Profit is the incentive that drives our market economy. Firms make production, pricing, and hiring decisions based on their quest for profit. But what happens when a firm discovers that it can make dramatically higher profits by stopping production altogether? In December 2000, due to wild swings in the market for electricity, Kaiser Aluminium faced just such a decision. Kaiser Aluminium had contracted with Bonneville power for all of its electricity needs and found itself in the unique position of being an electricity consumer and, potentially, an electricity reseller. By December 2000, Kaiser faced a difficult decision of continuing its current aluminium production and profit levels, or closing the plant to dramatically increase its profit by simply reselling its electricity. When making production decisions, firms must consider both their costs and revenues. One important concern for many firms is utility costs. In 1996, Kaiser Aluminium Corporation in Spokane, Washington, entered into a five-year agreement with Bonneville Power to purchase a fixed amount of power at the price of $22 per megawatt hour, with the right to resell any unused electricity back to Bonneville Power at the current market price. Each company took a risk in this arrangement, with Kaiser Aluminium risking the possibility that energy prices would fall, and it would remain locked into an agreement to pay the $22 per megawatt hour, regardless of current prices. Bonneville Power risked the possibility that energy prices would substantially increase, and it would remain locked into an agreement to supply Kaiser Aluminium a set amount of electricity for $22 per megawatt hour, regardless of current prices. In 2001, due to a shortage of e
Profit is the incentive that drives our market economy. Firms make production, pricing, and hiring decisions based on their quest for profit. But what happens when a firm discovers that it can make dramatically higher profits by stopping production altogether? In December 2000, due to wild swings in the market for electricity, Kaiser Aluminium faced just such a decision.
Kaiser Aluminium had contracted with Bonneville power for all of its electricity needs and found itself in the unique position of being an electricity consumer and, potentially, an electricity reseller. By December 2000, Kaiser faced a difficult decision of continuing its current aluminium production and profit levels, or closing the plant to dramatically increase its profit by simply reselling its electricity.
When making production decisions, firms must consider both their costs and revenues. One important concern for many firms is utility costs. In 1996, Kaiser Aluminium Corporation in Spokane, Washington, entered into a five-year agreement with Bonneville Power to purchase a fixed amount of power at the price of $22 per megawatt hour, with the right to resell any unused electricity back to Bonneville Power at the current market price. Each company took a risk in this arrangement, with Kaiser Aluminium risking the possibility that energy prices would fall, and it would remain locked into an agreement to pay the $22 per megawatt hour, regardless of current prices. Bonneville Power risked the possibility that energy prices would substantially increase, and it would remain locked into an agreement to supply Kaiser Aluminium a set amount of electricity for $22 per megawatt hour, regardless of current prices. In 2001, due to a shortage of electricity in the western US and several
other factors, the price of electricity began to skyrocket and fluctuate wildly, to more than $50 per megawatt hour in May, to nearly $175 per megawatt hour in August, to nearly $300 per megawatt hour in December.
Kaiser Aluminium weighed the trade-offs of producing aluminium or reselling energy. Using cost-benefit analysis, Kaiser made a profit maximizing decision. Although the company recognized its
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