Basic Economic Concepts

Basic Economic Concepts(contd)Lecture 3Amrit NakarmiEnergy Planning & Management21 Dec 2011

12/21/20111

Utility Function and Expected UtilityUsually consumers choose any set of goods which gives them the maximum utility or maximum expected value.The relationship between utility and wealth is given by the utility functionU = f (W)U =12/21/20112

Utility FunctionThe slope of the function is less inclined as we move to the rightThe slope is the marginal utility, MUOne has less value for wealth as one gets wealthierConsumers can be risk averse (diminishing marginal utility)Risk neutral i.e. indifferent (given by constant marginal utility)Risk Loving ( increasing marginal utility) very unusual characteristics12/21/20113

12/21/20114Production FunctionA production function is the relationship between the maximum output attainable and the quantities of inputs used as all the inputs are varied. In other words, a production function represents the technical efficient transformation of physical resources into products. It is technically efficient because in each point in the production function, the maximum product will be obtained from any given set of resources.

12/21/20115Production Function (example 1)

12/21/20116Production Function (example2)

12/21/20117Production FunctionThe best known production function is the Cobb-Douglas model:

12/21/20118Household Energy Consumption FunctionEnergy Consumption in the household can be given by the model:

where C =energy consumptionX1, Xn = explanatory variables such as household expenses, prices, salaries etc.b1, bn = elasticities of consumptions to explanatory variablesa = constantsect = residual trend autonomous increase rate

12/21/20119Production FunctionIt is easy to estimate to the parameters by taking logarithm and regression analysis.

The Short Run and Long RunThe short run is a period of time in which the quantities of at least one input is fixed and the quantities of the other inputs can be varied.The long run is a period of time in which the quantities of all inputs can be varied.Inputs whose quantity can be varied are called variable inputs and inputs whose quantity cannot be varied in the short run are called fixed inputs.12/21/2011

CostsMarginal cost of a firm is the increase in total cost resulting from a unit increase in output. Marginal cost is the change in total cost divided by change in output.MC =DTC/ DOUTPUTMarginal cost increases because each additional worker produces less output the law of diminishing returns.Marginal revenue The revenue that can be obtained from selling one additional unit of product.12/21/2011

Short Run CostsWrkr/dayOutput/dayTFCTVCTCMCAFCAVCATC0025025142525506.256.256.2512.502102550754.172.505.007.5031325751008.331.925.777.694152510012512.501.676.678.335162512515025.001.567.819.38

12/21/2011ExampleRupees/output

Short Run Costs12/21/2011

OutputCost/day

TCTVCTFC

Short Run Cost12/21/2011

OutputCost/output

AFCAVCATCMCWhen MC is exceeding ATC & AVC, then ATC and AVC are increasing. When MC is less than ATC & AVC, then both ATC and AVC are decreasing. MC cuts them at the minimum.

SRMC & LRMC12/21/2011

OutputAverageCost (ATC)

SRMC

LRMC

ATC0Q0

Q1Q2

Selecting the least cost plants in different output level, we can get the LRMC from the individual ATC of these plants.

12/21/201116MonopolyA monopoly is an industry in which there is only one supplier of a good, service or resource that has no close substitute, and in which there is a barrier preventing the entry of new firms.Legal Barrier to entry. Legal barriers to entry give rise to legal monopoly which occurs when a law, license, or patent restricts competition by preventing entry. (NOC, NEA, NTC (no more)Natural barrier to entry. Natural barriers to entry give rise to natural monopoly, which occurs when one firm can supply the entire market at a lower price than two or more firms can. ( pipelines, railways, transmission lines etc.)

12/21/201117Marginal cost, average total cost, marginal revenue, profit & loss in the short run

12/21/201118A single Price Monopolys revenue Curves

12/21/201119The Monopolys Output & PriceThere is highest profit whenMR = MCMR is always lower than D curve

12/21/201120Short run Profit, costs and demand

12/21/201121Allocative Efficiency of MonopolyA competitive industry will have demandcurve D and supply curve S.Equilibrium occurs where demand andsupply meet with Qc & Pc.If the industry is a monopoly, it tries tomaximize its profit, hence its marginal revenue will be MR lower than demand curve.The marginal cost curve for the monopoly will be the same as S curve. The monopoly tries to produceat which its MR and MC equals.Monopoly restricts output and raises the priceof the product or service.

12/21/201122Allocative Efficiency of MonopolySome features of monopoly:Monopoly prices are higher than in competition.Monopoly output is less than the competitive output.If the monopoly becomes more perfect, it can price discriminate and the price will be closer to the competitive rice.

12/21/201123Allocative Efficiency of MonopolyMonopoly is less efficient than competition.The maximum price consumers are willing to pay is shown by the demand curve. The difference between the maximum price they are willing to pay for each unit purchased and the price they do pay is called consumer surplus.A single price monopoly restricts production to QM, and sells the product or service at PM. Here consumer surplus is reduced, because they lose partly by having to pay more and getting less of the product or services. But here the consumers loss is not equal to monopolys gain. Monopoly gets less than the consumers loss. Since the output is restricted, the economy losses more than the loss in the consumer surplus.

12/21/201124Allocative Efficiency of MonopolyProducer surplus is the difference the producers revenue and the opportunity cost of production. It is the sum of the differences between price and the marginal cost of production.The total losses of the consumer and producer are called Deadweight loss. Deadweight loss measures the allocative inefficiency of the economy if production is restricted below its efficient level.

12/21/201125ElasticityThere is a strong link between energy and economy and the link is shown by the elasticity.

Elasticity of y with reference to variable x, is the percentage change in y due to percentage change in x.

12/21/201126ElasticityGDP elasticity of energy demand

12/21/201127ElasticityPrice elasticity of energy demand

12/21/201128Cross - elasticityIt is the relative change in consumption (demand) of a given form of energy to the relative price change of another energy form.

12/21/201129Energy IntensityIt is the ratio of energy consumption per unit output.Usually it measures the consumption of energy in unit GDP or 1,000 (Rs or USD).

12/21/201130Taxes and subsidiesTaxes can beSpecific (when tax amount is fixed; example: custom duties on petroleum products)Ad valorem (when tax is based on percentage; example: VAT and other levies)Subsidies

12/21/201131Products sold with Tax

If tax is increased in energy goods or services, the supply curve moves upward, thus increasing price and reducing quantity supplied.

12/21/201132Products sold with Tax and deadweight loss

Tax increase will create deadweight loss. It is better to increase tax in inelastic goods rather than elastic goods. Hence, its better to tax gasoline and apple juices because apple juice is more elastic.

12/21/201133Product sold with subsidy

When subsidy is given to the supplier, the supply curve shifts right. Suppose, $ 50 is given as subsidy per ton, then demand will increase to 500 megatons from 400 megatons, and the price will decrease to $150 per ton. Hence, $ 50 subsidy is shared by the producer $25 and the consumer $25.

12/21/201134Subsidy with quota

When quota is fixed by the government on the product such as 400 megatons, the price will remain $175, because the consumers are willing to have at this price. But the subsidy will be eaten by only the producer and consumers will not be benefited when a quota is fixed.

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