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Assessment 2 Case Study

(Oily Business)

16th September 2023

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Q1: When the government or producers decide to restrict oil supply, they reduce the

amount of oil available in the market. The supply curve therefore moves to the left as

follows:

Due to a decrease in supply, there is now a shortage of oil in the market, as demand

(Q2) exceeds supply (Q1). This led to an increase in oil prices, from P1 to P2. When supply

is limited and demand is relatively constant or even increasing, prices often rise (Boyle,

2023). This is because consumers are willing to pay higher prices for limited resources.

Q2: There are several possible factors that may lead to an increase in oil demand

Industrial production: Increased industrial production, especially in the manufacturing and

heavy industry sectors, requires more oil for production and start-up machinery and

equipment. The increase in industrial production shifts the demand curve to the right, and as

demand increases, oil prices rise from P1 to P2.

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Economic growth: Economic growth leads to an increase in industrialization and

transportation demand, resulting in an increase in demand for oil. The increase in economic

growth causes the demand curve D1 to shift to the right, indicating the need for more oil at

each price level. As demand increases, oil prices rise from P1 to P2.

Petrochemical production: The petrochemical industry uses petroleum as a raw

material for the production of chemicals and plastics. The increase in demand for

petrochemical products may also lead to an increase in demand for oil. The increase in

demand in the petrochemical industry has led to a rightward shift in the demand curve. As

demand increases, oil prices rise from P1 to P2.

Q3: Governments may explore the establishment of an oil price limit as a policy

option to address concerns connected to high oil prices. A price cap is a statutory upper limit

on price that the government sets in order to ensure that prices remain affordable for its

citizens especially during uncertain economic times.

Citizens' cost of living may rise as a result of high gasoline costs, which can

lower their discretionary income and overall standard of life resulting in the standard of living
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to drop. However, by restricting the price of oil, governments may unintentionally cause a

scarcity of resources.

For example, if the price ceiling is much lower than the equilibrium price, there might

be a shortage of oil since demand would outweigh supply at the lower price. These may result

in the establishment of black-market trades for oil due to the increased in demand, allowing

for price gouging to occur.

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In addition, companies may cut back on investment in exploration and production of

oil as a result of decreased earnings, which might result in a future with lesser supply but

demand remaining the same.

Price limitations while effective in the short run can have long term consequences.

Which is why they have to be implemented carefully by governments in order to ensure that

prices remain affordable for its citizens while still ensuring that the supply is able to keep up

with the increase in demand.

Q4: A primary factor contributing to Firms' reluctance to invest in renewable energy

is the consideration of costs, which can be classified into two categories: fixed and variable

costs.

Fixed costs, represent recurrent expenses that remain constant regardless of the

quantity of goods produced. In the renewable energy sector, these costs primarily take the

form of land, regulatory, and grid-related expenditures.

Land acquisition and leasing fees costs are typically incurred upfront and remain

constant, irrespective of energy production level. Further adding to it are regulatory costs

such as land surveys, licensing and permit fees, that can constitute a substantial expense. Grid

costs encompass the initial investment in grid connection infrastructure to the ongoing

maintenance and upgrading of substations and powerlines. These investments are crucial to

transmitting excess energy back to the grid and ensuring a reliable power supply yet

contribute significantly to a firm’s fixed cost, with research conducted in China estimating

that grid infrastructure in the nation would cost up to 6.1 billion USD in the year 2020 (Lin &

Li, 2015).
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Variable costs are expenses that fluctuate based on the quantity of goods or services a

business produces. In the realm of renewable energy, these costs manifest as operational,

environmental, and performance-related expenditures.

Operational costs encompass expenditures for repairs and replacements, with costs

varying depending on the severity of the issues, utilities and labour expenses, which rise

proportionally to increased energy demand. Environmental costs arise from adhering to

environmental compliance policies, such as emissions monitoring. Adapting to changing

regulations can lead to higher costs. Additionally expanding production to meet demand may

lead to higher emissions resulting in firms facing fines for breaching environmental

regulations. Performance costs pertain to the expenses incurred due to inefficient power

production. Renewable energy systems' efficiency can be affected by variable weather

conditions. These fluctuations in energy production result in additional costs as firms strive to

meet energy demand during periods of low renewable energy generation.

Lastly, industry analysts point out that the current output of renewable energy sources

falls short of meeting the rapidly growing demands of the global power market (Tan, 2021).

This shortfall translates into reduced profit potential for firms, further intensifying their

reluctance to invest in renewable energy. For fear that they may not recoup both the fixed and

variable costs associated with transitioning to renewable energy sources.

Q5: Fixed costs and variable costs help to illustrate the overall cost structure of a firm.

Understanding the distinction between fixed costs and variable costs is important as it allows

for effective decision making with regards to pricing, production levels, and overall business

strategy.

Fixed and variable costs are essential for conducting a break-even analysis. This

analysis helps a firm determine the level of sales needed to cover all costs and start
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generating profit. By understanding the portion of costs that are fixed and variable, a firm can

calculate their contribution margin, which is the difference between revenue and variable

costs (Estevez, 2023). This margin helps in assessing profitability and making adjustments to

enhance it.

Knowing the breakdown of costs also allows for more accurate financial planning and

budgeting. Fixed costs remain relatively constant, aiding in creating a stable budget, while

variable costs can be projected based on expected levels of production or sales.

Additionally, as fixed costs represent a long-term commitment, understanding them

helps in assessing the financial risk associated with these commitments. Variable costs, on

the other hand, can be adjusted more easily in response to changes in the business

environment (Vipond, 2019).

Analysing fixed and variable costs separately aids a firm to identify opportunities for

cost reduction and efficiency improvements helping to focus efforts on minimizing variable

costs while managing fixed costs efficiently.

In summary, the distinction between fixed and variable costs is fundamental for

effective financial management, aiding in cost control, profitability analysis, decision-

making, and efficient resource allocation within a business firm.

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References

Estevez, E. (2023, April 27). What is contribution margin? Investopedia.

https://www.investopedia.com/terms/c/contributionmargin.asp

Fernando, J. (2023, March 13). Law of supply and demand in economics: How it works.

Investopedia. https://www.investopedia.com/terms/l/law-of-supply-demand.asp

Lin, B., & Li, J. (2015). Analyzing cost of grid-connection of renewable energy development

in China. Sciencedirect.

https://www.sciencedirect.com/science/article/abs/pii/S136403211500547X

Tan, W. (2021, November 3). What 'transition'? Renewable energy is growing, but overall

energy demand is growing faster. CNBC. https://www.cnbc.com/2021/11/04/gap-

between-renewable-energy-and-power-demand-oil-gas-coal.html

Vipond, T. (2019, September 18). Fixed and variable costs. Corporate Finance Institute.

https://corporatefinanceinstitute.com/resources/accounting/fixed-and-variable-costs/