Chapter 2

Economics Of Non-renewable
Resources
Guido Pepermans

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Objectives
• Students should
• be able to explain different classifications of resources
• be able to use the Hotelling model under alternative modelling
assumptions, to answer questions on the optimal use of available
resources

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Outline
• Resource classification

• What is an ‘optimal and efficient’ use of resources under alternative

assumptions regarding market organization?

• Theory versus reality

• Recycling

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Key questions
• What makes a given resource exhaustible?
• How to use available resources optimally?
• Should we save resources for later or use them now?
• When to switch from one resource to another?
• Should those resources stay under control of a benevolent government or can
we let profit-maximizing resource owners decide?
• How does new information about the resource stock or future demand affect
price levels and production profiles over time?
• Has Hotelling’s theory of exhaustible resources been verified?
• Does it make a difference when recycling an exhaustible resource is possible?

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Classifying Resources

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A resource taxonomy
Natural Replenishment?
(↔ Economic replenishment)

No Yes
(=Depletable Resource) (=Renewable Resource)

Depending on human
Recyclable?
activity?

Yes No Yes No
(copper, gold) (oil, gas, coal) (water, biomass) (solar, wind)

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A resource taxonomy
• Watch out for misuse of the concepts!
• Proven reserve Maximum potential
• Resource endowment available for use

• Data sources

• R/P orders of magnitude

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Allocating Scarce Resources Over
Time

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Economics is about making choices

Avoid wasting resources! ( Economic Efficiency)

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Static efficiency
Price
Marginal cost
Net benefit

Supply
(Marginal cost)

𝑝∗

Demand

𝑞∗ Quantity

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Dynamic efficiency
Period 1 Period 2
Period 3

Period N

…..

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Allocating Scarce Resources Over
Time
The Hotelling model

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A 2-period model
• Demand is linear and constant over time

• Constant marginal extraction cost ()

• Fixed availability of the depletable or exhaustible resource
• The discount rate
• A benevolent social planner maximize Present Value of Net Benefits

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A 2-period model

𝑃𝑉 ( 𝑀 𝐵1 ) =𝑃𝑉 ( 𝑀 𝐵2 )

𝑀𝑈 𝐶 1

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A 2-period model

Net benefit Net benefit

period 1 () period 2 ()

𝑀𝑈 𝐶 1 𝑀𝑈 𝐶 2

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A 2-period model: analytical solution
• The problem

[ ] [ ]
𝑞1 𝑞2
1
L= ∫ ( 𝑎− 𝑏𝑞 ) 𝑑𝑞−𝑐 𝑞1 + ∫ ( 𝑎− 𝑏𝑞) 𝑑𝑞−𝑐 𝑞2 + 𝜆 ( 𝑄 −𝑞 1 −𝑞 2 )
• Lagrange function 0 1+𝑟 0

𝜕L 𝜕L
=𝑎 −𝑏 𝑞1 −𝑐 − 𝜆 ≤ 0 𝑞1 =0
• First-order conditions 𝜕 𝑞1 𝜕𝑞 1
𝜕L
𝜕 𝑞2 ( )
={ 𝑎 −𝑏 𝑞2 −𝑐 }
1
1+𝑟
−𝜆≤0 𝑞2
𝜕L
𝜕𝑞 2
=0
𝜕L 𝜕L
=𝑄 − 𝑞1 −𝑞2 ≥ 0 𝜆 =0
𝜕𝜆 𝜕𝜆
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A 2-period model: analytical solution
• Economic interpretation of the lagrange multiplier
• Change in the objective function if one relaxes the constraint by one unit

• Through solving the first-order conditions, we find

• This is known as Hotelling’s rule

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A 2-period model: analytical solution
• Assume ‘no scarcity’ → and

→ Time dimension is not important part of the problem

• Assume ‘scarcity’ → and
• Reserves are not sufficient to cover demand in both periods

