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Chapter 11: Problem 4

Older oil wells that produce fewer than 10 barrels of oil a day are called "stripper" wells. Suppose that you and a partner own a stripper well that can produce 8 barrels of oil per day, and you estimate that the marginal cost of producing another barrel of oil is \(\$ 80 .\) In making your calculation, you take into account the cost of labor, materials, and other inputs that increase when you produce more oil. Your partner looks over your calculation of marginal cost and says: "You forgot about that bank loan we received two years ago. If we take into account the amount we pay on that loan, it adds \(\$ 10\) per barrel to our marginal cost of production." Briefly explain whether you agree with your partner's analysis.

Short Answer

Expert verified
No, it is not correct to include the amount paid on the bank loan in the calculation of the marginal cost of production. A bank loan repayment is a fixed cost, not a variable cost, and hence doesn't affect the marginal cost which changes with the quantity produced. So the marginal cost of production remains at \$80 per barrel.

Step by step solution

01

Establishment of Terms

Firstly, it's crucial to understand what 'marginal cost' is. In economics, marginal cost is the change in total cost that arises when the quantity produced increases by one unit. In principle, it comprises the cost of labor, materials, and other inputs that increase when producing more oil. This typically refers to variable costs, which are costs directly proportional to the level of output.
02

Analysis of the Partner's Statement

Next, let's assess the partner's claim about the bank loan. The loan repayment is certainly a cost, but it's a fixed cost i.e., it doesn't change with the amount of oil produced. That is, whether the well produces 1 barrel or 10 barrels, the loan payment remains the same.
03

Conclusion

Since the loan repayment is a fixed cost and does not vary with the quantity of oil produced, it should not be included in the calculation of the marginal cost. Therefore, the partner's claim is not valid, and the marginal cost of production remains at \$80 per barrel.

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Most popular questions from this chapter

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