HE310: Energy Economics

Lecture XII Modeling Energy Demand 03 November 2011

Modeling Energy Demand

Energy Balances Modeling Energy Household or Consumer Demand
Budget Constraints Indifference Curve Income Expansion Path Engel Curve and Consumption Changes

Industrial, Commercial and Electricity Sectors

Marginal Revenue Product for a Producer

Econometric Issues
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Energy Balances
An accounting procedure
The primary sources of energy, the transformation of energy and the final consumption of energy

An overall snapshot of the energy situation at a given time for a given region
Sources of primary energy (E-prim) minus stock or changes (Stk) and losses (Loss) must balance with end use consumption (E-end) of energy products E-prim Stk Loss = E-end

The Total Primary Energy Supply (TPES)

What the region produces plus what they buy from others (imports) minus what they sell to others (export) minus international marine bunkers (bunkers: fuel oil sold to ships engaged in international transport) minus any stock or inventory changes (stock) TPES = production + imports exports bunkers stock 3

World Energy Balances, 2006

Disaggregated U.S. Energy Consumption, 2002

World Oil Balances, 2006

World Coal Balance, 2006

Modeling Energy
End-use demand
Consumers use energy for the end-use products they consume

Factor demand
All other sectors use energy as an intermediate good or as a factor of production

Modeling energy
Through simple optimization models, this illustrates how optimal decisions should be made for both enduse and factor demands for energy

Household or Consumer Demand

Consumers have n goods to choose A simple model

U ( X 1 , X 2 ,..., X n ), where U is the utility function and X i represents consumptio n of the i-th good. Y = P Q1 + P2Q2 + ... + PnQn = i =1 Pi Qi 1
n

where Y is the income, Piis the price of the i-th good and Qi is the amount consumed of the i-th good
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Budget Constraints
N = 80 2E Y = 320 PE:4 -> 8

N = Y/PN (PE/PN)E N are all non-energy goods, E are all energy goods PN is the price of non-energy goods, PE is the price of energy goods Y = 160, PE = 4, PN = 2 N = 80 2E

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Indifference Curve and Marginal Rate of Substitution

U = U (N , E) U = U (N , E) U = N 0.5 E 0.5
U = U U dN + dE N E U U dU = dN + dE = 0 N E dN U U = ( ) /( ) dE E N

The consumer would trade off N for E at point a.

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Map of Indifference Curves and Highest Utility on the Budget Constraint

The isoquant I1 represent a lower level of utility than I2 The slope of the indifference curve: The slope of the budget constraint:

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Tracing Out a Consumers Income Expansion Path

B1 = 160 B2 = 240 B3 = 320

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Engel Curve and Consumption Changes with Changing Energy price

Engel Curve Income on the horizontal axes Consumption of a good on a vertical axes

When the price lowers from 4 to 2 to 1, the optimal consumption of the two goods moves from a to b to c.

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Consumption as a Function of Price

Derived from the Engels Curve, putting energy consumption on the horizontal axes and the price on the axes gives the traditional demand curve

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Comparing a Subsidy with Equal Cost Cash Payment

A per unit energy subsidy The initial budget: PEE + PNN = B The subsidized budget constraint (PE - sb)E + PNN = B B = budget, sb = the subsidy per unit This subsidy is equivalent to a price decreases and moves the consumers from point a to b

Suppose giving the consumer the same amount of income as the subsidy costs the government at the original prices. The new budget line is represented by the dotted line that goes through point b. The consumer would choose point c under the increase income.
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Derivation of Demand Curve

Max U(E, N) subject to PEE + PNN = Y
Y - PEE + PNN = 0 = U(E, N) + (Y - PEE + PNN )

UE UN = PE PN

General solutions for E and N

E = f(PE, PN, Y) N = g(PE,PN, Y)

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Factor Demand for the Industrial, Commercial and Electricity Sectors

