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 formulate 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 after Q = 100, so that the supply has a flipped L shape). Marginal cost of production for the stripper wells is given by MC(Q_sw) = 20 + Q_sw. Assuming that the demand for crude oil is P = 40-0.2Q, what will be the price and output at the competitive market equilibrium? 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? What are the excess production costs associated with shifting production from the large scale producers to the stripper wells (i.e., the costs of the stripper well exemption)? Suppose that extraction of oil from a reservoir occurs at two wells controlled by independent operators/managers. Suppose that both can sell oil at the current market price of $60 per barrel and can extract oil at an average cost defined by AC = Q_1 + Q_2, i.e. increasing with the output produced at the two wells. Thus, increasing output forces the firm to pay not only for the marginal cost on the last barrel but also to incur higher costs for all barrels produced. The marginal costs of extraction for each of the two firms are equal to: MC_1 = 4Q_1 + 2Q_2 MC_2 = 4Q_2 + 2Q_1 The costs incurred by the two oil producers are interdependent. What will be the amount of oil that maximizes profits for producer 1? And for producer 2? If the two firms were to merge or otherwise coordinate their output choices, they would treat the average cost of extraction to be AC = Q, so that MC = 4Q (here Q = Q_1 + Q_2). Do you think that they could both benefit (increase their profits) from coordinating their output choices?

Explanation / Answer

Problem 1:

a) In competitive market, price = MC

40 - 0.2Q = 20 +100- Q

0.8Q = 80

Q = 100

PRICE = 20

b) If large scale producers can only produce 70 then

40 - 0.2Q = 20 +Q-70

1.2Q =90

Q = 75

Stripper well will produce 5 units

price would be 25

c) Extra cost incurred will be = 20 + 5 = 25

PROBLEM 3:

1. MC1 = MC2 = P

4Q1 + 2Q2 = 60

4Q2 + 2Q1 = 60

Q1 = 10

Q2 = 10

2. PRICE =MC

60 = 4Q

Q = 15

They will not benefit from coordinating because market price is fixed at 60.

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