Basic Concepts from Economics

© 2018 D. Kirschen and the University of Washington

1
 Let us go to the market...
• Opportunity for buyers and
sellers to:

– compare prices

– estimate demand

– estimate supply

• Achieve an equilibrium
between supply and
demand

© 2018 D. Kirschen and the University of Washington 2

 How much do I value apples?
Price
One apple for my break

Take some back for lunch

Enough for every meal

Home-made apple pie

Home-made cider?

Quantity

Consumers spend until the price is equal to their marginal utility

© 2018 D. Kirschen and the University of Washington 3
 Demand curve
Price • Aggregation of the
individual demand of all
consumers
• Demand function:

q =D(p )
• Inverse demand function:

Quantity
p =D- 1 (q)

© 2018 D. Kirschen and the University of Washington 4

 Elasticity of the demand
Price
• Slope is an indication of the
elasticity of the demand
High elasticity good
• High elasticity
– Non-essential good
– Easy substitution
Quantity

• Low elasticity
Price – Essential good
– No substitutes

Low elasticity good

• Electrical energy has a very
low elasticity in the short
Quantity
term

© 2018 D. Kirschen and the University of Washington 5

 Price elasticity of the demand
• Mathematical definition:

dq
q p dq
e= = ×
dp q dp
p

• Dimensionless quantity

© 2018 D. Kirschen and the University of Washington 6

 Supply side
• How many widgets shall I produce?
– Goal: make a profit on each widget sold
– Produce one more widget if and only if the cost of
producing it is less than the market price

• Need to know the cost of producing the next widget

• Considers only the variable costs
• Ignores the fixed costs
– Investments in production plants and machines

© 2018 D. Kirschen and the University of Washington 7

 How much does the next one costs?
Cost of producing a widget

Total
Quantity

Normal production procedure

© 2018 D. Kirschen and the University of Washington 8

 How much does the next one costs?
Cost of producing a widget

Total
Quantity

Use older machines

© 2018 D. Kirschen and the University of Washington 9

 How much does the next one costs?
Cost of producing a widget

Total
Quantity

Second shift production

© 2018 D. Kirschen and the University of Washington 10

 How much does the next one costs?
Cost of producing a widget

Total
Quantity

Third shift production

© 2018 D. Kirschen and the University of Washington 11

 How much does the next one costs?
Cost of producing a widget

Total
Quantity

Extra maintenance costs

© 2018 D. Kirschen and the University of Washington 12

 Supply curve
• Aggregation of marginal cost
Price or marginal cost curves of all suppliers
• Considers only variable
operating costs
• Does not take cost of
investments into account
• Supply function:

Quantity
p =S - 1 (q)
• Inverse supply function:

q =S(p )
© 2018 D. Kirschen and the University of Washington 13
 Price elasticity of the supply
Price or marginal cost

dq
q p dq
e= = ×
dp q dp
p

Quantity

© 2018 D. Kirschen and the University of Washington 14

 Market equilibrium
Price Supply curve
Willingness to sell

market
market equilibrium
clearing
price

Demand curve
Willingness to buy

volume Quantity
transacted

© 2018 D. Kirschen and the University of Washington 15

 Supply and Demand

Price
supply

equilibrium point

demand

Quantity

© 2018 D. Kirschen and the University of Washington 16

 Market equilibrium
q =D(p ) =S(p )
* * *

Price
supply p =D (q ) =S (q )
* -1 * -1 *

market • Sellers have no incentive

clearing to sell for less
price
• Buyers have no incentive
demand to buy for more

volume Quantity
transacted

© 2018 D. Kirschen and the University of Washington 17

 Centralized auction
• Producers enter their offers:
quantity and price
– Offers are stacked up to
Price
construct the supply curve
• Consumers enter their bids:
quantity and price
– Bids are stacked up to
construct the demand
curve
• Intersection determines the
market equilibrium:
– Market clearing price
Quantity
– Transacted quantity

© 2018 D. Kirschen and the University of Washington 18

 Centralized auction
• Everything is sold at the market
clearing price
• Price is set by the “last” unit sold Price supply
• Marginal producer:
– Sells this last unit
– Gets exactly its offer Extra-marginal
• Infra-marginal producers:
– Get paid more than their
offer demand
– Collect economic profit Infra-
marginal
• Extra-marginal producers: Quantity
– Sell nothing
Marginal producer

