| Consumer Surplus Gains from
Long-Run Competitive Prices
Effects on the Aggregate Economy
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 In the long run, competitive suppliers will enter the market if the competitive price, averaged across the peak and off-peak periods, is greater than the long-run average cost of output. The best estimate currently is that long-run average cost of producing power is around 3 cents/kwh. The details of this estimate are explored in Volume II of this report. In brief, the estimate is based on industry expansion into new technology. Modern technology gas turbines have improved fuel efficiencies compared to older versions of this type of power plant. The new efficiencies are even greater than those achieved by conventional steam generation. The best estimate is that new capacity can come on line at a price of 3 cents/kwh. This is long-run average cost including operation, maintenance, and capital costs. Let’s compare the operation cost of current capacity with this three cents/kwh for power production using new, state-of-the-art technology. Generation capacity in place has 2.2 cents/kwh for operation and maintenance and one cent/kwh for capital spending costs at current production levels. That is, old technology, conventional steam generation facilities, on average, cost around 3.2 cents/kwh, including operating costs plus the capital expenditures necessary to keep them in shape. Remember, however, that current production levels are artificially low because of under utilized capital during off-peak periods. If we expand the output of existing capacity by 25 percent, allowing for the additional fuel and marginal maintenance cost of the additional output, average cost of power production from currently installed capacity is 2.9 cents/kwh. In other words the average cost that we observe now is artificially high because output is artificially low. Average cost will fall as production expands, and when it does, currently installed capacity can produce power at costs favorable when compared to the new technologies. Based on these estimates, current capacity will continue to be productive. That is, currently installed generating capacity will be able to compete effectively compared to newly installed generation facilities. This is because the full cost of production from currently installed capacity including operation, maintenance, and capital reinvestment is 2.9 cents/kwh compared to 3 cents/kwh of newly installed capital. Produced power has to be transmitted and distributed to the final customers. Transmission and distribution costs are .9 cents/kwh at investor-owned utilities given current production levels. This includes the cost of handling customer accounts. Transmission is a very small portion of this. note 1 General administration is currently .5 cents/kwh. At the margin, additional power coming onto the system does not increase the cost of transmission, distribution, and general administration on a one-for-one basis. Indeed, the transmission, distribution, and administration cost of an additional kwh may be zero. Certainly this is true in the short-run case of flattening the seasonal cycle. In the longer term, there are probably some increased costs especially of distribution (customer metering and accounting). At the margin of the long-term competitive market, we forecast that the additional cost of transmission, distribution, and administration will be about the current average cost of distribution and transmission, that is, .9 cents/kwh. Thus, we estimate the long-term competitive price to be 3.9 cents/kwh on average. note 2 Consumer Surplus Gains from Long-Run Competitive Prices If long-run competition, implemented by the use of new and improved gas-fired or coal technologies drives the average price of power to 3.9 cents/kwh, average consumption will increase 42 percent. This decline in price will be associated with an additional increase in consumer surplus of $107.6 billion annually and a $24.3 billion increase in overall welfare to the economy. As we stressed in the previous chapter on the short run, there are two separate effects of lower prices on consumers and the economy. First, lower prices make consumers better off. The things that they are currently buying are cheaper. This is the first part of the increase in consumer surplus (the gains that consumers get from lower prices.) The second part of the improvement enjoyed by consumers depends on how much consumers react to the new, lower prices. The more they respond to lower prices, as measured by the price elasticity of demand, the greater the additional increase in consumer gain. Lower prices induce consumers to switch into electricity consumption and away from other energy sources and high-priced commodities. The bigger is this adjustment, the more substantial are the consumer gains to competition. The overall gain to consumers is the sum of these two components. At the same time, lower prices have both negative and positive impacts on producers. On existing sales by producers, lower prices mean less income for them, but simultaneously, as consumers buy additional power, sales increase. The net effect of competition is the sum of these parts, and in this case, we estimate that the overall welfare gains are quite substantial, perhaps as much as $24.3 billion annually. We have measured the impact of competition in three different ways, seasonal smoothing, efficient capacity utilization, and long-run capital expansion. Each approach yields a slightly different estimate. However, all three approaches to the impact of competition on price reveal big gains to the economy and overall lower prices to buyers and sellers. Competition is welfare improving regardless of the way we measure the change. How much of this additional consumption will be satisfied by currently installed capacity is unknown. Current capacity underutilization is 52 percent, but this primarily occurs off peak. How much efficiency can be obtained from the current capacity over the entire cycle depends on reliability factors and system control. At all events, power increases above the short-run forecast of 25 percent will come at higher costs because the fuel, operation, and maintenance cost of the marginally employed, peak load capacity in the current system is higher than the operating cost of the base load capacity. If we assume that the current capacity can only