Week 11: Real World Applications 10

Assume Daewoo, a hypothetical oil extraction company, has the following cost structure. It spends:

• $40/barrel on labor costs, raw materials, energy, and • $35/barrel on interest, depreciation, insurance, and administrative staff expense.

Read the textbook carefully, and answer the following questions.

• A recession hits, the market price of crude oil falls to $50 per barrel, and the profitability takes a hit. Should Daewoo keep running the mine? Elaborate.
• Russia invades Ukraine, the market price shoots up well above $100 per barrel, and competitors announce new expansion plans. Should Daewoo add the new capacity? Elaborate.

In this hypothetical example, Daewoo is a capital intensive company due to their high fixed costs. Daewoo should slow down there production a little bit but not stop production completely. They should keep production going until the variable costs are greater than the cost per barrel of oil, then production should stop. I do not believe that Daewoo should add to the new capacity. This is because the higher the mining capacity, the lower the prices will go. Once one company increases their capacity they use it, which puts everyone back in the same situation, however, the profit margin narrows with each expansion. This inflated price per barrel is not a permanent change so it may prove to be smarter to keep the current costs for the situation that the cost per barrel starts to fall. The companies that expanded may not make enough money with the decreased revenue per barrel resulting in bankruptcy.