Natural Resource Theory

Copyright, 1998 by Peter Berck

Introduction
Natural Resource Theory is the
economic theory of exhaustible and
renewable resources. These
resources last for more than one
period of time and so function as a
type of capital. They are also used
for food, fiber and energy and so
function as ordinary goods

Exhaustible Resource
Oil, Coal, etc.
Old growth trees
These provide value by being used
up.

Hotellings Model: 3
Equations
1. Capital Market Equilibrium
2. Feasibility
3. Flow Market Equilibria.

The Capital Market

Assets Earn a return through
Dividends
Dividends paid out from earnings of firms.
Car factory adds value to steel, labor etc.

Capital Gains
Stock can also have capital gain: its price
goes up.
All Exhaustible Nat Resource returns must
come from price change

Price Goes Up a Rate of

Interest
Hotellings Rule
Price of resource is P(t)
price at time 1 is P(1). (e.g. $700/th
bd ft for redwood.)
Put P(1) $ in
bank

Buy one unit

of Resource

Period 1

have $P(1)

have $P(1)
worth of
resource

Period 2

have $(1+r)
P(1)

have $P(2)
worth of
resource

so
When is it a good idea to by the
resource?
when p(2) >= (1+r) p(1)
If >, then everyone would want the
resource and nobody would want anything
else in their portfolio.
If <, then nobody would want the resource

So p(2) = (1+r) p(1)

And in general P(t+1) = P(t) (1+r).

Real Old Growth Redwood

Price
450
400
350

$/M B F

300
250
200
150
100
50
0
53

55

57

59

61

63

65

67 69
year

71

73

75

77

79

81

83

Use no more than there is

Second, the sum of the stumpage
cut, q(t), over time equals the
original stock of stumpage,
X = Q0 + Q1 + . . . + QT.

Demand and Supply

D(p, h) is the demand when price is p
and some shift variable (housing
starts if this is oldgrowth stumpage)
is h.
(3) Q(t)=D(p(t),h).

Solving the Model

p=p0(1+r)t,wherep0isinitialprice
Q(t)=D(p(t),h).
SO
Q(t)=D(p0(1+r)t,h).

D( p (1 r ) , h)
t

t o ,T

Left Over
Why is it equality?
Why not >
Why not <
Not so far fetched. Suppose global
warming bites and we give up coal
mining. What will coal then be worth?

D( p (1 r ) , h)
t

t o ,T

The solution

So all we need to do is to find p(0)

and possibly T if its not infinity
Then we will know p and Q for every tim
X

t o ,T

D ( p0 (1 r )t , h)

Backstop
Linear demand curve (and any other one
that hits the axis) has a choke price.
Choke price is the price that chokes off
demand for the resource.
At choke price some other technology is
used to meet demand (e.g. coal instead of
oil.)
P0 (1+r)T= Choke
If you know p0, and choke, you know T,
exhaustion time.

Hotelling in 4-Quadrants
Note: choke price, T.
demand

P0(1+r)t

p
q

450 line

Hotelling in 4-Quadrants
demand

P0 ert

p
q

450 line

Equilibrium: Green is X(0)

Area under curve is sum of all Qs.
demand

P0 ert

p
q

450 line

A choice of Po below

Too Low a
P0
demand

the equilibrium value

leads to more q in each
period, which is more
rt
P0 ethe
than X(0) by
red.

p
p

450 line

Increase in r
Red Bounded area must
p
equal green area
Initial price lower
T sooner
p
Two Price-time paths
p 0
must
q cross
0

450 line

P0 ert

Taking of the Redwood Park

In 1968 and again in 1978 the US
took a total of 3.1 billion bd ft of
standing timber from private
companies to form the Redwood
National Park
The amount by which the price of
Redwood went up as a result of the
take is called enhancement

Enhancement: Lowering
X(0)
p
Red price path is
result of red X(0)
Arrow shows size
of enhancement

450 line

p
0

P0 ert

p
0

Recall
X t

D( p (1 r ) , h)
j

j t ,T

Lets call the solution to this P(x(t)), the price

When stock is x at time t.
P(x(0) )= p0
P(x(t)) = p0 (1+r)t

Folded Diagram Model

p(x(t)) = p0(1+r)t
price as function of stock is same as price as function of time
price in year t + 1 is just p(x(t) q(t)) which is also p0(1+r)(t+1)
n

q(t )

p(x(t)

) = p0(1+r)(t+n)

price after n years of cutting equals the price

at
n
q(t )n years (1+r) n.
time t ,(p0(1+r)t) times the interest factorfor
t

Choose n so that the Park taking equals

Enhancement: Years
Method
p
X(0) is again red area.
Arrow shows numberpof
years need to wait to
0
find equivalent

450 line

P0 ert

p
0

Value of Enhancement
The 1978 Park taking was 1.4billion
board feet, which is the equivalent of
2.26 years of cutting.
price 1978, was $311 per MBF.
real interest rate7 percent
2.26years at 7percent real per year
or 17percent of price

Conclusion
Govt paid $689 million for second
take
enhancement was $583 million
Therefore the US paid nearly twice
for the park

Continuous time example

Interest is exp(-rt) rather than (1+r)-t
Integral replaces summation
Demand function has no choke price
(makes it easier)

Example: Q = p

x 0 Q(p 0 e rt )dt.
0

x 0 p e
-
0

- rt

dt.

- rt

e
x 0 p
r
-
0

-
0

Example Concluded:
Reduced Form
- rt

e
x 0 p
r
-
0

-
0

p 0
r x 0

ln(p0 ) 1 ln( ) ln(r ) ln( x(0)