ECON 3170 Economic Discussion Questions


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You are required to submit one journal entry for each set of weekly readings.
Quantitatively, I expect this will correspond to roughly 1-2 pages of single-spaced
prose. Your grade will depend primarily on the quality of the thinking demonstrated
in your responses. To assess quality, I will ask myself the following questions: are
you attempting to formulate questions about what we are reading and discussing in
class? Are you reading carefully? Are you being “mindful” of how you are learning?
That is, are you being introspective about the learning process? The more insight a
journal entry provides into how you are engaging with the material, the better the
journal grade will be. Here are some sample questions that your journal entries
might specifically address:
(a) What is novel (to you) about this material?
(b) How does this material relate to what you knew already?
(c) What in the readings confused you? What might help you get unstuck?
(d) What questions did the readings answer for you? What questions remain in your
(e) How does your own personal experience relate to the readings? (f) What do the
main equations or graphs say in plain English?
(g) Why are certain relationships expressed as an equation?
(h) What assumptions are required for this equation to hold and how plausible are
The Economics of Resources or the Resources of Economics
Author(s): Robert M. Solow
Source: The American Economic Review , May, 1974, Vol. 64, No. 2, Papers and
Proceedings of the Eighty-sixth Annual Meeting of the American Economic Association
(May, 1974), pp. 1-14
Published by: American Economic Association
Stable URL:
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The Economics of Resources or the
R esources of Economics
exploited at too rapid a rate, and that in
consequence of their excessive cheapness
they are being produced and consumed
wastefully has given rise to the conser-
It is easy to choose a subject for a dis-
tinguished lecture like this, before a large
and critical audience with a wide range of
interests. You need a topic that is absolutely contemporary, but somehow peren-
vation movement.
The author of those sentences is not
Dennis Meadows and associates, not
Ralph Nader and associates, not the
President of the Sierra Club; it is a very
eminent economic theorist, a Distinguished Fellow of this Association, Harold
Hotelling, who died at the age of seventy-
nial. It should survey a broad field, with-
out being superficial or vague. It should
probably bear some relation to economic
policy, but of course it must have some
serious analytical foundations. It is nice if
the topic has an important literature in
the past of our subject-a literature which
you can summarize brilliantly in about
eight, just a few days ago. Like all eco-
eleven minutes-but it better be some-
nomic theorists, I am much in his debt,
and I would be happy to have this lecture
stand as a tribute to him. These sentences
appeared at the beginning of his article
“The Economics of Exhaustible Resources,” not in the most recent Review,
but in the Journal of Political Economy for
April 1931. So I think I have found something that is both contemporary and
thing in which economists are interested
today, and it should appropriately be a
subject you have worked on yourself. The
lecture should have some technical interest, because you can’t waffle for a whole
hour to a room full of professionals, but it
is hardly the occasion to use a blackboard.
I said that it is easy to choose a subject
for the Ely Lecture. It has to be, because
twelve people, counting me, have done it.
I am going to begin with a quotation
that could have come from yesterday’s
newspaper, or the most recent issue of the
American Economic Review.
perennial. The world has been exhausting
its exhaustible resources since the first
cave-man chipped a flint, and I imagine
the process will go on for a long, long time.
