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Dynamic efficiency
Recall static notion of Pareto efficient
resource allocation is that one cannot
change how resources are split to
generate larger gains from trade (without
making some one else worse off)
Dynamic efficiency
The notion of dynamic efficiency is
an intuitive concept.
First, lets consider the concept of
present (discounted) value.
Would you rather have $10,000 in
cash right now or 10 years from now?
Why (or why not)?
Dynamic efficiency
Reasons why most people would
rather have $10,000 today instead
of 10 years from now:
If we anticipate inflation (rising prices over time),
then the purchasing power of $10,000 will shrink
over time.
If we take the $10,000 today and invest it in, say,
government bonds, then we will have more than
$10,000 in 10 years.
Dynamic efficiency
Reasons why most people would
rather have $10,000 today instead
of 10 years from now (continued):
Pure rate of time preference: I want good things
now and would rather wait for bad things. I dont
know if I will be alive in 10 years, so why wait?
Strong current needs (e.g., college expenses, health
care expenses, basic food and shelter needs)
heightens ones pure rate of time preference.
Dynamic efficiency
Suppose that you have inherited
$10,000, which will be held in trust
for you for 10 years.
What is the least amount of cash you would accept
from me RIGHT NOW that would make you
willing to sign over the inheritance to me?
Your answer to that question is your present
(discounted) value of that future $10,000 payment.
Dynamic efficiency
As an aside, why might your present
discounted value of a $10,000
payment 10 years in the future
differ from that of someone else?
Different life circumstances, different investment
opportunities. Other?
Dynamic efficiency
Note: The discount rate (like
an interest rate) reflects the
time value of money:
The rate at which the present value
of a payment shrinks as the time of
payment is pushed off further into the
future
The rate at which the future value of current
interest-earning savings grows over time.
Dynamic efficiency
Since different people have different
discount rates, then at the prevailing
market interest rate, some people are
lenders (financial investors), while others
are borrowers.
Dynamic efficiency
Finance is an application of economics
that focuses on time value of money. We
will limit ourselves to an elementary
application of the time value of money.
Dynamic efficiency
Suppose that you will receive a single
guaranteed future payment i years from
the present, and your discount rate (interest
rate) is r. Then the present discounted
value (PV) of that future payment (FP) is
given by the following formula:
Dynamic efficiency
PV example:
$ future payment is $10,000. i = 2 years
from the present. r = 10% (0.10). Then:
PVFP =
$10,000/(1+0.1)2
=
$10,000/1.21
$8,264.63
Dynamic efficiency
Based on the preceding example,
the person is indifferent between
having $8,264.63 right now and
getting $10,000 two years from now.
Thus, literally, the $8,264.63 is the present
(discounted) value of $10,000 to be received two
years from now.
Dynamic efficiency
Final point on PV: If you will receive a
stream of payments over time (e.g., social
security payments), then the PV of that
stream of payments is found as follows:
PVFP =
i($ future payment, year i)/(1+r)i
Where i = 0, 1, 2, , n years.
Dynamic efficiency
Moving on
Our analysis of dynamic efficiency
will be based on a highly
simplified modeling framework,
which will provide an accessible
introduction to the topic, as well
as important insights, without
overwhelming you with complex
Dynamic efficiency
Simplifying assumptions:
There is a well-functioning competitive market for the
nonrenewable resource in question (no monopolies or
cartels)
Market participants are fully informed of current and
future demand, marginal production cost, market discount
rate, available supplies, and market price
We will look at the most basic dynamic case: two time
periods: today (period 0) and next year (period 1)
Dynamic efficiency
Simplifying assumptions, continued:
Marginal cost is constant
Market demand is steady state, meaning that demand in
period 1 is the same as in period 0 (no growing or shrinking
demand)
Dynamic efficiency
Model:
Demand: P = 200 Q
Supply: P = 10
Discount rate r = 10 percent (0.1)
Total resource stock Qtot = 100
Dynamic efficiency
Case 1: Ignore period 1 while in period
0 (live for today)
Price
200
150
100
50
Demand
Supply
0
0
20
40
60
80
100
Quantity
120
140
160
180
200
Price
200
150
CS = $5000
100
PS = $9000
50
Demand
Supply
0
0
20
40
60
80
100
120
Quantity
140
160
180
200
Price
CS = $1,250
150
100
PS = $7,000
50
Demand
Supply
0
0
20
40
60
80
100
120
140
160
Quantity
180
200
Price
CS = $1,250
150
100
PS = $7,000
50
Demand
Supply
0
0
20
40
60
80
100
120
140
Quantity
160
180
200
Hotellings rule
(P0-MC)/(1+r)0 = (P1MC)/(1+r)1
Marginal profit,
period 0
Marginal profit,
period 1
Hotellings rule
Hotellings rule
Hotellings rule
Intuition
If the PV of marginal profit is equal across time
periods (Hotellings rule), then firms have no
incentive to re-arrange production over time. This
solution also generates the largest PV of total gains
from trade over time.
Intuition
When a resource is abundant then consumption today does
not involve an opportunity cost of foregone marginal profit
in the future, since there is plenty available for both today
and the future. Thus, when resources traded in a
competitive market are abundant, P = MC and thus
marginal profit is zero.
As the resource becomes increasingly scarce, however,
consumption today involves an increasingly high
opportunity cost of foregone marginal profit in the future.
Thus as resources become increasingly scarce relative to
demand, marginal profit (P-MC) grows.
Intuition
The profit created by resource scarcity in competitive
markets is called Hotelling rent (also known as resource
rent or by the Ricardian term scarcity rent). Hotelling rent
is economic profit that can be earned and can persist in
certain natural resource cases due to the fixed supply of the
resource.
Due to fixed supply, consumption of a resource unit today
has an opportunity cost equal to the present value of the
marginal profit from selling the resource in the future.
Intuition
How will the dynamically efficient allocation of the
fixed resource stock change if the discount rate r
becomes larger? Explain
Intuition
Suppose that the discount rate remains the same,
but the resource stock increases or decreases. How
will this affect the dynamically efficient allocation
of the resource stock?
Intuition
Under the dynamically efficient solution in our
simplified modeling framework, what is the
trend of price over time? Why?
Intuition
Real world: Natural resource commodity prices may rise or
fall over time because:
Marginal production cost might decrease (technology
improves) or increase (exploit cheapest sources first).
Demand may grow over time unless a new technology
displaces this demand (e.g., coal replaced firewood, natural
gas replaced coal, alt. energy replaces natural gas?),
Future demand and marginal cost cannot be known with
certainty.
Further Study
In a graduate natural resources economics class you could
evaluate dynamically efficient resource allocation for these
more complex and real-world cases:
more than 2 time periods
varying and/or uncertain demand
increasing and/or uncertain marginal cost of production,
and
"backstop" technologies allowing for substitutes.