Future Generation of Electricity in the UK - Essay Example

? Microeconomics: Future Generation of Electri in the UK may come partly from Nuclear Power, Hydro-Carbons, and Renewable Resources Student ID Number Course Title & Code Instructor’s Name Date Total Number of Words: 1,758 Introduction UK has been very much dependent over the use of a wide-range of energy resources which includes nuclear power, hydro-carbons such as gas and coal, and renewable energy resources such as the solar, wind, hydro and geothermal power (Wuthering-Heights, 2012; BBC News, 2006). Therefore, this study will analyze and discuss not only the market structure of UK’s energy industry but also some oligopolistic equilibrium models to discuss the best way in which these firms could maximize its profitability over its close competitors. As part of going through the main discussion, this report will discuss UK’s energy industry in relation to the use of stackelberg, cournot, and collusive equilibrium. Market Structure of UK’s Energy Industry In UK, there are only six (6) major gas and electricity sources that supply electricity within the domestic market (i.e. Centrica, the E.on, EDF Energy, RWE nuclear power, Scottish Power, and Scottish and Southern Energy) (Department of Energy & Climate Change, 2011). Specifically the economic term “oligopoly” means that the industry is being dominated by a relatively few number of sellers. In most cases, the sellers within an oligopolistic market are composed of only four (4) major players that dominate the entire industry (Hirschey, 2000, p. 451). The capital requirement of establishing a company that produces either renewable or non-renewable energy resources is very high (BBC News, 2012). Since the barriers-to-entry is significantly high (Hirschey, 2000, p. 451), very few influential people can establish companies that sell either renewable or non-renewable energy resources. Product characteristics dictate the ability of oligopoly firms to enter into collusion or cartels (Nechyba, 2011, p. 958). Considering the fact that the number of manufacturers of both renewable and non-renewable resources is relatively small, oligopolistic companies can enter into collusion with its close competitors in order to dictate or set the market prices of energy resources throughout the United Kingdom (Perloff, 2008, p. 445; Negbennebor, 2001, p. 291). Electricity as Public Goods Supply of electricity is one form of public goods because modern societies consider electricity as a necessity. Except for the free-riders, the supply of electricity is considered as non-rival and excludable goods primarily due to the fact that people in different areas can get access to electricity and that people who could not afford to pay the price of electricity will have to be excluded from the use of electricity (Free, 2010, p. 267; Cohen, 2001, p. 70). Intertemporal choice examines the trade-off costs and real value out of investing in both non-renewable and renewable energy resources. When conducting an intertemporal choice, the firms should carefully study the long-term socio-economic benefits that the firm can get out of investing in renewable energy resources. For instance, if the market price of gas is constantly increasing and will remain unstable, which among the available renewable energy resources (i.e. solar, wind, hydro and geothermal power) could provide the firm with the best return on investment (ROI)? According to Smith and Taylor (2008, p. 50), “externality is the term used to describe the cost or benefit that is not calculated into costs or profits of production”. Therefore, negative externality includes the cost of not investing in renewable energy resources. A good example of negative externality is air pollution and acid rain caused by burning coal in a power plant. Positive externalities of renewable energy resources includes lesser air carbon emissions (Thomas et al., 2006, p. 73). Other than environmental characteristics and policy, the choice of uncertainty is highly dependent on the future costs and benefits associated with the use of renewable and non-renewable energy resources (Pindyck, 2002). For instance, considering the high costs of non-renewable resources like fossil fuels or gas, the long-term benefit of investing in solar energy panels is better if the energy companies will have a suitable environment to put up the solar panels (i.e. whole-year round sources of sunlight, etc.). Stackelberg Equilibrium The stackelberg model is referring to a situation wheren the industry leaders are the ones who make the first strategic move which will be followed by the rest of the players (von Stackelberg, 2011, p. 134; He et al., 2007). It means that dominant firms are the ones that can secure their profit maximization whereas other firms only follows whatever strategies the dominant firms are implementing. Before applying the concept of Stackelberg in the case of oligopolistic firms, it is important to know that any decisions made by an oligopolistic firm can somehow affect the sales performance of its competitors (von Stackelberg, 2011, p. 134). It means that the market players within an oligopolistic industry are interdependent with one another in the sense that oligopolistic players should pay close attention to the busienss strategies made by its close competitors before a company will be able to maximize its expected profit (Scherer and Ross, 1990, p. 199). To help us analyze the market competition within the UK energy sector, the prisoner’s dilemma can be used to closely examine how these firms would cooperate or compete with one another including the benefits and payoffs associated with the firm’s strategy in comparison to the business strategy used by its close competitors (Lipsey and Chrystal, 2011, p. 191; Foster-Pedley and Hertzog, 2006). When using this particular game theory, it is important to take note that electric companies are better off if they decide to enter into collusion as both companies would invest in renewable energy resources (as represented on the lower right-hand box). If both companies decided to create their own individual strategies by not investing on renewable energy resources, both