Econ Geek Question

[Boris]

disclaimer: I am an econ geek. but I've been out of school for awhile.

company A owns rights to extract a natural resource, say oil.

company A must invest in technology and equipment to extract said resource.

How does the company's willingness to invest in technology vary with the price of said resource?

This is a real life argument that came up the other day. One icehole claimed the answer was "obvious". I felt pretty strongly in the opposite direction. But I havn't put too much thought into it.

[gumpzilla]

Disclaimer: I know essentially nothing about economics except for vague memories of a high school econ class.

That said, since profit is probably something like linearly correlated with price (bad assumption, but something to start with), the more expensive it is the more you should be willing to invest, because the marginal benefits from dollars spent on technology will be higher for the same amount of money invested, if everything else is the same (another bad assumption). You can make this as complicated as you want and then it gets tricky, but on the surface it seems that's the way it should go.

[CardSharpCook]

It is a direct relationship. As the resource goes up in value the benefits of research also go up, therefore investment in research goes up.

[threeonefour]

actually the correct answer is that it depends on why the price of the resource varied. also, how much much it actually varied relative to alternative investments/projects.

here is something to think about:

suppose the price of the oil in the ground went up 10%. suppose the interest rate on a 20 year Tbill(or whatever your alternative investment is) is 5%. furthermore suppose your petroleum market forecasters predict that oil will continue to rise at 10% annually(on average) with a 90% degree of certianty for the next 20 years.


a lot of companies would be less inclined to drill the oil in that scenerio than if the price was only rising 2%. the reasons why are obvious. at 2% the oppurtunity cost of leaving it in the ground is much higher.

i am multitabling so i am not really going to proofread this but everything i have said is more or less accurate.

[ihardlyknowher]

It is not obvious if the price of technology and equipment goes up with the price of the resource. I.e. more demand for the equipment because everybody who has these rights will want to mine it (due to its increased price). But this in turn will increase supply of the resource, and decrease the price. Repeat until equilibrium is reached.

[drewjustdrew]

I would think there is no desire to invest in technology until the price and expected future price of oil exceeds the opportunity cost of investing the money in other projects. So on a graph with price of oil on x axis and cost of investment on y (including opportunity cost) it would be a flat line, then it would slope up directly with the price of oil.

[smb394]

[ QUOTE ]
actually the correct answer is that it depends on why the price of the resource varied. how much much it actually varied relative to alternative investments/projects.

[/ QUOTE ]

Yes.

Essentially, as the marginal price/marginal cost per each unit of extraction of this resource is positive, then this company will do so. Where it gets interesting is when we meet diminishing returns.

[sammysusar]

I guess if you ignore all other factors the answer is simple : you would invest more if the price went up. But in real life there are alot of other factors as others have pointed out.
If it a beginning Econ class they would tend to ignore these other factors.

[Boris]

this is a real life problem. not an argument about the correct answer to an econ quiz. I got into an argument about why a particular company was sucking the exhaust pipe.

[benfranklin]

The decision to invest obviously requires that the expected price received for the product exceeds the cost of production. The question is whether the current price will be sustained or increased over the life of the investment. The current price, in and of itself, is not a major factor.

The current price is a temporary equilibrium of current supply and demand. If the underlying supply and demand factors are stable enough for a confident forecast, then estimated future price levels can be used to evaluate the investment. The more unstable the underlying factors, the riskier the investment.

In this particular case, the demand side can be considered fairly stable. With a given infrastructure of heating equipment and automobiles, it would take a long time and a lot of investment to reduce the need for energy in those two areas.

The supply side is very unstable, subject to the whims of nature, wars, dictators, fanatics, and OPEC. The real life example of this very situation involves shale oil in the western US. During the energy crisis of the late 70's, we had the technology to extract oil from shale rock. As I remember, oil would have to go to $X/bbl, and remain there for some period of time, to justify the capital expenditure needed to implement this technology. At that time, oil was over $X/bbl, but it was assumed that if this technology was implemented, OPEC would increase supply enough to drive the price back under that level. Whether or not that was true, it appears that that was a big consideration in the decision. And those kinds of considerations are much more important in a decision of this kind than the current market price.

[threeonefour]

[ QUOTE ]
this is a real life problem. not an argument about the correct answer to an econ quiz. I got into an argument about why a particular company was sucking the exhaust pipe.

[/ QUOTE ]

my argument is valid whether or not you are talking about a quiz or a real company.

the simple truth is that it matters why prices vary. it also matters what they vary relative to.

From 1980 to 1995 (i am fudging these numbers but this is definitely true for a long period in the late 20th century) the price of gasoline rose. but the price of gasoline relative to other goods actually dropped. so the nominal price of gas rose, but in reality gas was cheaper. when gas was 2$ a gallon in 2001 or so, it was actually cheaper than it was in the eighties, in real terms.

also, to repeat my above post, if the the price is rising at a rate faster than the interest rate, then you probably shouldn't be taking it out of the ground. you ever wonder why lumber companies cut trees down when they do? or why wine companies age their wines for x years before they sell it? as long as prices is rising faster than the interest rate you are making money by holding out.

[manpower]

I'm not really sure what answer you're looking for, and I think you should just go ahead and post your side to the argument you've had, but I'll point out something that no one has bothered to say yet:

Non-repleneshing natural resources, namely oil, are limited and will eventually run out. This is important because if you assume a]that oil will continue to increase in value and b]that the company has a pretty good idea exactly how much oil they have in their specific field. It's possible (though by no means certain) that it will be a good idea for them to NOT invest.

Here's an example of when the above would be true. If an investment affects only production capacity (not efficiency or cost of extraction). It is not in the company's best interest to boost production when the time-value of a large expenditure on say, a new drilling platform, would be less profitable than an alternative investment, namely, leaving the oil in the ground until it's worth $200 a barrel and investing the money in t-bonds until then.