© 2018 D. Kirschen and the University of Washington 19

 Bilateral transactions
• Producers and consumers trade directly and
independently
• Consumers “shop around” for the best deal
• Producers check the competition’s prices
• An efficient market “discovers” the equilibrium
price

© 2018 D. Kirschen and the University of Washington 20

 What makes a market efficient?
• All buyers and sellers have access to sufficient
information about prices, supply and demand
• Factors favouring an efficient market
– Number of participants
– Standard definition of commodities
– Good information exchange mechanisms

© 2018 D. Kirschen and the University of Washington 21

 Examples
• Efficient markets:
– Open air food market
– Chicago mercantile exchange

• Inefficient markets:
– Used cars

© 2018 D. Kirschen and the University of Washington 22

 Consumer’s Surplus
• Buy 6 apples at 10¢
• Total cost = 60¢ Price
• At that price I am
15¢
getting apples for which Consumer’s surplus
I would have been
10¢
ready to pay more
Total cost
• Surplus:
5+4+3+2+1=15¢
6 Quantity

© 2018 D. Kirschen and the University of Washington 23

 Economic Profit of Suppliers
Price Price
supply supply

π
Profit
demand
demand Cost
Quantity Quantity
Revenue

• Cost includes only the variable cost of production

• Economic profit covers fixed costs and shareholders’
returns
© 2018 D. Kirschen and the University of Washington 24
 Social or Global Welfare

Price
supply
Consumers’ surplus

+
Suppliers’ profit demand

= Social or global welfare Quantity

© 2018 D. Kirschen and the University of Washington 25

 Market equilibrium and social welfare

Operating point
π π
supply supply

Welfare loss
demand
demand
Q Q

Market equilibrium Artificially high price:

• larger supplier profit
• smaller consumer surplus
• smaller social welfare
© 2018 D. Kirschen and the University of Washington 26
 Market equilibrium and social welfare

Welfare loss
π π
supply supply

demand
demand
Operating point
Q Q

Market equilibrium Artificially low price:

• smaller supplier profit
• higher consumer surplus
• smaller social welfare
© 2018 D. Kirschen and the University of Washington 27
 Market Equilibrium: Summary
• Price = marginal revenue of supplier
= marginal cost of supplier
= marginal cost of consumer
= marginal utility to consumer

© 2018 D. Kirschen and the University of Washington 28

 Time varying prices
• Market price varies with offer and demand:
– If demand increases
• Price increases beyond utility for some consumers
• Demand decreases
• Market settles at a new equilibrium
– If demand decreases
• Price decreases
• Some producers leave the market
• Market settles at a new equilibrium
• In theory, there should never be a shortage
• Encourages efficient use of resources

© 2018 D. Kirschen and the University of Washington 29

 Time-varying prices vs. fixed price
• Assume fixed price = average of market price
• Period of high demand
– Fixed price < marginal utility and marginal cost
– Consumers continue buying the commodity rather
than switch to another commodity
• Period of low demand
– Fixed price > marginal utility and marginal cost
– Consumers do not switch from other commodities
• Inefficient allocation of resources

© 2018 D. Kirschen and the University of Washington 30

 Concepts from the Theory of the Firm

© 2018 D. Kirschen and the University of Washington

31
 Production function
y = f (x1,x 2 )
• y: output
• x1 , x2: factors of production
y y
x2 fixed x1 fixed

x1 x2

Law of diminishing marginal return

© 2018 D. Kirschen and the University of Washington 32
 Long run and short run
• Some factors of production can be adjusted
faster than others
– Example: fertilizer vs. planting more trees
• Long run: all factors can be changed
• Short run: some factors cannot be changed
• No specific duration separates long and short
run
• Long run = long term
• Short run = short term
© 2018 D. Kirschen and the University of Washington 33
 Input-output function
y = f (x 1 ,x 2 ) x 2 fixed
The inverse of the production function is the
input-output function
x 1 = g ( y ) fo r x 2 = x 2

