Chapter 3. Future Projects of Gas Industry

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The great evil in economics is not communism, not socialism, not capitalism, not landlords or bosses, not unions, not feudalism or industrialization or automation, not progress or lack of it, and not any scarcity of natural resources.

No, the great evil in economics is COERCIVE MONOPOLY.

Fred E. Foldvary

Introduction

This work analyses the possibilities of natural gas production as one of the most commonly used source of energy, reviews the changes in the structure of world energy, and represents forecasts for the further development of deposits and trade policies of Russia and European Union.

In the last 40 years the consumption of natural fuel resources (oil, gas and coal) increased by 2.5 times and now they compose nearly 90% of the global energy balance.

Today there are different forecasts on the development of the world energy issues, because of the considerable depletion of natural resources. Due to the limited interior of the Earth and the necessity to provide energy for international community, it is put in the forefront to find the most efficient use of all sources of energy. It should be noted that in recent years it has been done a significant technological progress in the use of both traditional and non-traditional sources of energy for heat and electricity output.

Actually, today it is obvious that natural gas is an effective kind of fuel.

Environmentally and economically it is the most convenient source of energy and excellent technological primary product in most petrochemical processes. At the same time, natural gas quota in the world energy balance is low (24%)¹ that does not meet its advantages compared with other fuels. Moreover, the growth rate of gas industry in most countries is also not so high. Exceptions are countries such as Russia, the Netherlands, Norway and some others in which the natural gas today is the main source of energy, and in which we can assume that «Petroleum Age» was replaced with

«Golden Age of Gas» or «Methane Age».

1 International Energy Agency http://www.iea.org/aboutus/faqs/gas/

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At the same time over the past half century, the total share of the three major natural energy resources (oil, coal and natural gas) has slightly changed. In spite of the policy initiatives, the economic efforts to conserve energy and the development of nuclear energy, as well as unceasing attempts in developing the alternative sources of energy, the share of oil, coal and natural gas has decreased from 94% in 1965 just till 88% at present time².

Presumably, the share of fossil fuels will decline gradually, but it will be expected a significant increase of natural gas that, according to the International Energy Agency (IEA), will take the first place among the energy resources, provided that it will become the main automobile fuel.

Today the share of natural gas consumption in the world energy is 24%, as we said before, and is slightly inferior to oil and coal. At the same time the share of natural gas in the energy balance of developed countries is about the same as the world average – about 22-23%³. In developing countries the energy balance is still dominated by traditional energy sources (coal and oil) and this share does not exceed 18%, however it is growing fast. The main factors contributing the further growth of natural gas consumption are, first of all, the increase of the number of central stations that are gas- powered, secondly, the increase of gas consumption in the residential sectors, thirdly, the evident decline of attractiveness of nuclear power in the last decade and finally the further universal decisions of environmental problems.

Financial crisis (2007-2008) has also influenced the energy sector. Oil and gas industry have felt the declining of investment, the delay of execution rates and the cancellation of projects. According to the International Energy Agency (IEA), the investment budgets of oil and gas companies in May 2009 were reduced approximately by 21% compared with the corresponding period 2008. In absolute terms, it comes almost to $ 100 billion.

According to the IEA, in the period from October 2008 to May 2009 all over the world, more than 20 large-scale oil and gas projects for exploration, production and transportation at the cost of more than $ 170 billion and the production volume of approximately 2 million barrels of oil and 1 billion m3 of gas per day have been postponed indefinitely. Another 35 projects with a production volume of 4.2 million barrels of oil and 2.3 billion m3 of gas per day were delayed up to 18 months. The

2 Energy Use in the New Millennium. Trends in IEA Countries. – International Energy Agency, 2013.

3 http://www.iea.org/aboutus/faqs/gas/

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greatest difficulties have experienced the companies with relative high cost of oil and gas extraction, as well as a sector of small and medium enterprises.

However, in some cases, the occurrence of delays in execution of investment contracts takes place because of the complexity nature of civil and legal relations of energy infrastructure rather than to the crisis, if an owner of these objects is the only one subject of economic relations – State and investor is private sector. Unhandiness of these projects of public-private partnership (PPP), high investment costs, long payback periods of financial investments, complex schemes of economical mobilization of financial resources combined with different institutional investors, different objective factors determine the case that the share of revised contracts and the difficulties of their implementation will be considerable also further.

At the same time, large and expensive energy projects are difficult not only to be launched, but also to be interrupted. The estimation of technical and economic projects requires also a lot of cash facilities. It takes a lot of time, efforts and means to develop business models and financial schemes, to establish special financing project, to attract investors. The construction lasts for years and payback period of investment for a decade. But if there is a decision to start a project, the money is invested, it has an important economic, political and strategic importance (exactly such projects are in the field of natural gas), then it is also difficult to stop a project without major economic, financial, social, political and other consequences for government, business and society.

In the light of the argument above, in this thesis we analyze the origin and the development of industrial economy considering worldwide extraction, production and refining of gas. The first chapter consists of the representation of the economic theory in natural monopoly and monopolistic competition models and in particular, the emergence of economies of scale in gas production. The second chapter is composed by the historical analysis of the development of gas industry and international export/import relationship between Russian Federation and EU using the data of Gazprom and European gas-distribution companies, with particular focus on South Stream and Southern Corridor. Russia accounts for 34%⁴ of EU natural gas imports, making it the leader supplier of natural gas to the EU. While European demand growth will likely remain weak, import dependence is going to increase due to the decline in European gas production. Europe will continue to be a significant importer for Russia, and Russia will remain a key supplier for Europe. The last chapter considers the

4 https://csis.org/publication/russia-eu-gas-relationship-partnership-necessity

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analysis, forecast and outlook of world energy market, mostly, in Russia and EU, with particular focus on the environmental problems, development and perspectives of various types of gas and the ways of its transportation.

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Chapter 1. Industrial Economic Theory

1.1. Economies of Scale and Monopoly Power

Economies of scale (EOS) are the key determinants of market structure and entrance for any company. In fact, the phrase «bigger is better», that can be found in many economics textbooks, reflects the history of economies of scale. The economies of scale facilitate a firm or an industry in identification and measurement of the horizontal boundaries that identify the quantities and the varieties of products and services that it carries out. The scope of the horizontal boundaries varies across industries, in conjunction with importance of scale economies.

