Analyzing Energy Demand

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 Main Points
◼ Energy Demand.
◼ Diff. between energy demand and energy
consumption.
◼ Reasons for energy demand.
◼ Consumer Demand for energy: Utility
Maximization Problem.
◼ Cost Minimization: Problem of the Producer.
◼ Three common indicators in analyzing
change in demand.
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 Energy Demand
◼ Prior to the first oil shock, the energy sector had a
supply-oriented focus where the objective was to
meet a given exogenous energy demand by
expanding the supply.
◼ But since early 1970s, energy caught the attention of
policymakers because of sudden price increases and
thus energy demand became an important issue that
needs certain economic models to help in analyzing
and forecasting energy demand.

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 Energy demand
◼ It refers to any kind of energy used to satisfy
individual energy needs for cooking, heating,
travelling, producing….. etc.,
◼ Where energy products are used as fuel and
therefore generate demand for energy
purposes.

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 Diff. between energy demand and
energy consumption
Energy demand Energy consumption
◼ It describes a relationship ◼ It takes place once the
between price (or income or decision is made to purchase
some such economic variable) and consume (i.e. it is an ex
and quantity of energy. post concept). It refers to the
manifestation of satisfied
◼ It exists before the
demand and can be
purchasing decision is made measured.
(i.e. it is an ex ante concept—
◼ But energy demand and
once a good is purchased,
energy consumption can be
consumption starts). used interchangeably.

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 Economic Foundations of Energy
Demand
◼ The principle for estimating and analyzing the
demand for energy is not different from that for
any other commodity.
◼ But there are characteristics of energy demand,
institutional features of energy markets, and
problems of measurement that require particular
attention in analyzing energy markets.
◼ But the microeconomic foundation of energy
demand is same as for other commodities.

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 Reasons for energy demand
1) Households consume to satisfy certain needs, and they do so
by allocating their income among various competing needs so
as to obtain the greatest degree of satisfaction from total
expenditure.
2) Industries and commercial users demand energy as an input
of production and their objective is to minimize the total cost
of production.

➢ Therefore, the motivation is not same for the households and the
productive users of energy and any analysis of energy demand
should treat these categories separately (Consumer demand for
energy & Producer demand for energy)

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 Consumer Demand for energy:
Utility Maximization Problem

◼ The microeconomic basis for consumer energy

demand relies on consumers’ utility maximization
principles. Such an analysis assumes that :
➢ Consumers know their preference sets and
ordering of the preferences.
➢ Preference ordering can be represented by some
utility function .
➢ The consumer is rational in that he/she will
always choose a most preferred bundle from the
set of feasible alternatives.
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 Just To Remember
➢ Indifference curve:
It shows the various combinations of two goods that give
the consumer equal utility or satisfaction. A higher
indifference curve refers to a higher level of satisfaction,
and a lower indifference curve refers to less satisfaction.

➢ Budget Constraint:
It is the limitation on the amount of goods that a consumer
can purchase imposed by his or her limited income and the
prices of the goods.

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 How to Determine the optimal demand of
energy from consumer point of view?

◼ Consider you have 100 L.E to be allocated

between energy E and another good X. If
one unit of energy costs 5 L.E and one unit
of X costs 20 L.E
If the utility function is 𝑼 = 𝑿𝟎.𝟓 𝑬𝟎.𝟓 ,

Then detect the optimal level of E & X?

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 Steps:
1. You have to construct Budget constraint.
2. Get MRS ( slope of Indifference curve)
which is equal to

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 𝑃𝑥
3. Get slope of Budget constraint,-
𝑃𝑦

4. Equate the two slopes and solve.

( here at this point, the budget line is tangent

to the indifference curve)

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Utility Maximization

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 What if the price changes?

◼ If the Price of energy Doubles, will

this affect the optimal demand for
energy and for the other
commodity?

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 Energy Demand Curve for
individual

◼ The individual’s energy demand schedule can

be drawn using these optimal points
detected.

◼ As It is noticed as P increases Optimal

Quantity demanded for energy decreases.