increase output by 25 percent, then the additional 17 percentage points of output induced by the long-run competitive average price of 3.9 cents/kwh will come from newly installed generation facilities. In this case, the existing capital will experience a decline in average revenue that is not offset by an increase in output. Lower prices mean lower net income to sellers. If average price in the industry falls from 6.9 cents/kwh to 3.9 cents/kwh, net income for existing utilities will decline by $38.5 billion annually. This includes the extra production costs they incur as they expand production by employing existing capacity during its idle time and the revenue declines that they experience on all output because of the lower, competitive price. Of course, the long run comes after the short run. We expect short run competitive effects to generate net income declines of $5 billion annually with this number growing to as much as $38.5 billion annually in the long run. The speed at which competition can be expected to move from the short run to the long run is discussed in detail in Volume II. On net, competition raises overall welfare by $24.3 billion annually, albeit with redistributional effects. Effects on the Aggregate Economy GDP Moroney (1990) studied the cross sectional relation between output per worker and capital and energy intensity in a sample of market and centrally planned economies. note 3 For the market economies, the elasticity of output per worker to energy intensity ranged from .15 to .19. Our analysis suggests that electricity use will increase by a minimum of 13.4%, with a long run increase of as much as 42.4 percent. Electric energy comprised 36.3 percent of total energy use in 1995 in the United States. Hence our long-run estimate of usage translates to an increase in total energy use of 15.4 percent. Using the midpoint of Moroney’s elasticities, our estimates of increased electricity use translate to GDP increases of 0.8 and 2.6 percent, respectively. The current data on GDP offers some perspective. GDP totaled $7,340.4 billion in 1995 (annual rate for the 4th quarter). The minimal increase of electricity usage of 13.4 percent would have increased GDP in 1995 by $60.70 billion. Had we obtained long-run competitive prices and use of electricity in 1995, GDP would have been higher by $190.85 billion. Examine Figure 6. Each year that competition is delayed costs the American economy output of this magnitude.
Figure 6 Employment Additional output in the electricity industry will use additional labor input. Simple estimates of the gain in employment are generated by dividing the gain in output by labor productivity; this is a measure of output per worker. 121.2 million persons were employed in the final month of 1995, yielding output per worker of $60,560. Dividing the estimated increases in output that will result from deregulating electricity production by output per worker yields increased employment of 1.0 to 3.15 million people. Effects on Inflation Electricity prices are not a direct component of the basket of consumer goods used to calculate the Consumer Price Index. Electricity is an intermediate good whose influence on the price level stems from its effects on producer prices. The proper calculation is thus based on the Producer Price Index. The portion of the PPI accounted for by prices of electric power is 5.37 percent. Assuming prices for all other producer commodities remain constant, the reduction in electricity prices of 13.4 percent to 42.4 percent due to competition will cause the PPI to fall by 0.7 to 2.3 percent. Consumer prices can be expected to fall by the same percentage. Hence, in one stroke, a years worth of inflation can be wiped out simply by deregulating the production of electricity. Effects on Productivity Growth Much research effort has been directed at causes of the slower pace of economic growth in the last few decades relative to the early post-war period. The basic conclusion of this research is that the decline in output growth is due to a decline in productivity growth. Simply put, the economy continues to mobilize capital, labor, and raw material inputs at historical rates, but the rate of increase in the productivity of these inputs began to slow considerably in the mid-1970s. A common conjecture is that the decline in productivity growth is related to sharp increases in the price of energy during this period (23 percent in the period 1973-1974, 34 percent during 1979-1980). To assess the importance of energy price changes to productivity growth, Jorgenson examined econometric models of production at the industry level, incorporating inputs of energy and materials in addition to capital and labor. note 4 His main objective was to understand the varying relation between the energy intensity of production and productivity growth. For our purposes however, it is important to note that Jorgenson found that "a decline in the price of electricity stimulates technical change" in 23 of the 35 industries studied. A sharp decline in electricity prices will lead to a jump in productivity growth. Dynamic Gains from Competition We live in an era in which many are concerned with the competitiveness of American industry. Many proposals to increase international competitiveness involve trade policies which threaten to restrict consumer choice and raise prices. Deregulation of electricity involves no such deleterious effects on consumers and would immediately increase American competitiveness relative to the rest of the world. The dynamic gains from allowing competition to serve the market for electric power are likely to be many times the magnitude of the static welfare gains of $1.9 billion to $24.3 billion identified earlier. These gains come from many sources. For instance, electricity costs will decline as the returns to innovation are enhanced in a competitive market. Although this is virtually certain to take place, it is equally obvious that these cost decreases cannot be estimated before the innovations take place. As identified in Jorgenson’s work, declines in the price of electricity will stimulate productivity growth in many industries. Deregulation of electricity prices offers in one stroke the opportunity to reverse the productivity slowdown that has plagued the aggregate economy in the last quarter of this century. Notes:
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