Friday, August 7, 2009

Micro-economic Analysis of Waxman-Markey bill: Part 1: No Limits

I haven't seen an analysis of the provisions in the Waxman-Markey bill in terms of basic supply and demand. This post is also an attempt to make back-of-the-envelope calculations on how much the individual household has to pay additionally if Waxman-Markey is implemented. This post is a bit wonky, but should be accessible to a lay person. Any comments and suggestions are welcome.

Let us first consider the relatively simpler case of power generation. We first start with the assumption that the producers of electricity have a constant (marginal) cost (The implications of relaxing this assumption will be addressed in subsequent posts). For example, the (marginal) cost of electricity is ~$0.12/KWHr.

Fig. 1. Price vs. Quantity, assuming a constant marginal price for energy. The intersection of the two lines is the equilibrium price (same as the marginal price) and the equilibrium quantity, which is the quantity that will be consumed.

The demand curve (which is the curve representing the quantity demanded Q at any price P) is downward sloping, as the demand is likely to be high if energy is cheap. For example, people drive more (resulting in more demand for energy) when gas is cheap and less when it is more expensive.

Note: One could argue that nobody demands CO2, and therefore this whole argument is flawed. However, even though CO2 is a pollutant, which is a "bad" rather than a "good" that we actually want, supply-demand arguments are still applicable. This is because the CO2 is actually a byproduct of the good that we seek, which is energy.

In the absence of any limits the quantity of CO2 emitted is the equilibrium quantity, which happens to be 5.6 GigaTons in the US (~44,000 lbs of CO2/per person). In the next post, we will focus on limits and the basis for determination, taxation vs. cap and trade etc.

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