Question

1. Tenet Oil Production (TOP) is the largest producer of offshore crude oil and natural gas in Country X. With the aging of her existing oil fields, the company is considering a proposal of developing an oil well located in the Atlantic Ocean acquired 2 years ago. TOP is considering whether to develop the Atlantic Ocean oil well next year. Some relevant financial figures of this proposal are as follows: • The $800 million of initial acquisition cost of the oil well paid 2 years ago • A total of $50 million budgeted for installing oil drilling equipment if the management team decides to develop the oil well

a. Explain whether the above two items should be counted as the opportunity cost of developing the oil well in the Atlantic Ocean.

b. Facing the criticism on the potential pollution caused by offshore oil rigs, TOP has announced that they are going to donate $10 million to WWF, no matter they are going to develop the new oil well in the Atlantic Ocean or not. Will this affect the opportunity cost of developing the oil well? Explain your answer.

Answer 1

Ans.

a)

The opportunity cost of any particular decision, such as to produce a given level of output, can be determined by measuring the benefit forgone by not implementing the next best alternative.

The money spent in the past on the firm’s plant and equipment is what economists call a sunk cost. Because sunk costs cannot be altered, they cannot affect an optimal decision, which is forward looking. Sunk costs are therefore ignored in decision making.

$800 million of initial acquisition cost of the oil well paid 2 years ago is in the nature of the sunk cost.

A total of $50 million budgeted for installing oil drilling equipment if the management team decides to develop the oil well will be nature of the opportunity cost.

b)

In this case we have been informed that TOP has announced that they are going to donate $10 million to WWF, no matter they are going to develop the new oil well in the Atlantic Ocean or not.

Which signifies that this payment of donation is not related to decision of the management whether to develop the oil well or not. This will be in the nature of regulatory cost and not opportunity cost for the given project. Because it has no bearing on the economic decision of the firm.