Resources and Energy 8 (1986) 185497.

North-Holland

FUEL CONSERVATION UNDER RATIONAL EXPECTATIONS OF THE ENERGY PRICE EVOLUTION F. WIRL*
University of lkhnology.
Vienna. Austria

Received November 1984 final version received November 1985

It is supposed, that a consumer demands a service rather than a commodity. This service can be generated from a durabk and nondurable good, e.g. thermal comfort is the product of two at least partially substitutable factors: fuel and capital (insulation. heating system). Now, the choice of an eflicient fuel conservation programme requires that the consumers integrate the counteractions of the energy producers. This leads formally to a (differential) game situation, where it will be shown that the expansion of capita) stock based on a myopic analysis may lead to a too large investment in fuel conservation.

1. Introduction

This paper picks up a particular aspect of energy conservation, namely anticipating the future energy price from the profitability of individual conservation investments and deciding then on the allocation of an adequate budget. This interdependence is often neglected by analysts, who depart, usually, from increasing fuel prices to prove that fuel conservation is highly profitable and will cut fuel demand substantially. However, this way of reasoning neglects that the market price for fuels depends on the actual demand pressure, and a shift in the demand curve - due to the aggregate of individual profitability considerations of the above type - may imply prices different from the ones assessed at the beginning of the investment venture. Since energy conservation seems to be an important target for policy makers in the industrialized world, the following critical remarks contain also a political dimension. To address the interactions between consumers and producer(s) a differential game situation is modelled. Actually, since the analysis is purely theoretical, the underlying model may cover also situations other than the one indicated in the title. The integration of rational consumer demand over time derived from optimizing relation seems to be lacking in many articles *I am grateful
referee. for valuable comments from P. Jansen. E. Dockner and from the anonymous

0165-0572/86/S3.50

1986. Elsevier Science Publishers B.V. (North-Holland)

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F. Wirl, Fd

cammmtbn

concerned with the marketing strategy for a producer. Some attempts to rationalize dynamic demand behaviour focussed on the adjustment costs and/or price uncertainty model - among others, McLaren (1979) - which has aIso been used in Wirl (1985) to investigate conditions for either stable or volatile commodity prices. The basic idea for the following analysis is that consumers enjoy some utility from a service rather than from particular commodities. In many cases such a service is the product from a combination of durable and non-durable commodities, e.g., a car plus gasoline provide mobility, a house, its insulation conditions and fuel deliver thermal cosiness and so on. In many cases these input factors are substitutable among each other, e.g., more capital can reduce fuel requirements for the same degree of service and vice versa. This paper concentrates on the intertemporal interdependence between the demand for a non-durable good, called fuel, and its supply, while most investigations in this field concentrate on either demand or supply. The literature on energy demand is extensive, e.g., Pindyck (1979), Nordhaus (1977), the survey by EMF4 (1981), Abodunde et al. (1985), Clements (1985) and assumes exogenous fuel prices. The investigations of supply, in particular the investigations of optimal resource extraction policies, suppose (a time invariant) demand, e.g., the original development by Hotelling (1931) Dasgupta and Heal (1974, 1979) Kemp and Long (1980). Stiglitz and Dasgupta (1982), Tolley and Wilman ( 1984). Similarly to the literature on exhaustible resources, this paper applies modern optimal control theory (Pontriyagins maximum principle) to investigate intertemporal market equilibria; see one of the standard textbooks on this subject, e.g.. Arrow and Kurz (1970), Kamien and Schwartz (1981) and Schti and Thompson (1981) are treatises of economic problems; Bryson and Ho (1975) and Sage and White (1977) apply control theory to engineering examples.

2. Consumers demand Suppose a large number of individual, similar (competitive) consumers and the demand for fuel at time t, denoted by 4. given by the relation

where k denotes the capital stock and p(t) the current price of fuel. Eq. (1) can be motivated from the competition among the different services. Another way to view this relation is to consider it as a generalization of a consumers problem to find the tradeoff between instantaneous utility (p) from comfort (C) and the costs of fuel consumption 4 associated

