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 opportunity costs, it was convinced that given the volatility of the energy market, it was in a better position to protect itself in the long run by making its difficult decision of stopping the production of aluminium. Although this was a dramatic example, companies face decisions every day that require them to make choices among alternatives. While the corporation, its shareholders, workers, consumers, and local taxing bodies, may disagree about what is the best decision, the profit motive allows our market economy to run relatively smoothly while giving companies the greatest possible freedom to make the decisions that are best for themselves. Given the information from above, if you were an economist for Kaiser Aluminium, what would you have suggested that Kaiser do: continue to produce aluminium or shut down and resell energy? Would your advice change if you were advising Kaiser more broadly? Suppose you also had to consider the reactions from shareholders, customers, and employees, from the decision by Kaiser. In your answer, be sure to use the terminology and concepts discussed in the module. Be sure to discuss trade-offs, opportunity cost, cost-benefit analysis, and the profit motive in your analysis.
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
market, it was in a better position to protect itself in the long run by making its difficult
decision of stopping the production of aluminium. Although this was a dramatic example,
companies face decisions every day that require them to make choices among alternatives.
While the corporation, its shareholders, workers, consumers, and local taxing bodies, may
disagree about what is the best decision, the profit motive allows our market economy to
run relatively smoothly while giving companies the greatest possible freedom to make the
decisions that are best for themselves.
Given the information from above, if you were an economist for Kaiser Aluminium, what
would you have suggested that Kaiser do: continue to produce aluminium or shut down and
resell energy?
Would your advice change if you were advising Kaiser more broadly? Suppose you also had
to consider the reactions from shareholders, customers, and employees, from the decision
by Kaiser.
In your answer, be sure to use the terminology and concepts discussed in the module.
Be sure to discuss trade-offs, opportunity cost, cost-benefit analysis, and the profit motive in
your analysis.
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