000
40000
Non-Op
30000
20000
Opec
10000
1970197519801985199019952000
Year

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.
 
 
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The Cartel Model
Market for Oil

P

P

One Country’s Oil
MC

S=MC
ATC

Profit
Profit

MR’

Pcartel
PPC

MR

D
Qcartel
 

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MR

QPC

Q
 

Qquota

QPC Qcheat Q

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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.
 

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Electricity
• 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.
 

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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.

 

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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.
 

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An Unregulated Simple Monopoly
MCMonopoly

P
Pmonopoly

MR
Qmonopoly
 

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D
Q

 

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An Unregulated Natural Monopoly
P

Pmonopoly
D

MR
Qmonopoly
 

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ATC
MCMonopoly
Q
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An Regulated Simple Monopoly
MCMonopoly

P
Pmonopoly
Pregulated

MR
Qmonopoly Qregulated
 

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D
Q
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An Regulated Natural Monopoly
P

Pmonopoly
D
Pregulated

MR
Qmonopoly

 

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Qregulated

ATC
MCMonopoly
Q

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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.
 

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