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OAQPS Economic Analysis Resource Document

5.2 PEIS Modeling Approach: Conceptual Framework

This section examines the impact of the regulations that affect the production costs for facilities in an affected industry. It provides an overview of the basic economic theory of the effect of the regulations on facility production decisions and the concomitant effect on market outcomes. The framework presented here employs standard concepts in microeconomics to model the supply of affected products and the impacts of the regulations on production costs and the operating decisions. The three main elements are
  • regulatory effects on the manufacturing facility,
  • market responses, and
  • facility-market interactions.

The remainder of this section describes each of these main elements.

   5.2.1    Facility-Level Effects

At any point in time, the costs that an existing facility faces can be classified as either unavoidable (sunk) or avoidable. In the former category, we include costs to which the firm is committed and that must be paid regardless of any future actions of the firm. For instance, debt incurred to construct a production facility must be repaid regardless of the facility's production plan and even if the facility ceases operation prior to full repayment, unless the range of viable alternatives includes the declaration of bankruptcy by the owners. The second category, avoidable costs, describes any costs that are foregone by ceasing production. These can be further refined to distinguish between costs that vary with the level of production and those that are independent of the production level. For example, production factors such as labor, materials, and capital (except in the short run) vary with the level of output, whereas expenditures for facility security and administration may be independent of production levels, but avoidable if the facility closes down. The determination of both the avoidability and the variability of firms' costs is essential to the analysis of economic responses to the proposed regulations.


5 EIA Framework

 5.0 Intro

 5.1 Alternative
   for Economic
   Impact Analysis

 5.2 PEIS Modeling

 5.3 PEIS Modeling

 5.4 Economic
   Impact Results

The current technical features of these facilities reflect the historical economic environment and managerial decisions of the firm. The existence of the fixed factors give rise to (eventually) diminishing marginal returns to production and, along with the terms under which the firm may purchase variable inputs, condition the shape of the cost curve of the facility. Figure 5-3 illustrates the derivation of a facility supply function for a subject product from the classical U-shaped structure of production costs with respect to output. Let AVAC be the facility's average variable (avoidable) cost curve and ATAC the average total (avoidable) cost curve for producing the product. The vertical distance between ATAC and AVAC is the per-unit average cost of nonvariable avoidable costs, which approaches zero as the number of units of output increases. MC is the marginal cost of producing the product, which intersects AVAC and ATAC at their respective minimum points. All these curves are drawn conditional on input prices and the technology in place at the facility.

Managers of existing facilities face operating decisions of whether to operate at all and, if so, the optimal rate of output.  Depending on market structure, they may also face choices in the prices they pay for purchased inputs and the price they charge for their produced commodity.  The facility supply function is the section of the marginal cost curve bounded by the quantities qm and qM.  qm is the minimum economically feasible production rate that is determined by the minimum of the AVAC curve, which coincides with the price pm.  Suppose the market price of the subject product is less than pm.  qM is the largest feasible production rate that can be sustained at the facility given the technology and other fixed factors in place, regardless of the output price.  In this case, the firm’s best response is to close the facility and not produce because P < ATAC implies that total revenue would be less than total costs if the facility operated at the associated output levels below qm.  Based on profit-maximizing behavior, these managers will select the output rate where the additional contribution of output to revenue (marginal revenue or MR) is equated to its additional contribution to cost (marginal cost or MC).  For facilities competing in perfectly competitive markets this is where market price equals marginal cost, that is, at [P*, Q*] in Figure 5-3.  Profits or quasi-rents are the difference between total revenues and total costs.  This reflects annual return to the fixed factors and, as pointed out by  Friedman (1962), is a consequence of  the firm’s operating decision, not a determinant of it.  The fixed and variable costs (“contractual costs” in Friedman’s terminology) are the determinants of the equilibrium (profit-maximizing) output rate.

   Figure 5-3

Now consider the effect of the proposed regulatory control costs.  These fall into one of two categories:  avoidable variable and avoidable nonvariable.  These proposed costs are characterized as avoidable because a firm can choose to cease operation of the facility and, thus, avoid incurring the costs of compliance.  The variable control costs include the operating and maintenance costs of the controls, while the nonvariable costs include compliance capital equipment.  Figure 5-4 illustrates the effect of these additional costs on the facility supply function.  The facility’s AVAC and MC curves shift upward (to AVAC' and MC') by the per-unit variable compliance costs.  In addition, the nonvariable compliance costs increase total avoidable costs and, thus, the vertical distance between ATAC' and AVAC'.  The facility’s supply curve shifts upward with marginal costs and the new (higher) minimum operating level (qm') is determined by a new (higher) pm'.

