Price elasticity of demand is applied in determining pricing decisions. The nature and value of price elasticity determine a firm's profit maximising strategy; increasing or reducing price. The nature of particular markets makes principal-agent problem an inherent feature and companies must design appropriate measures to deal with the problem. Markets can be categorised into four depending on the number of firms, behaviour of the firms, among other factors. This paper explains the concept of price elasticity of demand, principal-agent problem and market structures. In addition, it explores how these features are reflected in the market for natural gas in Arizona. The paper also studies the characteristics of the market for natural gas and determines whether it is a monopolistic competition, monopoly or oligopoly.
Price elasticity of demand
Price elasticity of demand is the change in quantity demanded resulting from a unit change in the price of a product. It measures how sensitive consumers are to the changes in the price of a product. A higher price elasticity of demand implies that the demand is price elastic hence consumers are more sensitive to changes in price than when the price elasticity of demand is low. Firms operating in markets with inelastic demands (low price elasticity of demand) can increase their revenues by charging higher prices. On the other hand, a firm in a market where price elasticity of demand is high will lose revenue if it increases its price.
Agency relationship occurs when one party (principal) gives the author or right to another party (agent) to transact the businesses of the principal. In any agency relationship, the agent should act in the best interest of the principal. Principal-agent problem arises when the agent is not acting in the principal's best interest. In some markets, principal-agent problems lead to market failure.
Utility companies are supplies of natural gas to the citizens. These companies are regulated by the government, though recent deregulation has reduced government’s control. For example, in the state of California, public utilities are under the watch of the California Public Utilities Commission. The objective of the government, both state and federal, is to provide efficient energy and an affordable cost. Since the government does not provide energy directly to the public, utility companies act like selling agents of the governments. Agency problem arises when utility companies focus on maximizing profit at the expense of government’s objective of providing efficient energy solutions. In most cases, the volume of sales has a significant impact on the firm's earnings. Therefore, utility companies initially focused on increasing their volume of sales and this conflicted with the regulator’s interest of providing cost-effective energy. The regulator has since introduced a system in which the earnings of the utility companies by adjusting rates whenever sales are below the desired amount. In other circumstances, utility companies may influence prices by controlling supply and demand for natural gas. Currently, there is no regulation on prices and the interaction of demand and supply determines the price. For instance, a utility company may restrict the supply of natural gas thereby leading to an increase in the market price.
The market for natural gas
The market for natural gas in Arizona is an oligopoly. Even though there are many companies distributing natural gas in USA, they are local distributors whose activities are limited to individual states. There are very few national distributors in the market. This is a characteristic of oligopolistic firms. They are interdependent in their operations and may form cartels to regulate the pricing of products and sharing markets. In some cartels, companies distribute market share on a regional basis and a firm is prohibited to sell in a region allocated to another firm. Local distributors of natural gas in US follow a similar method as many firms have restricted their operations to particular states. For instance, in Arizona State, there are only two major companies; Southwest Gas Corporation and Transwestern Pipeline.
In addition, market sharing implies less competition unlike in monopolistic competition markets. In some states, for example, Florida, there is only one local distributor. It is oligopolistic markets that are characterised by low competition as there are few firms. Moreover, local distributors differentiate their products in packaging, after-sales services, among other ways. The distributors do not engage in price competition measures and are interdependent in their behaviours. Such features are only found in oligopolistic markets hence the natural gas market in US is an oligopoly market.
In markets where there is stiff competition, products have a high elasticity of demand as consumers can easily change from one firm to another. Consumers on natural gas in US are less responsive to changes in prices of natural gas due to high costs of switching and the fact that only a few distributors operate in the state. Local distributors and other public utilities are selling agents whose interests may sometimes conflict with those of the principals thereby leading to the agency problem. Players in the market need to coordinate and develop measures to accommodate the interests of all parties as agency problems may lead to market failure. There are a few local distributors of natural gas in Arizona. The distributors do not engage in price wars are interdependent in their pricing decisions. In addition, their products are slightly differentiated. These features imply that the market for natural gas in Arizona is oligopolistic.