Transcript resource rent

Sustainability:
A Neoclassical View
Introduction
In the next two chapters, move beyond
our efficiency versus safety debate over
pollution control standards, and consider
long-run impacts
 Shift focus from allowable standards for
pollution to right targets for the
exploitation of natural capital

Natural Capital

Natural capital includes:
 Resources (Sources) that are inputs into the
economy
○ Renewable: water, wood, fish, and soil
○ Nonrenewable: minerals, oil, the genetic code
in species
 Environmental waste sinks
○ Land, air, water, human body
Stock and Flow Pollutants

Stock pollutants: Pollutants that
accumulate in the environment
 Examples: CO2, nuclear waste

Flow pollutants: Pollutants that do their
damage relatively quickly and are then
either diluted to harmless levels or
transformed into harmless substances
 Examples: acid rain, smog, and noise or heat
pollution
Environmental Sinks

Just like depletion of sources, stock
pollutants exhaust natural capital by filling up
environmental sinks.
 We all carry in our fat cells residues of the
pesticide DDT even though it was banned in the
early 1970’s
 Chlorofluorocarbons released into the atmosphere
today will contribute to ozone depletion for
decades
 Some high-level nuclear wastes retain their toxicity
for tens of thousands of years
Sustainability
A responsibility to future generations to
manage the planet’s resources and control
our emissions of stock pollutants
 Definition: Providing the typical person
alive in the future with a standard of living,
including both material and environmental
welfare, at least as high as that enjoyed by
the typical person alive today

Neoclassical vs. Ecological

Sustainability discussions have divided
economists into two broad groups:
 Neoclassical
 Ecological

Key Difference: To what extent can
created capital, or human made capital,
substitute for natural capital?
The Neoclassical View
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Natural and created capital are substitutes in the
production process
Technological optimists: as resources become
scarce, prices will rise, and human innovation will
yield high-quality substitutes
Nature is resilient: pressure on ecosystems will
lead to marginal, predictable degradation, but no
surprises
The global spread of market-based economies
provides a powerful foundation for achieving a
sustainable future
The Ecological View
Natural and created capital are
fundamentally complements
 Technological pessimists: as sinks and
sources are exhausted, human welfare will
decline, perhaps dramatically.
 Nature can lose its resilience; collapse of
some of the ecological foundations of the
economy are becoming more likely.
 Globalizing world economy is
unsustainable. Needed: a largely expanded
role for government to aggressively protect
our dwindling stock of natural capital

Measuring Sustainability:
Gross Domestic Product
GDP is the government’s measure of the
final value of all goods and services
produced and consumed in the market
each year; it also equals the income
earned and spent by consumers
 GDP is a bad measure of sustainability:
whether the typical person is better off or
not in the long run

Problems With GDP
fails to include the value of nonmarket
production
 fails to subtract the costs of growth
 fails to account for the depreciation of the
capital (human-created and natural) used
up in production
 reflects the experience of the “average”
rather than the “typical” person

An Alternative:
Net National Welfare
Neoclassicals and
Net National Welfare
 Neoclassicals
assume that NNW
for the median individual has been
rising over time and that we are
thus living in a sustainable
economy
 They argue for achieving the
maximum NNW over time, a goal
known as “dynamic efficiency”
Calculating Net National Welfare
Externality Costs: Chapter 8
 Costs of Clean-up and Abatement:
Chapter 9
 Depreciation of Natural Capital: Next
couple of slides!

Natural Capital Depreciation
Depreciation is a measure of how much
capital is used up in the production process
 Recall that resource rents develop when
access to resources are restricted, and
prices get bid up above the economic cost
of production
 Productive Investment of resource rents is
critical to provide future generations with a
higher standard of living

Mr. Bill in Billsville
Mr. Bill has an oil field containing 100
barrels of oil on his property.
 He can hire a firm from a neighboring town
to pump his oil at an economic cost of $1
per barrel, but because it is scarce, the
price of oil is $2 per barrel, well above cost.
 Scarcity of the oil means that Mr. Bill can
earn a resource rent of $1 per barrel from
its production.