Mr. Dooley noticed that “th’ Supreme
Coort follows the iliction returns.” He
would be glad to know that economic
theorists read the newspapers. About a
year ago, having seen several of those respectable committee reports on the advancing scarcity of materials in the United
Contemplation of the world’s disappearing supplies of minerals, forests, and
other exhaustible assets has led to demands for regulation of their exploitation. The feeling that these products
are now too cheap for the good of future
generations, that they are being selfishly
States and the world, and having, like
everyone else, been suckered into reading
* Professor of economics, Massachusetts Institute of the Limits to Growth, I decided I ought to
find out what economic theory has to say
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about the problems connected with exhaustible resources. I read some of the
literature, including Hotelling’s classic
article-the theoretical literature on exhaustible resources is, fortunately, not
very large-and began doing some work of
my own on the problem of optimal social
management of a stock of a nonrenewable
but essential resource. I will be mentioning some of the results later. About the
time I finished a first draft of my own
paper and was patting myself on the back
for having been clever enough to realize
that there was in fact something still to be
said on this important, contemporary but
somehow perennial topic just about then
it seemed that every time the mail came it
contained another paper by another economic theorist on the economics of exhaustible resources.1 It was a little like
trotting down to the sea, minding your
own business like any nice independent
rat, and then looking around and suddenly
discovering that you’re a lemming. Anyhow, I now have a nice collection of papers
on the theory of exhaustible resources; and
most of them are still unpublished, which
is just the advantage I need over the rest
crease through time. It can only decrease
(or, if none is mined for a while, stay the
same). This is true even of recyclable
materials; the laws of thermodynamics
and life guarantee that we will never recover a whole pound of secondary copper
from a pound of primary copper in use, or
a whole pound of tertiary copper from a
pound of secondary copper in use. There
is leakage at every round; and a formula
just like the ordinary multiplier formula
tells us how much copper use can be built
on the world’s initial endowment of copper, in terms of the recycling or recovery
ratio. There is always less ultimate copper
use left than there was last year, less by
the amount dissipated beyond recovery
during the year. So copper remains an
exhaustible resource, despite the possibility of partial recycling.
A resource deposit draws its market
value, ultimately, from the prospect of
extraction and sale. In the meanwhile, its
owner, like the owner of every capital
asset, is asking: What have you done for
me lately? The only way that a resource
deposit in the ground and left in the ground
can produce a current return for its owner
is by appreciating in value. Asset markets
can be in equilibrium only when all assets
in a given risk class earn the same rate of
return, partly as current dividend and
partly as capital gain. The common rate of
society in which such things have private
return is the interest rate for that risk
owners) much like a printing press or a
class. Since resource deposits have the
building or any other reproducible capital
peculiar property that they yield no diviasset. The only difference is that the natdend so long as they stay in the ground, in
ural resource is not reproducible, so the
equilibrium the value of a resource deposit
size of the existing stock can never inmust be growing at a rate equal to the
rate of interest. Since the value of a de1 The Review of Economic Stutdies will publish a group
of them in the summer of 1974, including my own paper posit is also the present value of future
and others by Partha Dasgupta and Geoffrey Heal,
sales from it, after deduction of extraction
Michael Weinstein and Richard Zeckhauser, and
costs, resource owners must expect the net
Joseph Stiglitz, from all of which I have learned a lot
price of the ore to be increasing exponenabout this subject. I would especially like to thank
Zeckhauser for conversation and correspondence, and
tially at a rate equal to the rate of interest.
for the kind of reading of the first draft of this Lecture
If the mining industry is competitive, net
of you.
A pool of oil or vein of iron or deposit of
copper in the ground is a capital asset to
society and to its owner (in the kind of
that one only dares to hope to get because it is so close
to Christmas. The final version reflects his comments.
price stands for market price minus margi-
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nal extraction cost for a ton of ore. If the
extraction costs, or the obvious analogy
industry operates under constant costs,
for monopoly. The market price can fall or
that is just market price net of unit extrac-
stay constant while the net price is rising
tion costs, or the profit margin. If the
if extraction costs are falling through time,
industry is more or less monopolistic, as is
and if the net price or scarcity rent is not
frequently the case in extractive industry,
it is the marginal profit-marginal revenue
That is presumably what has been hap-
less marginal cost-that has to be growing,
pening in the market for most exhaustible
and expected to grow, proportionally like
the rate of interest.
are not some econometric studies designed
This is the fundamental principle of the
to find out just this. Maybe econometri-
too large a proportion of tkle market price.
resources in the past. (It is odd that there
economics of exhaustible resources. It was
cians don’t follow the iliction returns.)
the basis of Hotelling’s classic article. I
have deduced it as a condition of stock
Eventually, as the extraction cost falls
equilibrium in the asset market. Hotelling
thought of it mainly as a condition of flow
equilibrium in the market for ore: if net
price is increasing like compound interest,
owners of operating mines will be indifferent at the margin between extracting and
holding at every instant of time. So one
can imagine production just equal to
demand at the current price, and the ore
market clears. No other time profile for
prices can elicit positive production in
every period of time.