Suppose a firm sell good X To produce X, it needs energy (E) and non-energy (NE) Max = PXX(N, E) PNN PEE Assume XE >0, XN > 0, XEE < 0, XNN < 0
E = PX X E PE = 0 PX X E PE = PX X N PN X E PE = X N PN XE XN = PE PN N = PX X N PN = 0
Factors should be hired up to the point where the ratio of their marginal products is equal to the ratio of the prices Factors should be hired up to the point where the marginal product per dollar is equal across factors
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Marginal Revenue Product for a Producer

The slope of marginal revenue product
PE X E = PX X EE E

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Econometric Issues
Energy demand equations can be estimated on actual energy data using statistical techniques Many energy demand models have been estimated ignoring the supply side of the market
Shifting demand and supply over time trace out prices If both the demand and supply curves shift, we will not get the demand or the supply curve

Simultaneous system bias

This problem occurs when an equation is estimated from a simultaneous system Unaccounted for random events are called errors
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Changes in Demand and Supply over Time

a) The demand equation can be estimated b) The supply equation can be estimated c) The resulting nine data points make neither the demand nor the supply curve be estimated
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Price and Error are Related in Demand

A positive error raises the price A negative error lowers the price This relationship between the errors and the price affects the estimates
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The Price and Errors are not Independent

Small circles: observations when the errors and price are not related When the estimation is based on the observations represented by the xs, the estimated line would be steeper than the true line
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When to Use OLS to Estimate Demand

When supply is perfectly elastic, errors in the demand equation do not influence supply. OLS is appropriate If governments regulate price as they have often done in the electricity sector, random shifts in demand are the prevented from changing the price. OLS is appropriate If marginal costs are flat (i.e., the supply curve is the marginal cost curve in a competitive market), supply will be perfectly elastic. OLS is appropriate
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Primary Results of New Survey Work

The average elasticities in most categories are well behaved. The short run price and income elasticities are usually between about 20% and 60% of the long run price and income elasticities
The exceptions on price: vehicles miles traveled, kerosene and fuel oil The exceptions on income: coal, residential energy, residential gas and industrial gas

In most cases, there is a quite lot of variation across studies

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Variations in Price and Income Elasticities

Coal price elasticities are reasonably consistent across studies but income elasticities are negative for the U.K. and positive for Japan and Colombia Diesel fuel estimates are income elastic and are all from developing countries All elasticity estimates for the highway fuel demand (gasoline and diesel fuel) are from Europe and income elastic The average price elasticity of gasoline is -0.6 and the income elasticity is 0.7 Non-petroleum energy sources are more income elastic than oil and the heavier end of the barrel
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Key Points
Energy balances
An accounting procedure and TPES

Modeling energy
Household budget constraints, indifference curve and Engel curve

Comparison of a per unit energy subsidy and equal cost cash payment Derivation of energy demand curve
Factor demand and marginal revenue product of a producer

Econometric issues
Identification problem and simultaneous system bias Uses of ordinary least squares (OLS)
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Supplements
Determinants of Demand in Energy Markets Various Elasticities A Theoretical Framework for Deriving Energy Demand Empirical Results and Interpretation of Elasticity of Energy Demand Demand for Crude Oil
Estimated Equation, Derivation of Long-run Elasticity and Empirical Results

Survey of Empirical Studies (Dahl, 1993 and 1994)

Oil Price and Income Elasticities; Gasoline Price and Income Elasticities; Transport Fuel Demand Elasticities

Price Elasticities of U.S. Consumer Expenditures Price Elasticities of U.S. Investment Expenditures
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Determinants of Demand in Energy Markets

Non-price determinants
Income or GDP: Per capita or aggregate Prices of related goods Cause a change in demand: The demand schedule shifts
An increase in population shifts the demand curve to the right
At every price, more energy is demanded

Price/quantity relationship
Does not provide a whole picture
But fundamental and a starting point

Price changes lead to changes in the quantity demanded

Price does not change demand
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Elasticity of Demand (Recap)

Elasticity
A measure of the percentage change in one variable in respect of a percentage change in another variable

Elasticity of demand
Usually taken to refer to the (own) price elasticity of demand.