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The Hotelling model extended
• The Hotelling model can be extended in many ways, for example by
• Considering more than 2 periods (with the time horizon being endogenous)
-period model
• Adding substitutes for the exhaustible resource
• Renewable
• Exhaustible
• Making alternative assumptions on the marginal extraction cost
• Constant marginal extraction cost ()
• Increasing

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An -period model
• The -period model • Total MC and thus price rises over time
• Linear and constant demand over time • increases as it reflects scarcity
• Constant • Extracted quantity decreases over time
• Resource stock • Resource is fully depleted at
• Discount rate
• Price of last unit extracted (in period ) equals
• Analytical solution is more difficult highest price anyone is willing to pay
• Choke price
• ‘Smooth’ transition to resource exhaustion

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An -period model: analytical solution
• The problem

{∫ } { }
𝑁 𝑞𝑡 𝑁
1
• Lagrange function
L=∑ 𝑡 −1
( 𝑎 −𝑏𝑞 ) 𝑑𝑞− 𝑐 𝑞𝑡 + λ 𝑄 − ∑ 𝑞𝑡
𝑡 =1 ( 1+𝑟 ) 0 𝑡 =1

𝜕L 1 𝜕L
• First-order conditions = { 𝑎− 𝑏𝑞 𝑡 −𝑐 } − 𝜆 ≤ 0 𝑞𝑡 =0
𝜕 𝑞𝑡 ( 1+𝑟 ) 𝑡 −1
𝜕 𝑞𝑡
𝑁
𝜕L 𝜕L
=𝑄 − ∑ 𝑞𝑡 ≥ 0 𝜆 =0
𝜕𝜆 𝑡 =1 𝜕𝜆
• Solution () ( 𝑝 𝑡 +1 −𝑐 ) =( 1+𝑟 ) ( 𝑝𝑡 − 𝑐 )

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An -period model: a renewable substitute
• Assumptions • At some point in time , transition will occur
• Depletable resource is oil (), renewable resource is as choke price
biofuel ()
• Depletable resource: constant
• Price after transition:
• Renewable resource: constant • The backstop price
• Perfect substitutes • Total of the depletable resource will
• Demand is linear and constant never exceed
• and
• Depletable resource is fully exhausted
• Transition remains smooth
• Resources are extracted faster
• Exhaustion occurs faster
• Consumption of the renewable resource only
begins when the depletable resource is fully
exhausted

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An -period model: a renewable substitute
• Assumptions • Marginal user cost declines over time
• Depletable resource is oil (), renewable resource is
biofuel () • Resource not necessarily physically
• Depletable resource: increasing depleted
• Renewable resource: constant
• Perfect substitutes
• Demand is linear and constant
• and

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An -period model: a depletable substitute
• Assumption • First use the resource that is cheaper to
• Two depletable resources () with extract
different but constant MEC until completely exhausted at
• Transition when total MC are equal
• Price increase slows down after the switch
• Due to lower MUC

• Transition will be smooth

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A ‘what if’ analysis
• Increase in the interest rate ()
• Price path will start lower, with steeper growth path
• Resources will be extracted faster, thus will be exhausted faster
• Increase in size of the known resource stock (ceteris paribus)
• Assume that the initial price remains unchanged
• With unchanged , some fraction of the resource will be left in
• Initial price should decrease and should increase (with constant )
• Increase in demand for the resource (in all periods)
• Old price path would result in earlier resource exhaustion at a final price below the choke price
• Prices must increase in all periods and resources will be exhausted earlier
• Lower extraction cost of the backstop technology
• Some reserves would be left at if the old price path would apply
• Initial price must fall to stimulate resource demand
• Demand for the depletable resource drops to zero at

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Perfect competition versus monopoly markets
• Perfect competition
• Same outcome as benevolent social
planner outcome
• (Profit) margin increases with
• Despite constant MC, profit > 0 due
to scarcity rent

