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07 Application Returns to Scale in Electricity Supply

07 Application Returns to Scale in Electricity Supply -...

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241B Lecture Application: Returns to Scale in Electricity Markets We work from Nerlove (1963): a classic study of returns to scale in a regulated industry. The Electricity Supply Industry In 1963, the US electricity industry was characterized by: Privately owned local monopolies who supply power on demand. Rates (electricity prices) set by regulators. competition in the market for factor inputs or through long term contracts with labor unions. in the same market and rates are no longer strictly regulated. The Data in 44 states. The variables are: total costs, factor prices (the wage rate, the price of fuel, the rental rate of capital) and output. investment theory (Jorgenson 1963) tells us that (as long as there are no costs in a period-to-period basis from itself at a rental price (the user cost of capital) ( r + ) ± p I r is the real interest rate, is the depreciation rate and p I is the price of capital. With this logic, capital can be treated as a variable factor of production, just like labor and fuel inputs. Data construction:
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Output, fuel and labor costs (which together with capital costs make up total costs) from the Federal Power Commission. Wage rate - statewide average wage for utility workers. Capital costs - ideally calculated as reproduction cost of capital times user cost of capital. Due to data limitation, constructed from interest and depreciation Why do we need econometrics? average cost curve is downward sloping? Because the electricity industry faced average cost curve. Nerlove pioneered the method of accounting for di/ering factor prices by estimating a parameterized cost function. B is likely to produce more electricity, because it is more e¢ cient. Connecting the two observed output levels would lead one to wrongly infer increasing returns to scale, when the upward slope of the average cost curves implies decreasing returns to scale. (See Figure 1 for this lecture) Cobb-Douglas Technology To derive a parameterized cost function, we start with a Cobb-Douglas production function Q i = A i x 1 i 1 x 2 i 2 x 3 i 3 ; where Q i i ±s output, x i 1 i ), x
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