In general, economies of scale⁵ are defined as «reduction in cost per unit resulting from increased production, realized through operational efficiencies».

Economies of scale allow some companies to achieve a cost advantage over their competitors. Alfred Marshall has made a distinction between internal and external economies of scale⁶. When a firm reduces costs, time for completion and increases production, internal economies of scale are achieved. External economies of scale occur outside of the firm, within an industry in form of merger and acquisition or expansion or adding more product or service in the company’s offerings.

External economies and diseconomies of scale are benefits and costs associated with expansion of a whole industry and result from external factors on which a company has a little or no control.

External economies of scale include the benefits of positive externalities received by companies as a result of the development of an industry or the whole economy. For example, as an industry develops in a particular region an infrastructure of transport of communications or pipeline transportation will develop so that all industry members can benefit from their similarity or nearness.

External diseconomies are costs that are outside the control of a single company and result from the growth of a specific industry. For example, negative externalities, such as road congestion, can result from the growth of an industry in a specific region.

5 Investopedia provide the definition on financial and economic terms. Retrieved from http://www.investopedia.com/articles/03/012703.asp

6 Alfred Marshall 1842-1924, Economic Journal, 1924

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Resources may become exhausted and the price of resources may rise as demand exceeds supply.

Let us now consider increases in scale production in the long run. A company’s efficiency is affected by its size. Large companies are often more efficient that small ones, because they can earn from economies of scale, but companies can become too large and suffer from diseconomies of scale. As a company expands its scale of operations, it is said to move into its long run. The benefits arising from expansion depend on the effect of expansion of productive efficiency that can be defined by looking at changes in average costs at each stage of production.

As already mentioned, a company can increase its scale of operation in two ways: internal and external. Internal economies of scale mean that the size of the individual firm matters, i.e. larger firm have a cost advantage over smaller firms.

External economies of scale mean that the size of the industry matters. A company that tries to expand will face increasing costs, but as the industry as a whole expands, the costs of the individual firms are lowered.

These two types of EOS have different implications for market structure:

 An industry with purely external EOS typically consists of many small companies that perfectly compete with each other.

 Internal EOS, however, because large companies have cost advantages over small companies, are characterized by an imperfectly competitive market structure. By growing, a company can expect to reduce its average costs and become more competitive.

Here there are the types of internal economy of scale:

 Technical economies are the cost savings a company makes as it grows larger, and arise from the increased use of large scale mechanical processes and machinery. For example, a mass producer of motor vehicles can benefit from technical economies because it can employ mass production techniques and benefit from specialization and a division of labor.

 Purchasing economies are gained when larger companies buy wholesale and achieve purchasing discounts. For example, a large supermarket chain can buy its fresh fruit in much greater quantities than a small fruit and vegetable supplier.

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 Administrative savings can arise when large companies spread their administrative and management costs across all their plants, departments, divisions, or subsidiaries. For example, a large multi-national can employ one set of financial accountants for all its separate businesses.

 Large companies can gain financial savings because they can usually earn money more cheaply than small firms. This is because they usually have more valuable assets which can be used as security (collateral), and are seen to be at lower risk, especially as compared with new businesses. In fact, many new businesses fail within their first few years because of cash-flow insufficiencies.

For example, for having a bank overdraft facility, a supermarket may be charged 2 or 3 % less than a small independent retailer.

 Risk bearing economies are often derived by large companies who can bear business risks more effectively than smaller companies. For example, a large record company can more easily bear the risk of a «flop» than a smaller record label.

Economic theory also predicts that a single company may become less efficient if it becomes too large. The additional costs of becoming too large are called diseconomies of scale. Here there are the examples of diseconomies:

 Larger companies often suffer poor communication because they find it difficult to maintain an effective flow of information between departments, divisions or between head office and subsidiaries. Time lags in the flow of information may also create problems in terms of the speed of response to changing market conditions. For example, a large supermarket chain may be less responsive to changing tastes and fashions than a much smaller, «local» retailer.

 Co-ordination problems also affect large companies with many departments and divisions, and may find it much harder to co-ordinate its operations than a smaller company. For example, a small manufacturer can more easily co- ordinate the activities of its small number of staff than a large manufacturer employing tens of thousands.

 «X» inefficiency is the loss of management efficiency that takes place if a company becomes large and operates in uncompetitive markets. Such losses of efficiency include over paying for resources, such as paying managers salaries higher than needed to secure their services, and excessive waste of

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resources. «X» inefficiency means that average costs are higher than would be experienced by companies in more competitive markets.

 Low motivation of workers in large companies is a potential diseconomy of scale that results in lower productivity, as measured by output per worker.

 Large companies may experience inefficiencies referred to the principal-agent problem. This problem is caused because the size and complexity of most large companies means that their owners often have to delegate decision making to appointed managers that can lead to inefficiencies. For example, the owners of a large chain of clothes retailers will have to employ managers for each store, and delegate some of the jobs to managers but they may not necessarily make decisions in the best interest of the owners. For example, a store manager may employ the most attractive sales assistant rather than the most productive one.

- 11 - 1.2. Economies of Scale and Market Structure

In this section we will present the theoretical models that better describe the market structure of energy industry that is characterized by large economies of scale more precisely in the first part we will describe Cabral’s monopolistic model. We deal with the case where one firm dominates the entire market, or almost the entire market.

A dominant firm my be classified as one that «owns» from 50% to 100% of a market and no close rival. The second part describes Krugman’s model of monopolistic competition. We consider the behavior of individual firms. This will allow us to introduce two additional characteristics of firms that are prevalent in the real world. In various sectors, firms produce goods that are differentiated from one another. In the case of certain goods, those differences across products may be small, while in others the differences are much more significant. Performance measures vary widely across firms. We will see how internal economies of scale and product differentiation combine to generate some new sources of gains of trade via economic integration.

International trade do not need to be the result of comparative advantage.

Instead, it can result from increasing returns or economies of scale, that is, from a tendency of unit costs to be lower with larger output. Economies of scale give countries an incentive to specialize and trade even in the absence of differences in resources or technology between countries. Economies of scale can be internal or external.

Economies of scale can lead to a breakdown of perfect competition, unless they take the form of external economies that occur at the level of the industry instead of the firm.

