Innovation & Management in the Energy Industry

Lecture 1 – Introduction

• Course overview• Basics of Microeconomics

Course Overview

Who am I?

• Christian JaagPhD (University of St. Gallen)

• Managing Partner, Swiss EconomicsEconomic consulting in network economics with a focus on regulation and competition economicsLecturer (University of St. Gallen, University of Zürich, EPFL)

• Former AssignmentsHead of Regulatory Economics, Swiss PostVisiting scholar, Rutgers UniversityCFO (interim), joiz social tv

• Contactchristian.jaag@epfl.ch; christian.jaag@swiss-economics.chwww.swiss-economics.ch

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Goal of the Course

At the end of the course the student is expected to be able to explain the main economic and political forces behind energy demand and supply as well as the rationales for economic policy in the energy sectors. The student must be able to use economic tools and principles to analyze energy issues and to formulate energy policy instruments.

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General Motivation and Context of the Course

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TechnologySociety

Innovation and Mgmtin Energy

Politics

EconomyRegulation

Course Outline

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Date Topic Presenters1 Feb 17 Course overview

Basics of microeconomicsChristian Jaag

2 Feb 24 Market failureRegulation: Institutions and current issues

Christian JaagProf. Matthias Finger

3 March 3 Innovation Christian Jaag

4 March 10 Sustainability and regulation Christian Jaag

5 March 17 Student presentationsInvestment decisions

StudentsDr. Urs Meister

6 March 24 Student presentations Students

7 March 31 Exam

Recommended reading:Carol A. Dahl (2004). International Energy Markets: Understanding Pricing, Policies and Profits. PenWell

Student Presentation

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• 9 groups• 20 minutes presentation per group• 10 minutes discussion per group• Deadline for presentation slides:

Noon of the day before the presentation• Late submissions will result in a lower grade

Student Presentations

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March 17• Carbon emission markets: the problem they attempt to solve and how• The cost of nuclear energy: how to price risk• Current and future drivers of energy demand

March 24• The future of electric energy storage between base- and peak load; effect of

decentralized energy production• Electric energy price forecast in light of supply-, demand- and regulatory

scenarios• Smart grids and smart meters: costs and benefits• Unbundling vs. vertical integration• The future of fossil fuels• Swiss Energy Strategy 2050

Basics of Microeconomics

What is Microeconomics?

Study of the behavior of individuals in making decisions on the allocation of limited resources.

• Individuals may be persons or firms.• Persons strive for happiness o utility maximization• Firms strive for profit o profit maximization

Why is this relevant for innovation and management in the energy industry?

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Basics of Microeconomics

Principle of Comparative Advantage

Demand

Supply

Characterizing Demand and Supply

Equilibrium and Welfare

Basics of MicroeconomicsPrinciple of Comparative Advantage

Opportunity cost: value of the best alternative forgone

Examples?

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Basics of MicroeconomicsPrinciple of Comparative Advantage

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Good 1

Good 2

Good 1

Good 225 100

100Production possibilityfrontier in country A

Production possibilityfrontier in country B

Opportunity cost per unit of good 1 in country A: 1/4 unit of good 2

Opportunity cost per unit of good 1 in country B: One unit of good 2

o Country A as a comparative advantage in producing good 1o Country B as a comparative advantage in producing good 2

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Basics of MicroeconomicsPrinciple of Comparative Advantage

Example: Both countries wish to consume the same amount of both goods

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Good 1

Good 2

Good 1

Good 225 100

100100

2050

Basics of MicroeconomicsPrinciple of Comparative Advantage

Example: Both countries wish to consume the same amount of both goods

Country AAutarchyGood 1 20 Good 2 20

TradeGood 1 100Good 2 0

Trade allows for specialization and the exploitation of comparative advantages

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Country B

50 50

0100

Total

7070

100100

Basics of MicroeconomicsPrinciple of Comparative Advantage

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Good 1

Good 2100

Joint productionpossibility frontier

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125

200

Basics of MicroeconomicsPrinciple of Comparative Advantage

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Basics of MicroeconomicsPrinciple of Comparative Advantage

David Ricardo (1772-1823)

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Basics of Microeconomics

Comparative Advantage

Demand

Supply

Characterizing Demand and Supply

Equilibrium and Welfare

Basics of MicroeconomicsWillingness-to-Pay

• Let Alice be a consumer and 𝑍 be some good.

• Alice’s willingness-to-pay (𝑊𝑇𝑃) for a given quantity 𝑞 of 𝑍 is the monetary value she attaches to this quantity 𝑞 of 𝑍.