It is hard to overemphasize the importance of this tilt in the time profile for net
price. If the net price were to rise too
slowly, production would be pushed nearer
in time and the resource would be exhausted quickly, precisely because no one
would wish to hold resources in the ground
and earn less than the going rate of return.
If the net price were to rise too fast, resource deposits would be an excellent way
to hold wealth, and owners would delay
production while they enjoyed supernormal capital gains.
According to the fundamental principle,
if we observe the market for an exhaustible
resource near equilibrium, we should see
the net price-or marginal profit-rising
exponentially. That is not quite the same
thing as seeing the market price to users
of the resource rising exponentially. The
price to consumers is the net price plus
and the net price rises, the scarcity rent
must come to dominate the movement of
market price, so the market price will
eventually rise, although that may take a
very long time to happen. Whatever the
pattern, the market price and the rate of
extraction are connected by the demand
curve for the resource. So, ultimately,
when the market price rises, the current
rate of production must fall along the
demand curve. Sooner or later, the market
price will get high enough to choke off the
demand entirely. At that moment production falls to zero. If flows and stocks have
been beautifully coordinated through the
operations of futures markets or a planning board, the last ton produced will also
be the last ton in the ground. The resource
will be exhausted at the instant that it has
priced itself out of the market. The Age of
Oil or Zinc or Whatever It Is will have
come to an end. (There is a limiting case,
of course, in which demand goes asymptotically to zero as the price rises to infinity, and the resource is exhausted only
asymptotically. But it is neither believable nor important.)
Now let us do an exercise with this apparatus. Suppose there are two sources of the
same ore, one high-cost and the other lowcost. The cost difference may reflect geographical accessibility and transportation
costs, or some geological or chemical difference that makes extraction cheap at one
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site and dear at the other. The important
thing is that there are cost differences,
though the final mineral product is identical from both sources.
It is easy to see that production from
both sources cannot coexist in the market
for any interval of time. For both sources
to produce, net price for each of them
must be growing like compound interest
at the market rate. But they must market
their ore at the same price, because the
product is identical. That is arithme-
must be that the low-cost producer is the
first to enter. Price rises and output falls.
Eventually, at precisely the moment when
the low-cost supply is exhausted, the price
has reached a level at which it pays the
high-cost producer to enter. From then on,
his net price rises exponentially and production continues to fall. When cumulative production has exhausted the high-
cost deposit, the market price must be
such as to choke the demand off to zeroor else just high enough to tempt a still
tically impossible, if their extraction costs
higher-cost source into production. And
so it goes. Apart from market processes, it
So the story has to go like this. First
one source operates and supplies the whole
lower-cost deposits before the higher-cost
is actually socially rational to use the
market. Its net price rises exponentially,
You can take this story even further, as
and the market price moves correspondingly. At a certain moment, the first source William Nordhaus has done in connection
with the energy industry. Suppose that,
is exhausted. At just that moment and not
somewhere in the background, there is a
before, it must become economical for the
technology capable of producing or substisecond source to come into production.
tuting for a mineral resource at relatively
From then on, the world is in the singlehigh cost, but on an effectively inexhaustsource situation: the net price calculated
ible resource base. Nordhaus calls this a
with current extraction costs must rise.
exponentially until all production is choked.
“backstop technology.” (The nearest we
now have to such a thing is the breeder
off and the second source is exhausted. (If
reactor using U238 as fuel. World reserves
there are many sources, you can see how
it will work.)
of U238 are thought to be enough to provide
Which source will be used first? Your
instinct tells you that the low-cost deposit
will be the first one worked, and your instinct is right. You can see why, in terms
of the fundamental principle. At the beginning, if the high-cost producer is serving the market, the market price must
cover high extraction costs plus a scarcity
rent that is growing exponentially. The
low-cost producer would refrain from
undercutting the price and entering the
market only if his capital gains justify
holding off and entering the market later.
