Econ 510 Test One

Levels of the Electricity Market

(1) Generation (2) Transmission generation and transmission are wholesale segment (3) Distribution (4) End users distribution and end users are retail segment • Transmission and distribution - considered natural monopolies • Generation may not be a natural monopoly! - Calls for restructuring of electricity markets

If Q and X are substitutes, what is sign εPx? coal and natural gas for electricity

+

If Q and X are complements, what is sign εPx? coal and boiler

-

Important Lesson from Cali Power Crisis

- Markets will not work if regulatory restraints (e.g., price ceilings) prevent proper price signals from being sent

opportunity cost

value of the next-best use of one's resources - example: costs of a hydropower unit - direct cost of water may be zero - opportunity cost of water = money foregone by not selling the same amount of water for irrigation

Total Surplus can be calculated as follows:

value to buyers minus cost to sellers

A given tax will cause a bigger deadweight loss if demand and supply are:

elastic

total costs of production

fixed + variable costs

load cycle

pattern of electricity consumption over time

Variable Costs

related to the amount of electricity produced

A new technology that helps firms reduce production costs will cause a

shift to the right of the supply curve

If the price in a market happens to be below equilibrium, there will be a ________ in the market, and the price will tend to ________

shortage, rise

When the price of a good increases

the quantity supplied of the good will increase.

Deadweight loss in a taxed market occurs because:

the tax causes the market to trade less than the optimal units, so all the surplus of the units not traded is lost

Fixed Cost

unrelated to how much electricity is produced - Capital costs (power plants are typically large and require infrastructure to operate) - In the long run, fixed costs become variable => all equipment and even the whole plant can be sold

Price Elasticity

ε = % change quantity/ % change in price

Suppose that a scientific study just published demonstrates that eating apples makes people much healthier. How will this affect the equilibrium price and quantity in the market?

Both the equilibrium quantity and price will increase.

Government intervention

Idea: set P = MC and then cover losses some other way • The presence of market failure can justify government intervention in electricity markets • Types of intervention - Government ownership of utilities (common outside the U.S.) - Price regulation of utilities (common in the U.S.) - Private investor-owned utilities (IOU's) - Regulatory commissions set prices at such levels that allow utilities to cover costs and have a certain return on their investment

Cali Power Crisis

In 1996, CA electricity prices were among the highest in the U.S. • To correct high rates, CA began restructuring its market: - Goal: to reach Model 4 - First: achieve competition in wholesale market - Ultimately: full retail competition as well • By 2000, competitive wholesale market and a price ceiling in retail market (to lower rates) Problems: - Consumption increased in 1990's, but capacity did not - CA relied heavily on natural gas, whose price shot up in 2000 - Dry weather and salmon management restriction reduced hydropower in CA The summer of 2000 was very hot - Not enough capacity to meet peak demand • Wholesale market prices increased dramatically • Retail prices remained capped • Financial hardships and bankruptcies of utilities • Brownouts and blackouts

Suppose the price of corn syrup increases. Given that corn syrup is a major ingredient in the production of soft drinks, how will this affect the equilibrium price and quantity in the soda market?

The equilibrium price will increase and the equilibrium quantity will decrease.

All of the following occur when a tax is levied on a good, EXCEPT:

total surplus increases

The producer surplus can be expressed graphically as the area:

above the supply curve and below the price of the good

The consumer surplus can be expressed graphically as the area

below the demand curve and above the price of the good

during peak periods

both total variable and average variable costs increase

A price increase will cause consumer surplus to

decrease

When a tax is imposed, the quantity traded in a market will ________ and total surplus will ________.

decrease, decrease

The producer surplus represents the

difference between the price of the good and the cost to the seller

Consumer Surplus is

difference between what the consumer is willing to pay and what the consumer has to pay

A price increase will cause producer surplus to

increase

Monopoly in electricity markets

Able to set a price for its product (not a price-taker) • A profit maximizer • Supplies at MR = MC (marginal revenue = marginal cost) • Compared to a perfectly competitive market: produces less of the good and charges a higher price

Problems with Price Regulation

Measuring expenses - Utilities have incentives to boost up expenses - Example: the utility owns a coal mine and sells coal to itself • Such transfers should not be counted, but sometimes are • Computing rates of return - Rates of return depend on monetary policy and may change • Example: the Fed raises interest rates on Treasury bonds => rate of on utility bonds also increases - What is the correct rate to use? • Measuring the value of capital stock - Inflation: should we use original or current value?