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Say I use two fuels to heat my home (space heating): oil and wood. I purchase both in bulk, at a price decided at the time of purchase.

Wood is cheaper per kWh, but I purchase both because oil has other uses (heating water for example, plus it's sometimes useful to have redundancy). So I purchase, say, three tonnes of logs for £300, and 1800 litres of oil for £1100.

When a given fuel has been used, I must purchase some more at the market price.

Now, the price of oil has collapsed and it is now may be cheaper per kWh to use it for space heating.

So, one any one night, how do I decide which fuel to use? Should I be using the market price at the time of use, or the purchase price?

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Assuming you plan to keep both oil and wood in stock, and they both give you the same quality of heating, presumably you should burn whichever will cost less for you to replace. That would be the fuel that will cost less to buy in the future when you buy it.

If you don't have any special knowledge about what prices will do in the future, I think the most neutral position would be to assume they will stay where they are now, so you should burn whichever currently has the lowest market price - oil in your scenario.

Having done that you could if you wanted to sell the wood that you didn't burn, which you say is worth more than the oil, buy the exact quantity of oil that you did burn, and have money left over. That must be better than burning the wood.

I've assumed for simplicity that there are no transaction costs incurred in the act of buying and selling.

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  • $\begingroup$ Perhaps an easy way to conceptualize why this argument is reasonable is by thinking about this in terms of currency. If you have two currencies and one has begun to devalue, which do you spend? If you are holding oil reserves and wood reserves, you MUST use one or the other, and you must replace whatever you use, then holding oil allows the continue devaluation of your oil stock. $\endgroup$ – 123 Jan 21 '15 at 5:04
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This is a normative question and there is no "correct" unswer in any reasonable sense. There us, however, some general considerations. First, unless you are considering selling the fuel there is no reason to worry about prices at all. Second, if you are entertaining the idea, than you should look not at the market prices as such, but at how much money you will be able to get for it. There is no reason at all to consider what you have already paid. It is generally a good idea to evaluate decisions in terms of opportunity costs.

Of course, this ignores all matters concerned with expectations, comparative advantages, regrets and such, but nobody will be able to adress them better then you. Sort for not being very helpful.

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  • $\begingroup$ I confirmed I must purchase more when the fuel is depleted. There surely is a reason to worry about prices, in the above example there's no reason to purchase wood if it's more expensive... $\endgroup$ – Dan Gravell Jan 19 '15 at 20:38
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    $\begingroup$ Surely you should worry about prices when you are purchasing more. However it doesn't matter when you have made a purchase already, unless you are willing to sell it. $\endgroup$ – Nikita Toropov Jan 19 '15 at 21:31

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