Example: amount of fuel required to produce a

certain amount of power with a given plant

© 2018 D. Kirschen and the University of Washington 34

 Short run cost function
c SR (y )=w 1 ×x 1 + w 2 ×x 2 = w 1 ×g ( y ) + w 2 ×x 2

• w1, w2: unit cost of factors of production x1, x2

c SR (y )

© 2018 D. Kirschen and the University of Washington y 35

 Short run marginal cost function
c SR (y )
Convex due to law
of marginal returns

dc ( y )
y
SR

dy
Non-decreasing function

y
© 2018 D. Kirschen and the University of Washington 36
 Optimal production
• Production that maximizes profit:
m ax
y
{ ×y - c SR ( y )}

d { ×y - c SR (y )}
=0
dy

dc SR (y ) Only if the price π does not depend

= on y  perfect competition
dy
© 2018 D. Kirschen and the University of Washington 37
 Costs: Accountant’s perspective
• In the short run, some costs are
variable and others are fixed
• Variable costs:
– labour
Production cost [$]
– materials
– fuel
– transportation
• Fixed costs (amortized):
– equipment
– land
– Overheads
• Quasi-fixed costs
– Start-up cost of power plant
• Sunk costs vs. recoverable costs Quantity

© 2018 D. Kirschen and the University of Washington 38

 Average cost
c(y ) =cv ( y)+ c f

c( y ) c v (y ) c f
AC ( y)= = + =AVC (y )+ AFC (y )
y y y

Production cost [$] Average cost [$/unit]

Quantity Quantity

© 2018 D. Kirschen and the University of Washington 39

 Marginal vs. average cost

MC AC
$/unit

Production

© 2018 D. Kirschen and the University of Washington 40

 When should I stop producing?

• Marginal cost = cost of producing one more unit

• If MC > π next unit costs more than it returns
• If MC < π next unit returns more than it costs
• Profitable only if Q4 > Q1 because of fixed costs

Average cost [$/unit] Marginal

cost
[$/unit]
π

Q1 Q2 Q3 Q4

© 2018 D. Kirschen and the University of Washington 41

 SRAC vs. LRAC

$/unit
SRAC LRAC

y* Quantity

© 2018 D. Kirschen and the University of Washington 42

 SRAC vs. LRAC
Short-run average
$/unit cost curves
LRAC

y* Quantity

© 2018 D. Kirschen and the University of Washington 43

 SRAC, SRMC, LRAC, LRMC

LRMC
$/unit SRMC
SRAC
LRAC

y* Quantity

© 2018 D. Kirschen and the University of Washington 44

 Costs: Economist’s perspective
• Opportunity cost:
– What would be the best use of the money spent to make the
product ?
– Not taking the opportunity to sell at a higher price represents a cost
• Examples:
– Use the money to grow apples or put it in the bank where it earns
interests?
– Growing apples or growing kiwis?
• Comparisons should be made against a “normal profit”
– What putting money in the bank would bring
• Selling “at cost” means making a “normal profit”
– Usually not good enough because it does not compensate for the risk involved
in the business

© 2018 D. Kirschen and the University of Washington 45

Risks, Markets and Contracts

46
 Concept of Risk
• Future is uncertain
• Uncertainty translates into risk
– In this case, risk of loss of income
• Risk = probability x consequences
• Doing business means accepting some risks
• Willingness to accept risk varies:
– Venture capitalist vs. retiree
• Ability to control risk varies:
– Professional traders vs. novice investors

© 2018 D. Kirschen and the University of Washington 47

 Sources of Risk
• Technical risk
– Fail to produce or deliver because of technical problem
• Power plant outage, congestion in the transmission system
• External risk
– Fail to produce or deliver because of cataclysmic event
• Weather, earthquake, war
• Price risk
– Having to buy at a price much higher than expected
– Having to sell at a price much lower than expected

