Energy Economics and Markets

Learning Objectives

Define energy economics and the concepts of supply and demand.

Explain how the market price of energy is determined.

Describe factors that can shift energy supply and demand.

Define an externality and explain its relevance to the energy sector.

The Economics of Energy

Why do gasoline prices go up and down? Why are some energy sources used more than others? The answers lie in energy economics, which studies how people and societies make decisions about the production, distribution, and consumption of energy resources. At its core are the fundamental principles of supply and demand.

Supply and Demand

The energy market is where energy resources are bought and sold. Like any market, it is governed by supply and demand.

Supply: The total amount of an energy resource (like oil, natural gas, or electricity) that producers are willing and able to sell at a given price.

Factors affecting supply: Discovery of new reserves, technological advances (e.g., fracking, more efficient solar panels), government regulations, and geopolitical events.

Demand: The total amount of an energy resource that consumers are willing and able to buy at a given price.

Factors affecting demand: Population growth, economic activity, weather (e.g., a hot summer increases demand for electricity for air conditioning), and energy efficiency measures.

Price Determination

The market price of energy is determined by the interaction of supply and demand. The price settles at an equilibrium point where the quantity supplied equals the quantity demanded.

If demand increases while supply stays the same (e.g., during a heatwave), prices will rise.

If supply increases while demand stays the same (e.g., a new oil field comes online), prices will fall.

If supply decreases (e.g., a major refinery shuts down), prices will rise.

Externalities: The Hidden Costs

A major issue in energy economics is the concept of externalities. An externality is a cost or benefit of an economic activity that is experienced by an unrelated third party.

Negative Externality: A cost imposed on others. The pollution and greenhouse gas emissions from burning fossil fuels are classic negative externalities. The market price of gasoline does not include the long-term costs of climate change or the health costs of air pollution; these costs are borne by society as a whole.

Positive Externality: A benefit received by others. The development of a new, cheaper solar panel technology benefits everyone by reducing pollution.

Governments often try to address externalities through policy. For example, a carbon tax is a policy designed to make producers pay for the negative externality of their CO₂ emissions. Conversely, a subsidy for renewable energy is a payment designed to encourage its positive externalities.

Key Terms

Energy Economics: The field of study concerned with the supply and demand of energy resources in society.
Supply and Demand: A fundamental economic model of price determination in a market. It concludes that in a competitive market, the unit price for a good will vary until it settles at a point where the quantity demanded equals the quantity supplied.
Equilibrium Price: The market price where the quantity of goods supplied is equal to the quantity of goods demanded.
Externality: A side effect or consequence of an industrial or commercial activity that affects other parties without this being reflected in the cost of the goods or services involved.
Subsidy: A sum of money granted by the government to assist an industry or business so that the price of a commodity or service may remain low or competitive.