Question
Envigorate Partners makes wood pellets that it sells to power plants. The power plants burn the wood pellets to generate renewable electricity. Envigorate has located
Envigorate Partners makes wood pellets that it sells to power plants. The power plants burn the wood pellets to generate renewable electricity. Envigorate has located a large wood pellet processing plant very close (less than a mile away) to renewable electricity generator ABC Electric Company.Envigorate Partners break even cost per ton of wood pellets delivered to ABC Electric of $72 is detailed below.
Envigorate Partners Break Even Wood Pellet Price (Per Ton): ABC Electric
Fixed Cost[1]
$50
Variable Cost of Production
$20
Transportation Costs
$2
Total
$72
If Envigorate Partners sells pellets to XYZ Electric, a renewable electricity producer that is located 50 miles away, its break even cost is $80 per ton because transportation costs are $10 per ton as opposed to $2 per ton when the pellets are delivered to ABC Electric.
ABC Electric can pay up to $72 per ton for pellets and remain profitable while XYZ Electric can pay up to $75 per ton for pellets and remain profitable.
Explain why ABC Electric can "hold up" Envigorate by offering to only pay $67 per ton: a price below Envigorate's break even.
[1] The fixed cost of $50 per ton covers the $5 million cost of building the pellet processing plant with an assumed useful life of 100,000 tons.
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