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Economic Analysis Of Externalities, Cost Structures, And Market Outcomes In Steel And Water Supply Industries

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    1 Economic Analysis of Externalities, Cost Structures, and Market Outcomes in Steel and Water Supply Industries 1. The production of gasoline causes air pollution but the damage from this pollution is not priced and is not factored into the price of gasoline. Markets are interconnected, and the price of gasoline affects the cost of transportation; the cost of transportation affects how easy it is to get people and goods, including food, from one place to another and thus affects the value of land for housing and the cost of food; the cost of transportation also affects the market for cars and public transportation; and all of these affect people’s budgets. Given this interconnection of markets, what are the consequences of an unpriced (and unregulated) externality in the market for gasoline? If there are competitive markets in all these other markets, are they likely to produce an efficient allocation of these other goods? Explain the reasons for your answer. Answer: - ### T he consequences of an unpriced and unregulated externality concerning the market price of gasoline has been existing long and in markets related to energy generation and consumption, many more distortions tend to come into picture that has the potentiality to create opportunities for bettering the situation but that are not considered to be externalities as these distortions falls outside the purview of the study and the committee that keeps in touch with them only briefly. It would be a valid attempt if we can try to identify and quantify at the same time those externalities and that would help in recognizing the consequences concerning the externality in the market of gasoline. One form of market distortions that has the capability of affecting energy markets is the presence of market power. In the extreme cases there exist a single supplier of energy (monopoly) or s single buyer (monopsony). In such cases a firm having the market power can affect the price and also the quantity that is being traded to fulfill its own advantages And imply costs on others that exceed its gains. Cartels, such as OPEC, or large purchasers of oil, such as the United States, can exhibit market power. Another form of market distortion that can greatly impact the energy markets is the enforcement of taxes or subsidies that do not help at all in correcting externalities but rather are imposed to augment revenue and thereby aidi ng support to an industry or serve some other purpose. The primary concern of this is the subsidies for oil exploration have encouraged the swift e xpansion of the petroleum based industry and hence ra i sing the volume of externalities generated by the production and consumption of petroleum and petroleum based resources. Information asymmetries and public goods are two additional cases of market failure that coul d affect energy markets. So, from this study, we quantify to the extent possible the no internalized externalities conditional on the existing set of market regulations, taxes, subsidies, and market distortions from all sources.

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    2 ### Now, if there are efficient allocations for all other services in the other markets then it is possible to generate an efficient allocation of gasoline. For example, increased corn prices owing to the production of bio - fuels do not gives a broad picture as they tend to result from the proper functioning of the market. This is not to actualize and say that higher corn prices are unimportant or it should npt be looked upon from the standpoint of public concern and policy. But still there exist no market failure to correct nor is there an externality to internalize. Another vital example can be put here regarding the distortion of social costs across space, time or varying population groups but the fact of the matter is that such distributional issues may become of great concern to policy markets but these barely represent externalities. 2. [Based on BH pp 201 - 217] The Stalin Steel Company burns coal in its factory to produce steel. But, it is now required to abate the emissions from its use of coal. (a) Suppose this emissions reduction raises (i) only Stalin’s fixed costs of production, or (ii) only Stalin’s variable costs of production, or (iii) both Stalin’s fixed and variable costs of production. In each case, using both words and the appropriate diagrams, explain how emission reduction affects Stalin’s supply curve of steel. (b) Stalin Steel is one of three firms that make up the Slovakian steel industry, and the other two firms already meet emission restrictions for the production of steel, and therefore face no change in their cost of production. Using both words and the appropriate diagrams, explain how Stalin’s emission reduction affects Slovakia’s steel industry supply curve. (c) The Slovakian steel industry grows over time as the economy expands, the demand for steel increases, and new firms enter the steel industry, new factories are built and old factories sometimes shut down. Pollution control regulations also change over time, and become more stringent. In its planning for a new round of tighter air pollution control regulations on its steel industry, the Slovakian government is considering grandfathering the original three firms in the Slovakian steel industry. How would grandfathering affect the steel industry (the original three firms, firms that entered the steel industry later, and firms that are thinking of entering the steel industry). How would grandfathering affect consumers of steel? How would it affect the rest of the Slovakian public? Answer: - ( a) This can be illustrated on the basis of the following supply curve for steel production that shows the amount of revenue generated in the y axis and the no of unit sold in the x axis . As can be seen if the fixed cost of production of the company is increased then the amount of revenue gained from the selling of steel is lessened as the volume of selling is not mentioned to be getting altered here. So, if the fixed price is taking a upper turn the volume of revenue would come down.

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    3 On the contrary if the fixed cost remains stagnant due to the changes and only change occurs in variable component then also the volume of revenue obtained from the selling of steel declines but not to a great extent as variable cost generally is not going to surpass the fixed cost and is quite less in comparison to the fixed cost and liabilities. S o, the ultimate effects of variation in the margin of operating gain from the selling of steel would not get a huge downfall if only the variable cost rises keeping the Fixed cost unchanged. Lastly, if in some circumstances both the costs rises it can then create problem as it may so happen that total cost of production (that is combination of Fixed and variable costs) may well surpass the total profit earned from the sales and this is a crisis for the company since it creates a no gain situation for it as there is no profit. (b) As per the information provided within the question, it is evident that barring the Stalin and Slovakian steel industries the other two steel industries are not coming into the picture from the standpoint of comparison since the other two concerns has already reduced down the effect of extra cost owing to the fact that they already abiding by the emission restrictions for a long period but for Stalin and Slovakian steel industries since they have recentl y put into the venture so the comparison would mainly revolve around these two.

