Supply and Demand and Energy Prices

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SUPPLY AND DEMAND AND ENERGY PRICES

The quantity of energy supplied is the flow of energy brought onto the market, and the quantity of energy demanded is the amount of energy purchased for a particular period of time. Quantity can be measured in terms of the number of kilowatt hours produced by an electric generator in a day, the number of barrels of oil or cubic feet of gas brought to the market in a month, or the number of tons of coal produced and sold in a year. Primary energy takes the form of fossil fuels or electricity from primary, sources including hydro, nuclear, solar, geothermal, and biomass, while secondary energy is electricity generated from fossil fuels.

DATA SOURCES

Data on the quantity of energy supplied, called energy production, are available from a variety of government, trade association, and international sources. Some of the better sources include the U.S. Energy Information Administration, the American Petroleum Institute, the International Energy Agency, and the United Nations. Secondary energy quantity is reported as net or gross. Net energy is the amount of energy produced and gross is the amount of primary energy required to produce it.

Quantities of energy demanded and supplied are reported in a bewildering variety of ways. The three typical units of measurement are energy content, volume and weight. Energy content includes British thermal units in the United States or kilocalories and kilojoules in the rest of the world, as well as coal or oil equivalents. Kilowatts are the most common units of measurement for electricity and are sometimes applied to other energy sources as well. Weights are most often expressed as short tons, long tons or metric tonnes. Volumes are expressed as barrels, cubic feet, gallons or liters.

DETERMINANTS OF ENERGY SUPPLY

The quantity of energy supplied is a function of the economic and technical variables that influence the cost of bringing the energy source to market and the price that a supplier receives for the energy source in the market. For example, in a competitive market the quantity of coal (Qs) supplied at the mine mouth is a function of the price received for the coal (P); the price of the capital necessary to produce the coal, such as drag lines, cutting tools, and loaders (Pk); the price of labor, which includes wages, salaries, and indirect labor costs (Pl); the price of using land or any other natural resource or other factor of production (Pn); and technical variables that could include the technologies available and the geology of the deposits (T). An increasing T in this context represents better technology or more favorable geology.

Prices of other related goods also influence quantity supplied. For example, uranium production may produce vanadium as a byproduct. Thus, uranium and vanadium are complementary goods or are goods produced together. When the price of vanadium increases, uranium production becomes more profitable and will increase. Gas found with oil is called associated gas and is considered complementary to oil in production. If the price of oil goes up, drillers may look harder for oil and find more gas to produce as well.

Alternatively, goods may be substitutes in production. If the price of other minerals increase, coal producers may look for other minerals and produce less coal. If gas is nonassociated, it is found without oil and is a substitute for oil in supply rather than a complement. If the price of natural gas, a substitute good (Ps) or a good that could be produced instead of oil, increases, drillers may spend less time looking for oil and more time looking for and producing nonassociated gas, thus decreasing oil production.

Governments often interfere in energy markets and their policies may influence quantity supplied. For example, environmental regulations (Er) that require less pollution or more safety when producing fuels decrease the quantity of fuel supplied. Such regulations in the United States include the removal of sulfur from fuels, the addition of oxygenates to gasolines in some areas of the country, and more safety in coal mines. Additional environmental regulations increase cost and should decrease quantity supplied. Aggregate market supply also depends on the number of suppliers (#S) in the industry.

We can write a general supply function as follows:

The sign before each variable indicates how the variable influences quantity supplied. A minus sign indicates they are inversely related and a positive sign indicates they are directly related. Thus, in the example of coal, raising the price of coal is likely to increase quantity supplied, whereas raising the price of labor is likely to decrease the quantity supplied.

For nonrenewable energy sources such as fossil fuels, expectations about the future price and interest rates influence the current quantity supplied. Expectations of higher future prices should cause less production today and more production tomorrow.

ELASTICITY OF SUPPLY

A measure of how responsive quantity supplied is to a variable (say price) is called the elasticity of supply with respect to that variable. Elasticity of supply is the percentage change in quantity divided by the percentage change in the variable in question or If the supply price elasticity of oil is 1.27, it follows that if the price of oil increases by 1 percent, the quantity of oil supplied increases by 1.27 percent. A cross elasticity of supply indicates how quantity produced is related to another price. For example, if the cross elasticity of oil supply with respect to the price of gas is 0.15, then if the price of gas increases 1 percent, the quantity of oil produced goes up 0.15 percent. Because energy production is capital-intensive, supply price elasticities are larger or more elastic in the long run than in the short run. The long run is the time it takes for producers to totally adjust to changing circumstances and allows for totally changing the capital stock. In contrast, in the short run capital stock is fixed and total adjustment does not take place. Often the short run is considered a year or less, but the exact length of time depends on the context.

