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Qanda 15
Qanda 15
Qanda 15
Discussion questions
As the text explains, under the conditions specified in this chapter, an increase in
extraction costs has an effect on the optimal extraction path qualitatively equivalent to a
change from conditions of perfect competition to monopoly, other things being equal
(compare Figures 15.4 and 15.12 to confirm this). We also established (on page 525) that a
revenue subsidy (or negative revenue tax) is equivalent to a decrease in extraction costs.
Therefore a revenue subsidy, which in effect reduces (post-subsidy) extraction costs, could be
set at a rate consistent with inducing a monopolistic extractor to extract at the socially-
efficient rate through time. Note that a subsidy (or tax) on royalties will not have this effect
(see page 525).
This quotation suggests that to obtain a complete and coherent account of natural
resource matters, one should be willing to adopt a multi-disciplinary approach.
That is very much the line we take in this text, even though our interest is very
much that of the environmental economist.
However, in studying environmental issues, the economist will soon find that the
interactions between the economic and environmental systems necessitate taking
on board some of the content and approaches of the physical, earth and life
sciences. Moreover, questions of distribution of income and wealth within and
between nations, and over time, and issues of policy design and implementation,
ensure that socio-political considerations will always be significant.
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choice really is about when to use them. If the rents from exploitation can be
used to fund research and promote technological progress, or to accumulate
human and human-made capital, that should benefit later generations more than
the bequest of unexploited non-renewables. Of course, this view is somewhat
partial (and other issues arise when we deal with renewable resources); but it is
useful to bring it into consideration whenever decisions are to be made about
resource conservation.
We will leave you to do this without any extra help from us. Relevant material
can be found in Chapters 2, 4 and 19.
Problems
1. Consider two consecutive years, labelled 0 and 1. You are currently at the
start of year 0. The following information is available. There is a single fixed
stock of a non-renewable resource; the magnitude of this stock at the start of
year 0 is 224 (million tonnes). The inverse resource demand functions for this
resource in each of the years are
P0 = a – bR0 and P1 = a – bR1
in which a = 107 and b = 1. The constant marginal cost of resource extraction
is 5. All (non-physical) units are in European units of utility. The social
welfare function is discounted utilitarian in form, with a social utility discount
rate of 0.1. Given that the objective is to maximise social welfare over periods
0 and 1, calculate the amounts of resource that should be extracted in each
period, subject to the restriction that at least 104 units of the resource should
be left (unextracted) for the future at the end of period 1. What is the resource
price in each period
(a) in utility units;
(b) in Euros, given that U = log(C), where U is utility units, log is the natural
logarithm operator, and C is consumption (or income), measured in Euros?
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Question: Find R0 and R1, P0 and P1
Solution:
(15.2)
(15.3)
(15.4)
Since the right-hand side terms of Equations 15.3 and 15.4 are both equal to zero, this
implies that
Using the demand function Pt = a - bRt, the last equation can be written as
where P0 and P1 are gross prices and P0 - c and P1 - c are net prices. Rearranging this
expression, we obtain
This will uniquely define the two prices that are required for welfare maximisation.
Using Maple we obtain:
> start;
start
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> eq1 := P0 =a-b*R0;
eq1 := P0 a b R0
> eq2 := P1 =a -b*R1;
eq2 := P1 a b R1
> eq3 := R0 + R1 + SSTAR = SBAR;
eq3 := R0 R1 SSTAR SBAR
> eq4 := P1 -c =(1+rho)*(P0 - c);
eq4 := P1 c ( 1 ) ( P0 c )
> eqns :=(eq1,eq2,eq3,eq4);
eqns := P0 a b R0 , P1 a b R1 , R0 R1 SSTAR SBAR ,
P1 c ( 1 ) ( P0 c )
> sys :=solve ({eqns},{P0,P1,R0,R1});
b SSTAR b SBAR a b SSTAR b SBAR c
sys := { R1 ,
b ( 2 )
b SSTAR b SBAR a c 2 a b SSTAR b SBAR c
R0 , P0 ,
b ( 2 ) 2
2 a 2 a b SSTAR b SBAR b SSTAR b SBAR c
P1 }
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> subs ({rho=0.1,a=107,b=1,c=5,SBAR=224,SSTAR=104},sys);
{ R1 58.00000000, R0 62.00000000, P045.00000000, P1 49.00000000}
We could also solve this problem directly from Hotelling’s rule noting that this requires
and by substituting for the prices from the demand equations, and using
the resource stock constraint to express R1 in terms of R0. Try this now.
(2)
(3)
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It should be clear from inspection of (2) that one circumstance under which (2)
collapses to (3) will be if ct = 0 for all t. A second circumstance in which this
would occur is if marginal cost is a constant proportion of the gross price so that
we have
ct = aPt
Then
and so
Then we have
So if marginal extraction costs are always zero or if marginal costs are a constant
proportion of gross price, then the rate of growths of net and gross prices will be
equal (notice that the first condition is in fact a special case of the second where
the proportionality factor a = 0).
This does not, by itself, prove that these are the only conditions under which that
result is true. However, with some a little maths (which we do not go through
here) that result can be established. A proof can be based on the method of
contradiction; only if the proportionality referred to above is valid can the two
growth rates be equal.
Note that with a finite resource stock such a path cannot be sustained
indefinitely, unless Pt were so large that Rt = 0 always.
If marginal extraction costs are not constant over time, then it is the net price (or
rent, or royalty) that must be constant over time, rather than the gross price. With
rising marginal costs, this may allow a solution in which the gross price rises
through time, until demand damps down to zero, even where = 0.
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5. In the case of perfect competition, if the private discount rate is
higher than the correct social discount rate, explain, with diagrams,
why the market will exhaust the resource too quickly.
The key to this answer lies in recognising that we can exploit Figure 15.6 and the
discussion surrounding that for an answer. If the price path with its origin at the
point P0 were the one corresponding to the correct social discount rate, then the
associated resource depletion path would be socially optimal. However, if
private firms are faced with a higher private discount rate, then the price path
associated with the initial point P 0/ (and its associated resource depletion path) is
privately optimal (that is, wealth maximising). Under the conditions discussed in
this chapter, the private plan depletes the resource too quickly.
The answer to this question is in all essentials that given on pages 521-522 concerning ‘An
increase in the size of the known resource stock’. Assuming that the conditions given there
are generally valid, then Figure 15.7 demonstrates the main results for a one-off discovery
(pushing known stock size from one level to another higher level:
The price will be lower and the output level higher at all points in time until exhaustion
The date of exhaustion will be further into the future
Figure 15.8 implies what would happen to the path of oil prices for a sequence of discoveries.
It is interesting to note what has actually happened to oil prices over a very long horizon.
This can be seen in the chart below, showing the world price of crude oil from 1861 to 1991.
The line which generally lies below the other is the nominal price of crude oil; in the dollars
of the year in question; the upper line, more variable in magnitude on the chart, is the real
price of oil, expressed in terms of $ US 1993. The real price is the one we should really look
at in considering oil price movements, as it abstracts from changes in price which are
attributable merely to changes in the general level of prices. It is evident that the real price of
crude oil fluctuated around a more-or-less constant level over a large part of the last 100
years. Although demand has been growing over this period, continual new discoveries and
falling extraction costs have resulted in a price path not too dissimilar from that shown in
Figure 15.8.
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