F. Wid, Fuel wnsermtion

187

withCandS

which yields the static relation (1). It is assumed that f is sufficiently smooth, i.e., at least twice continuously differentiable and that capital can replace to a certain extent the needs of fuel: X-CO. Examples of such substitutions are numerous, e.g., a better insulation will reduce the demand for fuel. Obviously, higher fuel prices will imply an immediate cutback in fuel purchases (reducing also the service level): J,<O, and hence this may be called the short-run effect. The specification of the second derivatives of the demand relation (1) reflects diminishing returns for capital: fuhO and increased price sensitivity, associated with higher capital stock: &SO. Regarding the sign of fPP no explicit assumption is introduced, but for a monopolistic energy market it is implicitly required that the producers profit function is concave in p at all times. Assumption 2. Suppose, that the demand of a (typical) consumer satisfies relation (l), whereby / is twice continuously differentiable with negative first derivatives and & 2 0, fpll I; 0. With respect to gross investment u(t), the consumer faces costs A(u(t)), where clearly no investment means no expenses, A(O)=O, and larger conservation programmes are associated with higher costs, A>O. Regarding the second derivatives of the cost function, three different structures are considered: A>0 A(u) = u A<0 increasing marginal costs, constant marginal costs, decreasing marginal costs.

The consumers natural aim is to minimize the present value of the overall expenses. It is herewith assumed that the stock k(t) depreciates at a constant rate S(t), 620, and that no resale market exists for already utilized capital equipment (irreversibility), i.e., A(u) would equal zero for negative u. Hence, due to relation (1). u(r) will be non-negative all the time, because scrapping, for no return, already installed and still fuel reducing equipment is clearly suboptimal. This assumption of irreversibility is not restrictive, but seems
The assumption of a constant rate of capital depreciation is chosen for convenience. but not essential to the arguments developed in the paper. For example. the supposition of a tixed lifetime for each investment would introduce delayed responses into the differential equation (3) and thereby complicate the derivations.

188

F. Wid, Fuel co-n

actually realistic for the example of energy conservation. One reason is that existing equipments cannot be demounted in many instances, e.g., insulation, but simply rotten over time. In mathematical terms, each consumer tries to solve the following optimal control problem in order to implement an efficient, i.e., minimal cost programme:

mine-"(dWWh 3 W 0
R=u(t)-dk(r),

p(t))+ A(W) dt, 40) =ko,

(2)
(3)

where r >O denotes the discount rate and the fuel price (p(t)} is exogenously given for each particular consumer. The fact that the actions of one individual have no impact on the market price does not imply that a consumer cannot anticipate the future evolution. Actually, if the personal calculations by a (typical) consumer indicate for a given price the profitability of undertaking some additional investment, then he will conjecture that the other consumers will most likely react in a similar way. But the aggregate of individual actions causes a shift in the demand for fuel, which in turn will cause the producers to adapt their strategy too. This process of rationally expecting the future price trend can be modelled as a differential game between consumers and producers. The optimixation problem for the supply side is developd in section 3 for different market structures. The (current value) Hamiltonian of the optimization problem (2) subject to (3) is
H=pf+A+rt(u-Sk),

(4) are suppressed.

whereby in eq. (4). but also subsequently, the arguments Differentiating (4) with respect to control gives

H,= A+R,
and the costate of the capital stock evolves along the differential equation

(5)

A=A(r+S)-p/,.

(6)

The second derivative of the Hamiltonian with respect to control (LegendreClebsch condition) equals the corresponding derivative of investment costs,

H Myi=

A.

(7)

F. Wid. Fuel

conwrvotion

189

In case ,4hO, simple further differentiation of H reveals that the Hamiltonian is convex in capital stock and control, and hence the necessary conditions are also sufficient for an optimal capital adjustment programme. This programme in turn implies also the optimal consumption path for the nondurable good. 3. Supply The supply sector consists actually of two industries: one supplying the durable, the other supplying the nondurable commodity. It is supposed, that the impact on the first industry is negligible, e.g., insulation programmes account only for a negligible fraction in the overall construction intention. In the case in which this interdependence is essential for a particular investigation, the analysis can be extended in analogy to the second industry to three players: consumers, construction and energy industry. Such an extension would strengthen the results below because then myopia overestimates the price of energy but underestimates the costs of reconstruction so that such a consumer would aim for a capital stock which is overcapitalized against the dependence on both factors. The basic argument for the supply conditions of the non-durable good is developed for a monopoly, but carries over to other market structures, like oligopoly (Nash-Coumot) and competition. Moreover, all these cases are covered by a relation. where the price for fuel is negatively inclined to consumers capital structure. This property of the supply behaviour is a sufficient description for the subsequent analysis to derive the dynamic market equilibria. The monopolist who faces the demand /(&(&p(r)) and (convex) production costs c(/(k(r),p(t))) tries to maximize the present value of prolits subject to the evolution of the consumers capital stock k(t),

max e-{dr)f@(& - 4fW. 7 fdr)) Pm 0

&=14(r)-6k(r),
k(0) k,. =

p(r))]} dr,

(8) (9)

