Natural Resource Economics Midterm Final Set 2

Front 1

Why can there be a large profit incentive for a cartel like the Organization of Petroleum Exporting Countries (OPEC) to form? Once formed, why is there a further profit incentive for individual cartel members to exceed their assigned quotas? What happens if all cartel members fall back into the habit of behaving like price-taking quantity-adjusters? Are cartels inherently stable or unstable? Use an appropriate diagram to support your arguments.

Back 1

As described in the lecture on this topic, we might start from a long-run competitive equilibrium where marginal cost is equal to price for each producer and both are also equal to the minimum of the long-run average total cost, so everyone is making zero economic profits (which is just fine, because all resources used in production are thus making just as much as they could make in any other use). If the individual firms get together and act like a collective monopoly, they can assign to each one a “share” of the overall market demand, so that the horizontal sum of these allocated demand shares will equal overall market demand. Each firm can act as though it has monopoly power over that share of the market and price accordingly, like a monopolist, by producing only to the point where marginal cost is equal to marginal revenue. This output restriction pushes up price so that it is greater than average cost and each producer will make a positive profit. This is the incentive to cartelize.

However, if individual producers are used to being price-taking quantity-adjusters, they observe the current price and expand output as long as this price is greater than their own marginal cost of production. If enough cartel members begin to think of the cartel price as exogenous and given, like a market equilibrium price, and expand their output, a glut of the product can develop (Q’) and drive prices down to P’, below even what they were in the original competitive equilibrium, Pc. All producers would then make negative profits (losses) and be worse off than before the cartel formed. Not shown in the left-hand diagram, but would be given by the distance between point C on the “atc” curve and price P’ in the market, times the quantity associated with point C in the left-hand diagram. This is just the amount by which average total costs exceed price, times the number of units produced. Not a happy outcome.

Front 2

Energy security in the face of U.S. reliance on imported oil remains a continuing concern. Use a diagram where the U.S. imports a substantial share of the oil it consumes. In terms of consumer surplus, explain how we can conceptualize the risk presented by a potential embargo on oil supplies to the U.S. (assume all imports would stop with an embargo). How might we use import tariffs or quotas to reduce the magnitude of this risk? Identify the deadweight loss of U.S. net benefits that would represent the “cost” of this increased energy security

Back 2

With imports, price would be P0, domestic production would be Q1 and imports would be Q5-Q1. An embargo would limit consumption to just Q1 in the short run. This would lead to a short-run loss in overall social surplus (i.e. producer surplus plus consumer surplus) given by the triangle formed by the short-run vertical supply curve, the domestic demand curve, and price PO. Furthermore, of the remaining social surplus, the speckled area would be transferred from domestic consumers to domestic producers. Domestic producers would gain a big windfall, but domestic consumers would lose a huge chunk of their consumer surplus. This dramatic change is unlikely to be popular with voters, so legislators often seek to insulate domestic consumers from the threat (chance) of an embargo.

If the domestic price can be raised to P1 either by an import tariff or a quota, domestic output would be stimulated to increase to Q2, forming a new short-run supply curve at that quantity. The overall lost social surplus in the event of an embargo would then be lower, and a smaller amount of consumer surplus would be handed over to producers if an embargo occurred. However, the cost of this increased energy security is the deadweight loss associated with the tariff, which is just the two tiny triangles (between Q1 and Q2, and between Q4 and Q5) because the rectangle representing the tariff revenue accrues to this society. With an import quota, we would forgo that tariff revenue, allowing it to be kept by foreign suppliers, so that the domestic deadweight loss is the entire trapezoid between P0 and P1, bounded by the domestic supply and domestic demand curves. See the additional figures and discussion in that lecture

Front 3

What are the main factors that prevent the U.S. from relying exclusively on renewable energy sources such as wind power and solar power? How does the economic viability of renewable energy depend upon whether the social costs of the carbon emissions from fossil fuels are internalized through carbon prices or cap-and-trade programs?

Back 3

Intermittency: Wind power is available only when the wind blows, and solar power is available only when the sun shines. The fact that we still don’t have very good storage technology for electricity is one factor that prevents wider reliance on these renewables. Molten salt technology is at the demonstration stage, but not yet in wide use.

Long-term debt financing: Given that the cost of these renewable sources is almost entirely fixed costs, long-term debt financing makes sense, but it is not yet widely enough available.

Feed-in tariffs (FIT): These have been popular in Europe, but the US has tended to rely on renewable portfolio standards instead. Feed-in tariffs encourage investment in renewable technologies because they guarantee that a supplier will get a certain price for excess renewable energy delivered to the grid. These guarantees shift the risk to the utility (although it is still borne by the rest of society as consumers of the utility.

