Suppose that the market supply of crude oil is the sum of the supply from \"larg

Question

Suppose that the market supply of crude oil is the sum of the supply from "large scale" producers and that from "stripper wells". Under the assumption that the market is perfectly competitive, we can expect each firm to forumulate supply plans according to the marginal cost of production. Suppose that "large scale" producers can produce collectively no more than 100 barrels per day at a constant marginal cost equal to $5. (presume that the cost of producing an extra barrel becomes infinitely high are Q=100, so that the supply has a flipped L shape). Marginal cost of production for the stripper wells is given by MC(Qsw)=20+Qsw.

a. Assuming that the demand for crude oil is P=40-0.2Q, what will the price and output at the competitive market equilibrium?

b. Suppose that the government intervenes in the market by imposing a pro-rationing scheme according to which large scale producers cannot exceed the quota of 70 bpd. If the stripper wells' output is not regulated, what would you predict will be the equilibrium prices and output levels?

c. What are the excess production costs associated with the shifting production from the large scale producers to the stripper wells (i.e., the costs of the stripper well exemption)?

Explanation / Answer

a) MC of producing 1 bpd for stripper wells is = 20 + 1 = $21. Now large scale producers produce maximum 100 bpd so Price for producing 101 bpd i.e. 100 from large scale producers and 1 from stripper well is = 40 - 0.2*101 = $19.8. Here we can see than Psw < MCsw so stripper well will not do any production. Finally Q = 100 bpd and P = 40 - 0.2*100 = $20

b) If large scale producers cannot produce more than 70 bpd. Then

We can see from the table that when Qsw is 5 then MCsw = P so Q = 75 bpd and P =$25.

c) Extra cost of production is the sum of extra MC spent for 71st to 75rh barrel i.e. = $16+$17+$18+$19+$20 = $90

Qls Qsw Total Q MCsw Price 70 0 70 20 26 70 1 71 21 25.8 70 2 72 22 25.6 70 3 73 23 25.4 70 4 74 24 25.2 70 5 75 25 25 70 6 76 26 24.8 70 7 77 27 24.6

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