Living Economics

Windfall Profit
Unexpected market gain resulting from uncontrolled circumstances might serve as incentives to correctly allocate scarce resources.

At least 3 big aluminum companies in the Northwest shut down or sharply curtailed production of aluminum in December 2000. Instead, they are taking the huge amounts of government-provided, low-cost hydro-electricity they would have used for that process and selling it back to the government for nearly 25 times what they paid (Milwaukee Journal Sentinel).

For example, the Kaiser Aluminum's Mead smelter near Spokane, WA earned about $47 million by taking the electricity it had contracted to buy at $22.50 a megawatt hour from the federal Bonneville Power Administration and selling it back to the government for $555 a megawatt hour in December 2000. The Power Administration in turn sold the electricity to California which was facing a breakdown in its electricity supply system due to poorly conceived and implemented de-regulation.

The plot got even thicker. Under pressure from local and federal officials, Kaiser agreed to pay its idled employees their regular wages and benefits until the smelter reopened. Kaiser employees were not the only workers that got paid for not working. Irrigation farmers were also paid up to $440 an acre not to farm. The water thus saved could then be used to generate more electricity to be sold to California (NY Times).

The low-cost contracts that were signed in 1995 between the aluminum companies and the federal power administrators guaranteed the industry a set amount of electricity at a set price. The contracts were generally regarded at the time as important incentives to keep industry and jobs in the Northwest.

This story illustrates how a market system based on long-term contracts works. A contract defines the legal rights and obligations between the contracting parties. Unless there are provisions to renegotiate the terms under specified contingencies, the parties are bound to honor those terms. During the period when the contract is in force, situations might change in favor of one party or another. Windfall profit1 or unexpected loss happens which might look extremely unfair to the unlucky party from hindsight. But if the terms of the contract are not respected, then there is no point in making the contract. And without binding contracts, a lot of potentially beneficial market exchanges would not take place.

Of course, the power contract could have specified that the electricity must be used for the specified purpose, or the electricity has to be sold back to the power authority at the preferential price. In other words, a use-it-or-lose-it right to the power. But the federal power authority might not be able to impose those conditions in a buyers' market or even have the foresight to expect such a contingency. Even if these conditions were present, it is still a bad idea to restrict the use of scarce resources. If the power must be used for aluminum production regardless of its opportunity cost2, Kaiser would have been forced to use the power for a lower-valued purpose instead of reselling the power to power-hungry California. That sure would be a lose-lose situation.

Note:
  1. Windfall profit is unexpected market net gain that is uncontrolled by the gainer.
  2. Windfall profit is unexpected market net gain that is uncontrolled by the gainer.
  3. The cost of a resource or an action is measured by the value of the current best alternative opportunity, rather than by its committed value. As such, opportunity cost could be higher or lower than the committed cost depending on the abundance or lack of alternative uses for a given resource.
  4. The cost of a resource or an action is measured by the value of the current best alternative opportunity, rather than by its committed value. As such, opportunity cost could be higher or lower than the committed cost depending on the abundance or lack of alternative uses for a given resource.
References:
  • Milwaukee Journal Sentinel. 12/29/2000. "Profit from power; aluminum companies reselling their cheap electricity."
  • New York Times. 5/1/2001. "River's power aids California and enriches the Northwest."
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