Lecture 5 & 6 Cost Benefit Analysis & Non-renewables Flashcards
Hotelling Rule
Hotelling’s theory addresses a fundamental decision for an owner of a nonrenewable resource: Keep the resource in the ground and hope for a better price the next year, or extract and sell it and invest the proceeds in an interest-bearing security.
Because there is no dividend or interest payment in the case of resource ownership, only a resource price increase can guarantee equal return of all the assets.
Illustrate the Hotelling-rule with an appropriate equation.
Pic 7
Price path without extraction costs according to the Hoteling rule
The price and value of the resource increase over time for both functions to reflect the scarcity in supply (i.e. the opportunity cost to extract).
Price growth is steeper with a higher interest rate, and flatter with a lower interest rate.
Resource depletion is initially faster for R1 than R0
Price path without extraction costs according to the Hoteling rule:
Lower interest rate…
Slower increase in price path
Slower resource depletion
Slower decline in demand
Higher starting price
Price path without extraction costs according to the Hoteling rule:
Higher interest rate…
Faster increase in price path
Faster resource depletion
Faster decline in demand
Lower starting price
Extraction sequence associated with Hotelling path
The extraction sequence is an optimal depletion path which is characterized by decreasing demand over time
Linear and isoelastic demand with Hotelling
Linear case: firms do not let prices exceed the choke price to keep demand steady and ensure the whole resource stock is used.
There exists a level of pR for which no resource is sold.
Isoelastic case: even with indefinitely high price, a positive (though indefinitely small) quantity of resource is demanded. There is no threshold / choke price.
What happens at the choke price?
At the choke price, demand becomes zero, and there is a switch to an alternative resource or to a ‘backstop’ technology.
Explain the effects of exploration
A change in stock of the resource impacts the price
An increase in the supply leads to a lower price and higher demand
There is no change in slope of price path
Explain the effects of a backstop-technology
A backstop technology provides resources at a constant marginal cost for an indefinitely long time
pB: price of backstop technology = choke price
Do Hoteling until the point of the backstop
Hotelling rule: Monopoly
· Monopoly and perfect competition choose the same path (same Hoteling rule) because the resource constraint is binding for both market forms
· Price growth is exactly like in perfect competition: = 1 + r
· Assumption: constant elasticity of demand
Impact of market form on resource extraction and stock depletion
Pic 8
Resource depletion in competitive and monopolistic markets
Resource depletion outcomes differ between competitive and monopolistic markets. In a monopoly:
- Longer time to depletion
- Higher resource net price in early years
- Lower net price in later years.
Hotelling rule: critique / discussion of the assumptions
· Ownership guarantees: often not given
· Change in monopoly power
· Political and economic conditions in developing countries
· Which backstop technology? When?
· Perfect foresight: not realistic
· Variable extraction costs
Explain the importance of the elasticity of substitution between
non-renewable resources and capital.
Sustainability of Economic Growth
Resource Scarcity Mitigation
Incentives for Innovation
Policy Implications
Economic and Envrionmental Tradeoffs
Sustainability of Economic Growth:
A high elasticity of substitution means that capital (e.g., technology or infrastructure) can more easily replace non-renewable resources in production.
This flexibility reduces the economy’s dependence on finite resources, supporting long-term economic growth.
Resource Scarcity Mitigation:
When substitution is easier, resource depletion has a smaller impact on production costs and economic output.
A low elasticity of substitution implies that resource scarcity will significantly constrain production and increase costs.
Incentives for Innovation:
Higher elasticity encourages investment in alternative technologies and capital that can replace resource use (e.g., renewable energy systems).
Lower elasticity signals a need for urgent resource conservation and innovation in resource-efficient technologies.
Policy Implications:
Policymakers must account for elasticity when designing taxes or regulations for non-renewable resources.
Higher elasticity suggests policies should focus on promoting substitution technologies, while lower elasticity emphasizes conservation and sustainable resource management.
Economic and Environmental Trade-offs:
The ease of substitution determines how the economy balances resource depletion with environmental goals.
Greater substitution elasticity reduces environmental pressure by decreasing resource extraction, but low elasticity demands stricter resource-use controls.
