Environmental Economics 2 Lecture 6 Non-Renewable Resources

Overview of this part… Natural Resources theory: Non-renewables Renewables Applied studies of theory – is it true? Fisheries Forestry Energy security – valuation issues Climate Change

Health warning This lecture contains a lot of maths. Later lectures won’t be quite so bad (promise!!!) Key: understanding the concepts, not necessarily the maths Though if you can handle the maths this would be great.

Readings This lecture largely based on chapters 7,8,9 of HSW More advanced – see Conrad and Clark chapter 3 Other sources (go to if don’t follow above): Perman et al

Definitions Non-renewables – eg coal Renewables – eg fish stocks or flows (eg wind)

Concepts you will need to have an idea of… Hamiltonian – specialised form of Lagrangian – see Perman or Pemberton and Rau if you don’t understand this in this lecture. Market structures – monopoly, oligopoly, perfect competition – see basic micro text book to refresh if you’ve forgotten! Discounting – intertemporal issues. See Perman.

Hamiltonian Hamiltonian helps to solve the control problem. Similar to Lagrangian. ) , ( ] [ t q x g H l p + = ð profit plus change in stock valued by shadow price. To maximise => = ¶ q H l · - = ¶ x H and These conditions and equation of motion (change in x) give a set of differential equations which define an optimal solution. (it also has to satisfy travers ality conditions but we won ’t go into this – see HSW 186 - 188)

Discounting Social rate of time preference => reduce future values to reflect this. Usual notation: discount rate is r (occasionally i). 1/((1+r)^t) gives you the multiplier to reduce any value in time t to the current time. Eg 1/1.08 may give you the multiplier for t=1 and r=8% => £1 = £0.925926 Note r=8% does not lead to 0.92 in period t=1, because 1.08 in t=1 would be equal to 1 in t=0 (0.92 in t=0 does not equate to £1 in t=1 => try it!)

The basics If LHS is greater than RHS it pays to reduce extraction If LHS is less than RHS it pays to increase extraction But note, adjustment is inherently unstable!

The basics (2): No Substitute for the ER Resource is progressively exhausted on the price path. Eventually resource may be exhausted but this can take infinitely long!

The Basics (3): Backstop exists Resource is progressively exhausted on the price path. But now when price reaches Backstop Price the producer must have nothing left. For this to work initial price must be ‘correct’ Lower is r, higher is initial price and lower is extraction initially

Extensions to model: Effect of Extraction Costs Now net income (price minus extraction cost) must rise at rate of interest. But if extraction costs fall, then initially extraction increases. Price time

Extensions to the Model (3) New Discoveries Effect is similar to an decrease in the price of the substitute – you extract faster. With unanticipated discoveries we see the following pattern:

Extensions to Basic Model (2) Capital Costs These are part of extraction costs and are sensitive to interest rates. If ‘r’ rises then extraction costs rise, resulting in slower extraction. But higher is ‘r’ faster is extraction on Hotelling grounds. Technology Changes If backstop price falls, extraction must increase. If technology lowers extraction costs, extraction also increases initially.

Economic Approach to Resource Use: Theoretical Background Capital Theory Approach In equilibrium the returns from buying machines = the total return from holding the numeraire asset => (vt+1 + μt+1)/ μt=1+ rt+1 If out of equilibrium then there is the chance of pure profits from arbitrage. The own rate of return = rental income/price If rate of return of using machines and numeraire good is different this can only be accounted for by a change in the price => vt+1= rt+1 μt-(μt+1 - μt ) So the difference in interest rates must be accounted for by a change in the price of the asset.

Capital Theory In the continuous form: where is the time derivative (increase or fall in the price of capital). This is the short-run equation of yield or the arbitrage equation.

Non-Renewables

Renewables

Growth function

Equilibrium

Equilibrium

Market Structure The market structure of an industry may be important in determining the rate of extraction of a resource. Here we will take the earlier analysis further, building on mathematical techniques of comparative dynamics.

Competitive Industry

Competition

Consumer Surplus

Hamiltonian

Monopoly

Hamiltonian

Hotelling Rule for Monopoly

Perfect Competition

Monopoly

Comparison

Comparative dynamics Figure 9.1 in Hanley, Shogren and White

Conclusions Initially competitive industry extracts more rapidly than monopoly but then less rapidly as the price increases towards the backstop price. Initial price for monopoly is higher than that for competitive industry. Then increases more gradually towards the backstop price, Rate of price increase for monopolist is less than discount rate, otherwise resource can be purchased by speculators, stored and sold at later date, so reducing monopoly profits.

Heroic Assumptions Non-linear extraction costs => solving for extraction path for competitive industry formidable problem Exploration issues Resource scarcity Uncertainty

Does it work? Will examine this in later lecture on empirical validation.