   5.2.2    Market Effects

To facilitate this discussion, it is assumed that prices for the commodities affected by regulation are determined in competitive markets. In this case, the individual facilities have negligible power over the market price and, thus, take the price as "given" by the market. The market supply curve is defined as the horizontal summation of the individual facility

   Figure 5-4

supply curves, and a market demand curve is the sum of the demand curves for all demanders of the product. As shown in Figure 5-5(a), under perfect competition, market prices and quantities are determined by the intersection of market supply and demand curves. The initial baseline scenario consists of a market price and quantity (P, Q) that is determined by the downward-sloping market demand curve (DM) and the upward-sloping market supply curve (SM ) that reflects the sum of the individual supply curves of affected as well as unaffected facilities.

Now consider the effect of the regulation on the baseline scenario as shown in Figure 5-5(b). In the baseline scenario without the proposed standards, at the projected price, P, the industry would produce total output, Q, with affected facilities producing the amount qa and unaffected facilities accounting for Q minus qa, or qu. The regulation raises the production costs at affected facilities, causing their supply curves to shift upward from Sa to Sa' and the market supply curve to shift upward to SM'. At the new with-regulation equilibrium, the market price increases from P to P' and market output (as determined from the market demand curve, DM) declines from Q to Q'. This reduction in market output is the net result from reductions at affected facilities and increases at unaffected facilities. Unaffected facilities will not face an upward shift in their product supply curves, so their response to higher product prices is to increase production. Foreign suppliers (i.e., imports), which do not incur higher production costs due to the regulations, will respond in the same manner as these unaffected producers.

   5.2.3    Facility-Level Response to Compliance Costs and New Market Prices

The firm's response to a proposed regulatory action is both facilitated and constrained by commodity and financial market relationships that make up the economic system. The firm's adjustments discussed above reflect efforts to respond to the regulation in a profit-maximizing fashion. This may lead, for example, to changes in output that, when aggregated across all producers, lead to changes in the market-clearing price and feedback on the firms to alter their decisions. These adjustments are typically characterized as a simultaneous interaction of producers, consumers, and markets. Thus, to evaluate the facility-market outcomes the analysis must go beyond the initial effect of the regulation and project the net effect after the market(s) has adjusted.

   Figure 5-5

Given changes in market prices and costs, the facility operator will elect to either
  • comply with the regulation and continue to operate, adjusting production and input use based on new revenues and costs, or
  • cease production at the facility and exit the market.

These options can be extended to the multiproduct facility where product lines may be closed if product revenues are less than product-specific avoidable costs, and/or the entire facility may be closed if total revenues from all products do not exceed facility-specific avoidable costs.

Therefore, after the interaction of facility and market forces is considered, the operating decisions at each individual facility can be derived. These operating decisions include whether to continue to operate the facility (i.e., closure) and, if so, the optimal production level based on compliance costs and new market prices. The approach to modeling the facility closure decision is based on conventional microeconomic theory. This approach compares the ATAC--which includes all cost components that fall to zero when production discontinues--to the expected post-regulatory price. Figure 5-4 illustrates this comparison. If price falls below the ATAC, total revenue would be less than the total avoidable costs. In this situation, the owner's cost-minimizing response is to close the facility. Therefore, as long as there is some return to the fixed factors of production, that is some positive level of profits, the firm is expected to continue to operate the facility.

If the firm decides to continue operations, then the facility's decision turns to the optimal output rate. Facility and product-line closures, of course, directly translate into reductions in output. However, the output of facilities that continue to operate will also change depending on the relative impact of compliance costs and higher market prices. Increases in costs will tend to reduce producers' output rates; however, some of this effect is mitigated when prices are increased. If the market price increase more than offsets the increase in unit costs, then even some affected facilities could respond by increasing their production. Similarly, supply from unaffected domestic producers and foreign sources will respond positively to changes in market prices.

The approach described above provides a realistic and comprehensive view of the effect of the regulations on responses at the facility level as well as the corresponding effect on market prices and quantities for the affected commodities. This is a substantial improvement over analytical methods that do not account for facility-level responses such as quantity adjustments, input adjustments, and closure of product lines, or methods that ignore the effect of these regulations on market prices when determining the change in revenues and costs at the facility level. Methods that do not allow for production adjustments at the facility level essentially assume that firms cannot or will not adjust to changes in production costs. Without responses at the facility level, no credible model for a change in market prices as a result of the regulations exists. Both of these assertions--unresponsiveness of firms to market conditions and market price changes in response to regulation—seem unwarranted by observation.

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