developments.
A. Basic Marginal Cost Theory
The rationale for setting price equal to marginal cost may be
clarified using Fig. 1. Let EFGDo be the demand curve (which
determines the kilowatt-hours of electricity demanded per
year, at any given average price level), while AGS is the supply
curve (represented by the marginal cost (MC) of supplying
additional units of output).
At the price p, and demand Q, the total benefit of consumption
is represented by the consumers willingness to pay, i.e.,
the area under the demand curve OEFJ, and the cost of supply
is the area under supply curve OAHJ. Therefore, the net benefit,
or total benefit minus supply costs, is given by the area
AEFH. Clearly, the maximum net benefit AEG is achieved
when price is set equal to marginal cost at the optimum market
clearing point G, i.e., ( po, Po). In mathematical terms, the
net benefit (NB) is given by
Q
NB =I m ) d e -
JQ m e ) d e
where p(Q) and MC(Q) are the equations of the demand and
supply curves, respectively. Maximizing NB yields:
d(NB)ldQ = P(Q) - MC(Q) = 0
which is the point of intersection of the demand and marginal
cost curves (PO, Qo). Next, we add to this static analysis, the
dynamic effect. of growth of demand from year 0 to year 1,
which leads to an outward shift in the demand curve from Do
to D l . Assuming that the correct market clearing price po
exists in year 0, excess demand GK will occur in year 1. Ideally,
the supply should be increased to Ql and the new optimal
market clearing price established at p1. But data concerning
the demand curve Dl may be incomplete, making it difficult
to locate the poinLt .
Fortunately, system data permit the marginal cost curve to
be determined more accurately. Therefore, as a first step, the
\
E \
I I I l l .b
0 0 Qo Q’ Q1 kwh
Fig. 1. Supply and demand diagram for electricity consumption.