• The benefit that Alice derives from buying an extra unit of 𝑍 is called Alice’s

marginal willingness-to-pay 𝑀𝑊𝑇𝑃 .

• Law of Demand: 𝑀𝑊𝑇𝑃 decreases in quantity.

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Basics of MicroeconomicsDemand – Illustration

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1 2 3 4 5 6

Example

𝑞 = 3

𝑊𝑇𝑃 = area under columns up to 3

𝑀𝑊𝑇𝑃 = area under column 4 (the extra benefit of an additional unit)

𝑞

𝑝

Basics of MicroeconomicsDemand (I)

• Let 𝑝 be the price charged for a unit of 𝑍.

• If 𝑀𝑊𝑇𝑃 < 𝑝, then Alice will not buy the respective additional unit of 𝑍.

• If 𝑀𝑊𝑇𝑃 ≥ 𝑝, then Alice will buy the respective additional unit of 𝑍 and enjoy a marginal consumer-surplus of (𝑀𝑊𝑇𝑃 – 𝑝).

• Whether Alice demands an additional quantity of 𝑍 is determined by her 𝑀𝑊𝑇𝑃.

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Basics of MicroeconomicsDemand (II)

• Alice’s demand function consists of all her 𝑀𝑊𝑇𝑃𝑠.

• Since Alice would maximally pay a price equal to her 𝑀𝑊𝑇𝑃 for the respective units consumed, her demand generates a relation between price and quantity.

• Assuming the goods to be infinitely divisible, the demand function can be represented by a curve.

• Background «ceteris paribus» assumption: Other factors affecting demand are kept constant (prices of other goods, Alice’s income etc.).

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Basics of MicroeconomicsDemand – Illustration

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𝑞

𝑝

𝑑

Alice’s MWTP = Alice’s demand function d

Basics of MicroeconomicsChanges in Consumer Surplus

• Recall that consumer surplus is defined as (𝑀𝑊𝑇𝑃 –𝑝).

• Suppose the price of good 𝑍 increases.

• With a higher price, Alice’s demand decreases.

• This implies a change in the consumer surplus.

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Basics of MicroeconomicsIllustration of Consumer Surplus

𝑝

𝑞 𝑞

𝑝

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consumer surplus

Basics of MicroeconomicsChange in Consumer Surplus due to Price Increase

loss in consumer surplus due to reduced consumption

loss in consumer surplus due to paying a higher price for the units still consumed𝑝

𝑞 𝑞

𝑝

𝑞′

𝑝′

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total loss in consumer surplus

final consumer surplus

Basics of Microeconomics

Comparative Advantage

Demand

Supply

Characterizing Demand and Supply

Equilibrium and Welfare

Basics of MicroeconomicsAssumption of Perfect Competition

• A firm cannot influence the price, as it is too small relative to the frictionless market, on which completely identical goods are traded.

• If the firm were to increase the price, then it will not sell anything, since all demand will go to its competitors.

• If the firm were to decrease the price, then all demand will turn to the firm, which will exceed its capacity.

• Thus, the only decision variable of the firm is the quantity q it supplies to the market.

• Firms are therefore called «price takers» in perfectly competitive markets.29

Basics of MicroeconomicsSupply Function

• Given its cost structure, a price-taking firm maximizes its profits:

max𝑞

𝑝𝑞 − 𝑐 𝑞

� 𝑝 − 𝑐′ 𝑞 = 0� 𝑝 = 𝑐′ 𝑞

• Thus, at profit maximum, price equals marginal cost!

• For any given price 𝑝, the firm will supply the quantity 𝑞, such that 𝑝 = 𝑐′ 𝑞 .

• The marginal cost function 𝑐′ 𝑞 is the firm’s supply function.

• Marginal cost is assumed to be constant or increasing in quantity. 30

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Basics of MicroeconomicsDerivation of the Supply Curve

𝑞

𝑞

𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 𝑐(𝑞)

𝑡𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 𝑟(𝑞)

𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡 =𝑐(𝑞)𝑞

𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑐𝑜𝑠𝑡 =𝜕𝑐(𝑞)𝜕𝑞

= 𝑐′

𝑝𝑟𝑖𝑐𝑒 𝑝

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Basics of MicroeconomicsIllustration of the Supply Function

𝑞

𝑝𝑝 = 𝑐′(𝑞)

𝑆𝑢𝑝𝑝𝑙𝑦 𝐹𝑢𝑛𝑐𝑡𝑖𝑜𝑛

Basics of MicroeconomicsProducer Surplus

• In analogy to consumer surplus, the area between the market price and the supply function is called producer surplus.