External economies give an important role to history and accident in determining the pattern of international trade. When external economies are important, a country starting with a large advantage may keep the advantage even if another country could potentially produce the same goods more cheaply. When external economies are important, countries can conceivably lose from trade.

- 12 - 1.2.1. Monopoly

The model of monopoly is based on the assumption that there is a well-defined market with one single supplier. The monopolist sets price p and consumers demand quantity 𝐷(𝑝). To sell a quantity 𝑞, the seller must set a price 𝑃(𝑞), where 𝑃(∙) is the inverse function of 𝐷(∙). By producing 𝑞, the monopolist incurs a cost 𝐶(𝑞). Then it is assumed that the seller chooses a price to maximize profits⁷.

It is the same thing to choose the optimal price or to choose the optimal output.

That is, even though the monopolist is assumed to set price and consumers choose quantity as a function of price, we can think of the monopolist as choosing the optimal quantity it let consumers to buy and then setting the corresponding price. So, we treat the monopolist decision as that of selecting an output price. Profit maximization occurs if the firm uses the optimal rule that marginal revenue equals marginal cost. It can be considered as well-known elasticity rule:

𝑝 − 𝑀𝐶

𝑝 = 1

𝜖 ,

where 𝑀𝐶 is marginal cost and 𝜖 =^𝜕𝐷

𝜕𝑝 ∙^𝑝

𝑞 is the price elasticity of demand⁸. In other words, a monopolist should set a price-cost margin that is greater the lower is the price elasticity of demand.

Figure 1 depicts the optimal price (and margin) for different demand functions.

The graph on the left shows a low-elasticity demand curve. Optimal price (and margin) is greater than for a high-elasticity demand curve (graph on the right).

7 Introduction to Industrial Organization, Luìs M.B. Cabral, 2000, MIT Press (MA), London, England.

8 We may also write the equation as 𝑝 1 −¹

𝜖 = 𝑀𝐶, it shows more clearlyv that the monopolist optimally sets a markup over marginal cost.

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Fig. 1 Demand Elasticity and Optimal Monopoly Margin

If firms are not price takers, it is necessary to develop additional tools to describe how they behave. The simplest market structure to examine is that of a pure monopoly, where a firm faces no competition. But pure monopolies are fairly rare.

Aside from utilities, one is hard pressed to find a good example of a firm that control 100% of its market. It is not uncommon, however, to find industries where one of the firm commands a market share of 50% or more, and a set of small firms divide the remainder of the market among themselves.

Figure 2 shows the position of a single, monopolistic firm. The firm faces a downward-sloping demand curve, shown in the figure as 𝐷. The downward slope of 𝐷 indicates that the firm can sell more units of output only if the price of the output falls.

A monopolistic firm chooses an output such that marginal revenue, the increase in revenue from selling an additional unit, equals marginal cost, the cost of producing ad additional unit. This profit-maximizing output is shown as 𝑄_𝑚, the price at which this output is demanded is 𝑃_𝑚. The marginal revenue curve 𝑀𝑅 lies below the demand curve 𝐷, because marginal revenue is always less than the price. The monopoly’s profits are equal to the area of the shaded rectangle, the difference between price and average cost times 𝑄_𝑀.

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Fig. 2 Profit Maximization by a Monopolist

It is well known that monopoly pricing implies allocative inefficiency. The price set by a monopolist is greater than marginal cost. The output set by a monopolist is lower than the optimal output. It means that an increase in output would increase social welfare, for the marginal willingness to pay would be greater than the marginal cost.

Competition is the way of achieving the efficiency lost in monopoly pricing.

However, if fixed costs are large (economies of scale is very significant), then the competition may not be viable alternative. An extreme situation is given by a natural monopoly. It is the case when the cost structure is such that costs are minimized with one supplier only. In these situations, direct regulation of the monopolist may be the optimal solution.

Natural monopoly is a distinct type of monopoly that may appear if there are extremely high fixed costs of distribution, and it exists if a large-scale infrastructure is required to ensure supply. Examples of infrastructure include cables and grids for electricity supply, pipelines for gas and water supply, and networks for rail and underground. These costs are also sunk costs, and they deter entry and exit.

In the case of natural monopolies, trying to increase competition by encouraging new entrants into the market creates a potential loss of efficiency. The efficiency loss to society may exist if the new entrant had to duplicate all the fixed factors, that is, the infrastructure.

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In other words, it may be more efficient to allow only one firm to supply to the market because allowing competition would mean a wasteful duplication of resources.

Natural monopolies are common in markets for «essential services» that require an expensive infrastructure to deliver the good or service, such as in the cases of water supply, electricity, and gas, and other industries known as public utilities. Because there is the potential to exploit monopoly power, governments tend to nationalize or heavily regulate them.

Here let us consider the simple case of monopoly regulation. There is a firm with a cost function:

𝐶 = 𝐹 + 𝑐𝑞 ,

where F is fixed cost and c marginal cost⁹. Without regulation, the monopolist sets price at the monopoly level, 𝑝^𝑀 (Fig.3). The social optimum would be to set price at marginal cost, monopoly price implies that output is lower than optimum and that allocative efficiency is lower than optimum by the area 𝐸. For the monopolist, it receives a variable profit 𝜋 = 𝑞^𝑀(𝑝^𝑀− 𝑐), so that net profit is given by 𝜋 − 𝐹.

A first natural solution for a regulator is to force the monopolist to set price equal to marginal cost: 𝑝^𝑅 = 𝑐, where 𝑅 stands for «regulated». In this case, output is given by 𝑞^𝑅 and maximum allocative efficiency is achieved (𝐸 = 0). One problem with marginal cost pricing is that it may imply negative profits for the firm. This is certainly the case when marginal cost is constant. It means that variable profit 𝜋 = 0 and therefore total profit is 𝐹.

9 For simplicity, we assume marginal cost to be constant.

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Fig. 3 Unregulated and Regulated Monopolies.

It is clear that a firm cannot survive if it makes losses of 𝐹. To solve this problem, the regulator might give the firm a subsidy of 𝐹. However, this would likely create additional problems. The regulator may have to raise taxes elsewhere in economy for to obtain the value 𝐹. The efficiency loss implied by these taxes, 𝐸^′, may be greater than the efficiency loss that marginal cost pricing is supposed to eliminate, 𝐸. The possibility to transfer from the regulator to the regulated firm gives the former more discretion, and opens the doors for the possibility of regulatory capture¹⁰.