© 2018 D. Kirschen and the University of Washington 48

 Managing Risks
• Excessive risk hampers economic activity
– Not everybody can survive short term losses
– Society benefits if more people can take part
– Business should not be limited to large
companies with deep pockets
• How can risk be managed:
– Reduce the risk
– Share the risk
– Relocate the risk
© 2018 D. Kirschen and the University of Washington 49
 Reducing the Risks
• Reduce frequency or consequences of technical problems
– Those who can reduce risk should have an incentive to do it!
• Owners of power plants
• Reduce consequences of natural catastrophes
– Owners and operators of transmission system
– Design systems to be able to withstand rare events
• Enough crews to repair the power system after a hurricane
• Security margin in power system operation
– Limits the consequences of rare but unpredictable and
catastrophic events
– Increases the daily cost of electrical energy
– Does not cover all possible problems because that would cost
too much
© 2018 D. Kirschen and the University of Washington 50
 Sharing the Risks
• Insurance:
– All the members of a large group pay a small
amount to compensate the few who suffer a big
loss
– The consequences of a catastrophic event are
shared by a large group rather than a few
• Grid operator does not have to pay
compensation in the event of a blackout

© 2018 D. Kirschen and the University of Washington 51

 Relocating Risk
• Possible if one party is more willing or able to
accept it
– Loss is not catastrophic for this party
– This party can offset this loss against gains in other
activities
• Applies mostly to price risk
• How does this relate to markets?

© 2018 D. Kirschen and the University of Washington 52

 Characteristics of markets
• The time of delivery of the goods
• The mode of settlement
• Any conditions that might be attached to this
transaction

© 2018 D. Kirschen and the University of Washington 53

 Spot Market

Spot
Sellers Buyers
Market

• Immediate market, “On the Spot”

– Agreement on price
– Agreement on quantity
– Agreement on location
– Unconditional delivery
– Immediate delivery

© 2018 D. Kirschen and the University of Washington 54

 Examples of Spot Markets

• Examples
– Food market
– Basic shopping
– Rotterdam spot market for oil
– Commodities markets: corn, wheat, cocoa, coffee
• Formal or informal

© 2018 D. Kirschen and the University of Washington 55

 Advantages and Disadvantages
• Advantages:
– Simple
– Flexible
– Immediate
• Disadvantages
– Prices can fluctuate widely based on
circumstances
– Example:
• Effect of frost in Brazil on the price of coffee
beans
• Effect of trouble in the Middle East on the price
of oil

© 2018 D. Kirschen and the University of Washington 56

 Spot Market Risks
• Market may not have much depth
– Not enough sellers: market is short
– Not enough buyers: market is long
• Lack of depth causes large price fluctuations
– Small producer may have to sell at a low price
– Small purchaser may have to buy at a high price
– “Price risk”
• Relying on the spot market for buying or selling large
quantities is a bad idea

© 2018 D. Kirschen and the University of Washington 57

 Example: buying and selling wheat

• Farmer produces wheat

• Miller buys wheat to make flour
• Farmer carries the risk of bad weather
• Miller carries the risk of breakdown of flour mill
• Neither farmer nor miller control price of wheat

© 2018 D. Kirschen and the University of Washington 58

 Harvest time

• If price of wheat is low:

– Possibly devastating for the farmer
– Good deal for the miller
• If the price is high:
– Good deal for the farmer
– Possibly devastating for the miller
© 2018 D. Kirschen and the University of Washington 59
 What should they do?
• Option 1: Accept the spot price of wheat
– Equivalent to gambling
• Option 2: Agree ahead of time on a price that
is acceptable to both parties
– Forward contract

© 2018 D. Kirschen and the University of Washington 60

 Forward Contract
• Agreement:
– Quantity and quality
– Price
– Date of delivery (not immediate)
• Paid at time of delivery
• Unconditional delivery

© 2018 D. Kirschen and the University of Washington 61

 Forward Contract

Contract (1June)
1 ton of wheat at $100
on 1 September

Maturity (1 September)
Seller delivers 1 ton of wheat
Buyer pays $100
Spot Price = $90
Profit to seller = $10 62
© 2018 D. Kirschen and the University of Washington
 How is the forward price set?
Spot Price

Time
• Both parties look at their alternative: spot price
• Both forecast what the spot price is likely to be