Mr Bill in Billsville
1. How much will Mr. Bill’s net income
(economic profits) rise for the year?
2. If Mr. Bill spends all the income on a new
giant screen TV (which he keeps
locked up in his bedroom), how much
worse off are his children?
3. If Mr. Bill’s family were the sole residents of
the country of Billsville, how much would
Billsville GDP rise?
4. How much would Billsville NNW rise?
The Depreciation Rule
Depreciation of oil equals the measured
value of the resource rent
 The resource rent is what future
generations are losing by our exploitation
of natural capital today
 It is also the amount that must be saved
and invested if resource depletion is to be
sustainable

Investing Resource Rents:
Alaska
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Alaska, an oil-rich state has exploited its natural
resources and invested the resource rents into a
giant investment fund called the Permanent Fund
Each year, earnings from this fund are paid out to
all Alaskans, totaling about $1,000 per person
per year
Alaska has also invested in roads,
telecommunications, and better education
This may not fully compensate future generations
for the exploitation of resources, but it does
suggest how the current generation can
substitute created wealth for natural wealth
Measuring Resource Rent
A Problem With the Depreciation
Rule
Resource rent is measure using today’s prices.
But prices today may not accurately reflect the fair
value that future generations are liable to place on
natural capital.
Market
systems may account for this if
producers expect the prices of natural capital
to rise at a rapid rate due to future shortages;
they will hold off exploiting their holdings in
order to reap greater profits
Profit-Based Conservation
Problems with Profit-Based
Conservation
 Property rights in developing countries are
often uncertain, leading to “use it or lose it”
behavior
 Uncertainty about future needs and
preferences
 People prefer current over future
consumption
Bottom line: resource rent reflects a lower
bound of the true reduction in wealth due to
the drawdown in the stock of natural capital
The Usefulness of NNW
 Indicator of progress
○ A rising NNW would tell us that society would
be better off because current increases in
welfare would not come at the expense of
future generations
 Sustainable resource use
○ The difference between GDP and NNW that
results from resource depletion must be
productively invested in order to insure
sustainability
Genuine Progress Indicator
One attempt to calculate NNW: the
Genuine Progress Indicator (GPI)
 The formula again:
NNW = GDP + non-market output

 - externality and clean-up costs
 - depreciation of natural capital
 - depreciation of created capital
Growth in per Capita GDP vs. per
Capita GPI
No
correlation
between
GPI
growth
and GDP
growth
New Topic: Future Benefits
and Discounting
From a social point of view, there is a
major opportunity cost to foregone,
productive investment
 Investment of $100 today is worth more
than the same investment in the future
(not because of inflation– because the
investment is productive!)

PDV of Savings from Compact
Fluorescents
Cash Outlays for Investing
in Lighting
Discounting

When future benefits are not weighed as
heavily as current benefits, we say that the
future benefits are “discounted”
 Due to the interest or profit that might be earned,
cash resources on hand today are more valuable
than cash resources available at a later date

The amount we would put aside today to grow
to a certain benefit in the future is the present
discounted value (PDV) of that benefit
PDV Formula

PDV = $X/(1+r)T
 The
PDV of $X received in T years is
the amount of money one would need
to invest in the present to just receive
$X in T years, at a specified rate of
interest, or discount rate, r
Application: Clean up or Invest Elsewhere?
Assume no environmental bond
 Discount future benefits and costs at
rate of growth of NNW to determine
which outcome is dynamically efficient
 As always, at the efficient outcome,
victims could be fully compensated, but
generally won’t be

Application: Clean up or Invest Elsewhere?
Private Profit Rates vs.
Public Discount Rates
The Office of Management and Budget
requires a uniform 5% discount rate
 The EPA typically uses a 3% discount rate
 Private firms often require 15%-20% profit
rates for investment

 This is higher for two reasons
○ They reflect only private benefits of investment
○ High returns are required to induce people to
save and invest rather than to consume today
(what economists call positive time preference)
What is the “right” discount rate?
For private sector actors, use the private
opportunity cost of investment funds: the
expected rate of profit on an investment of
comparable risk.
 For social decisions, use the social
opportunity cost of investment funds: the
rate of growth of NNW!
 Studies suggest that over the long term,
this is from 0% to 2%.