Given the problems of marginal cost pricing, an interesting alternative is that of average cost pricing. Under this condition, the firm is forced to set the lowest price consistent with making non-negative profits, that is, price is equal to average cost. This situation is shown in Figure 4, where 𝑝^𝐴 = 𝐴𝐶(𝑞^𝐴) and 𝑞^𝐴 = 𝐷(𝑝^𝐴). This solution is intermediate between those of marginal cost pricing and unregulated monopolist.

10 By regulatory capture, we mean the situation whereby firms invest resources into influencing the regulator decisions, to the point that the latter reflect the objective of profit maximization more that that of welfare

maximization. In fact, if the regulator is not actually influenced, the use of resources attempting to do so is socially wasteful.

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Fig. 4 Average Cost Reduction

In the terminology of regulation theory, we say that rate-of-return¹¹ is a low- power incentive mechanism. For example, price varies in the same measure as cost, a fact that minimizes the incentives for cost reduction. At the other extreme, we have the most high-power incentive mechanism. This is the mechanism whereby price is set beforehand and does not change at all, even if cost changes. Roughky speaking, this is the essence of the price cab regulation mechanism. This mechanism provides maximum incentives for cost reduction.

11 The mechanism that in the past has mostly been used for regulating utilities is that of rate-of-return regulation. This is a mechanism whereby prices are set so as to allow the firm a fair rate of return on the capital it invests. Roughly speaking, it corresponds to average cost pricing.

- 18 - 1.2.2. Monopolistic Competition

Somehow related with the natural monopoly is the case of monopolistic competition. Considering the monopolistic competition we can say that a firm making high profits normally attracts competitors. That is why the possibility of pure monopoly is rather rare in practice. The oligopoly is the market structure that is more common to industries characterized by internal EOS. The analysis of the oligopolistic behavior is complex however because the pricing policies of the companies are interrelated. This work analyzes a special case of oligopoly, i.e. monopolistic competition. In the models of monopolistic competition, two key assumptions are made in order to get around the problem of interrelation:

 Companies can differentiate their products from that of their competitors. That means they are not perfect substitutes but only to some degree. This assumption assures that firms have some degree of monopolistic power and are somewhat insulated from competition.

 Each company takes the prices charged by its competitors as given, i.e. it ignores the impact of its own price on the prices of other companies: even though each company faces competition it behaves as if it were a monopolist.

A firm in a monopolistically competitive industry is expected:

 to sell more the larger the total sales of the industry and the higher the prices charged by its rivals.

 to sell less the larger the number of firms in the industry and the higher its own price.

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Fig. 6 Free Entry and a Downward Sloping Demand Curve

To incorporate these properties, we assume that a typical monopolistically competitive company faces a downward-sloping demand curve of the form¹²:

𝑄 = 𝑆 × 1 𝑛 − 𝑏 𝑃 − 𝑃

The terms in the demand equations are the followings:

 𝑄 is an individual firm’s sales

 𝑆 is the total sales of the industry

 𝑛 is the number of firms in the industry

 𝑏 is a constant term representing the responsiveness of a firm’s sales to its price

 𝑃 is the price charged by the firm itself

 𝑃 is the average price charged by its competitors.

In order to find the market equilibrium, we assume that all companies face identical demand and cost functions. In a symmetric equilibrium, the state of the industry can be described without going into details of each company. Everything that has to be known is the number of companies in the industry and what price a typical company would charge. Moreover, once n and 𝑃 are known, we can ask how they are affected by international trade.

12 Krugman, Paul, and Maurice Obstfeld. International Economics: Theory and Policy, 7th ed. (Boston: Pearson Addison-Wesley, 2005).

- 20 - We follow a three step approach:

 Derive the relationship between average costs and the number of firms in a market.

 Determine the relationship between the number of firms and the price charged.

 Find the equilibrium number of firms where no entry or exit occurs.

Here we analyze how the number of companies and average costs influence the monopolistic company.

The cost function of a company is given by

𝐶 = 𝐹 + 𝑐𝑄¹³

where 𝐹 is fixed costs and 𝑐 are constant marginal costs.

At the symmetric equilibrium, individual output is then given by 𝑄 = 𝑆 𝑛 . The companies’ average costs are defined as the cost per unit, and are given by

𝐴𝐶 =𝐶 𝑄 = 𝐹

𝑄+ 𝑐 =𝐹

𝑆𝑛 + 𝑐¹⁴

We can see that:

 The larger the number of firms 𝑛 in the industry, the higher the average cost for each firm because the less each firm produces.

 The larger the total sales 𝑆 of the industry, the lower the average cost for each firm because the more that each firm produces.

Considering price and marginal revenue, we show that, in order to determine the relationship between the number of firms and the price, it is useful to look at the relation between price and marginal revenue of a monopolistic competitor first. Assume that each company faces a linear demand function described by

𝑄 = 𝐴 − 𝐵 ∙ 𝑃 ⇔ 𝑃 = 𝐴 𝐵−𝑄

𝐵

13 Krugman, P. (1979) ―Increasing Returns, Monopolistic Competition, and International Trade‖, New York.

14 Krugman, P. and Obstfeld, M., Melitz M. J. (2012), International Economics – Theory and Policy, 9th Edition, Boston Pearson Addison-Wesleys, New York. (p.162)

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Total revenue (𝑇𝑅) of such a firm is given by the price times quantity sold:

𝑇𝑅 = 𝑃𝑄 = 𝐴

𝐵𝑄 −𝑄² 𝐵

The marginal revenue is the extra revenue a firm gains from selling one additional unit. It is given in this case by

𝑀𝑅 =𝜕𝑇𝑅

𝜕𝑄 = 𝐴 𝐵−2𝑄

𝐵 = 𝑃 −𝑄 𝐵

Considering the number of firms and the price, if we rearrange the parameters, we see that the gap between price and marginal revenue depends on the initial sales 𝑄 of the firm and the slope of the demand curve 𝐵:

𝑃 − 𝑀𝑅 =𝑄 𝐵

If we take the average price charged by the competitors as given, we can write our demand function as

𝑄 = 𝑆 1 𝑛 + 𝑏𝑃 − 𝑆𝑏 ∙ 𝑃

where 𝑆 1 𝑛 + 𝑏𝑃 = 𝐴 and 𝑆𝑏 = 𝐵.