◼ Therefore, Energy D-C is downward slope.

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 Just to Remember
◼ Isoquant:
It is the locus of all technically efficient
combination of inputs which yield a given amount
of output.
◼ Cost line:
It shows the different combinations of two inputs
( say capital & energy) that a firm can buy given
the total expenditure and the prices of the factors
of production.

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 Cost Minimization Problem of the
Producer
◼ In case of producers, the theory of the producers
is used to determine the demand for factors of
production.
◼ Based upon the theory of the producer, the
producer would try to find the combinations of
inputs that would minimize the cost of production.
◼ How can this be achieved mathematically?
◼ When the slope of Isoquant (Marginal rate of
technical substitution MRTS) equals slope of cost
line.
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 Problem
◼ Consider a firm has the following production
function
1 2
𝑄= 𝐾 3𝐸3
It will produce 80 units of output and faces prices
for capital and energy as follows: Pk=15, Pe =10.
Find the cost-minimizing bundle of capital and
energy.
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 Three common indicators in
analyzing change in demand

1) Growth Rates

2) Demand Elasticity

3) Energy Intensity

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Why energy indicators useful?
◼ Link energy use to relevant activity
measures like GDP and Production
Value.
◼ Energy indicators are a helpful tool for
policymaker, and can also be used to
predict future development in energy
use.

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 1. Growth Rates
i. Year-on-year growth rate: It is calculated
year after year to get historical series.
𝑎 = (𝐸𝑡+1 − 𝐸𝑡 )/𝐸𝑡
Where,
𝒂 = annual growth in demand,
𝑬𝒕+𝟏 = energy demand in year t+1
1

𝑬𝒕 = energy demand in year t

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 Growth Rates
ii. Annual Average growth rate over a period: It provides
a picture for the entire period .

𝟏
𝒂𝒈 = (𝑬𝒕𝟏 Τ𝑬𝒕𝟎 ) 𝒕𝟏−𝒕𝟎 -1
Where,

𝒂𝒈 : annual growth rate over a period.

𝑬𝒕𝟏 : energy demand in period t1 ( Ending period)

𝑬𝒕𝟎 : energy demand in period t0 ( Beginning period)

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 Example
◼ According to BP Statistical Review of World Energy,
the world primary energy consumption was 9,262.6
Mtoe in 2000. The demand increased to 11,104.4 Mtoe
in 2007 and 11,294.9 Mtoe in 2008. Calculate

i. The growth rate of demand between 2007 and 2008.

ii. The annual average growth rate between 2000 and

2008.
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 2. Demand Elasticities
◼ Elasticities measure how much (in percent) the demand
would change if the determining variable changes by 1%.

(∆𝑬𝑪𝒕 Τ𝑬𝑪𝒕 )
𝒆𝒕 =
(∆𝑰𝒕 Τ𝑰𝒕 )
Where,
EC: energy consumption
𝐈 : driving variable of energy consumption as GDP,
price, income…..etc
∆: change in the variable.
t: a given period
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 Demand Elasticities
◼ In any economic analysis, major variables are considered for
elasticities: output or economic activity (GDP), price and
income.
◼ Output or GDP elasticities of energy demand indicate the rate of
change of energy demand for every 1% change in economic output
(GDP or value added).
◼ Normally the GDP growth is positively related to energy demand but
the value of elasticity varies depending on the stage of development
of an economy.
◼ It is normally believed that the developed countries tend to have an
inelastic demand with respect to income (i.e. the elasticity less than 1)
while developing countries have an elastic energy demand with
respect to income.
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 Price Elasticities
◼ Price elasticities indicate how much demand
changes for every percent change in the
energy price.

◼ Price elasticities are negative numbers,

indicating that an increase in price results in a
decrease in energy demand.

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 Price Elasticities
◼ A distinction is normally made between short-term and
long-term price elasticities.
➢ The short-term price elasticity captures the instantaneous
reaction to price changes.
In the short run, consumers do not have the possibility to
change their capital stock and can only change their
consumption behavior and hence only a partial reaction is
normally felt.
➢ The long-term price elasticity would capture the effect of
adjustments over a longer period.
consumers have the possibility of adjusting their capital
stock as well as their consumption behavior.