Evaluating sustainability:
The Project Level
Although neoclassicals belive that
system wide, the economy is
sustainable, individual projects may be
unsustainable.
 To decide, apply benefit-analysis,
discounting future net benefits at the
rate of growth of NNW.

Evaluating sustainability:
Project Level Example
Replant a forest: Costs today $10m
 Future benefits in 20 years: $20 m in
resource rent from harvest, $5 m in
recreational and ecosystem benefits.
 Is not replanting more profitable at a
15% profit rate? Is not replanting
sustainable, discounting at 1%?

Evaluating sustainability:
Project Level Example
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Project Costs: $10 m
Project benefits at 15%: $1.53 m
Replanting not profitable
Project benefits at 1%:
$20.48 m
Replanting sustainable
Government should require replanting under
a sustainability rule.
High Market
Discount Rates
Using high discount rates dramatically
shortens the time horizons of investors: a
20% discount rate implies an expected
payback period of only 5 years.
 Along with open access to common
property, high market discount rates
explain why our actions today might
penalize the welfare of future generations:
market actors seldom look more than 5-8
years into the future.

Neoclassical vs. Ecological
Neoclassicals: in spite of open access and
high discount rates, we are still making
enough investments to insure overall
sustainability. Due to rapid technological
progress, NNW is rising
 Ecologicals: open access and high
discount rates have already led to the
unsustainable exploitation of natural
capital

Nonrenewable Resource
Economics 101
The Hotelling Model
Earlier, we introduced the concept of
profit-based conservation
 Economists use a simple model,
originally credited to Harold Hotelling to
derive the predicted relationship
between resource stocks and prices
over time

Billite Equilibrium
Suppose 100 tons of a brand new
mineral, Billite, is discovered
 Billite entrepreneurs intend to sell all
their Billite either this year or next
 What happens to the price of Billite over
time?

Assumptions
Billite is produced at a constant marginal
cost of $10, up to the supply limit of 100
tons
 The Billite industry is competitive (100
small producers each with one ton each)
 Investors can earn a 10% interest rate
elsewhere in the economy
 The inverse demand curve for Billite is the
same in both periods: P = $80 - q

Billite Supply and Demand, Two
Periods
Equilibrium?
Assume half selling their Billite during period
1, and the other half selling their Billite during
period 2. This is not an equilibrium.
 One producer can shift their sales from
period 2 to period 1; this lowers the period 1
price, but allows the producer to earn enough
interest on her period 1 profit to earn more
than she would have had she sold her goods
in the second period.

Equilibrium

By “guess and check”, the equilibrium is:
 Period 1: Q = 51, P = $31
 Period 2: Q = 49, P = $29
Hotelling Outcomes
Given a positive discount rate, the stock
will eventually all be sold, even if additional
periods are added to the model; the price
will rise to the choke price ($80): just high
enough to eliminate all demand
 Since this market is competitive, the
outcome is dynamically efficient and
maximizes the present value of the net
benefits to producers and consumers

Equilibrium in the
Hotelling Model
In equilibrium, note that the resource rent
rises between the two periods by a figure
very close to the discount rate
 Thus the equilibrium condition for the
Hotelling Model is

 RR2 = (1 + r)RR1

The Hotelling Model provides a precise
forecast of the growth path of resource rent
and thus nonrenewable resource prices
Testing the Model
Over the last 40 years, most nonrenewable resource prices have shown no
signs of rising at all
 There are two possible explanations for
this

 Market actors see no long term shortfalls of
these basic commodities within a relevant time
frame
 Mining and processing technology has
enabled the mining of lower grade ores
Related Issue: Intergenerational
Distribution of Natural Capital
Because the wealth represented by
natural resources has been endowed
100% to the current generation, we have
dictatorial power over resource decisions
 Since we own all of the resources today,
our perceived wealth is increased
 Higher perceived wealth increases
demand, and leads to greater levels of
exploitation

Dictatorial Power, Prices, and
Resource Rent