But just the reverse will be true. Any price
high enough to keep the high-cost producer in business will tempt the low-cost
producer to sell ore while the selling is
good and invest the proceed< in any asset paying the market rate of interest. So it energy for over a million years at current rates of consumption. If that is not a backstop technology, it is at least a catcher who will not allow a lot of passed balls. For a better approximation, we must wait for controlled nuclear fusion or direct use of solar energy. The sun will not last for- ever, but it will last at least as long as we do, more or less by definition.) Since there is no scarcity rent to grow exponentially, the backstop technology can operate as soon as the market price rises enough to cover its extraction costs (including, of course, profit on the capital equipment involved in production). And as soon as that happens, the market price of the ore or its substitute stops rising. The "backstop technology" provides a ceiling for the market price of the natural resource. This content downloaded from on Thu, 31 Mar 2022 13:53:58 UTC All use subject to VOL. 64 NO. 2 RICHARD The story in the early stages is as I have T. ELY LECTURE 5 large compared with the scarcity rent on told it. In the beginning, the successive the coal input, so the market price at grades of the resource are mined. The last which the liquefied-coal-synthetic-crude and highest-cost source gives out just activity would now be economic is rising when the market price has risen to the more slowly than the rate of interest. It point where the backstop technology be- may even fall if there are cost-reducing comes competitive. During the earlier technological improvements; and that is phases, one imagines that resource com- not unlikely, given that research on coal panies keep a careful eye on the prospec- has not been splashed as liberally with tive costs associated with the backstop funds as research on nuclear energy. In technology. Any laboratory success or any case, political shenanigans and mo- failure that changes those prospective nopoly profits aside, scarcity rents on oil costs has instantaneous effects on the form a larger fraction of the market price capital value of existing resource deposits, of oil, precisely because it is a lower cost and on the most profitable rate of current fuel. The price of a barrel of oil should production. In actual fact, those future therefore be rising faster than the implicit costs have to be regarded as uncertain. price at which synthetic crude from coal A correct theory of market behavior and a could compete. One day those curves will correct theory of optimal social policy will intersect, and that day the synthetic- have to take account of technological un- crude technology will replace the drilled- certainty (and perhaps also uncertainty about the true size of mineral reserves). Here is a mildly concrete illustration of these principles. There is now a workable technology for liquefying coal-that is, petroleum technology. Even before that day, the possibility of for producing synthetic crude oil from capacity and synthetic-crude plant cannot coal liquefaction provides a kind of ceiling for the price of oil. I say "kind of" to remind you that coal-mining and moving coal.2 Nordhaus puts the extraction-and- be created overnight. One might hope preparation cost at the equivalent of seven that the ceiling might also limit the con- or eight 1970 dollars per barrel of crude oil,suming world's vulnerability to political shenanigans and monopoly profits. I supincluding amortization and interest at 10 pose it does in some ultimate sense, but percent on the plant; I have heard higher one must not slide over the difficulties: and lower figures quoted. If coal were for example, who would want to make a available in unlimited amounts, that large investment in coal liquefaction or would be all. But, of course, coal is a scarce coal gasification in the knowledge that the resource, though more abundant than current price of oil contains a large modrillable petroleum, so a scarcity rent has nopoly element that could be cut, at least to be added to that figure, and the rent has temporarily, if something like a price war to be increasing like the rate of interest during the period when coal is being used should develop? for this purpose. In the meanwhile, the extraction and production cost for this technology is The fundamental principle of the economics of exhaustible resources is, as I have said, simultaneously a condition of flow equilibrium in the market for the ore and of asset equilibrium in the market for 2 As best one can tell at the moment, shale oil is a deposits. When it holds, it says quite a lot more likely successor to oil and natural gas than either gasified or liquefied coal. The relevant costs are bound about the probable pattern of exploitato be uncertain until more research and development tion of a resource. But there are more than has been done. I tell the story in terms of liquefied coal the usual reasons for wondering whether only because it is more picturesque that way. This content downloaded from on Thu, 31 Mar 2022 13:53:58 UTC All use subject to 6 AMERICAN ECONOMIC ASSOCIATION