The US oil market has demand schedule D, and domestic and foreign suppliers with schedules, S_US and S_FOR. Cartelization of foreign suppliers shifts S_FOR upward, increasing P, reducing consumption, and ceding a larger market share to domestic suppliers. Consumer surplus is reduced; some is recaptured as domestic producer surplus and as excess foreign profits; some is deadweight loss.

Teitenberg compares the vulnerability premium associated with our dependence on foreign oil against the costs of achieving oil self-sufficiency. First, cartels are inherently unstable, and are unlikely to be viable over the long run. Second, we can reduce our vulnerability to oil price shocks by improving our abilities to substitute alternative energy sources. Third, if we insist on relying solely on US-produced oil, oil will cost a lot more, we will deplete US reserves much faster, and we will even more dependent on foreign oil in the future.

We can encourage conservation via a tax on energy. The question is whether we should tax (impose a tariff on) imported energy sources only, or tax all energy.

1. A tariff on imported energy has effects similar to those of a foreign cartel: domestic producers capture some of foregone consumer surplus and the government collects tariff revenues, but there is deadweight loss as well.

2. A quota on imported energy such as implemented under the 1959 Mandatory Oil Import Program (see Tietenberg's Example 7.4, p. 173) is worse: deadweight losses are the same, and the money the government could capture as tariff revenues under a tariff are given to foreign quota holders as extra profits.

3. A tax on all energy sources, domestic and foreign, can be represented as an inward shift of the demand schedule, reducing consumption from foreign sources, but not increasing consumption of domestic sources.

The effects of a tax on oil only are likely to be quite different from the effects of a tax on all energy. If oil is taxed and natural gas is not, consumers will obviously start substituting gas for oil. The oil tax will generate more market distortions than a generalized energy tax.

Substitute (or "transition") energy sources include coal, hydro power, solar power and nuclear power. Any comparison of the relative costs of these should include their relative environmental costs. High-sulfur coal generates sulfur dioxide emissions causing acid rain, for example. Hydro power often involves massive disruptions of river ecosystems. Solar power is costly but safe, and involves minimal environmental impacts. Nuclear power is potentially cheap, but involves substantial risk costs which have halted new construction of nuclear power plants since the 1980's. Safe disposal of nuclear wastes is problematic.

Private markets would supply the appropriate amount of nuclear power if private suppliers bore the full liability costs. But the potential costs of nuclear accidents are too high for utilities to shoulder these liabilities themselves. The Price Anderson Act (1957) set a liability ceiling of $560 billion, and committed the US government to underwriting $500 billion of that. The current ceiling is higher, the government share of that liability is less, and utilities are paying into a compensation fund pool to cover potential liabilities. The problem with liability-sharing is that it reduces the incentives of individual utilities to minimize their own risks. In the insurance industry, this phenomenon is termed moral hazard, and justifies imposition of deductibles on liabilities of negligent parties.

The problem of locating nuclear waste storage facilities and other locally undesirable land uses (LULU's) involves NIMBY ("Not In My Back Yard") behavior. Location decisions tend to reflect the relative political clout of different communities, with LULU's ultimately located in low-income communities with inadequate political representation.

Utility Regulation

Utilities are generally monopolies, and their pricing structures are typically regulated by public agencies (e.g., Delaware's Public Service Commission) so as to provide a "reasonable rate of return" to investors in the utility. Utilities need to maintain adequate capacity for peak loads, but this capacity is idle during other periods. Peak-load capacity involves relatively low capital (fixed) costs but very high operational (variable) costs. Utilities generally use average-cost pricing, where the high costs of peak-load generation are offset by the low costs of off-peak generation. During peak-load periods, power is priced at less than its marginal cost, so consumers have inadequate incentives to conserve energy during those periods. Conversely, during off-peak periods, power is priced higher than its marginal cost, and consumers consume too little. Marginal-cost pricing would be most efficient, but such pricing schedules are very complex to implement and do not provide for the recovery of the utility's fixed costs.

By promoting energy conservation, utilities can defer capacity expansions, and thus defer rate increases. Utilities can encourage efficient energy use via peak-load pricing, setting higher prices for energy consumed during peak demand periods. (This approximates marginal cost pricing.)