Economics of Energy Policy

Monday, March 20

Sources of inefficiency

Externalities (market failure) Government failure (perverse

incentives)

Externalities in energy production and consumption

Coal mining Electricity generation Oil extraction and refining Gasoline use in automobiles

Quantity of coal mined

$

D

S=MPC only

qm

pm

S=MPC + MSC

q*

P*

External costs of extracting coal

Quantity of electricity from coal-powered generation

$

D

S=MPC only

qm

pm

S=MPC + MSC

q*

P*

External costs of electricity generation from coal

$

Quantity of gasoline

S = MPC

D

Qm

Pm

Total MC

Qe

Pe

External costs of using oil and its derivatives – e.g. refining oil into gasoline

Quantity of gasoline used by automobiles

$

D

qm

pm

External costs of gasoline use in automobiles

MC

Total MC

qe

Energy policy objectives Reduce import dependency ratio so

that U.S. is less vulnerable to unstable world markets

Manage domestic prices so that high energy prices do not dampen economic activity

Shift energy use from depletable to renewable sources

Reduce energy demand overall

Supply policy

Open new reserves in the U.S. Alaskan Wildlife Reserve

$

Quantity of petroleum

Domestic Supply SD

Domestic Demand

International Supply SI

Pw

Qd

SD2

QtQd2

At SD: ratio = (Qt – Qd)/Qt At SD2: ratio = (Qt – Qd2)/Qt

Price policy

Strategic oil reserves Short-term increase in domestic supply

Price controls Temporary restrictions on prices paid by

energy users (this was done in the 1970s)

$

Quantity of gasoline

D

S

Price control

Pm

QmQs Qd

Price controls (consumers’ price was set) in the 1970s resulted in shortages of gasoline

Alternative source development

Hydrogen cells Much of the R&D with federal funding

Wind farms Clean but loud

Solar power

Alternative approaches to encouraging conservation of gasoline:

Make cars more fuel-efficient Impact on gasoline use depends upon

elasticity of demand for driving Driving is less costly if cars use less gas

to travel any given distance Make gasoline more expensive

The cost of driving any distance is higher This may increase the demand for fuel-

efficiency, but not for miles driven

Miles of driving

$

D

MC

qm

pm

Changes in fuel efficiency standards so cars use less gasoline:

MC ‘

Impact on use of gasoline in cars depends upon the elasticity of demand for driving.

D’

$

Energy BTUs

MCcoal

MCwind

D

Qc Qw

How do we choose from among alternative energy sources?