1. 178.307 Markets, Firms and Consumers Lecture 7- Natural Resource Economics

2. Introduction Many firms employ natural resources – Non-renewable resources Coal Iron ore Oil – Renewable resources Fish Forests Distinction between exhaustible and non-exhaustible is not preferred.

3. What makes Natural Resources different? Time – The efficient use of natural resources depends on time. – This dynamic nature makes these inputs different from other inputs (like capital). Public Ownership – Many natural resources are not privately owned. – Forests, fisheries and mineral deposits are often owned by the state.

4. Elementary Capital Theory We consider natural resources as a form of capital. – We then derive the arbitrage equation. – Let p t be the price, v t be the rent of a durable asset. – Firm is indifferent between a numeraire asset and the durable asset. The last equation is expressed in continuous time.

5. Hotelling’s Rule Assume that – The stock is sterile. No benefit derives from holding the stock. – This implies rental value is 0. – For convenience, suppose extraction is costless. This defines the optimal extraction of a non- renewable resource (Hotelling, 1931).

6. Hotelling’s Rule Expanded The rule implies that the rate of price increase must equal r to maximise profits. This fundamental rule is difficult to put into practice. Some empirical studies provide some support for Hotelling’s Rule. – In strong form it assumes perfect foresight by firms. – Technological change must also be accounted for.

7. Are natural resources getting depleted? Economists used to be pessimistic. Jevons stockpiled paper. Post-war studies came up with surprising results. Prices (fundamental measure of scarcity) for natural resources have tended to fall. A price increase indicated in late 70s. Prices have since fallen again – Simon’s Bet

8. Simon’s Bet MineralQty (lbs)1980 price1990 price Copper196.56$200$163 Chrome51.28$200$120 Nickel65.32$200$193 Tin229.1$200$56 Tungsten13.64$200$86

9. How does the Market Economy solve scarcity? Economise on resources that become more expensive. – OECD oil-consumption peaked in 1978. Increase supply – exploration Innovate – Horizontal bores in oil- wells Reward Innovation – Patents – Fibre-optics, communication satellites- less copper.

10. Winner’s Curse Derived from auctions of drilling rights (1971). Auctions are common value auctions. Even if estimates of value are unbiased, they are dispersed. Even if risk averse, a firm may overbid based on a high provided estimate. Effect increases with increase in number of bidders.

11. Winner’s Curse Curse 1 – The bid exceeds the value of the tract and the firm loses money. Curse 2 – The value of the tract is less than expert’s estimate. – The firm is disappointed. Solving for optimal bid is not trivial. – More bidders implies you must bid aggressively to win. – More aggressive bidding means you are more likely to overestimate value. Winner’s Curse has been applied to other problems (IPOs).

12. Renewable Resources The problem here is the resource can reproduce. Solution concepts depend on tools of dynamic optimisation (and sometimes stochastic calculus). Hamiltonians beyond scope of this paper…it’s rocket science.

13. Forestry Rotation The fundamental rule for optimal exploitation of forests is the Faustmann solution. “Kaingaroa Timberlands aim to increase target rotation age from 25-26 years to 29-30 years over the next 10 years. CHH is moving towards target rotations of 28-32 years”. – Bruce Manley, NZ Journal of Forestry, November 2004.

14. Single Rotation

15. Multiple Rotation This occurs because the producer faces the same problem in every rotation, hence becomes a convergent geometric progression.

16. This simplifies to…

17. Differentiate with respect to T (quotient rule), set equal to 0.

18. Solution

19. Discussion Faustmann formula is difficult to employ because – Age of trees differ – Forests have multiple values, not just timber production Many natural resources however are extracted at rates above profit maximising levels.

20. Public Ownership Government’s may have different objectives than maximising long term profits. – NZ over-harvested native trees in 50s-70s. – Policy was to lower timber costs (flood market). – This would lower housing prices.

21. State Ownership can be source of inefficiency. Fundamental problem is the “Tragedy of the Commons”. An open access resource will be over- harvested with multiple users.

22. Tragedy of the Commons solved by: Private Property Rights – Access limited by prices, – Freedom of contract – Torts to recover damage from trespass. Used to have right to trespass when hunting game. Communal Property Rights – Access limited to members of a community. – Extraction rates determined by customs.

23. Public Property Access limited by – Regulations – Bureaucratic controls. But… – Property rights that are either unenforced or unenforceable lead to open access problems. Many fisheries managed as public property. – Incentives to over- harvest weakly influenced by regulations. – Enforcement costly and imperfect – Fishers subsidised!

24. References Thaler (1997) Anomalies: The Winner’s Curse. http://links.jstor.org/sici?sici=0895-3309%28198824%292%3A1%3C191%3AATWC%3E2.0.CO%3B2-Y