Natural Resource economics:

An Overview
Lecture 5
(Chapter 6)

1
A Resource Taxonomy

The three concepts used to classify the stock

of depletable resources are
 Current reserves are resources that can be extracted profitably
at current prices.
 Potential reserves depend on prices people are willing to pay for
resources. At higher prices, potential reserves are larger since
more expensive extraction techniques will be economically
feasible.
 The resource endowment represents the natural occurrence of
resources in the earth.
 The resource endowment is a geological concept, since the
endowment is not a function of prices, while reserves is an
economic concept.

2
FIGURE 7.1

Copyright © 2009 Pearson

Addison-Wesley. All rights
reserved. 7-3
 The USGS Classification (Fig 6.1)
A classification system based on both
economic feasibility and certainty of the
resource base.
 Identified resources are of known quantity and quality
based on geologic evidence
 Measured resources are those for which quantity and
quality are estimated with a margin of error less than
20%.
 Indicated resources have been estimated from sample
analyses and geologic projections
 Inferred resources are materials in unexplored
extensions of demonstrated resources (identified and
measured) based on geologic projections.
4
 The USGS Classification (Fig 6.1)
 Undiscovered resources are surmised to exist on
the basis of geological knowledge and theory.
 Hypothetical resources are expected to exist.
 Speculative resources are undiscovered
materials that may occur in known deposits in
favorable geologic settings.
 The six categories listed above will fall into an
additional category depending on the economic
feasibility of extraction. Reserves will be those
resources that are measured, indicated or
inferred and economic.
5
 Other Resource Classifications
 A depletable resource is not naturally replenished or is
replenished at a slower rate than extraction and thus and
can be exhausted. The depletion rate is affected by
demand, and thus by the price elasticity of demand,
durability and reusability.
 A recyclable resource has some mass that can be
recovered after use. Copper is an example of a
depletable, recyclable resource.
 Current reserves of a depletable, recyclable resource
can be augmented by economic replenishment and
recycling.
 A renewable resource is one that is naturally
replenished. Examples are water, fish, forests and solar
energy.
6
 Efficient Intertemporal Allocations: A two-
period model revisited
 Dynamic efficiency is the primary criterion when
allocating resources over time. Dynamic efficiency
assumes that society’s objective is to maximize the
present value of net benefits from the resource.
 Recall the two-period model from Chapter 5. In that
model, marginal user cost rises over time at the rate of
discount to preserve the balance between present and
future consumption. This model can be generalized to
longer time periods.
 An n-period model presented uses the same numerical
example from Chapter 5, but extends the time horizon
and increases the recoverable supply from 20 to 40.
7
 Efficient Intertemporal Allocations: A two-
period model revisited
 With constant marginal extraction cost, total marginal cost (or the
sum of marginal extraction costs and marginal user cost) will rise
over time. The graph 6.2b shows total marginal cost and marginal
extraction cost. The vertical distance between the two equals the
marginal user cost.
 Rising marginal user cost reflects increasing scarcity and the
intertemporal opportunity cost of current consumption on future
consumption.
 As costs rise, quantity extracted falls over time. Quantity extracted
falls to zero when total marginal cost reaches the maximum
willingness to pay (or choke price) for the resource.
 An efficient allocation thus implies a smooth transition to
exhaustion and/or to a renewable substitute.

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FIGURE 6.2 (a) Constant Marginal Extraction
Cost with No Substitute Resource: Quantity
Profile. (b) Constant Marginal Extraction Cost with
No Substitute Resource: Marginal Cost Profile

7-9
Transition to a Renewable Substitute
 An efficient allocation thus implies a smooth

transition to exhaustion and/or to a renewable

substitute.
 The transition point to the renewable substitute

is called the switch point.

 At the switch point the total marginal cost of

the depletable resource equals the marginal

cost of the substitute.

7-10
FIGURE 6.3 (a) Constant Marginal Extraction
Cost with Substitute Resource: Quantity Profile. (b)
Constant Marginal Extraction Cost with Substitute
Resource: Marginal Cost Profile

7-11
 Efficient Intertemporal Allocations: Transition to
Renewable sources (backstop)
 If a substitute or “backstop resource” is available, the depletable
resource will be exhausted at the choke price or at the marginal
extraction cost of a renewable substitute if lower than the choke
price. For the latter case, marginal cost still rises until the switch is
made to the substitute.
 If a renewable substitute is available, the depletable resource will
be exhausted sooner than it would have been without the
substitute. WHY??
 The transition point from only using the depletable to only using the
renewable substitute is called the switch point.
 At the switch point the total marginal cost of the depletable
resource equals the marginal cost of the substitute.

12
Transition to backstop: A Study (Islam, T (2003).

25,000
Energy used (Btu x10^15)

20,000
Backstop - South
15,000

10,000
Fossil fuel - South Backstop - North
5,000
Fossil fuel - North
-
1996 2046 2096 2146 2196
Year

13
 Market Allocations
Can actual markets produce dynamically efficient
allocations?
Is profit maximization compatible with dynamic efficiency?

Misconception about the perfect market:

 1. A belief that producers want to extract and sell the

resources as fast as possible to derive the most

value out of it

 2. Market is myopic and unconcerned about the

future

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 Market Allocations
 Markets will behave well as long as the property-rights
structures governing the resources are exclusive,
universal, transferable and enforceable. [Revisit
Chapter 2 concepts here.]
 A resource governed by a well-defined property rights

structure will then have both a use value and an

asset value to its owner.
 A use value is the value acquired when the resource

is sold, e.g. timber sales.

 An asset value is the value to the owner while the
resource is still in the ground. If the price of the resource
is rising, the resource in the ground is becoming more
valuable as long as it is saved 15
Market Allocations
 Presented with well-defined property rights
and reliable information about future prices,
producers will choose an allocation that
provides the maximum present value of net
benefits for society, or a dynamically efficient
allocation provided that social and private
discount rates are equal.
 If extraction of a resource imposes a third
party or external cost on society, an allocation
will not be efficient. The price of the depletable
resource would be too low and the resource
extracted too rapidly.
16