Production tax credits (PTCs): These have been less of an incentive than would be a direct subsidy to start-up companies. For a tax credit, they need to have existing tax liabilities. This often means a new company needs to find an investor with tax liabilities to become a part owner, which can be inefficient.

Scale: The sheer scale of the renewables infrastructure that would be necessary to supply the entire U.S. market for power is daunting.

The fact that fossil-fuel-generated electricity is produced without the internalization of the carbon externality it creates means that fossil fuels have an inappropriate advantage in the market. Renewable energy such as wind and solar has no carbon emissions. With carbon prices, wind and solar would become more competitive with conventional power technologies

Front 4

In the western U.S., water prices for urban use tend to be vastly higher than water prices for agricultural use. An efficient allocation of scarce water would require that the resource be reallocated among end users until the marginal net benefits are equalized across all users. Do high costs for delivered water account for these big differences in water prices, or does something else explain the economically inefficient allocations of water in the west? Explain carefully.

Back 4

There is not one single market for water in the west, where the net price will tend to equilibrate across end uses so that marginal net benefits are the same in all uses (as we considered in the first homework set of the quarter). Instead, water rights are allocated (historically) on the basis of “prior appropriation”—sort of a first-come, first-served rule. The owner of the senior water right can keep using as much as they have historically used, even in a severe drought. Junior water rights holders need to cut back if there is not enough water to satisfy all competing end uses. Since agricultural users arrived first in most of the west, they tend to hold the senior water rights. Cities developed much later, so they have junior water rights. Under western water law, there are also restrictions that say that agricultural users have to put their water to beneficial use on a regular basis, or they will forfeit their rights, and this has precluded long-term contracts for the sale or lease of agricultural water rights by urban users. If the right to a specific amount of surface water in a given year could be freely bought and sold, you would expect a lot of farmers to leave their fields fallow in a drought and make their revenues by selling their year’s water rights to the urban market instead. Right now, there are legal and institutional impediments that tend to prevent this from happening. Delivery costs for urban water are indeed higher than for agricultural water, but the difference is nowhere near enough to account for the vast differences in water prices in the two types of use.

Front 5

In December of 2008, with Russia’s support, a dozen large natural gas-producing countries founded an organization to study ways to set global prices for this fuel, much as OPEC does for crude oil. Using diagrams, illustrate the potential for cartel members to increase their profits by agreeing on output quotas, but also the risk that member countries will be likewise tempted to exceed these quotas. Explain how these two tendencies could lead to variability in natural gas prices according to the degree of discipline that can be imposed on cartel members.

Back 5

Here we would have been satisfied with the standard cartel story, competently laid out in a diagram. You would need to identify the two different shaded rectangles on the left. The smaller one answers the first part: profits from cartelization. The larger one answers the second part: temptation to free-ride on cartel price and behave like a competitor for more profit, unless everybody cheats, in which case prices collapse because of the glut on the market.

Front 6

We have illustrated the dynamically efficient extraction profile for an exhaustible resource, in continuous time, using a “four-quadrant diagram.” Sketch the simplest version of this diagram and label all features clearly. What was the purpose of this diagram?

Back 6

The purpose of the diagram was to show how the four essential ingredients—demand conditions, marginal extraction costs, total reserves, and the discount rate—conspired to determine what marginal user cost would be imputed for each period in the time profile of extraction. This diagram improves upon the two-period diagram by making it clearer how total reserves (the resource stock) helps dictate what MUC should be. It also extends the model to continuous time, highlighting the increase in dynamically efficient resource prices and the consequent steady decline in extraction/consumption of the resource over time. We aren’t going to simply use these types of resources at a steady rate until they are suddenly gone.

Instead, they will become more and more expensive—if we have been taking account of marginal user cost—and we will only run out at a point where the price has gotten so high that we don’t want the stuff anymore anyway.

Front 7

How can the OPEC oil cartel, by restricting the overall oil output of its member nations, exercise monopoly power over the world price of oil, especially when there are many other oil-producing countries which are not members of OPEC? Explain, using an appropriate diagram.

Back 7

Here we would accept the standard diagram for a dominant firm (cartel) and a competitive fringe. It would be nice to have a few words to explain that the cartel (OPEC) can act like a monopoly price setter, based on the MR curve associated with world oil demand after the competitive fringe has done its worst. This monopoly price then becomes the “world price of oil” and the competitive fringe supplies as much as it wants to, at that price—acting like standard competitive price-taking, quantity-adjusting firms.

Caution: OPEC’s power has waned in recent years, due in part to the western recession reducing demand, but also due to increases in the supply of natural gas in the US (fracking, etc.) which has decreased the demand for foreign oil. Recent attempts by OPEC to reduce member output substantially have been less successful.