Energy Market Case Study 1

ENERGY MARKET CASE STUDY 1 Questions (a) (i) Compare the changes in the price of natural gas and the changes in the price of electricity over the period between 1996 and the 2nd quarter of 2006. [2] Suggested Answer Outline: - Similarity (1m)

- Difference (1m) icity (ii) The change in the price of which fuel in that period has had the greatest impact upon the cost of living? Explain your answer. [3] Suggested Answer Outline: - Change in price of natural gas has greatest impact on cost of living (1m for correct identification) - Natural gas (and electricity) are most heavily weighted fuel components in UK retail price index (1m) - Among the different fuel types, price of natural gas also increased the most (62.8% over 10 years) (1m) (b) Explain an economic advantage that SSE might have lost through its decision not to launch a takeover bid in November 2006. [2] Suggested Answer Outline: - Internal economies of scale which lowers firm‟s average cost of through increase in production or - Increased market power which allows more effective monopoly pricing where the extent to which P>MC is greater, allowing firms to earn greater profits. (1m for identification of appropriate economic concept, 1m for explanation of advantage economic advantage to firm.) (c) Compare the supply curves of natural gas for the UK in March 2006 and October 2006, and explain any changes that have occurred. [5] Suggested Answer Outline: Using Extract 1 and 2: - Opening of new Norway pipeline resulted in - an increase in the supply of natural gas - an increase in PES of natural gas (2m for identification and explanation of change in supply.) (2m for identification and explanation of change in PES.) (1m for diagram.)

(d) Discuss what might happen to the demand for electricity as a result of the price changes identified in the case study. [8] Suggested Answer Outline: - Using concept of PED ailability of substitutes, especially close substitutes such as natural gas change in quantity demanded of electricity - Using concept of CED ectricity and other fuels is positive electricity and other fuels in demand of electricity - Applying the concepts of PED and CED in context of case data price of natural gas (close substitute of electricity) has increased more than price of electricity between 1996 and 2006. own price as households and firms will be substituting natural gas with electricity due to the greater increase in price of natural gas compared to electricity. - Evaluative comments is likely to be greater in long term as electricity consumers may be tied to contracts and unable to respond to price changes. price of natural gas remains below price of electricity, natural gas consumers may not switch to electricity. purchase new consumer durables like electric heaters and capital goods like generators. As such, the switch to electricity will only occur o if the changes in electricity and natural gas prices result in significant absolute price differentials o the price differential is expected to be persist o consumer durables and capital goods using electricity are competitively priced (e) Discuss whether the market for fuel in the UK displays economic efficiency or whether it provides an example of a market failure. [10] Suggested Answer Outline: Introduction - Economic efficiency comprises - Productive efficiency ve) - Allocative efficiency GCE „A‟ Levels November 2008 H2 Economics 9732/1 3 © Raffles Institution

- producing at where last unit of output fulfills P=MC - Market failure refers to inability of free market to achieve

Body Thesis - Economic efficiency in the UK fuel market is improving result in privatised energy firms focusing on profit maximisation objective. Profits = Total Revenue – Total Cost. The pursuit of profit maximisation reduces productive inefficiency as firms need to minimise cost to achieve profit maximisation objective. ) helps to increase competition in the energy market. Competition helps to reduce market power of individual energy firms. This will limit their ability to practice monopoly pricing. Extent to which P>MC is reduced. Hence, allocative inefficiency is reduced.

energy firms to monopoly price, hence improving allocative efficiency. - Although allocatively inefficient, large firms in the UK fuel market can reap economies of scale and produce nearer/at MES scale in production. Large firms can produce at lower average cost. Hence, consumers benefit from lower prices and greater quantities. - Industry may be dynamically efficient due to the abilities of firms to make long run supernormal profits. Innovations from R&D will allow firms to lower average cost of production and improve quality of product. Ofgem, fuel companies are more likely to use the supernormal profits for R&D. Antithesis: “Despite improvement made in terms of economic efficiency, UK fuel market is still inefficient and is an example of market failure”

profits to 445.4 million pounds, suggesting that the firm is making supernormal profits. 2) Firms in the industry plan mergers and take-overs. 3) Energywatch chief executive also alluded to the need for more competition and a price war in the gas market. ets enjoy market power. They can practise monopoly pricing which causes allocative inefficiency. and quantity do not respond to changing costs which results in allocative inefficiency. the lower wholesale prices of natural gas by increasing their quantity demanded of natural gas. In such a situation, allocative inefficiency occurs as consumers “under-consume” cheap natural gas. Europe‟s tightly regulated energy markets. Despite UK price of natural gas being three times more than that in Netherlands, gas pipeline connecting Netherlands and UK was only

running half-full. This represents allocative inefficiency as natural gas is not allocated to the highest bidding market. Conclusion Economic efficiency in the UK fuel market is improving due to UK‟s privatisation drive and the setting up of Ofgem and Energywatch. However, there remains economic inefficiency in the market due to relatively small number of energy firms in the market and the business strategies employed. Moreover, tightly regulated energy markets in other European countries hinder the attainment of economic efficiency in Europe‟s energy market, including UK‟s. Hence, the UK fuel market remains an example of market failure.