Question

Suppose that Sea Shell oil company (SS) is pumping oil at a field off the coast of Nigeria. At this site, it has an extraction cost of $30 per barrel for the first 10 million barrels it pumps each year and then $60 per barrel for all subsequent barrels that it pumps each year, up to the site’s maximum capacity of 90 million barrels per year.

Instructions: Enter your answers as whole numbers.

a. Suppose the user cost is $75 per barrel for all barrels and that the current market price for oil is $115 per barrel. How many barrels will SS pump this year?   million barrels.     

What is the total accounting profit on the total amount of oil it pumps? $ million.     

What is the total economic profit on those barrels of oil? $ million.

b. What if the current market price for oil rises to $145 per barrel, while the user cost remains at $75 per barrel?

How many barrels will SS pump?   million barrels per year.      

Instructions: Round the following answers to 1 decimal place.    

What will be its accounting profit?    $ billion.     

What will be its economic profit? $ billion.

c. If the current market price remains at $145 per barrel but the user cost rises to $120 per barrel, how many barrels will SS pump this year?   barrels.     

What will be its accounting profit? $.     

What will be its economic profit?   $.

Answer 1

Answer (A)

The probability that the product is reliable is 50% or 0.50.

The probability that the product is unreliable is 50% or 0.50.

The maximum amount consumer pays for the reliable product is $0.

The maximum amount the consumer pays for the reliable product is $200.

The price paid under such uncertainty is equal to the expected price of the product.

Calculate the price consumer will pay for this uncertainty as shown below:

Price =(0.50x0) +(0.50 x 200)

          = 0+100

         = $100

Therefore, the consumer will pay $100 to purchase one unit of the product under such uncertainty.

Answer (B)

The offer of the warranty ensures the consumer that the product is reliable. The maximum price that the consumer is willing to pay for the reliable product is $200.

Therefore, in the presence of warranty, the consumer will pay $200 for the product.

Extraction cost of the barrel is $30 per barrel.

The user cost is $55 per barrel.

Calculate the total cost of the first 10 million barrels as shown below:

Total Cost = Extraction Cost + User Cost

                    =$30+ $55

                   =$85

Calculate the total cost of the remaining 60 barrels as shown below:

Total Cost = Extraction Cost + User Cost

                   =$60 + $55

                  = $115

The piece per barrel is $95. The cost of the first 10 million barrels is less than the price.

Therefore, SS will pump 10 million barrels.

Calculate the accounting profit as shown below:

Accounting Profit = Revenue -Cost

                                 = (10x $95)-($85x10)

                                =950-850

                                 = $100

Calculate economic profits as shown below:

Economic Profit = Accounting Profit - Opportunity Cost

                             = 100-0

                             = $400

Therefore, the accounting profit is $400.

The economic profit is $400

Answer (C)

The user cost is $100 per barrel.

Calculate the total cost of the first 10 million barrels as shown below:

Total Cost = Extraction Cost + User Cost

                   = $30+ $100

                 = $130

Calculate the total cost of the remaining 60 barrels as shown below:

Total Cost = Extraction Cost + User Cost

                   =S60+ $100

                  =$160

The piece per barrel is $95. The cost is higher than the price. The SS will not pump any barrel.

Therefore, there will be zero profits.