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How do you calculate the maximum lump-sum tax that could be imposed on producers without affecting the short-run supply of electricity?

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In 1998, California's newly deregulated power market began operation. The large power utilities in the state turned over control of their electric transmission facilities to the new Independent System Operator (ISO) to assure fair access to transmission by all generators. The new California Power Exchange (CalPX) opened to provide a competitive marketplace for the purchase and sale of electric generation. The deregulation required electric utilities to split their business into generation, transmission, and distribution businesses. The utilities continue to own all of the transmission and distribution facilities, but the ISO controls all of the transmission facilities. Utilities provide all distribution services, but customers are allowed to choose their energy supplier. The utilities were all their electric generation to the Power Exchange and purchase all power for their customers through the Power Exchange. To illustrate the net amount of social welfare generated by a competitive power market, assume that market supply and demand conditions for electric energy in California are:

Qs = -87,500 + 1,250P (Market Supply)
QD = 250,000 - 1,000P (Market Demand)

Where Q is output in megawatt hours per month (in thousands), and P is the market price per megawatt hour. A megawatt hour is 1 million watt-hours, where watt-hours is a common measurement of energy produced in a given amount of time, arrived at by multiplying voltage by amp hours. The typical California home uses one megawatt hour of electricity per month.

A. Question: Graph and calculate the equilibrium price/output solution. Use this graph to help you algebraically determine the amount of producer surplus generated in this market.

B. Question: Calculate the maximum lump-sum tax that could be imposed on producers without affecting the short-run supply of electricity. Is such a tax apt to affect the long-run supply of electricity? Explain.

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Solution Summary

Calculations and graphs are provided for the equilibrium price and output in this solution. This solution is presented in an attached Word and Excel file.

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