Case summary: Chinas facing one of the worst energy crises in history.

The production cannot match the demand from both industrial sector and consumption sector. Some estimate that the energy shortage would soon reach 30 million kilowatt, which is more than double Shanghais peak consumption. Many actions have been implemented such as reducing coal export, increase transportation efficiency or reduce the coal price. However, these solutions seemed to be not effective and Chinas still facing huge problem of shortage. In fact, due to the disco-ordination from coal suppliers, some energy plans want to cut-off production which may lead to higher shortage between demand and supply. One of alternative options available for Chinese government is increase the electric price. One big question is the effectiveness of this plan, will price adjustment improve the situation or make it becomes worse. To find out the answer, its essential to understand the basic knowledge of demandsupply, elasticity and other managerial economics concepts. 1. Price elasticity of demand: the relationship between electric price and consumption Basically, price elasticity measures the responsiveness of a goods sales to changes in its price. An elasticity of demand ratio can be calculated by the percentage change in quantity and the percentage change in the demand determinant factor, ceteris paribus. In elasticity of price, we have the formula to calculate:

The ratio includes two characteristics: the sign and the size of price elasticity of demand. The sign tell us about the movement of quantity demanded when price increase or decrease. Firstly, Negative sign, which is usually observed in Ep, means that an increase in price of normal good will decrease the quantity demanded for that good. Thats why the demand curve has negative slope. Secondly, how big the ratio tell us about the sensitivity of demand regard to price. The bigger the number is, the higher customers price sensitivity level thus measure whether a change in price can lead to significant change in quantity or not. Geographically, this characteristic will be represented by slopes of demand curves. The steeper curve means elastic demand and vise vs. For example: if the demand elasticity for electric in Indian is -0.65 among residential users, 1% increase in electric price lead to a decrease of 0.65% of quantity demanded for electricity. In this case, Chinese government expects a significant negative ratio that mean their change can reduce their large gap between demand and supply. Apply the elasticity concept into China situation, governors must estimate the price elasticity of demand to understand whether their adjustment can be effective or not. Elasticity in turn depends in many factors. Firstly, price elasticity depends on necessity level. The higher necessity the good is, the less elastic the demand become. Chinese administrator hope their country ratio to be large. However, Electricity is a very vital source of energy in modern world. Almost activities spreading from production and daily lives need electricity. Thus, even if the price increases, people cannot cut-off the quantity demanded. So. In

short, price elasticity of electricity of china is somehow small or even inelastic. An increase in price might lead to very small cut-off in total consumption. Secondly, the availability also define price elasticity. When a good has many available substitution or the price of switching is cheap, its demand elasticity is quite high. For both general electric consumption and consumption for thermoelectric, its impossible to find a perfectly source of energy that match advantages of electric. Hydropower and Solar-power can replace the thermal sources, but they are costly and unproductive compare to thermal plants. Only small fraction of electric consumption can switch to these sources. Industrial sectors may see no advantages and benefits for changing their energy supply source. Last but not least, theoretically, demand elasticity for the whole industry seem to be inelastic compare to an individual firms. Thus, in the case of energy product, by applying theory of elasticity, the impact of a price increase on electricity consumption depends on the price elasticity of demand might be small and insignificant. 2. The price elasticity of the Indian demand for electricity has been estimated to be -0.65 among residential users and -0.45 among industrial users. If these elasticity apply to China as well, how will the impact of a price increase be spread between residential as compared with industrial users?

The demand elasticity of electricity in India is -0.65 among residential users and -0.45 among industrial users. These numbers mean that any 1% increase in electricity price lead to a decrease of 0.45% in industrial sector and 0.65% in residential sectors. The different between two numbers interfere that residential consumers are more price sensitive than industrial users. Reasons for that can be the number of available substitute, cost of switching. Industries demand huge amount of electric that other sources cannot efficiently substitute without significant capital requirement. Indian have many similarities to China, they are both developing country with high population, and thus we can apply these numbers into chinas situation.

In short, if we apply Indian ratios into Chinese case, we can interpret that a same 1% increase in electric price lead to larger response in residential user (0.65%) than in industrial user 0.45% decrease). The spread (0.2%) have impact on how the government should price between two users to reduce the shortage.

The absolute value of residential sector is higher than the industrial one, 3. Many Chinese organizations ignore the market system. For instance, they borrow money from banks and refuse to repay, thus creating bad debts for lenders. Likewise, they might consume electricity without bothering to pay the power supplier. Do such organizations cause the demand for electricity to be more or less price elastic?

If Chinese firms and families use electricity and does not care much about the ability to pay the fee just like bad debt in financial sector, they tend to careless about the electric price and its movement. These mindset lead to less price sensitive while using product. In other words, ceteris paribus, such organizations behavior make demand for electricity to me less price less elastic. A change in price leads to insignificant change in quantity demanded. This situation make the effort of increasing the price to save energy less effective. 4. Suppose that the Chinese government regulates the electricity industry through marginal cost pricing. a. How does the contract price of thermal coal affect an electric power plants marginal cost? b. If the contract price were raised to 99% of the spot market price, how would that affect the electric power plants production? a. Marginal cost pricing is The process of setting an item's price at the same level as the extra expense involved in producing another item. By using marginal cost pricing, a business helps keep their sales price down in order to encourage sales during slow periods or to gain market share. While marginal cost is the change in the total cost that eventually appears when the quantity produced changes by one unit. That is, it is the cost of producing one more unit of a good. In general terms, marginal cost at each level of production includes any additional costs required to produce the next unit.
Ceteris paribus, If the price of Coal are fixed below market price. It reduces the marginal cost of power plans to produce one more kilowatt. However, mining company in this case must bear different between actual marginal cost and market price of coal for each extra unit (e.g. one more ton). Thus, marginal cost of power plans can be reduced while mining firms must bear this reduction in their economic profit. With the same level of revenue, power plan will be better off while mining firms will be worse off. However, when all the contractual coal are supplied, if power plans want to increase production, it will face higher MC, or MC will increase because they must follow the market spot price.

b. Ceteris paribus, if the contract price were raised to 99% of the spot market price, power plan MC still lower than the market price, so they tend to produce more output to be benefits from this advantage. Maximizing profit output level will be higher. In case of mining firms, they can sell more via contract while reduce the gap between contractual price and market spot price. They also reduce other additional cost if selling product in market (advertising, reduce the money time circle, etc.) Thus, ceteris paribus, if the contract price were 99% market price, we expect significant increase in the production of power plans to narrow the gap between demand and supply. Conclusion: China are facing huge gap between demand and supply for thermoelectricity. Increase the price might not be so effective. However, price adjustment can be applied in short term with different policies for industrial users and residential users due to the different in price elasticity of demand. They should focus on increase the production and productivity in long term, or set a reasonable contract price for thermal between mining companies and power plans to increase both coals and electricity output without significantly hurt mining firms or power plans.