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elasticities of demand and supply

Free Market Pricing v. Price Controls in California Utilities
LEAD STORY-DATELINE: The Wall Street Journal, June 4, 2001.
Alfred Kahn, currently an economics professor at Cornell University, led the USA's drive to deregulate the airline industry as chairman of the Civil Aeronautics Board under President Jimmy Carter. What was argued at the time is in every freshman textbook on economics. In a normally functioning competitive market, price shocks have an immediate effect on supply and demand. Producers, such as Delta Airlines, respond to higher prices by boosting supply immediately (adding flights), and consumers respond by cutting back purchases (of air tickets). The price settles back to a new equilibrium level.

But that is not happening in California's wholesale electricity market, and Mr. Kahn was one of 10 economists who supported Governor Gray Davis' demand for the federal government to impose price caps on wholesale electricity. The Governor's motivation comes from some cold, hard facts, not to mention some cold offices last winter. The state's electricity bill jumped to more than $27 billion for 2000 from $7.4 billion in 1999, and the Governor expects the bill to reach $50 billion or more in 2001. The state government can no longer afford to supply all essential services. As a result of what he calls "unusual circumstances in electricity," Kahn favors the wholesale price caps. One "unusual circumstance" is the prevailing caps on retail prices for electricity.

President George W. Bush remains one of the free marketers. Apparently reading from Kahn's 1970's freshman economics text, Bush says that "price caps do nothing to reduce demand, and they do nothing to increase supply." If anything, complain Bush-thinking economists, price controls will lead to worse shortages because power companies cannot earn a decent return on their investment and will cut back plans to build new utility plants, making a bad situation worse. Kahn's uniqueness rebuttal goes something like this: Even if wholesale prices are left free to continue their ascent, it takes nearly two years for new power plants to come on line, so energy supplies remain limited. Meanwhile, wholesale producers are deliberately holding power off the market, forcing prices and their profits even higher. Moreover, since retail consumer prices are capped, consumers have no incentive to cut back on their consumption of electricity. The rising wholesale prices, a rising cost to the retail sellers of power, cannot be offset by raising their prices, putting a serious profits squeeze on California retail suppliers of electricity. Therefore, Mr. Kahn and like-minded economists advocate temporary price caps at wholesale to soften the increasing fiscal burden on the state government until new plants come on line. The price caps could be set at a level that would yield a strong return to the industry's investments.

Please answer the following questions

1. In the prototypical textbook case, demand and supply curves have "normal" slopes, not too steep, not to shallow, but just right. You might call it a "Goldilocks and the Three Bear's paradigm." In this case, suppose a price shock sends the price of the product (say, chicken soup) sharply upward. What kinds of adjustments take place?

2. Now suppose that Governor Davis of California decides that Goldilocks is paying too much for chicken soup and adequate nutrition is a necessity (the reason she is going about eating the soup of the three bears). The current market price of chicken soup is $1.00 per 10 oz. can; the Governor announces a price cap of $0.75 per 10 oz. can. In the usual supply and demand case, what is the consequence?

3. Is the answer to question 2 the same as the argument being made by President Bush and his economists?

4. But isn't the situation with electricity in California more complex than the consumption and production of chicken soup? Although the chicken soup industry has both wholesalers and retailers (grocery stores), doesn't electricity have some characteristics on the demand and supply side that are different? Why?

5. Is the answer to question four similar to the argument made by Mr. Kahn and other economists who favor a price cap on wholesale electricity prices? Why?

6. How would you characterize the elasticities of demand and supply in the retail electric power market? Why?

7. How would you characterize the elasticities of demand and supply in the wholesale electric power market? Why?

8. Why is the California "model" for deregulation of electric power a poster child for truly bad deregulation design?

Solution Preview

1. In the prototypical textbook case, demand and supply curves have "normal" slopes, not too steep, not to shallow, but just right. You might call it a "Goldilocks and the Three Bear's paradigm." In this case, suppose a price shock sends the price of the product (say, chicken soup) sharply upward. What kinds of adjustments take place?
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<br>From the statement: "The state's electricity bill jumped to more than $27 billion for 2000 from $7.4 billion in 1999, and the Governor expects the bill to reach $50 billion or more in 2001." We know that the demand for electricity is very inelastic. Because although the price is rising, the total consumption is still increasing. So the demand curve of electricity is very steep in this case: a big rise in price will only result in small decrease in demand. On the other hand, the technology growth also shift the demand curve to the right, and reaches a new equilibrium where price and quantity are both higher.
<br>The adjustment to the price increase should be a cut in demand in the market, and a price cap from the government.
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<br>2. Now suppose that Governor Davis of California decides that Goldilocks is paying too much for chicken soup and adequate nutrition is a necessity ...

Solution Summary

Characterize the elasticities of demand and supply in the wholesale electric power market

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