The relationship between marginal revenue and price in this case is therefore

𝑀𝑅 = 𝑃 − 𝑄 𝑆𝑏

And profit-maximizing company sets marginal revenue equal to marginal cost¹⁵ is 𝑀𝑅 = 𝑀𝐶.

15 Microeconomics Krugman 3rd Edition Solutions Manual.

- 22 - By setting 𝑀𝑅 = 𝑀𝐶 we get

𝑃 − 𝑄 𝑆𝑏 = 𝑐

We have already noted that we look at an equilibrium in which every company behaves identically, i.e. all charge the same price. This implied that each company’s output is 𝑄 = 𝑆 𝑛 . Using this information, we can find that the price is given by

𝑃 = 𝑐 + 1 𝑏 ∙ 𝑛

Thus equation says algebraically that the more companies there are in an industry, the lower the price each company will charge. This is because each company’s markup over marginal cost, 𝑃 − 𝑐 = 1 (𝑏 ∙ 𝑛) , decreases with the number of competing companies.

It is shown in Figure 7 as the downward-sloping curve 𝑃𝑃.

This result is quite intuitive: the more companies 𝑛 there are in the market, the more intense the competition among them will be. Therefore, price and number of firms are inversely related.

Fig. 7 The equilibrium number of firms

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Analyzing the monopolistic competition and trade, we see that with free trade, each country’s companies can concentrate production on a smaller range of varieties and import the rest. Thereby, the total amount of varieties available to consumers is increased while cost advantages associated to EOS can be exploited. Trade increases market size which is the variable that constrains the variety that can be produced and the scale of production. «...trade improves the trade-off between scale and variety that individual nations face¹⁶.»

Fig. 8 Effects of a larger market

While the details of external economies in practice are often quite subtle and complex, it can be useful to abstract from the details and represent external economies simply by assuming that the larger the industry, the lower the industry’s costs. When there are external economies of scale, the average cost of producing a good falls as the quantity produced rises. Economies of scale need not lead to imperfect competition if they take the form of external economies, which apply at the level of the industry rather than at the level of the individual firm.

16 Krugman/Obstfeld, p.121.

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1.3. Economies of scale, imperfect competition and trade

In the late 1970s, several researchers like Krugman, Dixit and Norman and Lancaster independently shaped the idea of economies of scale and imperfect competition that they can give rise to trade even in the absence of comparative advantage¹⁷. Other developed models of intra-industry trade based on economies of scale in intermediate rather than final goods. Then Paul Krugman developed in the most clearly and forcefully way the revolutionary nature of this new approach for the theory of international trade. His paper in the «Journal of International Economics», entitled

«Increasing Returns, Monopolistic Competition and International Trade» (1979), contains not only a new trade theory that let us clarify observed patterns of intra- industry trade, but also the seeds of a new economic geography where the location of production factors and economic activity can be stringently analyzed within the framework of a general-equilibrium model. The paper is short and achieves all of this information in only ten pages, and in a very simple and transparent form. The model is very simple. There is only one production factor, and returns to scale are represented by a linear cost function with fixed costs. Due to its simplicity, the model illustrates the key mechanisms in a particularly clear way.

The central feature in Krugman’s approach is economies of scale that are internal to the firm. It means that the firm can reduce its own average cost by expanding production. At this rate, markets cannot be perfectly competitive. Models of imperfect competition had often been avoided in trade theory because of their complexity.

Krugman applied the model of monopolistic competition due to Dixit and Stiglitz that found out to be well suited for the analysis of trade¹⁸. In the same vein, he assumed that there are n different goods, and that consumers to have a taste for variety that can be expressed by the following utility function:

𝑈 = 𝑣 𝑐_𝑖

𝑛

𝑖=1

17 Chapter 9 in Dixit and Norman’s book builds on unpublished notes by Norman from 1976 and 1978.

18 Trade models with external economies of scale had earlier been developed by Matthews (1949), Kemp (1964), Melvin (1969), Negishi (1969) and Chipman (1970).

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where 𝑐_𝑖 is consumption of the 𝑖^𝑡ℎ good and where 𝑣 ∙ is an increasing, concave function. Concavity is the key property as it expresses the taste for variety. There are no price differences between goods and it implies that the consumer would spread his resources regularly across as many goods as possible rather than only consume one good. Further, we assume that 𝑣 ∙ takes a particular form:

𝑣 𝑐_𝑖 =𝑐_𝑖^𝛾

𝛾 , 0 < 𝛾 < 1 (∎)

Notwithstanding this functional form was not used in Krugman’s original paper (1979), afterwards it has been widely used because of the simple and accurate analytical solutions that it provides¹⁹.

Krugman assumes further that there is only one factor of production – labor and that all goods are produced with identical cost functions. He represents increasing returns to scale by assuming that, for any good 𝑖 produced, the labor requirement 𝑙_𝑖 is given by

𝑙_𝑖 =∝ +𝛽𝑥_𝑖, 𝛼, 𝛽 > 0

where 𝑥_𝑖 is the output of good 𝑖, and ∝ is a fixed cost. If all markets are clear and there is free entry then all monopolistically competitive firms will have zero profits in equilibrium.

The model can be solved for the three unknowns: the price of each good relative to labor, 𝑝_𝑖

(where w is the wage rate), the output of each good, 𝑥𝑤 _𝑖, and the number of goods produced, 𝑛.

Let us first consider some aspects of the monopolistic equilibrium of this economy and then introduce a two-country version of the model from the perspective of trade and geography. Consumers maximize their utility subject to their budget constraint

𝑝_𝑖𝑐_𝑖 = 𝑤.

𝑛

𝑖=1

19 In his 1979 paper, Krugman assumes instead that v is such that the elasticity of demand decreases with income, which leads to slightly different conclusions and makes the exposition somewhat more complicated.

- 26 - This leads to the first-order condition

𝑣^′(𝑐_𝑖)

𝑝_𝑖 = 𝑣^′(𝑐_𝑗) 𝑝_𝑗 = 𝜆

for any two goods 𝑖 and 𝑗, where 𝜆 denotes the shadow value of income: the consumer’s marginal rate of substitution between the goods should equal the relative price. Then we obtain the individual’s demand function for good 𝑖 as

𝑐(𝑝_𝑖) = (𝜆𝑝_𝑖)^1(𝛾−1).

