1. Efficient Supply of Renewable and Non-Renewable Resources Econ 1661 Review Section February 24 th, 2012 Rich Sweeney (Based on slides from Robyn Meeks and Matt Ranson) 1

2. Lots to catch up on today Part 1: Non-renewable resources – Review two-period model – Go through practice problem Part 2: Review of open-access resources – Explanation of fishery biology graphs and efficient yeilds – No problem yet, as Prof. Stavins is going to finish this topic on Monday 2

3. Part 1: Non-renewable resources outline Static versus dynamic efficiency Two-period model – Mathematical solution – Graphical Solution Resource prices and Hotelling Rule 3

4. Static vs. dynamic efficiency Static efficiency – Economically efficient allocation maximizes net benefits (TB-TC) – At this point MB=MC – Key: incremental benefits associated with the last unit preserved are exactly equal to the incremental opportunity cost of preserving the last unit Dynamic efficiency – Economically efficient allocation maximizes the present value of net benefits – At this allocation, PV (Marginal Net Benefits) are equal across time periods Discounting: present value = future value / (1+r) t – Trade off between marginal net benefits in different time periods because of budget constraint (total stock of resource) – Dynamically efficient allocation: requires that present value of the marginal net benefit from the last unit in Period 1 equals the present value of the marginal net benefit in Period 2 (for 2 period model) 4

5. Non-renewable resources: dynamic efficiency Dynamically efficient allocation: PDV [MNB 1 (q 1 )] = PDV [MNB 2 (q 2 )] This allocation maximizes the present value of net benefits 5

6. Price = MUC + MEC Marginal extraction cost (MEC) Marginal user cost (MUC): “scarcity rent” is the opportunity cost of forgone future consumption is the additional marginal value of a resource due to its scarcity If MUC = 0 and P = MEC, then the resource is not economically scarce Marginal Opportunity Cost = MUC + MEC Non-renewable resources: dynamic efficiency 6

7. Example: 2-period non-renewable resource model Basic setup: – There are two periods. – There is a total stock of 20 units of oil in the ground. – Consumer demand for oil is: q 1 (p 1 ) = 20 – 2.5p 1 in period 1  p 1 (q 1 ) = 8 -.4q 1 q 2 (p 2 ) = 20 – 2.5p 2 in period 2  p 2 (q 2 ) = 8 -.4q 2 – The marginal cost of extracting the resource is: MEC 1 = 2 in period 1 MEC 2 = 1 in period 2 (because of improved technology) – The interest rate is r =.1 7

8. First, what quantities would be supplied in each period if producers were myopic? Real Question: What are the socially optimal (ie dynamically efficient) quantities of resource extraction in the two periods? Answer: Dynamic efficiency implies that we want to choose q 1 and q 2 to maximize the present discounted value of the net benefits of oil extraction in the two periods. So, we want to maximize: PDV[NB 1 (q 1 )]+PDV[NB 2 (q 2 )]...while taking into account the stock constraint: q 1 +q 2 = 20. Two-period non-renewable resource model 8

9. Mathematical solution Two equations define the optimal extraction in the two periods: – Condition #1 (Maximization): PDV [MNB 1 (q 1 )] = PDV [MNB 2 (q 2 )] This equation says that when the PDV of net benefits is maximized, the PDV of the marginal net benefits in period 1 must equal the PDV of the marginal net benefits in period 2. If this weren't true, then we could increase the discounted net benefits by switching a unit of extraction from period 1 to 2 (or vice versa), and so we wouldn't be at a maximum. – Condition #2 (Resource Constraint): q 1 +q 2 = 20 This is just the constraint that we can't extract more oil than we have. 9

10. Six steps to find the optimal q* 1 and q* 2 : – Step 1: Write down marginal extraction costs in each period. MEC 1 = 2 in period 1 MEC 2 = 1 in period 2 – Step 2: Write down marginal benefits in each period. Remember that marginal benefits are given by the inverse demand function. MB 1 (q 1 ) = p 1 (q 1 ) = 8 -.4q 1 MB 2 (q 2 ) = p 2 (q 2 ) = 8 -.4q 2 – Step 3: Calculate marginal net benefits in each period. Marginal net benefits are just equal to marginal benefits minus marginal extraction costs. MNB 1 (q 1 ) = MB 1 (q 1 ) - MEC 1 (q 1 ) = 8 - 4q 1 - 2 = 6 -.4q 1 MNB 2 (q 2 ) = MB 2 (q 2 ) - MEC 2 (q 2 ) = 8 - 4q 2 - 1 = 7 -.4q 2 Mathematical solution 10