The current value Hamiltonian, again omitting the arguments, equals H=pf-cc&-dk),

w-4

and differentiating yields a myopic, feedback formula (for interior solutions), H,=pf,,+ f -cf,=O,

(11)

190

F. Wid,Fwlccwwmhn

which

is the

lkmiliar rule that marginal revenues must equal marginal costr

p+&. fp
To justify eq. (11) suppose that the profit function is concave, i.e.,

(117

then, by the implicit function theorem, eqs. (11) and (12) ensure that there exists a function P,

p(t)= PVC(t)),

P=

+o,
IP

(13)

translating current consumer capitalization into current fuel prices. The inequality (12) puts some implicit constraints on fpp in the sense, that / should not be too convex. Loosely speaking, and neglecting the convexity of production costs, this states that already the short-run demand is elastic, at least for sufficiently high prices. If this is not the case (and many econometric investigations indicate this for the case of energy and fuel demand), then one can draw the scenario that the producer will charge high prices until demand gets sutliciently elastic (because /#SO and expanding capital imply an increase in relative price sensitivity) and relation (11) takes over. However, for competitive supply, short-run demand could be perfectly inelastic and still ensure a well-defined price, namely by the standard rule that price equals marginal costs,

PO) cCfMo.(Po)u~ =

(14)

which in turn implies a relation of type (13). An argument similar to the one for the monopolist could be developed for intermediate, oligopolistic markets (Nash-Cournot quantity equilibrium) also implying a relation of type (13). Returning to the case of the monopolist, it is necessary to draw attention to another implicit condition. The result of a myopic producer policy is tied to a symmetric equilibrium between the consumers and the producer(s). The analysis is thus confined to a Nash-Coumot intertemporal equilibrium between demand and supply. This is a very likely market equilibrium, if the supplying sector faces some competition (perfect or imperfect). However, in the case of a monopoly controlling the supply, then a Stackelberg equilibActually. the governments of consuming countries cdd cushion themselves against such an exploiting strategy of a monopoliit by cokctiag appropriate taxes on fuels. However, the final consumer will lind energy expensive in both cases.

F. Wid. Fuel conservation

191

is also possible. In this case the myopic price strategy is in general replaced by a dynamic modification of the golden rule: marginal revenues equal marginal costs. rium

4. Convex costs of capital expansion The assumption A >O is appropriate for situations where investment becomes more costly with increasing efforts. This requirement is similar (except for irreversibility) to the literature supposing convex or simpler quadratic costs in adjustment and allows phase diagram analysis. This assumption covers those cases where development proceeds smoothly and in small pieces. First suppose that the consumer is acting myopically, i.e., taking the current price also granted for the future and differentiate the maximum principle, eq. (5). with respect to time, substitute the costate differential equation and replace there the adjoint variable: I= -,4(u) to obtain Ii=

&l(r+b)+pj~.

(15)

Partial differentiation of (15) with respect to control and state indicates positive derivatives and hence the ti--0 isocline is downward sloping in the plane of state and control. Additionally, the k isocline is a straight line through the origin with slope 620 and hence a unique equilibrium ri=O=R is ensured, which is a saddlepoint. The qualitative nature of this solution is given in fig. 1. This figure provides a phase plane analysis to show the qualitative behaviour of the optimal strategy (bold arrows). Concentrating on the case of initial undercapitalization a decreasing investment strategy over time is pursued, but expanding capital stock to its equilibrium k,. However, the increase in capital stock causes a decline in fuel prices which moves simultaneously the ti=O isocline to the left, due to Assumption 1. Hence, the myopically ideal capital stock would be too large. The integration of the rationally expected producer strategy into the current -_ consumer actions gives a system of three differential equations,

d=-$(A(r+S)+p_&), li=u-dk, $=FlZ, which would require a three-dimensional

(16)
(17) (18) phase portrait. However, the long-

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F. Wid, Fuel emion

Fig. I. Phase plane analysis of optimal investment strategy and evolution or the capital stock.

