11.1 In the northeast United States and in eastern Canada, many people heat thei
ID: 2449407 • Letter: 1
Question
11.1 In the northeast United States and in eastern Canada, many people heat their houses with heating oil. Imagine you are one of these people, and you are expecting a cold winter, so you are planning your heating oil requirements for the season. The current price is $2.25 per US gallon, but you think that in six months, when you'll need the oil, the price could be $3.00, or it could be $1.50.
A. If you need 350 gallons to survive the winter, how much difference does the potential price variance make to your heating bills?
B. If your friend Tom is running a heating oil business, and selling 100,000 gallons over the winter season, how does the price variance affect Tom?
C. Which one of you benefits from the price increase? Which of you benefits from price decrease?
D. What are two strategies you can use to reduce the risk you face? Could you make an agreement with Tom to mitigate your risk?
E. Assuming you are both risk-averse, does such an agreement make you both better off?
Explanation / Answer
A.
Current price = $ 2.25
Total expenditure = 350 x $2.25 = $787.50
In case, the price goes up to $3, then total expenditure would be $1,050 ($3 x 350).
In this case, excess expenditure would be $262.50 ($1,050 - $787.50)
Variance is unfavorable by $262.50.
In case, the price decreases to $1.50, then total expenditure would be $525 ($1.50 x 350).
In this case, expenditure will be lower by $262.50 ($787.5 - $525)
Variance is favorable by $262.50.
B.
For Tom current revenue = 100,000 x $2.25 = $225,000
In case, the price goes up to $3, then total revenue would be $300,000 ($3 x 100,000).
In this case, excess revenue would be $75,000 ($300,000 - $225,000)
Variance is favorable by $75,000.
In case, the price decreases to $1.50, then total revenue would be $150,000 ($1.50 x 100,000).
In this case, revenue will be lower by $75,000 ($225,000 - $100,000)
Variance is unfavorable by $75,000.
C.
Tom benefits from price increase. I benefit from price decrease.
D.
First strategy would be to buy the oil at the present stage and to store it for future use. Second strategy is to reduce the use of oil to decrease the quantity demanded.
E.
There is no such agreement to mitigate my risk because in any case one of us will have to be at the unfavorable variance.
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