Indirect utility can easily be computed and is proportional to (𝑤 𝑝 )^𝛾 where

𝑝 = ( 𝑝_𝑖

𝛾 (𝛾−1)

)

𝑖

(𝛾−1) 𝛾

is a price index across goods. Thereby we can think of (𝑤 𝑝 ) as the real wage in this economy.

Turning to the monopolistic competitor, profits are maximized by setting the price so that marginal revenue equals marginal cost. With 𝐿 consumers, the firm’s total revenue is equal to 𝑝_𝑖𝐿𝑐(𝑝_𝑖) and its total costs are 𝛼 + 𝛽𝐿𝑐 𝑝_𝑖 ∙ 𝑤. Moreover, when a monopolist chooses price, the shadow value of income, 𝜆, can be treated as unaffected by the price, since there is a large number of goods. It is easy to verify that if marginal revenue is equal to marginal cost, the monopolist chooses a constant markup, 1 𝛾 , over marginal cost:

𝑝_𝑖

(𝛽𝑤)= 1 𝛾 .

This symmetry across goods implies that the price index in equilibrium will satisfy

𝑝 =𝑛^{(𝛾−1)𝛾} ∙ 𝑤𝛽 . 𝛾

- 27 -

We see that the price index is decreasing in product variety, n, and thus that the real wage and equilibrium utility are increasing in 𝑛. In this economy, new firms will enter the market, adding product varieties, until profits equal zero. Since profits are equal to

𝑝_𝑖𝑥_𝑖 − (𝛼 + 𝛽𝑥_𝑖) ∙ 𝑤

and all goods are symmetric and produced in equal quantity; this implies that equilibrium output is given by

𝑥_𝑖 = (𝛼 𝛽 ) ∙ 𝛾

(1 − 𝛾)≡ 𝑥 .

With this expression for determining the quantity produced of each good, the variety range of goods, 𝑛, is determined by

𝐿 = (𝛼 + 𝛽𝑥 )𝑛 ,

since the L consumer-workers have to allocate their labor supply to 𝑛 different goods.

Now that all equilibrium prices and quantities have been determined, we can analyze how the size of the economy that is given by 𝐿 (the number of consumer- workers), influences the equilibrium. First, the production of each good, 𝑥 , is not affected given our assumption on the shape of the utility function, but the number of goods proportionately increases with 𝐿²⁰. Second, per-capita consumption of each good decreases since 𝑐𝐿 = 𝑥 . Third, per-consumer welfare increases with 𝐿 since, as we have seen above, real wages increase in product variety. Thus, the larger economy permits more varieties to be produced, and this is the channel through which increasing returns to scale operate here. More generally, and in Krugman’s own analysis, increasing returns to scale may also increase the production of each good, thus lowering unit cost on a good-by-good basis. We are now set to examine the possibility of trade between countries.

Assume that there are two countries that are identical in preferences, technology, and size. We can then compare two cases: «autarchy», where there is no trade due to,

20 This is due to the specific utility function (∎). Krugman’s alternative assumption about the elasticity of the 𝑣(∙) function implies that the production of each good increases as the economy enlarges.

- 28 -

for instance, prohibitive transport costs, and another where the countries can trade freely at no cost. With trade, we can regard the size of the economy as the sum of the sizes of the two countries, and we can determine world production and consumption as if there were only one (large) country. Thus, the number of goods produced is now larger; since the countries are identical, the number of goods is twice what it would be under autarchy. Each country specializes in the production of some goods, thereby exploiting the economies of scale inherent in the fixed cost production function. Precisely which goods are produced where is not determined, however. Trade will amount to half of GDP of each country²¹, and consumers will enjoy a larger number of goods than under autarchy. The opening-up of trade will therefore be welfare-enhancing, despite the fact that both countries have identical technologies and factor proportions, since it increases product variety. Under Krugman’s assumption on the utility function²², it would also lower unit costs good by good. The allocation of goods across countries is not determined in the model; it may well happen that good 𝑖 is produced in one country while good j is produced in the other country, even though goods 𝑖 and 𝑗 are very similar. In that sense, the opening-up of trade generates intra-industry trade.

In this model we see that Krugman argues that in the absence of trade, consumer welfare will be highest in the region with the largest labor force. This is so because with Dixit-Stiglitz preferences, as seen above, the real wage (𝑤 𝑝 ) depends positively on the number of products 𝑛 that is greater in the region with the largest labor force. Thus there can be a tendency for labor to migrate to the region that happens to have the largest labor force, and thereby the greatest variety of products, at the outset. This mechanism gives rise to a cumulative process, resulting in concentration and urbanization. The model thus contains an element of (potentially dramatic) demographic change.

The critical evaluation of the determinants of economies of scale with respect to gas industry helps the companies to achieve competitive advantage. The aim is to help the service providers in gaining sustainable competitive advantage by optimizing time, costs and resources as well as formulating suitable strategies by considering the critical factors of economies of scale in capacity-constrained situation.

21 In general, if the countries were of different size, trade would be smaller.

22 In his 1979 paper, Krugman assumes instead that v is such that the elasticity of demand decreases with income that leads to slightly different conclusions and makes the exposition somewhat more complicated.

- 29 -

Gas industry is capital-labour-equipment intensive. It is capital intensive due to huge amount of capital employed, equipment intensive because of the number of process and procedures involved and human capital intensive due to involvement of concerned employees.

As the Gas value chain starts from exploration and production to marketing and distribution, the economies of scale for gas industry can be discussed with respect to cost optimization, time reduction and commercial viability of the project in a given period.

- 30 - 1.4. Natural Monopoly in Gas Industry

This paragraph considers some aspects of the functioning of natural monopoly companies. Gas-distribution organizations (GDO) are enterprises that carry out the activities in transportation of natural gas (hereinafter - gas) using the distribution networks from the main pipeline to the end users, so that the consumers purchase gas only for their own use and do not purchase it for the resale.

Having the status of economically and legally independent business corporations, GDO, however are typically natural monopolies of fuel and energy industry and therefore exposes itself a strict regulation, by state regulating authorities and local authorities.

This sector discusses the features of the economic activity of gas-distribution organizations and their regulation by the State, both now and in the near future.