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    4 Two scenarios may arise here. If the cost of emission restriction is large so that the total operating cost is large for Slokian steel then the profit margin of it will be lower in comparision to Stalin industries and this fact is pictorially a shown in the upper left corner of the diagram. On the contrary if the reverse thing happens that is if the total operational costs of Stalin steel industries be greater than the Slovakian steel industries then the plot would look like what is shown above in the upper right corner of the plot. And as can be seen that the total cost curve of the Stalin steel industries is lying above that of the Slovakian steel. (c) Grandfathering greatly affects steel industries. Steel has superseded the entire market today. It is everywhere. It is present in the car that we drive. It is in the building where we live and work. It is present in the tools and equipment that we use in every day basis. Steel industry of today is really exciting and competitive globally and in this context when there is emergence of new steel industries, it is inevitable that they would face steep challenges from the other steel industries that are already present in the market. For example, here the Stalin and the Slovakian steel industries are quite new in the market where as the other two steel industries have been doing their business for long and here if there is no grandfather meaning any support or back up plan for the new ones then they would at some point of time feel the pee r pressure originating from maintaining the same selling price keeping in with those of the other two steel industries and sometimes this is done even though it may incur some losses for the company for a short while. On the other hand if grandfathering effect is present for the newly formed steel industries then it would be really easy for it to spread itself effectively in the market place. Grandfathering may affect the consumer of steel in a variety of ways. It is not always possible for an individual consumer to scan through the entire market to know in detail which retailer is selling steel in what price and as the steel prices varies to great deal depending on basis of locality so the consumer located in some state may have to shell out some extra money where as the other consumer may have been expending less for the

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    5 same and all this originates from the grandfathering effect since it is the effect of grandfathering that has created the kind of anomaly of prices of steel in the market. This would not expected to affect the Slovakian people too much since the steel industry based in Slovakia is quite old and so it is expected that the steel prices there would be standardized to a good extent so the consumer would be able to have access to steel at affordable prices. 3. [See Lecture 2 - 21, Aggregate Welfare] The Bureau of Reclamation is an agency of the U.S. government that constructs and manages many dams in the western United States. The water from its dams is used for irrigating agriculture. Let’s assume that the Bureau is deciding what size dam to build at a particular location in Wyoming. The water yield, which we will assume will sell at a fixed price P per unit to the farmers, increases linearly with the size of the dam. Let's assume as well that the costs, as a function of water yield, Q, are U - shaped. (a) Draw the graphs of the average and marginal cost curves as a function of the water yield (Q). (b) If the dam is built, an irrigation district in the area would contract with the Bureau to buy the water from its dam. Now draw in the district’s demand curve for water, expressed as a function of P (c) Given these demand and marginal costs curves, use the diagram to identify the amount of water the Bureau would plan to sell (the water yield that it would select for the dam) if it wanted to maximize its profit acting competitively (not as a monopolist). Explain your answer. (d) Would that amount of water, determined in (c), maximize consumer’s plus producer’s surplus and therefore be socially optimal? Explain your answer. (e) In fact, the Bureau has been required by Congress to recover its costs rather than maximize profits in its water pricing. Recovering its costs means that it must set its prices so that its revenues exactly equal its costs. Using your diagram, identify the market equilibrium if the Bureau follows this mandate and engages in average cost pricing. (f) Compare the solution in (e) to the solution in (c). Identify the economic loss – the loss of consumer’s plus producer’s surplus from the solution in (e) compared to that in (c) – both verbally and in terms of an area in your diagram. Answer: - (a) The graphs showing the average and marginal costs as a function of water yield ( Q) is shown Below . Here Mc stands for short - run marginal costs, ATC average total cost, AVC average variable cost; AFC stands for average fixed costs.

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    6 (b) The district’s demand curve for water, expressed as a function of P (price is depicted in the following diagram. Where Q stands for the quantity of water being purchased and D1 is the demand curve. (c) The maximum optimal profit would be made possible if the company sells water at price P1 as is shown in the plot as it refers to that portion of the plot that demonstrates stability in the market prices of water. As any price below the P1 say p3 would mean that now more volumes of water can be purchased at a lower affordable prices by the customers but that would also mean that for the company it may not be so suitable as it is having to sell water at lower prices and it may not create a suitable situation for the concern.

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    7 Again, if we consider price P2 which is higher as compared to P1 then there would be lesser quantity of consumption of water as is depicted in the graph by the point Q2 . This again not a good situation of both from the standpoint of customers and the company. As company not expected to get now more customers for water and also consumers would find it difficult to shell out more money to get the requisite amount of water. So, the best optimal point is shown by the point (P1,Q1) meeting optimality. (d) The answer to this is yes it will create a situation that would enable maximize consumer’s plus producer’s surplus and therefore be socially optimal since the optimal price would see both ends both that of the customer and that of the producer and so on a large scale we can well tell that is would socially optimal as well as a society formed of many people so when the budget of every people is optimized then the optimal cost of the society is also expected to be optimized. (e) In this case as it tries to recover its cost only and not optimize its profits so it would mean that the doubling of the cost price of the manufacturing of water would be set as the selling price in this context. So, here the graph would be as following

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