MAY 1974 the equilibrium conditions have any ex- current price. If expectations about future planatory value. For instance, the flow mar- price changes are responsive to current ket that has to be cleared is not just one events, the consequence can only be that market; it is the sequence of markets for pessimism is reinforced and deepened. The resource products from now until the date initial disequilibrium is worsened, not of exhaustion. It is, in other words, a sequence of futures markets, perhaps a long eliminated, by this chain of events. In other words, the market mechanism I have sequence. If the futures markets actually just described is unstable. Symmetrical reasoning leads to the conclusion that if existed, we could perhaps accept the notion that their equilibrium configuration is stable; that might not be true, but it is at least the sort of working hypothesis we prices are initially expected to be rising too fast, the withholding of supplies will lead to a speculative run-up of prices frequently accept as a way of getting on which is self-reinforcing. Depending on with business. But there clearly is not a full set of futures markets; natural- which way we start, initial disequilibrium is magnified, and production is tilted resource markets work with a combination either toward excessive current dumping of myopic flow transactions and rather more farsighted asset transactions. It is supply. (Still other assumptions are possi- legitimate to ask whether observed re- ble and may lead to qualitatively different source prices are to be interpreted as approximations to equilibrium prices, or whether the equilibrium is so unstable that momentary prices are not only a bad indicator of equilibrium relationships, but also a bad guide to resource allocation. That turns out not to be an easy question to answer. Flow considerations and stock considerations work in opposite directions. The flow markets by themselves could easily be unstable; but the asset markets provide a corrective force. Let me try to explain why. The flow equilibrium condition is that the net price grow like compound interest at the prevailing rate. Suppose net prices are expected by producers to be rising too slowly. Then resource deposits are a bad way to hold wealth. Mine owners will try to pull out; and if they think only in flow terms, the way to get out of the resource business is to increase current production and convert ore into money. If current production increases, for this or any other reason, the current price must move down along the demand curve. So initially pessimistic price expectations on the part of producers have led to more pressure on the or toward speculative withholding of results. For instance, one could imagine that expectations focus on the price level rather than its rate of change. There is much more work to be done on this question.) Such things have happened in resource markets; but they do not seem always to be happening. I think that this story of instability in spot markets needs amendment; it is implausible because it leaves the asset market entirely out of account. The longer run prospect is not allowed to have any influence on current happenings. Suppose that producers do have some notion that the resource they own has a value anchored somewhere in the future, a value determined by technological and demand considerations, not by pure and simple speculation. Then if prices are now rising toward that rendezvous at too slow a rate, that is indeed evidence that owning resource deposits is bad business. But that will lead not to wholesale dumping of current production, but to capital losses on existing stocks. When existing stocks have been written down in value, the net price can rise toward its future rendezvous at more or less the right rate. As well as be- This content downloaded from on Thu, 31 Mar 2022 13:53:58 UTC All use subject to VOL. 64 NO. 2 RICHARD ing destabilized by flow reactions, the market can be stabilized by capitalization reactions. In fact the two stories can be T. ELY LECTURE 7 social interest in the pace of exploitation of the world's endowment of exhaustible natural resources. This aspect has been made to merge: the reduction in flow price brought to a head recently, as everyone coming from increased current production knows, by the various Doomsday forecasts can be read as a signal and capitalized into that combine a positive finding that the losses on asset values, after which near- world is already close to irreversible col- equilibrium is reestablished. I think the correct conclusion to be lapse from shortage of natural resources drawn from this discussion is not that ment that civilization is much too young either of the stories is more likely to be true. It is more complex: that in tranquil forecasts and judgments now-this con- conditions, resource markets are likely to track their equilibrium paths moderately and other causes with the normative judg- to die. I do not intend to discuss those vention already has one session devoted to from them. But resource markets may be just that-but I do want to talk about the economic issues of principle involved. First, there is a proposition that will be rather vulnerable to surprises. They