Joint Product Pricing. Pee-Wee Petroleum, Inc., operates oil and gas producing wells in the Overthrust Belt region. On average, for each barrel of oil pumped to the surface, one thousand cubic feet of natural gas is also recovered. Therefore, the company views oil and gas as joint products where each unit of production involves 1 bbl: 1 mcf. Marginal costs are $75 per unit of production.
Although each output is sold in perfectly competitive commodity markets; transport, handling and related costs have the effect of reducing the net price received by Pee-Wee. The net price/output and marginal revenue relations for oil is:
Po = $100 - $.000075Qo
MRo = TRo / Qo = $100 - 4.00015Qo
and for gas is:
Pg = $15 - .000025Qg
MRg = $15 - .00005Qg
where QO is barrels of oil and QG is mcf of natural gas sold per month.
1. Calculate the profit-maximizing price/output combination for oil and gas under current conditions.
2. Now assume that instability in the world oil market has caused the demand for domestic oil to double. Holding all else equal, calculate the new optimal price/output combination for oil and gas.