Chapter 4 – Theoretical Analysis
4.2 Price elasticity of Supply and Demand
Price elasticities are quite useful and important factors for policy design18, because the responsiveness of coal demand and supply to the price is important input to determine the effectiveness of the policy. For example, if production is very responsive, only a small increase in price may lead to strong increase in production. Such responsiveness on both demand and supply-side of the market influences the effects of the taxes, and consumption of coal globally.
One way of measuring such responsiveness of production and consumption is through demand and supply elasticities.
4.2.1 Supply elasticities
The responsiveness of quantity supplied to the price is called the price elasticity of supply. It is the percentage change in quantity divided by the percentage change in the price. We can write the elasticity of supply with respect to price as;
εs= % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑄𝑠
%𝑐ℎ𝑎𝑛𝑔𝑒 𝑃 = ∆𝑄𝑠/𝑄𝑠
∆𝑃/𝑃
The period of time influences the size of the coal supply elasticities. In the short run, (say one year) if the coal price goes up, the producers may be able to increase the production by a small amount. Since the coal mine is very capital intensive it takes around 5-7 years to open new mines. Thus, short run elasticities are quite low but in the long run producers are more adjustable to a price change. Therefore, long run elasticity is likely to be larger than short run elasticity. When the price elasticity of supply is low, then the percentage change in quantity is smaller for a given change in the price and the situation would be vice versa with higher price elasticity. Therefore, the size of the elasticity of supply is an important factor in determining the effectiveness of tax policy, especially the leakage rate19. This is illustrated in the graphs below (Figures 5 and 6).
18 Not only the price elasticity of Australian coal, it is important to know the price elasticity of all other
competitors and importers
19 Rises in emissions from non- participating countries
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Figure 5, represents the situation of a higher price elasticity of supply20. Producers are highly responsive to the price changes. In this scenario, when Australia introduces a tax on coal, it leads to greater reduction in Australia’s production and the supply to the international market.
At the same time, it also leads to higher leakage rate, meaning that increased production from other countries when Australia reduces its production would be stronger. As shown in the Figure 5, more than half of the reduced production from taxing country is compensated for by other countries (non- taxing countries). On the other hand, in Figure 6, lower price elasticity of supply leads lower reduction in Australia’s production and to a lower leakage rate, as the producers are less responsive to the price change.
By comparing both scenarios, net reduction in CO2 emissions is slightly higher in the scenario with higher price elasticity of supply, the reason being the negative shift in Australian production. Australia’s reduction is much bigger (G-G1) under higher price elasticity of supply.
At the same time, the carbon leakage rate is also much stronger, meaning that other producers also increase their production significantly. Therefore, the supply elasticity of coal is found to be is an important factor of the policy effect, with higher elasticity leading to stronger leakage effects.
20 No changes were made to the price elasticity of demand
Price
20 4.2.2 Demand elasticities
In contrast to the price elasticity of supply, price elasticity of demand is also an important factor for policy design. The responsiveness of quantity of consumption to the price is called the price elasticity of demand. It is the percentage change in quantity divided by the percentage change in the price. We can write the elasticity of demand with respect to price as;
εd= % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑄𝑑
%𝑐ℎ𝑎𝑛𝑔𝑒 𝑃 = ∆𝑄𝑑/𝑄𝑑
∆𝑃/𝑃
The price elasticity of demand of coal is less elastic or almost inelastic in the short run (Haftendorn & Holz, 2010a). Steam coal demand elasticity depends on various factors such as the power plant mix, the price of alternative fuels (natural gas or crude oil), the price of emission certificates, renewable energy prices and the total electricity demand. Thus, short run elasticity is likely to be lower than long run elasticity. The graphs below illustrate the importance of the size of the elasticity in determining the effectiveness of Australia’s tax policy (Figures 7 and 8).
In Figure 7, with higher price elasticity of demand, Australia’s tax policy leads to lower leakage rate and strong reduction in global CO2 emissions. The reason is that price increase is much lower in this scenario and the (rebound effect) increased production from other countries is relatively lower. The consumers are highly responsive to the price and, thus they react more
Price S1
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than producers when the price change in the global market. By contrast, in Figure 8, lower price elasticity of demand leads to lower reduction in global CO2 emissions due to high leakage rate.
By comparing both scenarios, net reduction in CO2 emissions is relatively higher with lower leakage rate in the scenario with higher price elasticity of demand.
4.2.3 Supply and demand elasticities
The above sections show how price elasticities a play major role in policy design. We have so far analysed each form of elasticity (supply and demand) while one of them remaining unchanged. In practice, the size of both elasticities may differ among the region or countries and even over periods. The effectiveness of Australia’s policy then depends on how all those elasticities assumed for the regions and periods play out.
By comparing the two scenarios, strong net reduction in CO2 emissions and lower leakage rate took place in the scenario which is shown in Figure 9. The figure shows that the leakage rate is lower due to the lower supply elasticity and higher demand elasticity. The coal producers from other countries are not able to increase their supply in larger amounts when Australia reduces its production. At the same time consumers are highly responsive to the price increase. Thus, they can reduce their consumption to a larger extent when the price change in the global market.
By contrast in figure 10, the leakage rate is much higher and net reduction CO2 emissions is
Price S1
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much low. Since the price elasticity of supply is higher, increase in other’s production will remain moderately high. In addition, demand elasticity is lower, and the consumers are not flexible to reduce the demand. According to Collier and Venables (2014) international coal market considers price elasticity of demand as high relative to the price elasticity of supply in the long run, closer to the scenario represented in Figure 9. Therefore, a tax on coal production may lead to greater reduction in CO2 emissions in the long run as per the theory. In the next chapter, I will construct a model and numerically apply it to examine the hypothetical tax on coal production as a supply-side climate policy option to reduce global CO2 emissions.
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