may second nature to everyone in this room. well, or at least not likely to rush away respond to shocks about the volume of What I have called the fundamental prin- reserves, or about competition from new ciple of the economics of exhaustible re- materials, or about the costs of competing technologies, or even about near-term sources is, among other things, a condi- political events, by drastic movements of current price and production. It may be quite a while before the transvaluation of sequence of futures markets for deliveries of the natural resource. This sequence values-I never thought I could quote Nietzsche in an economics paper-settles tion of competitive equilibrium in the extends out to infinity, even if the competitive equilibrium calls for the resource to be exhausted in finite time. Beyond the down under the control of sober future time of exhaustion there is also equilib- prospects. In between, it may be a cold winter. rium: supply equals demand equals zero So far, I have discussed the economic theory of exhaustible resources as a partialequilibrium market theory. The interest rate that more or less controls the whole process was taken as given to the mining industry by the rest of the economy. So was the demand curve for the resource itself. And when the market price of the resource has ridden up the demand curve to the point where the quantity demanded falls to zero, the theory says that the resource in question will have been exhausted. There is clearly a more cosmic aspect to the question than this; and I do not mean to suggest that it is unimportant, just because it is cosmic. In particular, there remains an important question about the at a price simultaneously so high that demand is choked off and so low that it is worth no one's while to lose interest by holding some of the resource that long. Like any other competitive equilibrium with the right background assumptions, this one has some optimality properties. In particular, as Hotelling pointed out, the competitive equilibrium maximizes the sum of the discounted consumer-plusproducer surpluses from the natural resource, provided that society wishes to discount future consumer surpluses at the same rate that mine owners choose to discount their own future profits. Hotelling was not so naive as to leap from this conclusion to the belief that laissez-faire would be an adequate policy for the resource industries. He pointed to This content downloaded from on Thu, 31 Mar 2022 13:53:58 UTC All use subject to 8 AMERICAN ECONOMIC ASSOCIATION MAY 1974 several ways in which the background The literature has several reasons for assumptions might be expected to fail: the expecting that private discount rates presence of externalities when several might be systematically higher than the owners can exploit the same underground correct social rate of discount. They fall into two classes. The first class takes it pool of gas or oil; the considerable uncertainty surrounding the process of explora- more or less for granted that society wasteful rushes to stake claims and exploit, ought to discount utility and consumption at the same rates as reflective individuals and the creation of socially useless wind- would discount their own future utility fall profits; and, finally, the existence of large monopolistic or oligopolistic firms in the extractive industries. There is an amusing sidelight here. It is not hard to show that, generally speaking, and consumption. This line of thought tion with the consequent likelihood of then goes on to suggest that there are reasons why this might not happen. One a monopolist will exhaust a mine more standard example is the fact that individuals can be expected to discount for the riskiness of the future, and some of the slowly than a competitive industry facing risks for which they will discount are not the same demand curve would do. (Hotel- risks to society but merely the danger of transfers within the society. Since there is ling did not explore this point in detail, though he clearly knew it. He did men- tion the possibility of an extreme case in which competition will exhaust a resource in finite time and a monopolist only asymptotically.) The amusing thing is that if a conservationist is someone who would like to see resources conserved beyond the pace that competition would adopt, then the monopolist is the conservationist's friend. No doubt they would both be surprised to know it. Hotelling mentions, but rather poohpoohs, the notion that market rates of interest might exceed the rate at which society would wish to discount future utilities or consumer surpluses. I think a modern economist would take that possibility more seriously. It is certainly a potentially important question, because the discount rate determines the whole tilt of the equilibrium production schedule. If not a complete enough set of insurance markets to permit all these risks to be spread properly, market interest rates will be too high. Insecurity of tenure, as William Vickrey has pointed out, is a special form of uncertainty with particular relevance to natural resources. A second standard example is the existence of various taxes on income from capital; since individuals care abo