© 2018 D. Kirschen and the University of Washington 63

 Sharing risk
• In a forward contract, the buyer and seller
share the risk that the price differs from their
expectation
• Difference between contract price and spot
price at time of delivery represents a “profit”
for one party and a “loss” for the other
• However, in the meantime they have been
able to get on with their business
– Buy new farm machinery
– Sell the flour to bakeries

© 2018 D. Kirschen and the University of Washington 64

 Attitudes towards risk
• Suppose that both parties forecast the same value
spot price at time of delivery

• Equal attitude towards risk

– Forward price is equal to expected spot price

• “Risk aversion”

© 2018 D. Kirschen and the University of Washington 65

 Attitudes towards risk
• If buyer is less risk averse than seller
– Buyer can negotiate a forward price lower than
the expected spot price
– Seller agrees to this lower price because it reduces
its risk
– Difference between expected spot price and
forward price is called a premium
– Premium = price that seller is willing to pay to
reduce risk

© 2018 D. Kirschen and the University of Washington 66

 Attitudes towards risk
• If buyer is more risk averse than seller
– Seller can negotiate a forward price higher than
the expected spot price
– Buyer agrees to this higher price because it
reduces its risk
– Buyer is willing to pay the premium to reduce risk

© 2018 D. Kirschen and the University of Washington 67

 Case 1:
• Farmer estimates that the spot price will be
$100
• Miller also forecasts that the spot price will
be $100
• They can agree on a forward price of $100

© 2018 D. Kirschen and the University of Washington 68

 Case 2:
• Farmer estimates that the spot price will be
$90
• Miller forecasts that the spot price will be
$110
• They can easily agree on a forward price of
somewhere between $90 and $110
• Exact price will depend on negotiation ability
and relative risk aversion

© 2018 D. Kirschen and the University of Washington 69

 Case 3:
• Farmer estimates that the spot price will be
$110
• Miller forecasts that the spot price will be
$90
• Agreeing on a forward price is likely to be
difficult unless they have widely different risk
aversions

© 2018 D. Kirschen and the University of Washington 70

 Forward Markets
• Since there are many millers and farmers, a
market can be organised for forward
contracts
• Forward price represents the aggregated
expectation of the spot price, plus or minus
a risk premium

© 2018 D. Kirschen and the University of Washington 71

 What if...
Spot Price

Forward
Price

Time
• Suppose that millers are less risk adverse
• Premium below the expected spot price
• Spot price turns out to be much lower than forward price because
of a bumper harvest
© 2018 D. Kirschen and the University of Washington 72
 What if...
Spot Price

Forward
Price

Time
• Farmers breathe a sigh of relief…
• Millers take a big loss
• The following year the millers ask for a much
bigger premium
• Is agreement between the millers and the
farmers going to be possible?
© 2018 D. Kirschen and the University of Washington 73
 Undiversified risk
• Farmers and millers deal only in wheat
• Their risk is undiversified
• Can only offset “good years” against “bad
years”
• Risk remains high
• Reducing the risk further would help business

© 2018 D. Kirschen and the University of Washington 74

 Diversification
• Diversification: deal with more than
one commodity
• Average risk over different
commodities
• Farmers may not want to diversify
their production because it could be
inefficient

© 2018 D. Kirschen and the University of Washington 75

 Physical participants vs. traders

• Physical participants
– Produce, consume or can store the commodity
– Face undiversified risk because they deal in only one commodity

• Traders (a.k.a. speculators)

– Cannot take physical delivery of the commodity
– Diversify their risk by dealing in many commodities
– Specialize in risk management

© 2018 D. Kirschen and the University of Washington 76

 Trading by speculators
• Cannot take physical delivery of the commodity
• Must balance their position on date of delivery
– Quantity bought must equal quantity sold
– Buy or sell from spot market if necessary
• May involve many transactions
• Forward contracts limited to parties who can take
physical delivery
• Need a standardised contract to reduce the cost of
trading: future contract
• Future contracts (futures) allow others to
participate in the market and share the risk