Information about supply elasticities would be highly useful for those involved in energy markets, but unfortunately little is available. Carol Dahl and T. Duggan (1996) surveyed studies that use simple models to estimate energy supply or elasticities. They found estimates for the various fossil fuels and uranium in the United States and concluded that studies estimating these elasticities using reserve costs are the most promising. Such studies yielded a U.S. gas supply own-price elasticity of 0.41, a uranium supply own-price elasticity from 0.74 to 3.08, an Appalachia coal supply own-price elasticity of 0.41 to 7.90, and a U.S. oil supply own-price elasticity of 1.27. Even less is known about cross-price elasticities. Dahl and Duggan (1998) surveyed oil and gas exploration models that include cross-price elasticities for oil and gas but did not find strong statistical results from any of the models.

DETERMINANTS OF ENERGY DEMAND

Energy demand is a derived demand. Consumers and businesses demand energy not for itself but for the services that the energy can provide. A consumer may want energy for lighting, space conditioning in the form of heat in the winters and cooling in the summer, and energy to run vehicles and appliances. Businesses often have these same needs and also need energy to run motors and for process heat.

For consumers, quantity demanded of energy (Qcd) is a function of the price of energy (P), the price of other related goods, disposable income (Y), and other variables (O) such as personal preferences, lifestyle, weather, and demographic variables and, if it is aggregate demand, the number of consumers (#C). Take for example the quantity of electricity demanded by a household. If the price of electricity increases consumers may use less electricity. If the price of natural gas, a substitute for electricity in consumption (Ps), decreases, that may cause consumers to shift away from electric water heaters, clothes driers and furnaces to ones that use natural gas, thus increasing the quantity of natural gas demanded. If the price of electric appliances (Pc) increases, or decreases quantity of electricity demanded. consumers may buy less appliances and, hence, use less electricity. Increasing disposable income is likely to cause consumers to buy larger homes and more appliances increasing the quantity of electricity consumed. Interestingly, the effect of an increase in income does not have to be positive. For example, in the past as income increased, homes that heated with coal switched to cleaner fuels such as fuel oil or gas. In the developing world, kerosene is used for lighting, but as households become richer they switch to electricity. In these contexts coal and kerosene are inferior goods and their consumption decreases as income increases. We can write a general consumer energy demand function as follows:

Again the signs before the variables indicate how the variables influence quantity. The sign before income (Y) is ±, since the sign would be + for a normal good and – for an inferior good. The sign before other variables is also ±, since the sign depends on what the other variable is. For example, colder weather would raise the demand for natural gas, but an aging population, which drives less than a younger one, would decrease the demand for gasoline.

For businesses the demand for energy is the demand for a factor of production. Its demand depends on the price of the energy demanded (P) as well as the price of its output (Po), technology (T) and prices of other factors of production—land, labor, and capital—that might be substitutes (Ps) or complements (Pc) in consumption. Environmental policy (Ep) might also affect the demand for fuel. If this is aggregate business demand for energy the number of businesses is also relevant.

We can write a general business energy demand function as follows:

The sign on technology (T) and environmental policy (E p) are uncertain and depend on the particular technology and policy. For example, environmental regulations requiring lower sulfur emissions favor gas over coal, while new technologies that make oil cheaper to use increase oil demand at the expense of gas and coal.

ELASTICITY OF DEMAND

The responsiveness of energy consumption to a variable can be represented by an elasticity, as was the case for energy production. Again the elasticity is measured as the percentage change in quantity over the percentage change in the variable. The demand elasticity is negative, since raising price lowers quantity demanded, and if it is less than –1, the demand is called elastic. Lowering price when demand is elastic means that quantity demanded increases by a larger percent than price falls, thus energy expenditures go up. Alternatively, raising price lowers expenditures. If the demand elasticity is between 0 and –1, then it is called inelastic. Now lowering price means that quantity increases by a smaller percent than price falls. Thus energy expenditures go down. Alternatively, raising price lowers expenditures.

INCOME ELASTICITIES

Income elasticities are positive for normal and non-inferior goods, since raising income increases total consumption of these goods. Goods with income elasticities greater than 1 are said to have income elastic demand. Suppose jet fuel has an income elasticity of 3. The in income goes up by 1 percent, the quantity of jet fuel demanded goes up by 3 percent and a larger share of income is spent on jet fuel. Such goods with income elastic demand are called luxuries and they become a larger share of spending as a person gets richer. If the income elasticity is between 0 and 1, it is called inelastic. As income increases, a smaller share of income is spent on goods with inelastic demand. Often necessities such are fuel for heating are income ineleastic.

A cross-price elasticity indicated how the quantity of one good changes when the price of another related good changes. The sign of the cross-price elasticity tells us whether goods are substitutes or complements. Take the case of a cement producer who needs a great deal of heat to produce cement. The producer's cross-price elasticity of demand for natural gas with respect to the price of the substitute good, coal, is the percentage change in natural gas demand divided by the percentage change in coal price. This elasticity for substitute goods will be positive, since an increase in the price of coal will cause an increase in the quantity of natural gas demanded. Alternatively, the cross-price elasticity of demand for complementary goods is negative. If the price of gas furnaces (a complement to gas) goes down, the cement producer may buy more gas furnaces, instead of coal furnaces, and use more natural gas.