companies’ production will be represented by the upper left-hand box. For example, in terms of profits as measured in millions of pounds, company A’s level of production is indicated as the left figures in each grid whereas company B’s level of production is indicated as the right figures in each grid. This study assumes that people in UK will strongly support the use renewable energy resources. In case company A and B decided to invest in renewable energy resources and get each one of them one-half monopoly output, then both companies will be able to earn a profit of ?20 million each. It means that both companies will have an equal share in the market. If only A invested in renewable energy resources and was able to gain one-half of monopoly output, then company A’s profit will be ?20 million as compared to company B’s ?15 million. It means that company B will lose some of its market share to company A (See Figure I – Prisoner’s Dilemma in an Oligopoly Market on page 6) Figure I – Prisoner’s Dilemma in an Oligopoly Market If company A & B cooperate with one another and both companies decided to invest in renewable energy resources, then the nash equilibrium is "20, 20". If company A & B do not cooperate with one another and both companies decided NOT to invest in renewable energy resources, then the nash equilibrium is "17, 17". In other words, imbalances between two companies can occur if only the dominating firm has decided to invest in the development of renewable resources but not the other companies. In terms of encouraging the people to patronize the use of renewable energy resources and the act of maximize the long-term low cost of using renewable energy resources, the company’s decision to invest in the development of renewable resources would somehow give the company a better long-term competitive advantage as compared to other players within the same industry. Based on a Stackelberg outcome, the dominating firm has the key advantage by being the first to invest in renewable energy resources. Because of economies-of-scale, the dominating firm will have better profit margin as compared to other similar companies. For this reason, the equilibrium price in a Stackelberg model is usually lower as compared to the equilibrium price of a Cournot model. (See Figure II – Comparison between Stackelberg and Cournot Equilibrium Model below) Figure II – Comparison between Stackelberg and Cournot Equilibrium Model Cournot Equilibrium Cournot equilibrium model analyzes the industry structure wherein the firms are competing based on the actual amount of their output. This particular economics model is based on the following assumptions: (1) all companies are selling homogenous product; (2) there is a free market competition and no collusion among firms; (3) the output of each company dictates the market price of electricity; (4) the number of companies within the said industry is fixed; and (5) companies are expected to develop their own strategy to increase and maximize their profitability. It means that firms are expected to have competing interests with regards to the cost of electricity and demand curve. For example, this study assumes that company A and B are highly dependent over the use of gas to generate electricity. If company A’s reaction curve is represented by D1, the price of the first company is set at “P2” with a quantity of “Q2”. Given that company B’s reaction curve is represented by D2, the price of the second company is set at “P1” with a quantity of “Q1”. Therefore, the price at cournot equilibrium is “P0” with a quantity of “Q0”. Assuming that company A decided to invest on renewable energy resources; then company A will be able to increase its expected output and gradually decrease its market price in order to compete with company B. Based on the company A’s reaction curve which is represented by D3, the price of the cournot equilibrium is at “P01” whereas the quantity is set at “Q01”. (See Figure III – Cournot Equilibrium below) Figure III – Cournot Equilibrium Collusive Equilibrium The market size and the number of firms that sell electricity affects the ability of firms to enter into collusion. The bigger the market size in terms of the total number of people within a population would mean that there is a bigger demand for electricity. The lesser the number of electricity suppliers would mean that the supply for electricity would be lesser as compared a situation that the number of electricity sources are many. Therefore, a lot of economists believe that the formation of oligopoly is similar to the development of anti-competitive activity within the regional or global markets. In an oligopolistic market, only the existing players within the said industry are assumed to have a perfect knowledge with regards to the production of both renewable and non-renewable energy resources (Hirschey, 2000, p. 451). This makes it more difficult on the part of other business people who wish to penetrate the UK energy industry. As a result, existing players within the UK electricity sector can easily enter into collusion as a way of monopolizing the entire energy sector. (See Figure IV – Collusive Equilibrium below) Figure IV – Collusive Equilibrium References BBC News. (2006). Guide to UK nuclear power. [Online] Available at: http://news.bbc.co.uk/2/shared/spl/hi/guides/456900/456932/html/nn5page1.stm [Accessed 28 November 2012]. BBC News. (2012, October 10). Alex Salmond launches ?103m renewable energy fund. [Online] Available at: http://www.bbc.co.uk/news/uk-scotland-scotland-business-19886553 [Accessed 28 November 2012]. Cohen, S. (2001). Microeconomic Policy. London: Routledge. Department of Energy & Climate Change. (2011, July 6). Huhne calls energy summit for small suppliers. [Online] Available at: http://www.decc.gov.uk/en/content/cms/news/pn11_060/pn11_060.aspx [Accessed 28 November 2012]. Foster-Pedley, J. and Hertzog, H. (2006). Financing strategies for growth in the renewable energy industry in South Africa. Journal of Energy in Southern Africa, 17(4), pp. 57-64. Free, R. (2010). 21st Century Economics: A Reference Handbook, Volume 1. 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