Sun Oct 16th, 2005 at 04:27:59 PM EST
This diary is motivated by two of Jérôme's comments (emphasis added):
The reason why gas prices determine power prices even though gas power plants only make 30% or so of the production capacity in the UK is simple: they are the marginal plants. By this, I mean that when power demand goes up or down, it is gas fired plants that are turned on or off, because (i) it's the most expensive power source and (ii) it's the easiest to turn on and off. (http://www.eurotrib.com/comments/2005/10/12/55316/323/3#3)
which motivated the following exchange:
Natural gas prices set the marginal price in the general European market, it doesn't matter if Germany has less gas-powered capacity, the price is still set by gas (unless you have unusual stuff like very high or very low hydro production in Scandinavia, or less nuclear available than usual in France, like during the heatwave two years ago)
While [the fact that electricity prices are set by gas prices because the latter are marginal] is elementary once one is introduced to the concept, most people have never heard of it. Given that this was one of the few points that Adam Smith made repeatedly in his Wealth of Nations, public misunderstanding of how marginal sources set the price of commodities must rank up there with people not knowing about Newton's laws of motion (a topic more dear to me personally).
That's right: there are some basic principles of economics that everyone should know about, economist or not. And really, while knowing about Shakespeare and the Second Law of Thermodynamics is part of what sets humans apart from animals, what you don't know about economics can
I am not an economist, but I have been teaching myself economics for a while by the unconventional method of reading the original works of the Masters, because I just can't stomach textbooks (yes, Mr. Samuelson, I am talking about you
). So, while I don't know much about economics I can tell you something about the founders of the discipline:
- Adam Smith wrote The Wealth of Nations to improve the public discourse of economic policy, to dispel myths, and to warn people about the dangers of letting businessmen advise legislators
- John Stuart Mill had a favourable opinion of socialism, but thought that socialist writers fell prey to persistent misunderstandings of basic economic principles, which detracted from their arguments and also from the effectiveness of their proposed policies
Why is this important? Because 230 years after Smith the lessons he tried to teach still haven't been learnt and the myths he tried to dispel are still with us. And because 150 years after Mill, his prophetic observations on the prospects of socialism having been vindicated, socialists still routinely have to get their foot out of their mouth if they want to make any economic sense. And that includes me, I suppose.
Anyway, I happen to be a firm believer that the best way to learn something is to teach it, so I am going to put myself on the line in order for us non-economists to get our heads around some basic economic principles and, more importantly, how they are related.
More after the fold.
I want to explore the fact that the market price of a commodity is regulated by the most expensive source that is put to use in order to satisfy demand. That is, in principle the price has very little to do with the actual cost of producing the whole quantity of the commodity that is sold, and everything to do with how much it costs to produce the last bit. This leads to rent payments to the owners of the static resources used to produce the commodity which can be quite large and wholly uncorrelated with the part the owner plays in the production process. However unfair this state of affairs may seem, it is important to realize that it is a necessity. At the end I will look into community ownership as a way to mitigate the perceived unfairness of the arrangement.
The Parable of the Breadmakers
One upon a time there was a breadmaker called Alice, who sold break at €1 per Kg. One day the demand for bread rose above the 4 Kg per day that she could bake. Another breadmaker, Bob, came around who could sell an equivalent loaf of bread for €2/Kg. This might be because Bob wastes a lot more flour than Alice, for example. People needed more bread than Alice could provide so they had to buy some from Bob, even though it was "overpriced". When they bought 4 Kg from Alice (all that she could bake) and 1 Kg from Bob, the average price was 1.2€/Kg, but each extra Kg cost €2 (the marginal
price). Now, as soon as Alice found out about Bob's price, she raised the price of her bread and, as long as it stayed below €2/Kg, people were better off buying from her first anyway. In fact, they soon ended up paying €2/Kg for all the bread. In this way, the marginal cost determined the price
. One family moved away and the demand for bread dropped below 4Kg again, putting Alice and Bob in competition. It was to Alice's interest to undercut Bob, but there was no need for her to go as low as €1: €1.95/Kg would do.
There are several morals to the story. First, these kinds of price increases tend to be persistent. Second, before Alice doubled her price, you used to be able to get 5 Kg of bread for €6, and afterwards you have to pay €10. Presumably it still costs a little under €6 to produce the bread, so you are paying a €4 premium to Alice apparently for nothing.
There are two essential ingredients for cooking this example: product equivalence and perfect information. These ingredients don't usually apply to everyday situations, but they do apply in financial commodities markets, such as the market for oil, or in the production and distribution of electricity. A third ingrediend is anonimity: if my little example happens in a small community, Alice's behaviour and "profiteering" will likely be frowned upon, but in a commodity exchange you don't know, nor does it matter, who you are ultimately trading with, as all trades are ultimately cleared through the exchange and who finally delivers your product may well be different from who you originally contracted with.
What is rent?
If you are wondering where the extra €4 that Alice was getting went, in many analogous situations they go to rent
. Let's take a long, hard look at the following diagram.
On the vertical axis I represent the rate
of production of some commodity, say, wheat. The first point I want to make is that everything in economics is measured in rates: time is essential even if (as in this particular case) it is implicit. On the horizontal axis I represent the unit price
of the commodity. The supply
curve indicates at what rate the commodity can be produced for less than the corresponding price. To the left of the supply curve there is a similar curve, representing the actual cost
(labour and raw materials) of production, instead of the price. The difference between the two is profit
. In this graph I am allowing a handsome 10% profit. Now, since the buyers pay the same price for all the produce, the amount of money spent (per unit time) is the area of the whole shaded rectangle, not just the area to the left of the supply curve. The dark gray area is an amount paid over and above what is needed to make up for production costs and for profit. In the case of crops, this is the rent
of land. Here's why.
Supose that wheat is selling for €1/Kg. Alice (who knows nothing about farming) has a house in the countryside surrounded by some fertile land. One day, Bob the agricultural engineer comes along and claims that if he could grow wheat on Alice's land, the yield would be so large that just €0.40/Kg would pay for the seed and his living expenses for the year. Alice agrees to allow Bob to do that, and split any profit with him. Assuming Bob is right, each of them makes €0.30/Kg. Bob makes a whopping 75% profit on his investment! Unfortunately for Bob, before it's time to plant next year Carol, who graduated from the same school as Bob, comes to Alice and offers her 2/3 of the profit. Alice decides to work with Carol next year. The numbers work out as before, but now Alice gets €0.40/Kg and Carol gets €0.20/Kg. Carol still makes a 50% profit. There is some rate of profit (say, 10%) below which nobody will be willing to front the money for this enterprise, but Alice can probably find someone (call him Dan) willing to give her €0.55/Kg. Dan still makes €0.05 on each €0.40 he invests, which is pretty good, but now 55% of the revenue goes to Alice's rent.
I don't know about you, but although I did not have a problem with the Alice of the previous section (she was getting rewarded for her work and superior skill), I do have some qualms about the Alice of this section: she's not doing any of the work or fronting any money, and she gets 11 times more money than Dan once he takes into account his expenses. And all this why? because the fertile land happens to be next to Alice's house. I think this is the basic reason why land ownership is so problematic, and explains the amount of blood that has been spilled over land reform over the last few hundred years.
Update [2005-10-18 16:37:15 by Migeru]: I may or may not come up with a third installment, but I am eager for feedback.