California Electricity Pricing

Questions for Analysis and Responses

Our approach to this case is built on the information that California electricity producers behave as price takers. This statement implies that the electricity market is perfectly competitive. Before answering the questions given, we briefly describe industry supply, marginal costs, and profits for perfectly competitive markets.

First, the industry supply curve is a sum of supply curves for individual producers. In turn, each firm's individual supply curve is the quantity supplied, from zero capacity to maximum capacity, at a price equal to marginal cost. Marginal cost is determined by taking the derivative of the cost function with respect to quantity. The cost function C(Q) for each firm is the sum of variable costs VC(Q) and fixed costs FC. Because VC(Q) in this case is VC*Q, the derivative of the cost function is VC. Therefore, for each firm, the marginal cost MC is equal to the total variable cost TVC (See Appendix A) and is constant.

In the short run, firms will generate profits if marginal costs exceed average costs. Substituting marginal costs for prices (see above), this means that if market prices are greater than average costs, suppliers will earn economic profits. Conversely, if market prices are less than average costs, some firms will choose to exit the market since they are not making enough money to cover fixed costs. In relation to this case, we will assume that prices are greater than average costs, and therefore each firm's supply curve is represented by its MC.

In the appendix, we provide the relevant calculations of industry supply and marginal costs for individual producers. The individual firm's data is sorted based on marginal cost (from low to high) and a column is added for cumulative supply (the sum of each firm's individual supply). The industry supply curve is a stepped curve plotting each firm's marginal cost against cumulative supply. See figure 1.

Figure 1

(a) Assuming that firms behave as price takers, what is the equilibrium price?

It is given that demand is perfectly inelastic at a quantity of 19,000 MW. Therefore, the equilibrium price is found at the intersection of the industry supply curve and the demand curve Q19,000. See figure 2.

Equilibrium Market Price: $72.50 (per MWh)

(b) Suppose it's summer and market demand increases to 20,000 MW. What is the new market price?

It is now given that demand is perfectly inelastic at a quantity of 20,000 MW. Therefore, the equilibrium price is found at the intersection of the industry supply curve and the new demand curve Q20,000. See figure 2.

Equilibrium Market Price: $82.50 (per MWh)

Conceptually, the new equilibrium price is a result of a rightward shift of the demand curve.

Figure 2

(c) What happens to the price if a drought takes the run-of-river plants out of operation? Consider the impact both during periods of high demand (20,000 MW) and low demand (19,000 MW). Comment.

The approach used in (a) and (b) is again taken here. In this situation, however, run-of-river plants produce zero supply due to drought. See Appendix B. As a result, the industry supply curve shifts left. See figure 3.

During Periods of Low Demand:

Equilibrium Market Price: $84.50 (per MWh)

Overall Impact: $12.00 (per MWh) increase due to the drought

During Periods of High Demand:

Market Price: $99.50 (per MWh)

Overall Impact: $17.00 (per MWh) increase due to the drought

Conceptually, we also conclude that a leftward shift of the supply curve would result in an increased equilibrium price for both periods of high and low demand. The non-uniform price increase is due to the "stepped" supply curve rather than a uniform linear supply curve.

Figure 3

(d) RKO has been running its facilities at full capacity and selling everything that it produces at the current market price. What would happen to RKO's profit if it stopped producing at Hunters Point 1&2? Consider separately the cases of high and low demand.

As a result of stopping production at Hunters Point 1&2, the industry supply curve shifts leftward for firms with marginal cost greater than Hunters Point 1&2. Here again as seen in (c), the equilibrium price increases for both periods of high and low demand. See Appendix C. See figure 4.

During Periods of Low Demand:

Equilibrium Market Price: $85.50 (per MWh)

Overall Impact: $1.00 (per MWh) increase

During Periods of High Demand:

Equilibrium Market Price: $105.50 (per MWh)

Overall Impact: $6.00 (per MWh) increase

To determine the impact of eliminating production at Hunters Point 1 & 2, we compare RKO's profits when these plants are operating (baseline) with those when the plants are shut down. We use equilibrium prices determined in (c) to calculate profits in the baseline scenario. Then we use the equilibrium prices determined above in (d) to compute profits in the second scenario. The profit equation is given below. Note that because the fixed costs are sunk, they will cancel out when comparing the profits of one scenario vs. the other.

Profit = Price*Quantity-[Total Variable Costs * Quantity + Fixed Costs] See Appendix C

During Periods of Low Demand: