Welcome to European Tribune. It's gone a bit quiet around here these days, but it's still going.

Energy and marginal pricing (updated)

by Migeru 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)
(http://www.eurotrib.com/comments/2005/10/12/55316/323/9#9)

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 kill you.
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:
  1. 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
  2. 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.

Alice's Garden

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.

Display:
Well now...that wasn't sooo painful...and I actually started to get a little bit of economic info into my brain (though retention will be another issue). But now this Mr Adam Smith does sound like a person to read more of...but will I? Please give us more of his wisdom in future lessons, Professor Migeru...

But don't worry about the lack of comments...I suspect people are saying, "huh, have to think on that one..."

"Once in awhile we get shown the light, in the strangest of places, if we look at it right" - Hunter/Garcia

by whataboutbob on Mon Oct 17th, 2005 at 12:41:15 PM EST
with the second law of thermodynamics?

I promise one day to do it....I promise.

Wonderful reading experience. This is one of the few laws of economy that I trust, it is an anthoopological rule, actually. That's why I trust it.

One day we should make a list of all the so-called economic laws that are pure bu---hit or those that are true as long as everybody agrees that they are true.

Migeru, I trust you for this endevour, if you ever dare to make it (no I can not ask it, it would be too much work).

Great diary.
A pleasure

I therefore claim to show, not how men think in myths, but how myths operate in men's minds without their being aware of the fact. Levi-Strauss, Claude

by kcurie on Mon Oct 17th, 2005 at 01:41:03 PM EST
with the second law of thermodynamics?

I promise one day to do it....I promise.

I'll take that as a compliment.

A society committed to the notion that government is always bad will have bad government. And it doesn't have to be that way. — Paul Krugman

by Migeru (migeru at eurotrib dot com) on Mon Oct 17th, 2005 at 03:43:25 PM EST
[ Parent ]
it is.


I therefore claim to show, not how men think in myths, but how myths operate in men's minds without their being aware of the fact. Levi-Strauss, Claude
by kcurie on Mon Oct 17th, 2005 at 04:05:28 PM EST
[ Parent ]
Go for it! I promise to try and understand!!

"Once in awhile we get shown the light, in the strangest of places, if we look at it right" - Hunter/Garcia
by whataboutbob on Mon Oct 17th, 2005 at 03:46:32 PM EST
[ Parent ]
if I can connect it with something interesting I will do my best.

But do not expect it soon.. je je

A pleasure

I therefore claim to show, not how men think in myths, but how myths operate in men's minds without their being aware of the fact. Levi-Strauss, Claude

by kcurie on Mon Oct 17th, 2005 at 04:07:17 PM EST
[ Parent ]
Even more important is balance of power.

In the gasoline and electricity markets there are very few players on the buy side with any power.  Large industrial electricity users can threaten and cajole price down by say proposing to build their own cogen and selling surplus to the grid, but the average Joe that buys gas a tank at a time or electricity via a meter really has no say unless there is a real PUC.

But with no power on the buy side, the natural tendancy is for price to constantly bang against the upside barrier.  Us sleemy (as my French boss use to mispronounce slimy)  oil traders were the only ones who ever tried to move things down, but generally that was damn hard to do for any length of time.

Regardless what the fairly tale believing "market forces will fix it" crowd say, the truth is unregulated markets work to reward the strongest players.

by HiD on Mon Oct 17th, 2005 at 01:47:43 PM EST
Regardless what the fairy tale believing "market forces will fix it" crowd say, the truth is unregulated markets work to reward the strongest players.

Now that's a quotable quote.

by afew (afew(a in a circle)eurotrib_dot_com) on Tue Oct 18th, 2005 at 02:43:05 PM EST
[ Parent ]
I like your drawing, but the shape of the supply curve needs to be improved. There should be steps in it, reflecting the incremental increase in supply that comes when the price passes each new technology point.
by asdf on Tue Oct 18th, 2005 at 12:19:12 PM EST
Granted, but I am trying to make a point about rent not technology. Besides, I am still unconvinced that there are sizeable jumps in the supply curve anyway. Technological advances happen with time, not with increasing prices. If the price of oil doubled tomorrow the shape of the supply curve would not change at all. On the other hand, if (say) nuclear fusion of deuterium-tritium became viable, the curve would change overnight but it would probably remain continuous.

A society committed to the notion that government is always bad will have bad government. And it doesn't have to be that way. — Paul Krugman
by Migeru (migeru at eurotrib dot com) on Tue Oct 18th, 2005 at 01:47:47 PM EST
[ Parent ]
If the price of oil doubled tomorrow

Sorry, I meant to say if the demand for oil doubled tomorrow (with the price rising accordingly) the market price would change discontinuously, but the shape of the supply curve would not change.

A society committed to the notion that government is always bad will have bad government. And it doesn't have to be that way. — Paul Krugman
by Migeru (migeru at eurotrib dot com) on Tue Oct 18th, 2005 at 01:58:31 PM EST
[ Parent ]
Yes, but there's no need for technology jumps in many cases. We know how to make wind turbines, they just aren't quite cheap enough. We know how to heat domestic water with solar panels, it's just too expensive. We know how to make public transportation, but at today's prices it's cheaper to drive.

Technology will (hopefully) change the shape of the demand curve. But the curve as it is today has steps in it.

by asdf on Tue Oct 18th, 2005 at 07:36:46 PM EST
[ Parent ]
We know how to make public transportation, but at today's prices it's cheaper to drive.

This is simply not true. It's just more convenient for people to drive, and they can afford the luxury.

As for the cost of wind... I thought once the turbine is in place the power is essentially free (at whatever average rate you get depending on location). The key is that a sizeable initial capital investment is necessary to install the turbine. Then you actually make money for the life of the turbine. So, in terms of cost per KwH, how much does wind currently cost (as a function of power)? Different locations will have diferent prices and I don't believe for a minute that you'd be able to see jumps with the naked eye if you plotted the worldwide distribution on the scale of my graph. The size of the initial capital investment is not the size of the jump in the supply curve.

What am I missing?

A society committed to the notion that government is always bad will have bad government. And it doesn't have to be that way. — Paul Krugman

by Migeru (migeru at eurotrib dot com) on Wed Oct 19th, 2005 at 04:06:13 AM EST
[ Parent ]
There is some cost for wind power, including the turbines, the maintenance, the distribution system, etc. When the price point gets above that cost, then wind power is profitable, and the supply becomes huge.
by asdf on Wed Oct 19th, 2005 at 11:14:59 AM EST
[ Parent ]
How about the wind farms that are already in place? Are those not profitable, or are those the only ones that are profitable at current price?

A society committed to the notion that government is always bad will have bad government. And it doesn't have to be that way. — Paul Krugman
by Migeru (migeru at eurotrib dot com) on Wed Oct 19th, 2005 at 11:19:46 AM EST
[ Parent ]


Display:
Go to: [ European Tribune Homepage : Top of page : Top of comments ]