Teddy Bloggie Blog Blogging

No, this isn't about bouncing coffee and energy. Here's what happened. My friend Chau instant messaged me the other night and wanted to know, as a part of her homework assignment, why as the price of coffee went up, consumption of instant coffee (which costs more) shrank but consumption of roasted coffee (cheaper alternative) stayed about the same. It took me a while to understand her question; and actually, she found out the answer before I understood her question. The answer is that the elasticity of demand for instant coffee and roasted coffee are not the same. Since caffeine is a socially accepted drug and lots of people are addicted to it, it has characteristics of other drugs, namely the total caffeine intake is not very elastic - you pretty much have to get your daily fix. When the price of coffee goes up, people substitute the cheaper version, in this case roasted coffee, for the more expensive instant coffee. Even if coffee prices soared, roasted coffee consumption will probably stay the same or maybe even increase. Roasted coffee would be considered to have an inelastic demand curve.

I didn't think much about this until I read about the California energy crisis that occurred last year. The principle of elasticity explains why withholding energy makes sense for companies in an inelastic industry like energy. As prices increase for energy, consumers still have to consume about the same amount since not doing so means either they're freezing or reading in the dark. In an inelastic market, even a slight decrease in supply can cause a jump in prices. Now that I think of it, that's also why the drug war is so beneficial for drug dealers (street drugs should be cheap except for the limit on supply and the inelastic demand). Going back to the California energy market though, the same principles apply. Energy has a few interesting properties. Natural gas is a homogeneous good, it's storable, its supply is limited by the available pipelines and people need it for cooking, cleaning, lighting, heating, cooling, etc. That's why the perfect competition, supply=demand arguments of classical economics break down. Here's Brad DeLong exploring the topic...

Administrative Law Judge Says El Paso Withheld Capacity

Economists' conventional knee-jerk belief is that it almost never pays a company to withhold output unless it has a durable monopoly. If it withholds output it loses sales. It gets a higher price for what it does sell, true, but its competitors take its market share--and that market share will be expensive to win back.

One of the nice things about being at Berkeley is that you can run into people who tell you when you are being an idiot, and thus you learn more stuff.

In this case that person if Professor Severin Borenstein, who carefully and patiently explains to me why the energy market is different. First, what does El Paso lose by withholding pipeline capacity for natural gas deliveries? It loses the pennies that are paid from shipping natural gas from one place to another, but the natural gas itself can be and is easily stored. It's not as if they had to idle factories or destroy output in order to withhold supply from the market. So withholding output is very cheap. Because one hydrocarbon molecule is much like another, there is no difficulty in regaining market share. So there are next to no costs from withholding output.

And there are enormous benefits. Full pipelines being run by competitors means that nobody else can expand supply if, as was the case, California natural gas storage tanks are dry. Inelastic demand means a small supply restriction provokes a large price increase. El Paso got only 15-20 percent of that increase. But so what? Suddenly deciding that pipeline maintenance had to be performed meant that El Paso (and its competitors) made out like bandits.

"The crux of the matter," Severin says, "is that when supply and demand are inelastic all standard intuitions about market power--derived from industries with elastic supply and demand--are badly, badly false. An HHI of 1200 means absolutely nothing at all, for it is irrelevant to the real question: can this firm through its own uncoordinated actions alone boost its profits by withholding supply?"