Week 2 - Chapter 3 Flashcards
Market Power
The extent to which an individual actor has the ability to influence market outcomes
Perfect Competition
Has to have 6 characteristics:
- Complete information—Everybody has all the information needed to make good decisions.
- No market power—No individual actor has the ability to influence the market outcomes, known as market power.
- Free entry and exit—Everyone is free to contract and all inputs are equally available.
- No constraints—There are no artificial pricing or volume constraints.
- Rational agents—All participants are behaving in their own self-interest; that is, producers are profit maximizing and consumers are utility maximizing.
- No externalities—All costs and benefits of a good are internalized in the transaction and price, and no costs or benefits have been unwillingly imposed on others
Externalities (Positive and Negative)
Benefits or costs unwillingly imposed on others
Positive: including knowledge and inventions paid for by one person and freely transferred to others for their benefit. Also, investments that reduce risk for a single participant in a system often create additional risk-mitigation benefits elsewhere in the system.
Negative: overabsorption of resources, pushing off costs to the future, and transfer of risks to secondary or tertiary parties to a transaction. Pollution, or environmental damage that is caused through the process of creating a good or service but not fully compensated for in the costs the producer has to bear. For this reason, the related costs of production are lower than they would be, which would typically induce a higher volume of output of both the product and its related pollution.
- Market Failure
Four categories:
- Internal market structure: where the conditions of (1) free entry and exit or (2) all agents acting as price takers fail to occur
- External market scope: when markets fail to include all of the effects of the participants’ behavior within them or, conversely, fail to include all participants that are involved in the use or allocation of resources within a market
- Information: where information is either costly or unavailable to all market participants, which can be compounded by agency relationships in which one person is expected to act on behalf (and in the best interest) of another person
- Market design issues introduced by government policy and regulation: though well intentioned, causing both intended and unintended consequences on market function
- Market Barriers
Restrictions in free entry or exit to markets, such as costly startup or shutdown charges or significant IP/Capital advantage
- Natural Monopoly
Industries or service providers for which it is only economically efficient to have a single provider. In these industries, a single provider persistently achieves cost improvements as it gets bigger (decreasing cost industries). Adding a second provider would raise average cost and reduce overall system efficiency.
(Many energy delivery architectures, including electricity grid distribution, exhibit this characteristic of decreasing costs)
Economic Rents
Excess profits above normal profits
Rent Seeking
Producers with monopoly power have the incentive to restrict others’ behavior or entry into the market, making them rent seeking. Rent-seeking behavior can lead to additional monopoly power through controlling the legislative process to further restrict competition or controls on their behavior, undermining competitive markets, or advertising to justify existence of their monopoly status. In both constructed and natural monopolies, safeguards should be established to ensure such firms don’t use their revenues and monopoly power to perpetuate their position through this rent-seeking behavior.
Cartel
Form of anti-competitive behavior
Intentional anticompetitive behavior can also occur in markets with a small number of firms, both on an ad hoc basis and through the formation of a cartel. A famous energy cartel, the Organization of the Petroleum Exporting Countries (OPEC), has had at times a tremendous amount of influence in the global oil industry. Cartels such as OPEC often intentionally restrict aggregate output across producers with the intention of seeing market prices go up, or rent-seeking monopoly behavior.
Establishing an aggregate supply cap and allocation mechanism across all cartel members, and when the cartel represents a meaningful amount of an otherwise constrained market supply, this can be an effective method of producer profit maximization at the expense of market efficiency and of customers. However, cartels can only be sustained if cheating can be prevented, since each firm (or country) in a cartel has an individual incentive to increase its production beyond its allocation and generate additional revenue. As a result, maintaining cartels requires a binding and enforceable mechanism to maintain cartel production caps or allocations among members.
Dumping
Form of anti-competitive behavior - when a firm enjoys a cost or protected market advantage in its home country and can sell at below market prices (or even at a loss) in another market and eventually drive out competition in that market.
Free-rider Problem
Commonly owned resources (also called the commons), including resources like land, materials, and minerals, have the potential to be public goods, unless they are specifically allocated to populations with sufficient enforcement mechanisms to ensure compliance. International fisheries, for example, are one form of a good that is still facing depletion due to this characteristic. Other examples of public goods include national defense, clean air and water supplies, and nonpatentable knowledge.
The problem with these public goods is that producers are rarely interested in providing them because they can never fully recover the costs of delivering them; this is also referred to as the free-rider problem. Both paying and nonpaying users will use, and potentially degrade, these public goods, and the revenue generated is insufficient to induce a profit-seeking firm to participate.
The typical solution for public goods is to use the power of government to provide these services and collect the cost of doing so through taxes. It is typical that a government regulates the ownership of common resources, pays for the upkeep of national parks and national defense, and ensures that the basic access to clean air and water is protected through environmental regulations and the reduction of the negative externalities of other behaviors. Beyond the borders of a single country, cooperative agreements and international treaties can deal with the issues affecting the global commons, or public goods collectively affecting all of the planet’s inhabitants.
Informational Asymmetry
Even when it is possible to ensure that markets have a robust interaction of buyers and sellers and that all effects and participants are internalized to any transaction, lack of transparency or costs to obtain the necessary information or surety can impede overall market function. These information asymmetries can occur for a number of reasons.
Principal-agent Problem
The person making a decision (the agent) is acting on behalf of the person who will have to bear the consequences of that decision (the principal). The agent may have a different set of incentives than the incentives facing the principal and therefore may choose to do things that are not always in the principal’s interest but serve the agent’s instead.
Adverse Selection
Arises when there is a difference in information between buyers and sellers, particularly with regard to the quality of a good being transacted. The idea is that the seller is typically much better informed about the quality of any good being sold than the buyer is, though occasionally the roles are reversed. This makes entering into transactions much more uncertain and risky, as at least one of the parties expect that they will be disadvantaged by the relationship.
Moral Hazard
A final manifestation of information asymmetries occurs after the relationship between buyers and sellers is established. Even if the contractual relationship is established on a sound and rational basis, one party may change behavior after the relationship is established
Crowding Out
One of the main examples of government failure is that of crowding out. Crowding out occurs when a government behaves in a way that supplants the need for the development of market structures and participants to deliver the same good or service. This can happen when governments favor one technology over another through incentives. It can also happen when grants of aid or technology, even though well-intentioned, such as free or subsidized energy generation components in the developing world, alter the incentives of local providers to deliver the same under nascent market structures.
Regulatory Capture
Government failure include regulatory risks, such as the possibility of (1) regulatory capture by large vested interests that can manipulate regulatory structures to their advantage (sometimes enhanced by overt corruption, such as bribes, kickbacks, and voter manipulation)
Sovereign Risk
government failure include regulatory risks, such as the possibility of (2) risks that all firms face from unexpected and uncompensated changes in laws or regulations that affect them (referred to as sovereign risk).
Behavioral Economics
Behavioral economics examines when the behavior of individuals may consistently and clearly differ from that predicted by the rational model of consumers as perfectly utility-maximizing individuals (rational choice economics).
Myopia
Typically, individuals place inordinate importance on things that are happening in the present or in the near future, compared to those in the distant future. This is known as temporal myopia (or just myopia in this context), a form of nearsightedness where things that are up close are much clearer (and therefore more valued) than things that are far away.
Heuristics
Individuals will also behave inconsistently with the rational actor model when faced with an excess of uncertainty or a lack of complete information, both of which can arise from the market failures described in the previous section. Rather than computing optimal responses systematically and logically, people tend to use heuristics or guidelines for quick decision making, including rules of thumb, anecdotes, and shortcuts, to arrive at decisions that may or may not be optimal from an economic point of view.
Market Interventions
Because most participants in the system are either individuals trying to maximize utility or firms trying to maximize profit, many interventions are conducted within the context of market participants trying to affect outcomes of the markets in which they operate. These are referred to as market interventions and can include simple business transactions, investments of capital or other resources, or even more coordinated attempts by the participants to improve the market’s function.
Policy Interventions
However, the tools of government and policy are also deployed with the intention of improving or impacting the function of the overall energy system. These policy interventions include regulation by governments and the establishment of open and fair markets but are also be direct interventions, such as investment, subsidy, or risk mitigation, for various desired outcomes.
Policy Risk
Policy risk—or risk arising from policies that are subject to change frequently, short-term or anemic interventions, transfers of power, or other alterations—nearly always introduces uncertainty into the market and reduces market participants’ willingness to invest capital; for example, they prefer to wait until the situation is clearer before committing substantial capital. Even the discussion of potential changes in policy long before any are made can introduce policy risk. Until it is resolved, policy risk can create uncertainty that slows down progress.
Cost of Capital
The rate of return required by investors in a project. This will determine what projects are feasible to undertake since the return should equal or exceed the cost of capital
Price or Quantity Targets
Intervening directly in the market by establishing price levels, floors, or ceilings can dramatically change market economics. Conversely, establishing required minimum or maximum quantities of something being delivered, like minimum fuel standards or maximum carbon emissions, can be equally effective in changing market behavior. (Renewable Portfolio Standards)
Subsidies
Direct financial supports provided by the government - carry risk if prematurely rescinded
Tax Breaks
Rather than a direct subsidy, another way to support firms by allowing them to pay less in taxes - carry risk if prematurely rescinded