The increase of number of gas-distributing organizations reduces their aggregate efficiency due to increased cost per unit:

𝐶_𝑖^𝑒𝑥𝑝 = 𝑐_𝑖^𝑒𝑥𝑝 ∗ 𝑞_𝑖 ≥ 𝑐₀^𝑒𝑥𝑝 ∗ 𝑄

𝑖 𝑖

𝑞_𝑖 = 𝑄,

𝑖

𝑞^𝑖 = [0, 𝑄]

In the formulas written above 𝐶_𝑖^𝑒𝑥𝑝 are the operating costs of 𝑖^𝑡ℎ competitor in the market, 𝑐_𝑖^𝑒𝑥𝑝 are the operating costs per unit of 𝑖^𝑡ℎ competitor in the market, 𝑐₀^𝑒𝑥𝑝 are the operating costs per unit of the single participant of the market, 𝑞_𝑖 is the production volume of 𝑖^𝑡ℎ competitor, 𝑄 is total volume of sales in the market, where 𝑃 is the price of a good (service), selling in the market, 𝑄^𝑆𝐺 and 𝑃^𝑆𝐺 are market volume and price of substitute goods respectively²³.

In the extreme case a company can satisfy the market demand in gas transportation for some territory, incurring fewer costs than total costs of two or more competitors.

23 Модель Повышения Эффективности Предприятия Естественной Монополии, Морозова Н.Н. (Московский Физико-Технический Институт, Москва), Выпуск № 4 / 2003

(Model Povysheniya Effektivnosti Predpriyatiya Estestvennoy Monopolii, Morozova N.N. (Moscow Institute of Physics and Technology State University), 4^th ed. / 2003)

- 31 -

A significant decrease of production costs by increasing production volumes of natural monopoly activities as gas supply, electricity transmission, heat and water supply is caused by the complexity and a high cost of supporting infrastructure.

Demand is determined mainly by its position in the market that is weakly dependent on substitute goods markets

𝑄 = 𝑄 𝑃, 𝑄^𝑆𝐺, 𝑃^𝑆𝐺 → 𝑄 (𝑃)

GDO provide services in gas transportation, therefore, they depend on the demand for their services and on their transporting gas. In general, there are two ways for demand on the services of GDO to fall:

 another organization will start providing similar services;

 consumer will refuse from gas consumption and switch to other fuels.

It does not matter for the consumer who gives him gas, he can choose the services of a competitor organization, but only if it would cost less for him without less reliability. To make gas delivered to the consumer, a system of pipes from the main pipeline to the consumer is required. Existing gas-distributing networks and their equipment are the property of GDO. Thus, an organization that wishes to provide services of the gas transportation from the main pipeline to the consumer must create its own infrastructure or negotiate with GDO for using its gas distribution networks and set the level of payment for gas transportation services lower than GDO or equal than prices. The creation and the maintenance of gas-distributing infrastructure, as mentioned above, is costly. Competition among GDOs in providing services nowadays is not favorable in the most cases, because such organizations have mostly great market power.

Here we consider the terms of a possible transition to a different type of fuel.

It should be noted that this situation could become a reality just in few years, when energy prices will be competitive. For example, now gas in Russia is significantly cheaper than other energy utilities.

It is advantageous for a consumer to replace fuel only if the result of such a transition decreases its fuel costs. The considered variant can be not to reduce the costs immediately, but over time, with conditions that such a transition is compensated within a reasonable period for the consumer; for example, in the present conditions of the

- 32 -

Russian economy due to its instability during the current period, usually it does not exceed five years. The admissibility condition of the transition is represented by

𝑃_𝑘^𝑌 (1 + 𝑟)^𝑘

𝑛

𝑘=1

> 𝑃_𝑘^𝐹𝐶 (1 + 𝑟)^𝑘

𝑛

𝑘=1

+ 𝐶^𝑖𝑛𝑣

where 𝑃_𝑘^𝑌 is retail price for gas in k^th period of time (period division is usually carried out by years), 𝑃_𝑘^𝐹𝐶 is retail price for fuel, alternative for gas, in k^th period of time, r is discounting interest, 𝐶^𝑖𝑛𝑣 is investment outlay concerned with changing of fuel, for example, technical re-equipment costs.

Additional investment costs may be concerned with the necessity to organize the infrastructure of delivering the fuel from supplier to consumer, but also with the necessity in technical re-equipment of consumer. Technical re-equipment does not mean only the complexity from the economic point of view, but it could become an insuperable barrier of the changing the fuel in general. Since the carrying out of such re- equipment leads to partial or complete shutdown of the facilities, that is inadmissible in some cases.

Gas prices, more precisely the costs of payment for gas in the consumer budget, affect the consumption volume and the level of non-payment for gas. With such gas prices, where its costs are a small share of all consumer costs, the consumer may use fuel inefficiently and thus obtain gas volumes exceeding its needs. If the price level is close to financial constraints, first of all, the consumer can reduce the gas consumption till the level that is below its needs, and then can start to pay partially for the consumed gas.

In the financial constraint for industrial consumers there is accepted the level of fuel consumption so that, as a result, the economic activity is not considered by a gas company-consumer as satisfactory. In this case, the technology should be changed or the production would be stopped, the last one means the termination of gas consumption.

Their paying capacity is the financial constraint of the facilities of community and population. For to reach the limit of paying capacity, first, the consumers reduce consumption volumes, and then gradually cease the payment for consumed gas. Starting

- 33 -

to sell gas with certain prices and increasing it leads only to an increasing of default in payment.

Since GDO carries out monopolistic activities in a field that is important to national security and life support of inhabitants, the State law restricts freedom in operating of GDO and at the same time reserves the possibility of control and, in a manner, administration. Public administration is carried out by regulation of GDO in following problems: price setting, property administration, licensing, and security of gas supply, taxation and industry regulation.

Price regulation is made in two stages: on the first stage there is the statement of the principles of reward calculating for GDO services, the second stage is direct calculation and confirmation of reward values.

By the economically justified level of the gas prices it is implied the value that is equal to the sum of the wholesale price on gas that is the price at the border of the gas pipeline and the distribution network, and the rate of its transportation from the main pipeline to the consumer.

GDO is in the technological chain between «Gazprom JSC», the company that carries out the extraction and transportation of gas through the pipelines till the border with the gas distribution network and the end user; given their position GDOs more stare price regulation.