run equilibrium capital stock k, is determined by the implicit relation

ew(~

+ 4 + pl;m, PI= 0,

(19)

which gives k, -K(p), K>0 by the implicit function theorem. The intersection of relation (19) with the supply policy (13) yields the long-run equilibrium. The steady state as well as the transient optimal paths are drawn in fig. 2, which now quantifies the amount of overambitious energy conservation due to myopic instead of rational price expectations. Fig. 2 provides an analysis of the variables price of energy and capital stock in the phase plane and supposes an initial undercapitalization for the price p. (k, <k,(po)), e.g., after a price hike due to cartelixations in supply. The broken arrow points at the capital expansion process based on myopic expectations and the bold arc describes the intertemporal equilibrium under rational price expectations. However, due to a slow adjustment programme, even a myopic consumer will tend to this equilibrium, if the consumer is allowed to change continuously his programme to account for actual price observation. For this modification, i.e., if the consumer need not stick to the original (at r=O) calculated plan, the myopic consumer will choose at any point in time the

F. Wirl, Fd wtucmatbn
PRIG E

193

P(K)

K(P)

Fig. 2. Phase plnne analysis of intertemporal equilibrium

in the variables(p.k).

wrong turnpike (i.e., the horizontal direction of the broken arc in Iig. 2) but continuous revision will drive him ultimately to the equilibrium. Hence, such long-run overreactions are more likely to happen for linear and concave cost schedules. However, the transient investments are suboptimal in this case of myopic expectation but continuous recalculation of the investment strategy, in particular of the initial capital adaption, is too large. But, if the consumer enters initially a binding contract, say with a construction firm, then a substantial misallocation of individual resources will be the result, as sketched in fig. 2.
5. Linear investment &stc A(u) = II

In case of linear capital adjustment the following optimal policy:

costs, the maximum principle implies

194

F. Wid, Fuel comavahn u(t)=P if

AC-l, 1= - 1, L>-1, (20)

=singular =o

arc

if if

where unuX denotes constraints on the maximal rate of investment efforts. Again, suppose that initially the consumers are insufficiently equipped with the durable commodity, then they will choose a most rapid approach path to the long-run strategy. In case urnaX large, then in fact a consumer will try to is move immediately to the equilibrium. In such circumstances, the myopic expectations lead to drastic misallocation as compared to the optimal adjustment based on correct expectations. Contrary to the case of convex adjustment costs and continuous revision, fig. 2 sketches the likely situation of overinvestment for consumer adaptations based on myopic expectations and for linear costs. To prove the above proposition it is sufficient to show that the singular arc is already the steady state, even if the counteracting producer strategy is correctly expected, i.e.. @ not necessarily equal to zero everywhere. For this purpose. differentiate the singular arc twice with respect to time and substitute relation (20) for L to obtain
W/;+fpL)+PflL~=0. (21)

which is only possible if @-0=x-. This ideal state is most rapidly reached for rational expectations of the price. while myopic price anticipation, even under the suppostion that the consumer can continuously revise his plan, will lcad to initial excess investment and the long-run optimum would be reached much later by depreciation. 6. Decreasing margid
investment costs

Some investments in energy conservation exhibit a deelining marginal cost structure vis B vis the investment effort, e.g., the first centimetre insulation of a house is for sure more expensive than the next additional eentimetre. However, due to the Legendre-Clebsch condition, then no interior solution of (5) can be optimal, but only bang-bang strategies will be employed. The principle of maximizing the Hamiltonian at any point in time yields the following condition:
u(r) = Urn

if

A*.-y<
A:=-=

A( it-)
U

-Yr),
4th

=O,Umax

if

A(u-)
IlN=

(22)

=o

if

:=

NU) T> U

-L(r),

F.Wir&Fuelcoaumbm

195

ie_ if average costs are less than the cost reduction due to a marginally better capital equipment, then a(t)=P, and zero if average costs exceed the future gain. At the point of quality, which represents the WeierstrassErdman comer condition, no decisive conclusion is possible. Analogous to the arguments for the linear case, myopic expectations with or without revisions of the initial plan imply for initial under capitalization an overambitious energy conservation programme and hence a waste of economic resources. While the short-run decision is similar to the linear case under both hypothesis myopia (with or without revision over tune) and rational expectations, the long-run behaviour is different. Actually, it can be shown, that once a switch in control is advisable, then it is optimal to change continuously between doing nothing and investing at the maximal rate. This chattering policy tries to maintain the ideal capital stock, but also taking advantage of the declining marginal cost structure. Since the capital stock remains unchanged by this policy, the long-run energy price would remain stable. However, in case of less ideal situations, e.g., delay between the date of investment and its effectiveness, or myopic expectations with revision of energy conservation programmes only at discrete time intervals, volatile prices are likely. Finally, under the additional assumption A(O)= 1 in all cases, the ideal capital stocks under the three different cost regimes can be compared (see fig. 3): For this purpose, consider the (&,A) plane and the A=0 isocline

tiK 9

-1

Fik 3. Comparison of ideal capital stocks versus convex. linear, concave investment costs.