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 Example
◼ The primary energy consumption in China
increased from 1,970 Mtoe in 2004 to 2,225
Mtoe in 2005. The GDP increased from 14,197
Billion Yuan in 2004 to 15,603 Billion Yuan in
2005 at constant 2,000 prices. What was the
GDP elasticity of energy demand in China?
Interpret. 28
 Energy Intensities
◼Energy intensities (also called energy output ratios)
measure the energy requirement per unit of a driving
economic variable (e.g. GDP, value added, etc.).
𝑬𝒕
𝑬𝑰𝒕 =
𝑰𝒕
Where,
𝑬𝑰: energy intensity for year t

𝑬𝒕 : energy consumption in year t

It: value of the driving variable (GDP, value added…)

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Energy Intensity
Driving Economic variables
Sector Driving economic variable

Whole country GDP

Industry Value added

Agriculture Value added

Commercial Value added

Transport GDP

Households GDP or private consumption

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 Reason
◼ The major reason for the development of this
national system of indicators of energy intensity
is to provide an understandable, readily
available, and transparent measure of the
performance of the economy with regard to its
use of energy.
◼ To update this system of indicators on a periodic
basis and make the data readily available to the
public and to analysts.

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EI
◼ A low energy intensity is desirable—as it indicates an
effective energy infrastructure.
◼ For example, large scale power plants tend to be
more efficient than small generating stations.
◼ Governments often aim to improve energy intensity
by targeting energy efficiency (replacing traditional
light bulbs with LED light bulbs).
◼ Improving EI is important as it encourages more
economic activity and GDP growth so that a country
can prosper, but not rely on increased energy
consumption to create this growth.

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 Trends
◼ Generally, EI gets worse during the early stages of industrialization as
economic advancement uses less effective equipment.
◼ After this rapid industrialization, the EI gets better as technology and
infrastructure improve (having paved roads).
◼ Once this is put into place, maintaining these assets is much cheaper
than putting them up in the first place.
◼ Other ways of lowering EI include advancing methods of extraction of
raw materials and increasing the efficiency with which production
materials can be obtained.
◼ Recycling aluminum can dramatically improve EI because so much
energy goes in to making aluminum in the first place.
◼ The countries with the best energy intensities are Switzerland and
Japan, meaning that they use the least energy to produce a unit of their
GDP.

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Drawbacks of using EI
◼ Related to GDP
◼ Related to energy consumption

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 The problems related to GDP as a
measure of output
1. The measure may be understated
By the existence of an underground or informal economy,
whose transactions may not be captured by national
statistics.
This is particularly true of developing countries where
many transactions do not get reported in market statistics
as they do not enter the market system.

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 The problems related to GDP as a
measure of output
2. GDP will be understated or overstated in the
foreign currency
◼ For international comparisons, conversion of the GDP to a common unit is
required. The use of foreign exchange rates is the obvious approach.
◼ Commonly, exchange rate is used to convert local currency GDP to US$.
This faces a problem:
◼ Currency values fluctuate but fluctuations in the exchange rate of a
particular currency may not necessarily be related to real changes
occurring in the domestic economy.
◼ Depending on the case, the GDP will be understated or overstated in the
foreign currency and would lead to distorted intensity.

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The problems related to GDP as a
measure of output
◼ For these reasons, various international
organizations (World Bank, for example) use
another measurement of GDP calculated by
converting the national currencies into US dollars
with ‘‘Purchasing Power Parities (PPP)’’.
◼ The PPP Values are based on a comparison of the
purchasing power of a typical ‘‘basket’’ of goods
and services, characteristic of each country’s
consumption pattern.

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 Problems related to measurement of
energy consumption
• Use of traditional energies in developing countries,
Data for which is often not accurate and not included in
analysis.
Exclusion of traditional energies can understate energy
consumption and accordingly, energy intensity significantly.

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