11. – Step 4: Write down the present discounted value of marginal net benefits in each period. Remember that the PDV of x dollars t years from now at interest rate r is PDV = x / (1+r ) t PDV [MNB 1 (q 1 )] = (1+.1) 0 * (6 -.4q 1 ) = 6 -.4q 1 PDV [MNB 2 (q 2 )] = (1+.1) -1 * (7 -.4q 2 ) = 6.363 -.363q 2 – Step 5: Write down conditions #1 and #2. Condition #1: Maximization PDV[MNB 1 (q 1 )] = PDV[MNB 2 (q 2 )], which we can rewrite as: 6 -.4q 1 = 6.363 -.363q 2 Condition #2: Resource Constraint – q 1 +q 2 = 20 Mathematical solution 11

12. Step #6: We finally have two equations (Conditions #1 and #2) and two unknown variables (q 1 and q 2 ). We can now use algebra to solve for the socially optimal q* 1 and q* 2 : 6 -.4(20 - q 2 ) = 6.363 -.363q 2  q* 2 = 10.952 q 1 + 10.952 = 20  q* 1 = 9.048 So, in this example, the socially optimal quantity of extraction is higher in period 2. Even though net benefits in period 2 are discounted, the marginal cost of extraction is lower in period 2. Thus, it makes sense to extract more in the second period, when extraction is cheaper. Mathematical solution 12

13. First 4 steps are the same as in the mathematical solution: – Step 1: Write down marginal extraction costs in each period. MEC 1 = 2 in period 1 MEC 2 = 1 in period 2 – Step 2: Write down marginal benefits in each period. Remember that marginal benefits are given by the inverse demand function. MB 1 (q 1 ) = p 1 (q 1 ) = 8 -.4q 1 MB 2 (q 2 ) = p 2 (q 2 ) = 8 -.4q 2 – Step 3: Calculate marginal net benefits in each period. Marginal net benefits are just equal to marginal benefits minus marginal extraction costs. MNB 1 (q 1 ) = MB 1 (q 1 ) - MEC 1 (q 1 ) = 8 - 4q 1 - 2 = 6 -.4q 1 MNB 2 (q 2 ) = MB2(q 2 ) - MEC 2 (q 2 ) = 8 - 4q 2 - 1 = 7 -.4q 2 – Step 4: Write down the present discounted value of marginal net benefits in each period. PDV [MNB 1 (q 1 )] = (1+.1) 0 * (6 -.4q 1 ) = 6 -.4q 1 PDV [MNB 2 (q 2 )] = (1+.1) -1 * (7 -.4q 2 ) = 6.363 -.363q 2 Graphical solution 13

14. Step 5: Draw the PDV of marginal net benefits in each period on the same graph (see following slides). – This graph is a little complicated, so be careful. – We'll put PDVs on the vertical axes. – We'll put extraction quantities (q 1 and q 2 ) on the horizontal axis, running in opposite directions. Since the total stock of the resource is 20, each of the axes will end at 20. By drawing the quantities in opposite directions on the same axis, we are building in the resource constraint (Condition #2). – We'll then plot the PDV of MNB in period 1 on the left side, and the PDV of MNB in period 2 on the on the right side. Graphical solution 14

15. Step 6: Find the optimal extraction quantities where the two lines intersect (see following slides). – This is just a graphical version of Condition #1 (maximization). – If we picked some other point, then we could increase the sum of discounted net benefits in the two periods by switching a unit of extraction from period 1 to 2 (or vice versa). Thus, we wouldn't be at a maximum. Graphical solution 15