© 2018 D. Kirschen and the University of Washington 77

 Futures Contract

2 tons at $110

1 ton
2 tons at $90 At $ 95

1 ton
At $115

All contracts for wheat

on 1 September

© 2018 D. Kirschen and the University of Washington 78

 Futures Contract
Shortly before 1 September Spot Price $100
bought 2 tons at $110
bought 1 ton at $95
sold 1 ton at $115

sold 2 tons at $110

sold 2 tons at $90

Delivers 4 tons
Sells 2 tons at $100
bought 2 tons at $90
sold 1 ton at $95

bought 1 ton at $115

Sells 1 ton at $100

© 2018 D. Kirschen and the University of Washington 79

 Futures Contract
bought 2 tons at $110
bought 1 ton at $95
sold 1 ton at $115
sold 2 tons at $100
sold 2 tons at $110 net profit: $0
sold 2 tons at $90

bought 2 tons at $90

sold 1 ton at $95 Spot Price = $100
sold 1 ton at $100
net profit: $15

bought 1 ton at $115

© 2018 D. Kirschen and the University of Washington
bought 3 tons at $100 80
 Importance of information
• Speculators own some of the commodity before it is
delivered
• They carry the risk of a price change during that period
• Need deep pockets
• Without additional information, this is gambling
• Information helps speculators make money
• Example:
– Global perspective on the harvest for wheat
– Long term weather forecast and its effect on the
demand for gas and electricity

© 2018 D. Kirschen and the University of Washington 81

 Options
• Spot, forward and future contracts: unconditional delivery

• Options: conditional delivery

– Call Option: right to buy at a certain price at a certain
time
– Put Option: right to sell at a certain price at a certain time
• Two elements of the price:
– Exercise or strike price = price paid when option is
exercised
– Premium or option fee = price paid for the option itself

© 2018 D. Kirschen and the University of Washington 82

 Example of Call Option
• Call Option with an exercise price of $100
• About to expire
• If the spot market price is $90 the option is
worth nothing
• If the spot market price is $110 the option is
worth $10
• Holder makes money if value > option fee

© 2018 D. Kirschen and the University of Washington 83

 Example of Put Option
• Put Option with an exercise price of $100
• About to expire
• If the spot market price is $90 the option is
worth $10
• If the spot market price is $110 the option is
worth nothing
• Holder makes money if value > option fee

© 2018 D. Kirschen and the University of Washington 84

 Financial Contracts
• Contracts without any physical delivery
B C
A
D

Financial
contract Physical Market
(Spot)

X Z
Y W

© 2018 D. Kirschen and the University of Washington 85

 One-way contract for difference
• Example:
– Buyer has call option for 50 units at $100 per unit
– Spot price goes up to $110 per unit
– Buyer pays $5500 for the 50 units in the physical
market
– Seller receives $5500 for the 50 units in the
physical market
– Buyer calls the option to buy 50 units at $100
– Seller transfers $500 to the buyer to settle the
contract
© 2018 D. Kirschen and the University of Washington 86
 Two-Way Contract for Difference
• Combination of a call and a put option for the
same price --> will always be used
• Example 1: CFD for 50 units at $100
– spot price = $110
– buyer pays $5500 on physical (spot) market
– seller receives $5500 from the physical market
– seller pays buyer $500
– buyer effectively pays $5000
– seller effectively gets $5000

© 2018 D. Kirschen and the University of Washington 87

 Two-Way Contract for Difference
• Example 2: CFD for 50 units at $100
– spot price = $90
– buyer pays $4500 to the physical (spot) market
– seller receives $4500 from the physical market
– buyer pays seller $500
– buyer effectively pays $5000
– seller effectively gets $5000
• Buyer and seller “insulated” from physical
market

© 2018 D. Kirschen and the University of Washington 88

 Minimum Efficient Size

Competitive market Natural monopoly

© 2018 D. Kirschen and the University of Washington 89

 Setting the price for a monopoly
MC
Price Marginal Cost
Demand

Average Cost

 𝜋 𝐴𝐶

 𝜋 𝑀𝐶

yAC yMC Output

© 2018 D. Kirschen and the University of Washington 90

 Minimum Efficient Size
Price Price

AC AC

p* p* Demand
Demand

MES Output MES Output

b

© 2018 D. Kirschen and the University of Washington 91

 Natural Monopoly

Price MC

Demand MC AC

pAC

pMC

yAC yMC Output

© 2018 D. Kirschen and the University of Washington 92