1%

F. Wid, Fd

eoawwtion

representing the equilibrium, then from q. (6) after inserting the long-run fuel price from ( 13) one derives

an upward sloping curve. Inserting the maximum principle along the steadystate capital stock: -A= A(&&)> 1 for convex, -A= 1 for linear, and -I= A(Uaux)/U=x< 1 for concave costs gives the ideal state. As intuitively expected, decreasing marginal costs provide an incentive to expand the energy conservation beyond the other two cases and hence a lower energy price can be expected. However, for less ideal circumstances, increasing returns to investment bear the risk of volatile energy prices. 7. conclusions The investigations within this paper focus on the aspects of consumer demand over time and simultaneously on the producers strategy to draw conclusions on the prospects of fuel conservation and the expectation of future energy prices. This approach contrasts the usual procedure to take demand as given and to compute solely the (optimal) policy for the producer(s). A particular purpose of this analysis was to show that the efficient planning of energy conservation programmes requires the anticipation of the counterstrategy of the producers. And the future producer strategy can bc assessed from the profitability of individual conservation measures. Hence, ambitious and *successful measures recommended on the present price situation will retrospectively be suboptimal. Therefore, more cautious efforts are suggested for each individual instead of expensive and sometimes exotic projects. Moreover, drastic conservation and reduction of fuel consumption in the years ahead is higly unlikely because it would not constitute a viable market clearing. The reason is, that substantial conservations require high prices, but these prices are very unlikely if demand is substantially reduced. Actually, recent individual consumer behaviour seems more rational and aware of this interdependence than the strategy of the policy makers, who often pursue still ad hoc targets in their energy policy. References
Abodunde, T.. F. Wirl and F. Koes~l, 1985, Energy demand elasticities: A reassessment,OPEC Review IX. 163-185. Arrow, KJ. and M. KUIZ 1970. Public investment, the rate or return. and optimal tiscal policy (Johns Hopkins University. Pre$s. Baltimore, MD/London). Bryson. A.E. and Y.E. Ho, 1975. Applied optimal control (Wiley, New York). Clements, K.W., 1985. The demand for energy used in secondary industry, Resources and Energy 7. 179-201.

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Dasgupta P. and GM. Heal. 1974. The optimal depletion of exhaustible resources, Review of Economic Studies, Symposium on the Economies of Exhaustible Resourocs. 3-28. Dasgupta, P. and GM. Heal, 1979, Economic theory and exhaustible resources (Cambridge University Press, Cambridge). EMFA 1981. Aggregate elasticity of energy demand The Energy Journal 2.37-75. Hotelling H.. 1931. The economics of exhaustible resources, Journal of Political Economy 39. 137-175. Kamicn. M.H. and N.L. Schwartz, 1981. Dynamic optimization, the calculus of variations and optimal control theory in economics and management (North-Holland. New York). Kemp. MC. and N.V. Long, 1980. Exhaustible resources, optimality and trade (North-Holland, Amsterdam). McLaren. K.R.. 1979. The optimality of rational distributed lags, International Economic Review 20. 183-191. Nordhaus. W.D.. 1977. The demand for energy: An international perspective (North-Holland, Amsterdam). Pindyck. R.S., 1979. The structure of world energy demand (M.I.T. Press, Cambridge. MA). Sage. A.P. and C.C. White. 1977, Optimum systems control (Prentice-Hall, Englewood Cliffs, NJ\. Sehti. S.P. and G.L. Thompson. 1981. Optimal control theory, applications to management science (Nijholf, Boston, MA). Stiglitx, J.E. and P. Dasgupta, 1982. Market structure and resource depletion: A contribution to the theory of intertemporal monopolistic competition, Journal of Economic Theory 28, 128 164. Tolley, G.S. and J.D. Wilmann, 1984. Depletable resource under international uncertainty, Resources and Energy 6.205-234. Wirl. F.. 1985, Stable and volatile prices. an explanation by dynamic demand. in: G. Feichtinger, ed., Economic applications of control theory (North-Holland. Amsterdam).