• Monopoly
• Marginal profit increases with
• Prices higher in immediate future but
lower in more distant future

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The model confronted with reality

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The Hotelling model with recycling

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Introduction

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A 2-period model with recycling
• Assumptions
• Demand is linear and constant over time
• 2 periods (but could be made endogenous)
• Recycling costs are quadratic
• A benevolent social planner
[ ] [
𝑞1 𝑞2 +𝑞𝑅
1
max 𝑊= ∫ ( 𝑎−𝑏𝑞 ) 𝑑𝑞−𝑐𝑞1 +
𝑞 ,𝑞 ,𝑞
1 2 0𝑅
1+𝑟
• Legend
• extraction in both periods
• Additional supply in period 2 due to
recycling of what was used in period 1
• Total stock of the resource
]
∫ ( 𝑎−𝑏𝑞 ) 𝑑𝑞−𝑐𝑞2 − (𝑒𝑞𝑅+0,5 𝑓 𝑞 ) 2
𝑅
0
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A 2-period model with recycling

[ ] [ ]
• Lagrange function: 𝑞1 𝑞2+𝑞 𝑅
1
L¿ ∫ ( 𝑎−𝑏𝑞) 𝑑𝑞−𝑐𝑞 1 + ∫ ( 𝑎−𝑏𝑞) 𝑑𝑞−𝑐 𝑞2 − (𝑒𝑞 𝑅 +0,5 𝑓 𝑞 2𝑅 )
0 1+𝑟 0

𝜕L 𝜕L
• First-order conditions

=(𝑎−𝑏𝑞1 )−𝑐−𝜆+𝜇≤0 𝑞1 =0
𝜕𝑞1 𝜕𝑞1
¿ ¿
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A 2-period model with recycling
• Solution (assuming is exhausted )

𝑝1 − 𝑐 ≤ 𝜆− 𝜇
{ 𝑝 2 − 𝑐 } ≤ ( 1+𝑟 ) 𝜆
{𝑝 2 − ( 𝑒+ 𝑓 𝑞 𝑅 ) } ≤ ( 1+ 𝑟 ) 𝜇
• Consider to 2 cases
• Period 1 use is not fully recycled
• Period 1 use is fully recycled

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A 2-period model with recycling
• Period 1 use is not fully recycled (common situation)
• This is the solution of the 2-period model with only a depletable resource

• From 2nd and 3rd condition, we derive

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A 2-period model with recycling
• For graphical simplicity, assumes
• Case 1
• Resource stock is large and equal to
• Without recycling
• and at
• Case 2
• Resource stock is smaller and equal to
• Without recycling
• and
• With recycling
• and
• Extraction in period 1:
• Extraction in period 2:

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Summary

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Key message
• Reserves versus resources
• Reserves are function of price level (economic), geological information, available technology
• Optimal use of resources (from a social planner perspective)
• Use cheapest resources to extract first
• Intuition: cost savings can always be invested and yield revenue at interest rate
• Hotelling’s rule determines the price path
• Marginal user cost () increases with interest rate
• With constant , the initial price and extraction period are such that all resources will be used
• Larger stock implies lower price and longer use (ceteris paribus)
• Lower backstop cost implies lower price
• Recycling is costly and will only develop from a given price level onwards
• In case recycling develops, it pushes prices down and stimulates resource use

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Literature
• MEDLOCK K. B. III (2009), the economics of energy supply, in L.C. HUNT and J. EVANS
(eds.), International handbook on the economics of energy, vol. 140: Edward Elgar publishing.
• See Toledo for a pdf of this chapter

• Optional
• TIETENBERG, T., (2000), environmental and natural resource economics, Harper Collins,
New York, p. 630
• PERMAN, R., MA, Y., MCGILVRAY, J. and COMMON, M. (1999), natural resource &
environmental economics (2 ed.). Harlow: Longman, p. 563.

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