Question

Suppose your uncle gave you an oil well like the one described in Section \(15.8 .\) (Marginal production cost is constant at \(\$ 50 .\) ) The price of oil is currently \(\$ 80\) but is controlled by a cartel that accounts for a large fraction of total production. Should you produce and sell all your oil now or wait to produce? Explain your answer.

Short answer

The decision largely depends on the expected increase in selling price. If the future price is expected to significantly exceed the current selling price minus the production cost, it might be profitable to wait and sell. However, the uncertainty associated with future price movements, the time value of money, and the production cost should also be considered.

Step-by-step solution

Analyzing the current situation

Currently, the selling price of oil is $80 and the production cost is $50. So, for each unit of oil sold, the net income will be $80-$50=$30. If all oil is sold now, the net revenue will be the net income times the quantity of oil produced.

Predicting the future situation

Expected future price is not clearly mentioned in the task. However, it is mentioned that the price is controlled by a cartel which implies that the future price might be higher due to reduced supply. If the future price increases, it will increase the net income (future selling price - production cost). However, waiting to sell also carries uncertainty and time value of money also needs to be considered.

Comparing both scenarios

If the expected future net income (future selling price - production cost) is significantly higher than the current net revenue ($30) then waiting and selling in the future would be a better decision. However, if the expected increase is not substantial or uncertain, it would be better to sell now and avoid the risk. In economics and finance, this is a common decision scenario called time value of money.

Key concepts

Oil Cartel Influence

The global oil market can be heavily influenced by oil cartels, such as the Organization of the Petroleum Exporting Countries (OPEC). These groups consist of several major oil-exporting countries that collaborate to manage oil production and price levels. By adjusting their oil output, cartels have the power to influence the supply in the market, which can lead to price fluctuations.

For example, if a cartel decides to reduce production, the limited supply can drive up the price of oil. This would be critical information for someone debating whether to sell oil now or wait. In the exercise, the mention of a controlling cartel suggests that future prices could potentially rise if the cartel decides to constrict supply, making it tempting to wait and sell the oil later at a higher price.

However, one must also be cautious, as cartels' decisions are not always predictable, and political or economic factors can affect their actions. Therefore, while the cartel’s influence could imply future price increases, these potential benefits need to be weighed against the risks of waiting, including price volatility and the possibility of unexpected policy changes.

Marginal Production Cost

Understanding marginal production cost is essential in making informed decisions about when to sell a product. It represents the cost of producing one additional unit of a good—in this case, one barrel of oil. According to the exercise, the marginal production cost for the oil well is constant at \(50.

This cost plays a crucial role in calculating profit margins and determining the minimum selling price needed to achieve profitability. If the selling price is above the marginal cost, it suggests that producing and selling oil would be profitable. The exercise presents a situation where the selling price (\)80) is currently higher than the production cost, resulting in a net income of $30 per unit. This serves as a baseline for judging whether to sell immediately or to wait for potentially higher prices, highlighting the importance of marginal costs in such financial decisions.

It's important to factor in other operational costs and potential cost increases over time that could affect overall profitability. Therefore, a deep understanding of the marginal production cost is pivotal when anticipating future profits and making a choice between immediate sales or speculative storage.

Future Price Prediction

Predicting future prices for commodities like oil is a complex task due to the numerous factors that can influence the market. These include political stability, technological advancements, global demand, and actions by oil cartels. In the provided exercise, the lack of a clear expected future price means that speculation plays a role. While the presence of a cartel suggests the possibility of reduced supply and higher prices, it is not guaranteed.

To make a more educated decision, one could look at historical price trends, current market conditions, and expert analyses. In the case of the exercise, the net revenue from future sales needs to outweigh the immediate profit plus any potential earnings from investing the immediate profits elsewhere—this is where the time value of money becomes pertinent.

Ultimately, if the predicted future revenue, accounting for uncertainties and the time value of money, is markedly higher than what could be obtained from immediate sales, it may make sense to wait. However, predictions are inherently uncertain. When considering future price predictions, it is important to consider the risk tolerance and the opportunity cost of not selling immediately, as forecasting inaccuracies can lead to financial miscalculations.