Energy Markets and Economic Efficiency

Lecture 1

Review of market efficiency

Slides

Pre-class

  • None

Post-class

  • Complete the homework on market efficiency and submit handwritten solutions to Canvas.

Key points

  • We review where market demand and supply curves come from, and map the notion of marginal benefits and costs to net benefits and welfare.
  • The market equilibrium will only be economically efficient (max net benefits) under three conditions:
    1. Perfect information
    2. Perfect competition (no market power)
    3. No externalities
  • You should be able to calculate the equilibrium price and quantity, surplus, and the deadweight loss from a market that is not efficient.

Additional material

  • “Two wrongs Two Wrongs Can Sometimes Make a Right: The Environmental Benefits of Market Power in Oil”, by J. Asker, A. Collard-Wexler, C. De Cannière, J. De Loecker, and C. R. Knittel” MIT CEEPR Working Paper

Lecture 2

Piguovian taxes + Social cost of carbon

Slides

Pre-class

  • Watch this video on the social cost of carbon.
  • Then read this academic article on recent work updating the calculation of the social cost of carbon.
    • Some of this will be a bit technical, and you should feel free to use AI for assistance. Pay attention to the key “ingredients” of the calculation and the conceptual issues involved.

Post-class

  • Complete the homework on discounting. This problem set asks you to do some calculations on your computer. Submit the table you generate on Canvas. You do not need to answer the other questions on Canvas, but come prepared to discuss your answers in class.
    • If you want to try using R for the exercises in this class, but have never used it before, you can check out this getting started guide.
  • Optional:
    • If you need a review of the market inefficiency from externalities, or how a Pigouvian tax can correct it, check out this video from Marginal Revolution University.
    • If you need a review of present value calculation, and discounting, see this Khan Academy video or this textbook chapter

Key points

  • Markets are efficient when all costs and benefits are borne by the parties involved in the transaction. Externalities thus lead to market failure.
  • Pigouvian taxes can restore efficiency, but do not eliminate all externalities.
  • Climate change is a particularly challenging externality to price due to the many affected parties and long time scales involved.
    • Know the basic science of climate change, and the difference between local vs global and flow vs stock pollutants.
  • Be familiar with the social cost of carbon and conceptually how it is calculated.
  • A particularly challenging aspect of this is the choice of discount rate, which can dramatically change the SCC.
    • Be comfortable putting things in present value terms, and understanding how discounting affects the value of future costs and benefits.

Additional material

  • Watch this short video by Catie Hausman on how a carbon tax works.
  • RFF explainer on the social cost of carbon.
  • Bill Nordhaus in NYRB, “Why the Global Warming Skeptics are Wrong”

Lecture 3

Dynamic efficiency

Slides

Pre-class

  • Keohane and Olmstead Chapter 6 (you can read online through BC library here)

Post-class

  • Complete the homework on the implications of the nonrenewable resource model for climate policy. Submit handwritten solutions to Canvas. We will discuss your answers next class.

Key points

  • Nonrenewable resources are economically unique because their consumption implies a unique opportunity cost: anything consumed today can’t be consumed in the future.
  • Efficient resource extraction maximizes the present value of net benefits.
  • The true marginal cost of extraction is the opportunity cost of the resource. This includes the marginal extraction cost and the scarcity rent (marginal user cost).
  • The Hotelling Rule describes a rule for extracting resource optimally. In the simplest case, it states that the scarcity rent should rise at the discount rate across two periods.
  • If property rights are well defined, and the market is competitive, a private resource owner will extract resources at the dynamically efficient rate.
  • You should know how to solved the two period model, and understand when the market extraction path will and won’t be optimal.

Additional material

  • The concepts we discussed are important for managing other natural resources unrelated to energy. An important example is groundwater management.