ESTIMATED ELASTICITIES

More statistical work has been done estimating demand elasticities. Dahl (1993a) surveyed this work for the United States. She found considerable variation in ownprice and income elasticities across studies with the most consistency for studies of residential demand and for gasoline. More products seem to be price and income inelastic and short run elasticities are more certain than long run elasticity. Short run price elasticities for a year are probably between 0 and –0.5 for energy products. Dahl (1995) surveyed transportation demand studies and concluded that the price elasticity of demand for gasoline in the United States is –0.6 and the income elasticity is just below 1. Dahl (1992, 1993b, 1994) looked at energy demand elasticities in developing countries and found that oil and price elasticities of demand are inelastic and near –0.3, while income elasticities of demand are elastic and near 1.3. Dahl (1995b) surveyed natural gas's own, cross and income elasticities in industrial countries but was not able to come to a conclusion about the magnitude of these elasticities. Studies are also often inconsistent about whether coal, oil, and electricity are substitutes or complements to natural gas.

ENERGY PRICES

Elasticities tell us how responsive are quantities demanded and supplied. In a competitive market where many buyers and sellers are competing with one another, the interactions of supply and demand determine the price in energy markets. To see how, we simplify demand and supply by holding all variables constant except price and quantity and graph both functions in Figure 1. Equilibrium in this market is at Pe where quantity demanded equals quantity supplied. If price is at Pl quantity demanded is Qd and quantity supplied is at Qs. There is excess quantity supplied and there would be pressure on prices downward until quantity demanded equaled quantity supplied. Thus interactions of demand and supply determine price.

CHANGE IN DEMAND

If one of the variables held constant in the demand curve were to change, it would shift the whole demand curve, called a change in demand. For example, suppose Figure 2 represents the world market for crude oil. The Asian crisis beginning in 1997 reduced Asian income, which in turn reduced Asia's demand for oil. This decrease in demand lowered price moving along the supply curve, called a decrease in quantity supplied.

CHANGE IN SUPPLY

The 1990s have seen technical changes in finding oil such as 3D seismic and horizontal drilling that have reduced costs. These technical changes shifted the supply of oil as shown in Figure 3. This shift is called a change in supply and is the result a change in the a variable other than the own price. The increase in supply lowers price causing a movement along the demand curve called a change in quantity demanded.

MARKET SETS PRICES

Thus, as economic and political events occur along with changes in demography, preferences and technology, shifting demand and supply interact to form prices in competitive energy markets. The above discussion assumes competitive markets where consumers and producers compete to buy and to sell products, and they have to take market price as given. This is probably the case most often for buyers of energy products. However, in the case of production, sometime market power exists. For example, in the oil market, first Rockfeller, then the large multinational oil companies, and state regulatory commissions such as the Texas Railroad Commission and then OPEC have exercised pricing power. In such a case, the producer tries to influence price or quantity in order to receive higher prices and earn excess profits.

FOSSIL FUEL PRICES

Figure 4 gives an historical overview of how fossil fuel prices have changed in response to market changes. Price availability varies from series to series and is reported for the period 1861–1998 for the well head price of oil (Poil), 1880–1998 for the fob mine price of bituminous coal, and 1922-1998 for the well head price of natural gas. Figure 4 shows the volatility of oil prices as cartels formed and raised prices and then lost control as higher profits encouraged entry by other. Since the oil market is a global market these prices would be similar to those on the world market, as would prices for coal. The coal market has been reasonably competitive, and from the figure, we can see its price has been more stable than oil. However, coal price has been increased by oil price changes since oil is a substitute for coal in under-the-boiler and heating uses.

Sometimes governments interfere with markets by setting price controls. In the United States wellhead price controls were set on natural gas sold into interstate markets beginning in the early 1950s. These controls which were not completely removed until the early 1990s and sometimes caused natural gas shortages. Prices, which had been reasonably stable, became quite volatile as the price controls were increasingly relaxed throughout the 1980s and into the 1990s.

For electricity, economies of scale have existed making it more economical for one firm to produce and distribute electricity for a given market. One firm would be able to monopolize the market and earn excess profits. This has led governments to regulate electricity in the United States and to produce electricity in most of the rest of the world throughout much of the twentieth century. In such a case, electricity price is set not by the market but by the government. In Figure 5 we can see the evolution of constant dollar electricity prices in the United States from the early 1900s to the present, based on the average real consumer price of electricity (Plec). The falling real price reflects the cost reductions in producing and distributing electricity.

As the size of markets have increased and the optimal size of electricity generation units have decreased more electricity markets are being privatized and restructured to allow more competition into the markets and less government control over pricing.

Carol Dahl

See also: Subsidies and Energy Costs.

BIBLIOGRAPHY

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