Sample Managerial Economics – Proposal Paper to Build Pipeline

Oil Company X is embarking on an audacious yet massive project. The sheer size of the pipeline means the Oil Company could end up being the sole provider of pipeline services especially across the entire United States mainland and Canada. The project is sure to experience certain barriers especially given its cross border nature. However, once completed the project could catapult Oil Company X to monopolistic status. Challenges to be experienced will include trade restrictions, change in product prices, and the interest rate if Oil Company X is to use some level of debt to accomplish the project. The project, once completed, is liable to economic shocks such as natural disasters and recessions and the possible entry of substitute goods. These economic shocks bear the capacity to affect demand and supply patterns and subsequently oil prices. Price changes, on the other hand, can adversely or positively affect the profits realized by Oil Company X.

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As aforementioned, the massive size of the pipeline could make Oil Company X a potential monopolistic company. However, the determinant of price still remains to be the interaction of supply and demand. The demand for oil is likely to rise after the completion of the project since oil will be readily available in both the United States and Canada. The small number of substitute goods to oil ensures that the prices of the commodity are not negatively affected. However, the occurrence of economic shocks could plunge either demand or supply downwards hence affecting price. Natural disasters can happen in the form of earthquakes and adverse weather patterns such as floods, tornadoes, or hurricanes. All these have the potential to affect the supply system hence causing a reduction in supply and subsequent losses in repairs to Oil Company X. if any of this occurred, supply would greatly reduce while demand remains the same creating a deficit in supply. This shortage in supply would drive prices upwards as buyers scramble for the little available quantities of the commodity. Oil Company X ends up suffering two damages. The first damage is due to losses incurred in the damage to their assets (pipeline system) while the second is due to the shortage in supply. Their competitors are likely to reap huge from the economic shock.

Economic shocks can also be due to factors that damage demand such as recessions, characterized by very high inflation rates. Consequently commodity prices skyrocket making demand to fall. Consumers opt for available alternative products of lower prices. Recessions disrupt the demand for a product as the product becomes unaffordable to a consumer who initially could afford it. This creates a reduction in demand leading to excess supply of the product in the market. Oil Company X will be forced to reduce commodity prices in order to sell off the excess or retain the excess. This lowers the profit margins of the company as its revenues reduce yet costs are increasing. The entrance of substitute goods into the market could adversely affect the prospects of Oil Company X. this is because substitute goods, unlike complementary goods, compete for demand from the same market. The substitute goods end up dividing the available demand. Moreover, substitute goods priced at lower prices could cause a negative shift in demand of oil offered by Oil Company X.

The occurrence of the aforementioned economic shocks impacts the equilibrium quantity and price of oil offered by Oil Company X. Price changes caused by inflation or recession will result in a movement along the demand and supply curves while natural disasters and entrance of substitute goods would result in a shift of the supply and demand curves. A recession or inflation will reduce the quantity demanded while increasing the equilibrium price and create a surplus in supply as shown in the figure below:

An entrance of a substitute commodity will result in a shift in the demand curve inwards. This insinuates a reduction in demand while the supply curve is unchanged. The equilibrium price and quantity both reduce as shown in the figure below:

Assuming Oil Company X holds market power, it becomes a monopoly firm. This firm is characterized by a single firm owning a large market share. This firm becomes a price setter that supplies a good with no readily available substitutes. This market structure also has barriers to entry that prevent other firms from entry into the market. This firm enjoys vast economies of scale. The firm’s demand curve is the market demand curve and is downward sloping. Pricing strategies at the disposal of Oil Company X in this case will include one price for all units sold, price discrimination, charging one price for all units allocated to a ‘club’. Price discrimination entails charging different prices for different market segments.

After completion of the pipeline, Oil Company X’s supply curve will shift to the right insinuating an increase in supply. Due to the nature of oil and its scarce substitutes, the market demand is also likely to follow suit and shift to the right insinuating an increase in supply. The quantity demanded increases at the same market price while the equilibrium point changes. These changes are shown in the figure below:

The total expected profit from the project is dependent on the total revenues and total costs. The total cost for the whole project from the Excel Schedule is $1,580.80 million while the total revenue is $3,085.50 million. These figures give a total profit of $1,514.70 million.

Assume there is a 10% probability of the pipeline leaking, with an expected liability of $3.2 billion which will be deducted from total profit. There is a 90% probability the pipeline will not leak. Determine the expected return on this investment, as well as the variance.

Given a 10% probability of the pipeline leaking and expected liability of $3.2 billion, and a 90% probability of the pipeline not leaking, the expected return from the project will be as calculated below:

Expected return = 0.1*-3,200 + 0.9*3,085.50

Expected return = $2,456.95 billion.

Variance = 0.1(-3200 + 57.25) + 0.9(3,085.5 + 57.25)

Variance = $2,514.2 million.

Risk = 50.14

The firm also has an alternative investment which will yield $1.6 billion over the course of the same 15-year period, with a probability of 80%, or $1.15 billion with a probability of 20%. Calculate the expected return, as well as the variance. The risk should be expressed as the standard deviation.

Expected return = 0.8*1,600 + 0.2*1,150

Expected return = $1,510 million.

Variance = 0.8(1,600 – 1,375) + 0.2(1,150 – 1,375)

Variance = $135 million.

Risk/standard deviation = 11.62

Perform a marginal analysis to determine if the firm should build the pipeline, considering currently available investments and opportunity costs.

The risk involved in building the pipeline is 50.14 while the risk involved in the alternative project is 11.62. A marginal comparison of these two projects based on the involved risk will influence Oil Company X to reject the pipeline and focus on the alternative investment. However, the pipeline has a higher return than the alternative investment. It would therefore be better for Oil Company X to invest in the pipeline because it varies returns that are almost double the alternative investment.

Reference

Ellickson, P. B. (2015). Market structure and performance. International Encyclopedia of the Social and Behavioral Sciences, 14, 9211-9216.

Gruber, J. K., Prodanovic, M., & Alonso, R. (2015). Estimation and analysis of building energy demand and supply costs. Energy Procedia, 83, 216-225.

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