• For every quantity 𝑞, the supply function denotes the minimum price at which the firm is willing to supply 𝑞.

• If this minimum price is smaller than the market price, then there is a surplus for the producer.

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Basics of MicroeconomicsIllustration of Producer Surplus

𝑞

𝑝

𝑝

𝑞

𝑐′(𝑞)

producer surplus

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Basics of MicroeconomicsChange in Producer Surplus due to Price Increase

𝑞𝑒 𝑞

𝑝

𝑝𝑒

𝑝′

𝑞′

original producer surplus

gain in producer surplus, due to the price increase of the already sold units

gain in producer surplus, due to the additionally sold units.

𝑐′(𝑞)

total gain in producer surplus

Basics of Microeconomics

Comparative Advantage

Demand

Supply

Characterizing Demand and Supply

Equilibrium and Welfare

Basics of MicroeconomicsElasiticities

Elasticities measure relative percentage changes between two variables:

Examples: Price elasticity of supply, income elasticity of demand,…

Why elasticities?• Independence of units used• Comparability between different goods

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𝜺 =

𝝏𝒒𝒒𝝏𝒑𝒑

=𝝏𝒒𝝏𝒑

𝒑𝒒

Basics of MicroeconomicsCharacterization of Goods by Means of Elasticities

𝒒: quantity demanded, 𝒃: income, 𝒑: price

• Law of demand holds

• Normal good energy

• Inferior good (“dirty” energy)

• Substitutes coal, gas

• Complements car, gas

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𝝏𝒒𝒊𝝏𝒃

𝒃𝒒𝒊

< 𝟎

𝝏𝒒𝒊𝝏𝒃

𝒃𝒒𝒊

> 𝟎

𝝏𝒒𝒊𝝏𝒑𝒋

𝒑𝒋𝒒𝒊

> 𝟎

𝝏𝒒𝒊𝝏𝒑𝒋

𝒑𝒋𝒒𝒊

< 𝟎

𝝏𝒒𝒊𝝏𝒑𝒊

𝒑𝒊𝒒𝒊

< 𝟎

Basics of MicroeconomicsCharacterization of Goods by Means of Elasticities

𝒒: quantity demanded, 𝒃: income, 𝒑: price

• Elastic demand

• Inelastic demand

• Do we normally observe goods exhibiting inelastic demand?

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𝝏𝒒𝒊𝝏𝒃

𝒃𝒒𝒊

> −𝟏

𝝏𝒒𝒊𝝏𝒑𝒊

𝒑𝒊𝒒𝒊

< −𝟏

Basics of Microeconomics

Comparative Advantage

Demand

Supply

Characterizing Demand and Supply

Equilibrium and Welfare

Basics of MicroeconomicsMarket Equilibrium

The equilibrium price 𝑝𝑒 is determined by • Graphically: the intersection of market demand and market supply

• Economically: 𝑀𝑊𝑇𝑃 = 𝑐′(𝑞)

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Supply

producer surplus

𝑞

𝑝

𝑝𝑒

𝑞𝑒

consumer surplus

Demand

Basics of MicroeconomicsWelfare Considerations (I)

• In markets with perfect competition, welfare (total surplus) is maximized in equilibrium.

• 1. Suppose any 𝑞 > 𝑞𝑒:

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𝑝𝑒

𝑞𝑒

𝑝′

𝑞′

A B CD

Price decreases to 𝑝′

A: transformed from producer surplus to consumer surplus

B+C: gain in consumer surplus

B+C+D: “loss” in producer surplus

net effect: decrease of total welfare by D compared to equilibrium

𝑞

𝑝

Demand

Supply

Basics of MicroeconomicsWelfare Considerations (II)

• 2. Suppose any 𝑞 < 𝑞𝑒:

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𝑝𝑒

𝑞𝑒

𝑝′

𝑞′

Price increases to 𝑝′

A: transformed from consumer surplus to producer surplus

B: loss in consumer surplus

C: loss in producer surplus

Net effect: decrease of total welfare by B + C compared to equilibrium

A BC

𝑞

𝑝Supply

Demand

Lecture 1Summary

• Microeconomics studies the behavior of individuals in making decisions on the allocation of limited resources.

• Trade allows for specialization and the exploitation of comparative advantages.

• Demand represents the buyer’s the marginal willingness to pay.• Supply results from profit maximization and equals the seller’s marginal

cost (under perfect competition).• Consumer surplus is the difference between the buyer’s marginal

willingness to pay and the price.• Producer surplus is the difference between the price and the seller’s

marginal cost.• Welfare is the sum of consumer surplus and producer surplus.

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