Question

You are the CEO of a crude oil producing company. Through your staff, you have complete cost information. At this current production level, 2000 barrels per day, your marginal cost of a barrel of crude is $35 with an average variable cost of $30 and average total cost of $40. What is your daily profit or loss? Show your calculation. Should you stay at this level of production or increase or decrease production? Explain your position clearly. What do you do if price increases to $45 per barrel? Explain.

Answer 1

The answer for this question will be much more direct if price per is provided also for provided before change.

Let us see the possible situations for solving the first part of the question:

> Situation 1. If Price of one barrel is equal to Average Variabe Cost (Short run)

*) if the firm operate at that level of output at which the price of one unit of output is equal to AVC, then it advisable to the firm to shut down since it is not profitable in short run i.e. earning revenues which are sufficient to cover up the variable costs. the tfirm can be shut down to avoid huge losses in the near future.

> Situation 2. If Price of one barrel is more than Average Variabe Cost (Short run)

*) if the firm operate at that level of output at which the price of one unit of output is equal to AVC, then it advisable to the firm to run the business either expectng a rise in price or fall in the cost of production. But in the long run it is not at all a profitable situation since, the predictablility is mostly uncertain and more risky.

> Situation 3. If Price of one barrel is equal to Average Cost (Long run)

*) if the firm operate at that level of output at which the price of one unit of output is equal to AC, then it advisable to the firm to shut down since it is not profitable in long run i.e. earning revenues which are sufficient to cover up all the variable costs. the firm can be shut down to avoid ending up with huge losses.

> Situation 4. If Price of one barrel is more than Average Cost (Long run)

*) if the firm operate at that level of output at which the price of one unit of output is equal to AC, then it advisable to the firm to run the business either expectng a rise in price or fall in the cost of production (and also by increasing the production levels provided that the firm is facing positive externalities that result in decreasing AC).

Let us see the most certain answer for the second part of the question:

the part of the question provides the information that the price of crude oil has gone up to $45 which means that the AC of the firm is less than the price which is profitabl for the firm to run the business by increasing the production level up to that level at which the price remains mare than the MC of that particulat level of output.