oil and costs

MC*

ATC*

AVC*

“A”

PriceOf Oil

Quantity of Oil

Firm in the Oil Drilling Business

Qe

P=MR=AR=D*

Here are the cost curves (MC*, ATC*, AVC* andimplied AFC (we will get to this in a minute) ) for a firm

in the oil drilling business.

MC*

ATC*

AVC*

“A”

PriceOf Oil

Quantity of Oil


Qe

P=MR=AR=D*

I am going to assume that the typical firm is a smallproducer relative to the whole market and they are A “Price Taker”. So the Price (“P”)=MR=AR=Demand.The Firms Demand Curve is “Perfectly ELASTIC” and

horizontal at “P=MR=AR=D*.

MC*

ATC*

AVC*

“A”

PriceOf Oil

Quantity of Oil


Qe

P=MR=AR=D*Assume the Firm is in equilibrium at Point “A”where The Price = MC* at the Lowest Point of the ATC* curve (Productive and Allocative Efficiency) .The firm is “Breaking Even”. Meaning the price they receive per barrel of oil at that point is equal to the ATC of producing that barrel (Explicit + Implicit Opp Costs).

The sum of AVC and AFC = ATC

Let’s see what this looks like on this graph.

MC*

ATC*

AVC*

PriceOf Oil

Quantity of Oil

Qe

P=MR=AR=D*

“B”AVC

“A”


We know Point “A” is the ATC of Producingthe “Qe” barrel of oil (last one brought out of the ground).

From Point “A” go down until you hit the AVC curve at Point “B”. Go over to Price axis and locate , in dollar terms, the AVC of producing the “Qe” barrel of oil.

MC*

ATC*

AVC*

PriceOf Oil

Quantity of Oil

Qe

P=MR=AR=D*

“B”AVC

Total Variable Costs

“A”


“AVC” represents the Average Variable Costof producing that last barrel of oil, “Qe”.If we want to find the TOTAL VARIABLE COSTSfor the firm, then we multiply AVC to produce one barrel of oil by the TOTAL QUANTITY at “Qe”.

The Area of Total Variable Cost is in BLUE.

MC*

ATC*

AVC*

PriceOf Oil

Quantity of Oil

Qe

P=MR=AR=D*

“B”AVC


Total Fixed Costs

“A”


We know ATC=AVC +AFC, so the difference between Point “A” and Point “B” is the Average Fixed Costof producing the “Qe” barrel of oil. The TOTAL FIXED COSTS of producing all the barrels of oil will be Average Fixed Cost of one barrel multiplied by the TOTAL QUANTITY at “Qe”.

The Area of Total Fixed Costs is in RED.

MC*

ATC*

AVC*

PriceOf Oil

Quantity of Oil

Qe

P=MR=AR=D*

“B”AVC


Total Fixed Costs

P=MR=AR=D1

Q1

“C”

“A”


Now, the Price the Firm receives for each barrel of oildecreases to “P=MR=AR=D2”. We need to locate our

New Price (MR)= (MC) Marginal Cost profit maximizing (Loss minimizing) quantity of output.

That will be Point “C” at “Q1”.(Remember, when price decreases, quantity supplied decreases

(Law of Supply)The firms Supply Curve is the Marginal Cost (MC) curve above

The lowest point of the AVC curve.Movement ALONG the Supply Curve from “A” to “C”.

Notice our Total Fixed Cost and Total Variable Cost areas change—like this…..

MC*

ATC*

AVC*

PriceOf Oil

Quantity of Oil

Qe

P=MR=AR=D*

“B”AVC


Total Fixed Costs

P=MR=AR=D 1

Q1

“C”

“A1” “A”


It is IMPORTANT to notice what happened here(toggle back one slide if you are not sure). WeMove to different points on our cost curves becauseour Quantity Supplied changed.

(1) ATC is now higher (“A1”, not “A”)—no longer at Productive Efficiency

(2) Variable Costs are less because we are producing less.

(3) While the Total Fixed Cost remain the same, the AFC that each barrel Of oil absorbs is higher than it was before.

But a more important thing is happening as a result….

MC*

ATC*

AVC*

PriceOf Oil

Quantity of Oil

Qe

P=MR=AR=D*

“B”AVC


Fixed CostsP=MR=AR=D 1

Q1

“C”Not making FC’s“A”“A1”


Given the new lower price, the firm is NOTmaking all of its costs. The new priceallows the firm to make ALL its Variable Costsand SOME of its Fixed Costs (remaining RED area).

The BLACK area represents TOTAL FIXED COSTS the firmcannot meet due to the lower price.

Should this firm stay in business?

MC*

ATC*

AVC*

PriceOf Oil

Quantity of Oil

Qe

P=MR=AR=D*

“B”AVC


Fixed CostsP=MR=AR=D 1

Q1

“C”Not making FC’s“A”“A1”


Should this firm stay in business?

The economics and accounting say YES!

As long as the price is enough to meet the firms Average Variable Costs, it should stay in business in hope the price will go back up as some producers exit the market or demand increases.

So, the firm and withstand a decrease in PRICE until it FALLS BELOW….

MC*

ATC*

AVC*

PriceOf Oil

Quantity of Oil

Qe

P=MR=AR=D*

“B”AVC


Fixed Costs

P=MR=AR=D2=

Q1

“C”Not making FC’s

“D”

“E”

Q2

P=MR=AR=D 1

“A”“A1” …The LOWEST POINT of the AVC curve—Point “D”

Point “D” is considered the point of “Exit” or “Shut Down” for the firm.

If the price drops below Point “D” it means the firm is NOT making ANY of its Fixed Costs AND NOT making someOf its VARIABLE COSTS. If the firm does not recover at least the cost of producing the additional barrel of oil (the Variable Cost) then it should not produce.


MC*

ATC*

AVC*

PriceOf Oil

Quantity of Oil

Qe

P=MR=AR=D*

“B”AVC


Fixed Costs

P=MR=AR=D2=

Q1


“D”

“E”

Q2

P=MR=AR=D 1

“A”“A1” …The LOWEST POINT of the AVC curve—Point “D”

Any Price BELOW Point “D” is considered the point of “Exit” or “Shut Down” for the firm.

If the price drops below Point “D” it means the firm is NOT making ANY of its Fixed Costs AND NOT making someOf its VARIABLE COSTS. If the firm does not recover at least the cost of producing the additional barrel of oil (the Variable Cost) then it should not produce.


MC*

ATC*

AVC*

PriceOf Oil

Quantity of Oil

Qe

P=MR=AR=D*

“B”AVC


Fixed Costs

P=MR=AR=D2=

Q1


“D”

“E”

Q2

P=MR=AR=D 1

“A”“A1”

Notice again as the PRICE deceases the Quantity Supplied decreases, movement ALONG the MC curve from Point “C” to Point “D” (lowest point on AVC curve).

The AVC of producing fewer barrels decreases BUT the ATC of producing fewer barrels INCREASES because FIXED COSTS are being spread out over few barrels of oil—Movement from Point “A1” to “E”.


MC*

ATC*

AVC*

PriceOf Oil

Quantity of Oil

Qe

P=MR=AR=D*

AVCP=MR=AR=D2=

Q1

“A”

“D” “Shut-Down” Rule—any price received BELOWthe Lowest Point of the AVC curve “C”. Not making ANY contribution to AFC and just covering AVC.


oil and costs

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