Microeconomics > Peabody Energy Corporation

The article I’ve chosen describes an energy company’s future plans to purchase additional resources -mines - , in order to enter the Chinese market. The Company mentioned is the Peabody Energy Corporation of St. Luis, which is the world’s largest shareholder-owned coal company. It has plans of purchasing two coal mines in Australia which could support the steel industry in the rapidly developing Chinese market.

There are several issues that can be discussed in relation to this expansion. First of all, all business firms have to purchase inputs to produce, and sell outputs. With other words firms demand factors of production in input markets and supply goods or services in output markets. In this case Peabody needs to buy coal mines, which is its input, in order to produce output, which is the coal. The coal is then used as an input for other firms, in this case steel companies, to produce other goods, which will be those firms’ output. Regardless of whether Peabody is a perfectly competitive or a monopolistic firm, it demands inputs, engages in a production, and produces output. Its number one incentive is to maximize profits, and thus to minimize costs.

If we examine the situation further, we’ll see that trying to maximize profit is what really happening here. We can instantly see that an economy of scale is working in favor of Peabody. As Mark Reichman, an analyst says “This is a size-and-scale business. It has high fixed-capital costs”. Peabody is a huge company, and has fixed costs that are really high. Fixed costs are costs that don’t depend on the firm’s level of output, and incurred even if the firm’s output is zero. Its average fixed costs are the total fixed costs divided by the number of outputs that are produced. Given the following equation, TC=TFC+TVC, its total variable costs are not that high. Variable costs are costs that depend on the level of production chosen. The more Peabody produces, the less its average fixed costs will be. It means that every additional unit of product it produces will reduce the amount of fixed cost per unit. It is also called spreading the overhead, when dividing the total fixed costs by more units of outputs, and average fixed cost declines as quantity rises. This is the economies of scale. Peabody should therefore increase its productions, and it will produce at reduced average fixed costs.

With its expansion to China, Peabody is hoping to satisfy a growing demand for coal for China’s “burgeoning” steel industry. The Chinese economy has been rapidly developing, and among others its steel industry. Peabody sees the opportunity of the huge need for its coal, so it’s planning to satisfy this need by acquiring new resources for its production. Peabody will invest a large amount of money into buying the two new coalmines, and it hopes to get a higher then average return on it. Australia is in a geographical proximity to Asia, and China, therefore Peabody can reduce transporting expenses. Another reason of buying additional mines is that its existing mines’ reserves are decreasing rapidly. Australia is the world’s largest coal-exporting country. Peabody exports to 14 countries, including Japan, Taiwan, and South Korea in Asia. This newest acquisition would give it access to the Chinese market. China’s expanding steel industry requires an enormous amount of coal. Since coal is the primary input in steelmaking, Peabody has a great opportunity if it goes to the Chinese market. Peabody will see a growth in investment, or capitals, a growth in production, and eventually, if everything goes well, a growth in profit. But decisions like this consider the long run status of the company. Peabody doesn’t make a decision as to what to do on the next business day, but instead it is part of a longer term strategic planning.

Of course when a firm makes a long run investment decision, it has to take opportunity costs into account as well. The firm’s priority is to get a fairly big return on its investment, bigger then it could get from other investments, or money market. Opportunity cost is what a company gives up when making a decision. In this case Peabody could have done other things with its money; that would be the opportunity cost. Future benefits have to outweigh its expected return of the market interest rate. The expected rate of return depends on the initial investment and the expected amount of revenue attributable each year to the project. The article doesn’t disclose further details of the transaction, because it’s still being negotiated.

 

 

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