16. Graphical solution 16

17. Graphical solution 17

18. Graphical solution 18

19. Graphical solution 19

20. Graphical solution 20

21. Graphical solution 21

22. Resource prices To calculate the optimal price in the two periods, we can just plug the optimal quantities into the inverse demand functions:  p 1 (q 1 ) = 8 -.4q 1 = 8 -.4 * 9.048 = 4.38  p 2 (q 2 ) = 8 -.4q 2 = 8 -.4 * 10.952 = 3.62 – NOTE: should be optimal real (current ) prices. Why aren't these prices equal to the marginal extraction costs? The answer is because the prices also include a marginal user cost (also known as scarcity rent) that accounts for the fact that once we extract a unit of oil, it is gone forever. To calculate marginal user cost, we just subtract the marginal extraction cost from the optimal price in each period:  MUC 1 = p 1 - MEC 1 = 4.38 - 2 = 2.38  MUC 2 = p 2 - MEC 2 = 3.62 - 1 = 2.62 22

23. Hotelling Rule At the dynamically efficient allocation of a non-renewable resource with constant MEC, the MUC rises over time at the rate of interest (the opportunity cost of capital) – This is the “no arbitrage” condition. We check the Hotelling Rule with for this example. The interest rate was r =.1, so MUC 1 * 1.10 = MUC 2 2.380952 * 1.10 = 2.619048 So Hotelling Rule does hold in this example. Question: What would happen if there were no property rights? 23

24. Part 2: Renewable, open-access resources outline Biological aspects of fisheries Efficient allocations: fisheries Issues of open-access in fisheries 24

25. Biological dimension of fisheries natural equilibrium (S cc ) – the population size that would persist in the absence of outside influences – stable – “carrying capacity” minimum viable population (S MVP ) – level of the population below which growth is negative – unstable – below this population the species could become extinct critical depensation 25 Logistic Growth Curve with Harvest Population growth increases as population increases Population increases lead to eventual decline in growth

26. 26 Biological dimension of fisheries sustainable yield – Population for which catch level = growth rate of population – This can be maintained maximum sustainable yield (S M ) population size that yields the largest catch that can be perpetually sustained maximum sustainable yield = maximum growth 26 Logistic Growth Curve with Harvest Population growth increases as population increases Population increases lead to eventual decline in growth

27. Few additional points on biological dimension Very small and very large populations generate small rates of growth One population level will have the greatest possible annual growth rate (maximum sustainable yield) Except for at the stock maximum, equilibrium at any desired yield can be achieved through 2 different levels of fishing effort (high and low) 27

28. Recall : Static Efficiency To achieve static efficiency (single time period), undertake policy to the point at which marginal benefits equal marginal costs 28 Total Benefits Total Costs Marginal Benefits Marginal Costs Net Benefits Q*Q* Total Benefits and Total Costs Marginal Benefits and Marginal Costs Q*Q*

29. Efficient sustainable yield We use three assumptions to simplify analysis/graphs: – price/fish constant over all catch levels – Constant MC of fishing effort – Quantity of fish caught proportional to existing stock of fish Static vs. dynamic – For details on impact of discount rate, see Tietenberg. 29 Efficient level of effort Slope=MB

30. 30 Efficient sustainable yield Efficient sustainable yield occurs where – MB=MC – Net benefits are maximized 30 Efficient level of effort Slope=MB

31. Market exploitation under open access 31 In an open-access fishery, the rent is a stimulus for new fishermen to enter – As long as TB > TC competitors will enter the market Under open-access, there will be an inefficient level of effort: – Effort will increase until TB=TC – Overexploitation, overcapitalization, depleted stocks – Rents dissipate entirely Total benefits (total revenues) Total cost Under open access

32. Reasons for E c :OPEN ACCESS Contemporaneous external cost: one fisher affects another (if I catch, you can’t and vice versa) Intertemporal external costs: take today, less for tomorrow Does not take into account future value MUC (this is why Hotelling rule for non-renewables required secure property rights) Market on its own cannot achieve efficient result. 32

33. Additional information Prof. Stavins will be taking questions at the end of class Monday. PRE-MIDTERM OFFICE HOURS: Rich and Liz will hold office hours together on Monday (2/27) from 5 to 7 pm, and on Tuesday (2/28) from 6 to 8 pm. Both sets of office hours will occur in room 401 in Taubman. We will post review notes and problems in advance, which we encourage you to review prior to coming to office hours. 33

34. Summer Undergrad RA Opportunity “The Economic Returns to Investments in Clean Energy Technologies in the American Recovery and Reinvestment Act of 2009” Faculty: Joe Aldy More info at: http://environment.harvard.edu/student- resources/undergraduate-summer-research- fund/opportunities http://environment.harvard.edu/student- resources/undergraduate-summer-research- fund/opportunities 34