Many people may think that engineering and economics are two very different fields, and there is some truth to that statement; however, to succeed in either field, it is necessary that the two fields eventually interact.
The Electricity Market
One example of the merging of these two fields is the electricity market, the market in which electricity for countries is bought and sold, an integral part of keeping any infrastructure running.
As previously mentioned in the introduction piece, I recently took a class on this specific market, and I think it is important to share this information so that others can know how this market functions and the hard work that is done to keep the country, and really the whole world, running.
To understand the electricity market, a quick lesson on basic economics is necessary. Before introducing any ideas, it is important to know one term: ceteris paribus. This is a Latin term that translates to “in theory,” or, more importantly, “when all things are equal.” This term will be used throughout this whole series to indicate when a term is being tested while every other factor of economics is equal. This is used because all study of economics is theoretical. Just remember, when Ceteris Paribus is used, it means when all things are equal, or in theory, whichever makes more sense in the sentence.
The Study of Economics
Economics is the study of scarcity. Scarcity is the belief that everything in life is limited. For example, there is not an infinite amount of trees on the planet, an infinite amount of food, or an infinite amount of drinkable water, but rather a finite and scarce amount. In business, for example, if a firm were to supply/create 10 cupcakes, only 10 cupcakes would be available to buy, no more. This belief that there is a limited amount of resources on the planet, in relation to supply and demand, is what promotes economic growth.
Every choice made in the world of business will almost always have a trade-off; this is known as opportunity cost. Opportunity cost is defined as the value of the next-best alternative that was given up. Going back to the cupcake example, if the company had the resources to make 10 cupcakes or 10 cookies, and the company chose to make the 10 cupcakes, their opportunity cost would be 10 cookies. Another example would be the choice of going to college or getting a job after high school. If the choice was college, the opportunity cost would be the money that could have been gained while working, and the career within that field. If the choice made was a job, the opportunity cost would be the knowledge gained at school and a future salary that could be higher.
Markets help people and society make these choices. Markets are systems where buyers and sellers interact, helping society determine what and how much gets produced, and who receives the good/service. The prices found on the market help to communicate information about scarcity, and this information is derived from the relationship between supply and demand.
The law of demand is that, ceteris parabus, if the price of a good/service increases, the demand will decrease; if the price decreases, demand will increase. Therefore, the law of demand just tells us that price and demand share an inverse relationship.
For future reference, demand, consumer value, marginal benefit (mb), and willingness to buy/pay are synonymous concepts.
Willingness to pay is the highest amount the consumer is willing to pay for a good/service, or the value a consumer sets on a good/service.
The law of supply is that, ceteris paribus, if the price of a good or service goes up, a company will supply more of that good or service; if the price goes down, the supply will go down; therefore, the relationship between price and supply is a positive relationship. Again, for future reference, I may say marginal cost (MC) or cost of production; it is a synonymous term to supply.
Marginal cost is the cost to make one more unit of a good/service.
Market equilibrium is when quantity demanded is equal to quantity supplied. Another way of thinking about this is that market equilibrium is reached when the buyer's willingness to pay is equal to the cost of production. When this happens, and it rarely does, the market clears at the equilibrium price, and both sides, sellers and buyers, can be happy.
As I said before, markets help us determine the scarcity of a good/service. If the price of the good/service is lower than the equilibrium price, there is a shortage of that good or service. This lower price, in comparison to a high consumer value, increases the quantity demanded. A shortage means that the quantity supplied is lower than the quantity demanded. The low price is caused by the fact that the firm is either losing money or not making much; therefore, there is no point in producing that much of the product. This imbalance between demand and supply means that not all buyers can be satisfied, as there is not enough supply to meet the demand. A surplus occurs when the price of a good/service becomes high; then a firm will want to produce more of its product, exponentially increasing supply, while demand stays the same. This causes an imbalance between supply and demand, with a higher quantity being supplied than quantity demanded.
Electricity Grid
That was a lot, but we can finally move on to the electricity grid now. To begin, it is important to know that it is the responsibility of whoever is in control of the trade of electricity to maintain as close to an equilibrium between the supply and demand of energy as possible. We will learn who controls the trade in the next part of the series.
The goal of this market is really to balance reliability and efficiency of energy distribution. If this balance isn’t met, specifically the balance of supply and demand, severe consequences may follow. The real problems really arise when there is a shortage. If there is excess demand, demand needs to be reduced.
Before I continue, you need to know a couple more terms. When multiple companies are selling the same product, product differentiation occurs; this is when one company will, in some way, make its product different and better to buy than its competitor's. However, in certain cases, especially for the electricity market, the good or service can not be different. In this case, there is no “better” electricity; it’s all the same. These are called homogeneous goods. Therefore, the only way to create product differentiation between homogeneous goods is to lower the price of the product to the cost of production.
A market of a homogeneous good with multiple competitors is called a perfect market.
Going back to the excess of demand now. Usually in a normal market, increasing the price of a product can reduce demand. However, there are two reasons why that method is not probable in this market.
The first reason is the speed of it. This method would take a long period of time to reduce the excess demand, and as I said before, it is the responsibility of whoever controls this market to make sure demand meets supply equally and vice versa.
The second reason is how inelastic this market is. What this means is that when people go out to buy eggs, they can see the prices, and the previous method of increasing prices to decrease demand may work. However, the pricing of electricity changes so quickly that demand response is limited, the only exception being the use of a smart thermometer that changes energy consumption according to electricity prices, and the fact that electricity is seen as a necessary commodity. All of these factors make people want to buy the product, no matter the price. This is what inelastic demand is: demand that is not affected whatsoever by the price of a good/service.
So what is done to reduce demand? That’s a reasonable question, and the answer to that is what is known as “rolling blackouts.” This is a gradual blackout for a short time (ie., 30 mins), between neighborhoods that are determined that energy is not necessary, compared to a facility like a hospital where it is necessary.
Now, if supply exceeds demand, there isn’t much of a consequence; supply will just be reduced by shutting down sources of power from most expensive to least. And you may be wondering why we don’t just store it in batteries. Well, we do, but it’s much less effective than you think. It is a really difficult thing to store electricity, and batteries can store energy, but it's not perfect; energy is lost when it is put into the battery and when it is stored. In general, any modern way of storing energy will not be perfect.
Different ways of storing energy include potential energy/thermal energy, which can later be converted to electricity for later use. So, to summarize, electricity must be consumed and produced at the same time for the market to succeed.