Topics Today 111308

1
Topics Today (11/13/08)

• Resources and Energy.
• Marginal user cost.
• Energy substitutes, exploration, technology.
• Read 14 from your outside reading list for next
  time.
• HW 6 is on website, due on 11/18/08.
• Exam 2 will be handed back in discussion
  sections.

2
Hotellings Rule of Resource Extraction

• Hotellings rule (p2 p1) / p1 r
• The proportional increase in the price of oil
  equals the discount rate.
• Costless extraction.
• If we introduce costs, then the marginal profit
  becomes Mp p MC, where MC is the marginal
  cost of extraction.
• A modified Hotellings rule follows
• (Mp2 Mp1) / Mp1 r
• The proportional increase in the marginal profit
  of oil equals the discount rate.

3
Extraction of Non-Renewable Resources

• Two costs to extracting a non-renewable resource,
  such as oil, today
• Extraction cost
• How much does it cost to obtain the resource?
• Obviously, only sell if P gt MEC (marginal
  extraction cost).
• User cost -- the opportunity cost of not having
  the resource to sell in the future.
• As a result, the price of the resource will be
  greater than the MEC.

4
Extraction of Non-Renewable Resources

• The owner of a non-renewable resource, such as
  oil, has two options to make money for next year
  
• Sell all the oil now, and invest the profits at
  interest rate r.
• Wait and sell the oil next year.

5
Extraction of Non-Renewable Resources

• Case A Expected price next year rises less than
  the rate of interest
• Present value of marginal profits next year is
  less than current value this year
• P1 - MEC gt (P2 - MEC)/(1r)
• The owner of the oil is better off selling the
  oil now and investing it.
• Leads to lower prices now (greater supply) and
  higher prices next year (lower supply).

6
Extraction of Non-Renewable Resources

• Case B Expected price next year rises faster
  than the rate of interest
• Present value of marginal profits next year is
  greater than current value this year
• P1 - MEC lt (P2 - MEC)/(1r)
• The owner of the oil is better off waiting to
  sell the oil next year.
• Leads to higher prices now (lower supply) and
  lower prices next year (higher supply).

7
Extraction of Non-Renewable Resources

• Prices adjust whenever one option (case A or B)
  looks better.  Thus, the market equilibrium is
  reached when the expected price of the oil rises
  at the rate of interest.
• P1 - MEC (P2 - MEC)/(1r)
• (P2-MEC)-(P1-MEC)/(P1-MEC) r Hotellings
  Rule.

8
Marginal User Cost

• Marginal user cost (MUC) -- the present value of
  foregone future extraction, at the margin.
• MUC arises because the resource is scarce.
• Ex/ using large quantities of water to keep lawns
  green.
• May be efficient in areas with abundant
  groundwater.
• May be inefficient in areas where groundwater is
  scarce.

9
Marginal User Cost

• Marginal user cost in period 1 in graph below
  equals 19, the price in period 1 minus the
  marginal extraction costs

muc
MNB P-MEC 80-Q-10 70-Q
10
Marginal User Cost
This illustrates the case where MUC in period 1
is 0 gt the resource is not scarce.


150
70
70/1.1 63.6
Marginal Net Benefit in 1
PV of Marginal Net Benefit in 2
70
70
Quantity in 2
Quantity in 1
MNB P-MEC 80-Q-10 70-Q
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Marginal User Cost

• P(t) MUC(t) MEC(t)
• If marginal extraction costs are constant, the
  marginal user cost rises at the rate of interest.
  
• Follows from Hotellings Rule.
• MUC(t) P(t) MEC(t).
• This implies that the present value of marginal
  user cost remains the same!
• Note that the price of a resource is greater than
  the MEC. 
• Higher prices are not, by themselves, evidence of
  abuse of market power.
• Higher prices result from the scarcity of the
  resource over time.

12
Marginal User Cost
13
Transition to a Renewable Substitute
t is the transition time.
14
Transition to a Renewable Substitute

• In the absence of a renewable substitute,
  depletion time is t.
• Effect of a renewable substitute when MEC lt MCs
• The non-renewable resource is depleted at t lt
  t.
• The future extraction value is lower with a
  substitute gt MUC is lower.
• More of the resource is extracted in earlier
  periods.