However, care should be taken to specify which elasticity of demand is being discussed
Cross elasticity of demand Income elasticity of demand
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Price Elasticity of Demand (Recap)

The responsiveness of the quantity demanded for a good to its own price Price elasticity of demand (p) p = % change in quantity (Q) % change in price (P) [dQ / Q] = [dP / P ] =1
p

Unit elasticity

p < 1
Inelastic demand Unresponsive to price change

p > 1
Elastic

Responsive to price change p = 0

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Cross and Income Elasticity (Recap)

Cross elasticity
The sensitivity of quantity demand for good x to price changes in good y (xy) = % change in quantity of x
xy

% change in price of y [ dQx / Q ] = [ dPy / Py ]

The greater the number of switchable, the closer will xy be to unity xy > 0, Two goods are called substitute xy < 0, Two goods are called complementary

Income elasticity
The responsiveness Q demand for a good to changes in income % change in of I = I (I) % change in I
= [dQ / Q] [dI / I ]
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Demand for Energy: Theoretical Framework (Nordhaus, 1979)

Preference relationship between two broadly defined goods
Energy services (E) Non-energy goods (X)

Utility function
U = U(E, X)

With budget constraint

Y = pEE + X Y = Income in terms of non-energy good pE = The relative price of energy to non-energy goods

This preference relationship yields consumption choices (or segments) representing a chosen point when faced by a particular constraint
This utility function yields consumption bundles such as c1, c2, .., cn
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Preference Function (E, X)

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Energy Demand Function: Derivation

Every time a consumer is faced with
Price-income pair (pE, Y) A choice of quantity (E, X)
n n

ct = X t + Ai Eit
i =1

( X t + i Eit ) i
t =1

Energy demand function, maximizing index of consumption ct, can be written subject to budget constraint
Eit = E(pit, Yt) Where pit is price of i-th energy resource at time t and income yt is the level of income at time t Eit = ki pit i Yi i , i = 1,......, N Function form

where ki = ( i Ai )1/(1 i ) , i = (1 i ) 1 , i = i (1 i ) 1

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Demand Equations for Estimation

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Elasticity of Demand: Empirical Results

Price Aggregate Transportation Residential Industry other than energy Energy
Dependant Variable: per capita energy in each sector
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Income
0.79 (0.08) 1.34 (0.08) 1.08 (0.12) 0.76 (0.16) -0.05 (0.12)

-0.85 (0.10) -0.36 (0.12) -0.79 (0.08) -0.52 (0.17) -0.58 (0.11)

Empirical Results: Interpretation

The long-run response of energy consumption to price is very substantial Most inelastic is transportation sector
Relative inelasticity is quite plausible The least possibility for technological substitution in this sector

Followed by intermediate values for industry other than energy and energy sector Residential sector is the most elastic
Relatively high elasticity is also plausible High degree of substitutability between fuels and capital in this sector

Income elasticity
Private automobiles are both highly income elastic and relatively energy-intensive High income elasticity of transportation
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Demand for Crude Oil (Cooper, 2003)

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The Estimated Equation

The estimated equation for the USA

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Derivation of Long-run Elasticity

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Derivation of Long-run Elasticity

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Empirical Studies (Dahl, 1993 and 1994): Demand for Oil and Oil Products
The demand for oil in developing countries
Income elastic and income elasticity is greater than 1.32 A small but negative price elasticity (-0.30)

The demand for oil products in developing countries

Long-run gasoline price elasticity is as high as -1.25 Short-run gasoline price elasticity is as low as -0.07 Income elasticity of gasoline is greater than 1 Kerosene appears to be less income elastic
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Oil Price and Income Elasticities

Source: Dahl (1993)

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Gasoline Price Elasticities

Source: Dahl (1994)

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Gasoline Income Elasticities

Source: Dahl (1994)

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Transport Fuel Demand

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Price Elasticities of U.S. Consumer Expenditures: 1970-2006 (Kilian 2008)

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Price Elasticities of U.S. Investment Expenditures: 1970-2006 (Kilian, 2008)

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