A tariff on GDO services for gas transportation to consumers, according to the current date procedure is formed using hang-the-expense approach. In other words, the calculated tariff is based on the principle of compensation of justified production costs incurred and obtain a reasonable profit.

A GDO profit is determined by the tariff and it does not increase by decreasing operating costs. Thus, process optimization and cost reduction do not improve the GDO economic situation and do not stimulate the improvement of economic indexes. Profit margin changes-over from the sphere of economic activity to the sphere of negotiations between the FEC²⁴ and the GDO on conditions that all payments from both the GDO and its counteragents will be implemented.

Necessary profit for economic activities, besides the need of the profit, includes the means for the payment of such taxes as income tax and property tax, dividend payment and interest on long-term loans, the means for investment. Obviously, the

24 Federal Energy Commission

- 34 -

value of all these items, perhaps excepting the means to pay taxes, can be widely varied, and therefore they are the subject to continuous discussions between GDO and FEC.

However, according to practical experience, the profit margin that is necessary for the economic activities of GDO is correlated with the extent of cash flow. In some cases, GDO, giving the data in FEC for the calculation of tariffs, determine the need of profit as a percentage, usually 3-5% of the GDO operating costs. Thus, the profits that are received by an enterprise become a function of operating costs that increases proportionally to the costs:

𝐸𝑃 = 𝜓 𝐶_𝑖^𝑒𝑥𝑝 → 𝑚𝑎𝑥, 𝑤ℎ𝑒𝑛 𝐶_𝑖^𝑒𝑥𝑝 → 𝑚𝑎𝑥

Some countries that faced the problem of regulation of natural monopolies developed and adopted different models of regulation, for example the rate of return regulation, RPI-X regulation²⁵ and competition for the market.

The method of regulation of the economic efficiency is based on the idea of compensation for the company that carries out the monopolistic activity of all costs and ensuring a level of profit that is not lower than the profit of companies of other industries that have the same level of risk. A similar idea is the basis of the principles of natural monopolies regulation of energy used, for example, in Russia.

According to this method, the service revenues are:

𝑅 = 𝐶 + 𝐾𝑟

where K is capital and r is return on equity.

RPI-X regulating method is directed for motivating the effective increase of a company. Within this model, the rates are fixed for a certain period of time, usually it is five years, the profit that is achieved due to effectiveness increase in this period remains in the company. After this time the rates are revised considering the rising of consumer price index and annual tariff reduction due to costs reduction. The revenue for the next accounting period:

𝑅₁ = 𝑅₀(𝑅𝑃𝐼 − 𝑋),

25 Price cap regulation is sometimes called "CPI - X", (in the United Kingdom "RPI-X") after the basic formula employed to set price caps.

- 35 -

where 𝑅₁ is revenue in the next accounting period, 𝑅₀ is revenue in the reference period RPI is consumer price index, X is correcting factor.

The idea of competition for a market is similar to the idea of holding a competition of performers. The right to do business activity is given to the competitor that had offered the best ratio price / quality. The model allows the use of market-based methods of price regulation in the sphere of natural monopolies.

Essential condition of holding such competitions is federal or public property of fixed assets of a natural monopoly company.

For to implement the motivation to costs reduction in the context of a state price regulation model in a company, we follow an abstract model of an «exemplary»

company, comparing the costs of a company with the cost of the an «exemplary»

company and giving award or penalty for a company for positive and negative deviations of financial results and costs different from the «exemplary». As the costs of

«exemplary» company there can be chosen the industry average costs as it is shown:

𝐶_𝑘^𝑒𝑥 = 1 𝑁

𝐶_𝑘𝑖 𝛼_𝑘𝑖

𝑁

𝑖=1

where 𝐶_𝑘^𝑒𝑥 is the «exemplary» measure of the cost share, 𝐶_𝑘𝑖 is the measure of the cost share of i^th GDO, ∝_𝑘𝑖 is the accounting coefficient and functioning features of a company of i^th GDO by the cost share (with k^th units).

Giving an award or a penalty for the company, it is expedient to focus not on the level of each cost share but on the total costs volume with respect to the «exemplary»

company:

𝐴 = 𝛽₁∆𝐶_𝑖, ∆𝐶_𝑖 ≥ 0 𝛽₂∆𝐶_𝑖, ∆𝐶_𝑖 < 0

where 𝛽₁, 𝛽₂ ∈ 0,1 are fixed coefficients, A is award if A > 0 and otherwise it is penalty, ΔC_i is the difference between total costs of «exemplary» company and i^th company.

Comparing a company with the «exemplary» company it should be carried out the correction in scale of activity and functioning features.

- 36 -

A very important index for cost items of the maintenance of gas emergency service (GES), network maintenance and repairing of pipelines is the length of networks.

∝_𝐺𝐸𝑆=∝_{𝑛𝑒𝑡𝑤𝑜𝑟𝑘} = 𝑓(𝐿^{𝑚𝑒𝑛𝑡})

where ∝_𝐺𝐸𝑆 is accounting factor of functional features of GES of given GDO, ∝_{𝑛𝑒𝑡𝑤𝑜𝑟𝑘} is accounting factor of features for maintenance and repair of the gas distribution networks of given GDO, 𝐿^{𝑚𝑒𝑛𝑡} is network length of GDO that is mentioned by taking into account the network heterogeneity.

Accounting of the network heterogeneity consists of the complexity of calculation of the network maintenance that depends on gas pressure (high, medium or low), state, position (in or outside the settlements), and the way of pipelines construction (underground or overground).

The last points of the model are general production costs and general administrative (or overhead) costs. The most important index for general production cost items and general administrative (or overhead) cost items is the total number of employees that depends, in turn, on network length and equipment on GDO balance:

∝_𝐺𝑃𝐶= ∝_𝐺𝐴𝐶= 𝑓 𝑁_𝑡 = 𝜑(𝐿^{𝑚𝑒𝑛𝑡}, 𝑁_{𝑖𝑛𝑠𝑡𝑟}^{𝑚𝑒𝑛𝑡})

where ∝_𝐺𝑃𝐶, ∝_𝐺𝐴𝐶 are accounting factors of features of general production costs and general administrative (or overhead) costs, 𝑁_𝑡 is the number of employees, 𝑁_{𝑖𝑛𝑠𝑡𝑟}^{𝑚𝑒𝑛𝑡} is total number of home gas equipment instrument on GDO balance.