15
Transition to a Renewable Substitute
Newell, R.G. 2006. Whats the Big Deal About
Oil? How We Can Get Oil Policy Right. Resources,
(Fall) 6-10. Available at www.rff.org.
16
Transition to a Renewable Substitute
Headline from New York Times (10/20/08)
Alternative Energy Suddenly Faces
Headwinds. Shares of alternative energy
companies have fallen even more sharply than the
rest of the stock market in recent
months. Natural gas at 6 makes wind look like
a questionable idea and solar power unfathomably
expensive, said Kevin Book, a senior vice
president at FBR Capital Markets.
17
Transition to a Renewable Substitute

• Most economists argue that an emissions price
  (through a green tax or cap-and-trade program) is
  most efficient way to transition to fuels with
  less carbon emissions.
• Incentives for fossil fuel producers to reduce
  emissions.
• Incentives for consumers to conserve.
• Incentives for renewable energy producers to
  expand and invest.

Fisher, C., and R. G. Newell. 2008. Whats the
Best Way to Promote Green Power? Resources,
(Summer) 10-13. Available at www.rff.org.
18
Transition to a Non-Renewable Substitute

• Ex/ Copper, once used extensively for plumbing
  and the transmission of electricity.
• Replaced by plastic in plumbing.
• Replaced by aluminum for distributing electricity.

19
Economic Reserves

• An economic reserve is a subset of natural
  resources which is economical to extract.
• The oil fields in the Gulf of Mexico are part of
  the worlds economic oil reserves. Why?
• Because it is profitable to extract them.
• The tar sand deposits of northern Alberta are a
  recent addition to the worlds economic oil
  reserves. Why?
• Until recently, it was not profitable to extract
  oil from the tar sands.

20
Economic Reserves

• Increases in information (e.g. through
  exploration) and increases in technology will
  make the economic reserves of natural resources
  larger.

21
Economic Reserves

• What is technological progress?
• Ex/ Iron-ore (used for steel).
• In 1947, there were only 5-7 years estimated left
  in northern MNs mines.
• In 1955, U.S. News World Report declared the
  worry about iron-ore scarcity to be over.
• A new technique called pelletization was
  discovered.
• Pelletization allowed profitable use of taconite
  ores, which were previously useless.
• Economic reserve increased.

22
Economic Reserves

• Exploration
• The search for new stocks of natural resources.
• Driven by prices and technology.
• Higher expected future prices lead to more
  exploration.
• Cost-reducing technology changes lead to more
  exploration.

23
Economic Reserves

• Example of exploration (Sep. 2006)
• Trio of oil companies (led by Chevron) discovered
  a huge new oil deposit in Gulf of Mexico.
• The discovery raised U.S. oil reserves by 50.
• The well was the deepest successfully drilled
  well in the Gulf (20,000 ft. below the sea floor).

24
Economic Reserves

• Suppose the economic reserves for oil increase
  due to either technology or exploration.
• Effects on marginal user cost?
• Effects on price?
• Effects on consumption of oil?

25
Increasing Marginal Extraction Costs

• Suppose the marginal extraction costs increase
  over time.
• Marginal user cost declines over time.
• The sacrifice made by future generations (as an
  additional unit is consumed earlier) diminishes.
• The future value of the resource is lower.
• Hotellings rule no longer applies to muc.
• Prices still rise over time, but not according to
  Hotellings rule.
• The entire reserve is not depleted because it is
  too expensive.

26
Increasing Marginal Extraction Costs
Transition to a renewable substitute at t
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Why is Hotellings Rule so difficult to verify?

• Difficult to observe MEC.
• Technology may reduce MEC.
• Scarcity may increase MEC.
• Exploration increases economic reserves, which
  influences MUC.
• Demand may change over time.
• Interest rates may change over time.
• All models are wrong, but some are useful.

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Results from Exam 2

• Average 22.66 / 28 (81)
• Min 15.75 Max 27.5
• Probable Grades
• A gt 25 (22 students)
• 24.25 lt AB lt 25 (7 students)
• 22.25 lt B lt 24.25 (39 students)
• 21.5 lt BC lt 22.25 (10 students)
• 19.5 lt C lt 21.5 (20 students)
• D or F lt 19.5 (11 students)