Harold Hotellings Theory - Essay Example

? Harold’s Hotelling Theory Number Department Introduction Harold Hotelling’s theory was proposed by Harold Hotelling. The theory states that owners of nonrenewable resources can only produce that (same) resource if it yields more value than the financial instruments that are available in the market, such as bonds and interest bearing securities. The basis of this theory is the assumption that owners of these nonrenewable resources are motivated solely by profits, and that the markets in which they operate are always efficient. Because of the practical nature of Hotelling’s theory, the theory is widely used by economists to make predictions on the price of nonrenewable resources such as oil. These economists make this prediction by studying the prevailing interest rates. According to Per-Olov and Karl-Gustav (2000, 78) upon evaluation and analysis, Hotelling’s theory of nonrenewable resources can still be found to be effective, its flaws notwithstanding. One of the qualities that Hotelling’s theory enjoys and derives vindication from is the fact that the theory generates fundamental implications on how the finite availability of nonrenewable resources affects resource extraction path and resource pricing. Because of this, renowned economists such as Gaurav and Komalirani (2009, 145) divulge that by this virtue, Hotelling’s theory has been instrumental in addressing the most fundamental question that is due to the agent or owner of the investment: the extent to which the nonrenewable asset should be consumed at the moment, and the extent to which the nonrenewable resources should be stored for future use (Per-Olov and Karl-Gustav, 2000, 78). In respect to the above, Hotelling’s theory helps the proprietor of the nonrenewable asset to make distinctions on current values of assets if they are to be extracted and sold, against the possible future increased value of the nonrenewable asset that will have been left unexploited. In this case, the proprietor will have to measure the unit of profit at a specific time, t against the discount rate which will be the inverse rate of return, ?. To determine the rate of return, the proprietor will have to determine: dividend rate or marginal productivity (the flow of the product being generated by marginal units of the resource); the change that will have acted upon the physical characteristics of the nonrenewable asset, over time; and the change that will have acted upon the nonrenewable asset’s market value, over time (Sun and Kaplan, 2010, 75). According to Anderson (2007, 54), Hotelling’s theory considers fast logistics as critical to the success of modern manufacturing industry. This is because people stay far away from work station and thereby have to use automobiles to commute. Likewise, the extraction of oil and other nonrenewable resources by far transcends the use of manual labour and must therefore assume the use of logistics. This reality is further compounded by the introduction and development of global logistic networks. The importance of logistics in Hotelling’s theory is seen in the acknowledgement of logistic curve as an instrument that is important in the estimation of future production, through the use of previously observed discoveries. The consideration of logistics in Hotelling’s theory is also underscored by it being instrumental in determining reliability (the most likely estimate and the upper-bound estimate). The upper-bound estimate is the logistic curve that has a growth rate of 6% and ultimate resource which is commensurate to 200 Giga-barrels (Gb) and a peak of 1970. Conversely, the most likely estimate refers to a logistic growth rate that is commensurate to 6%, final resource that equals 150 Gb and a single peak in 1965 (Kandelaars, 1999, 70 and Sanders, 2011, 25). In respect to the above, the value of the marginal unit of natural resources that are held in-situ, minus the cost of extraction will be the value of the resources which will be in the flow market. For instance, should p (t) be taken as the price the extracted resource fetches on the market and c (t) as the marginal expenditure of the extraction as date t, then the marginal value will be obtained by subtracting c (t) from p (t). This is the very reason the formula p (t) ? c (t) = ? (t) continues to apply (Bulte and Heijman, 1998, 56 and Renz and Weber, 2012, 21). The formula above clearly validates Hotelling’s theory, given that both the formula and Hotelling’s theory qualify the condition of asset market equilibrium and the principle that the net price of the nonrenewable or natural resource must have a growth rate which is concomitant with the rate of interest. The import of this is that if the marginal cost of extracting the resource is not dependent upon the rate of extraction and maintains uniformity over time, then the renewable asset’s market price will be: P'(t) = r (1 - c/ p (t)). P (t) The case immediately above will mean that the growth rate of an observed price for the nonrenewable resource will be tipped towards the interest rate, as the proportion of expenses in price continues to diminish and the rent precipitated by scarcity of natural resources soars (Conrad, M. J. 2010, 75 and Crum, 2008, 29-31). Nevertheless, Toman (1982, 483), Humphrey (2010, 10) and Hackett and Moore (2011, 370) contend that despite the benevolence which comes with Hotelling’s theory, some pitfalls equally accompany it. Particularly, while Hotelling’s theory makes plausible predictions on exponentially increasing the prices of the nonrenewable assets, the results obtained from empirical studies remain out of tandem with the theory. This is because the results obtained depict either constant resource prices or a decline in the same, over time. As a response to this contrast, many research researchers and economists have tried to seal the gap by introducing more variables, in order to study their effect on resource pricing. It is against the same backdrop that other economists and researchers have tried to use different econometric techniques, in order to produce rising data on resource prices. The import of this is that Hotelling’s theory does not grasp all the market and value dynamics that surround the management and trade in nonrenewable assets. Kalt and MIT (1981, 41) point out that the model that is provided by Hotelling also assumes that there is an automatic growth of natural stock, in the form of logistics. However, the natural stock can develop up to the maximum limit (also represented as X min) subject to the carrying ability of a given ecosystem. The truth of the matter nevertheless is that when the stock becomes depleted below the critical minimum (depicted as X min), the minimum feasible population, the renewable resource forfeits its ability to regenerate and resultantly becomes extinct. Hotelling’s theory fails to factor this reality which touches on the dynamic value that touches on logistics. At the same time, Hotelling’s theory fails to take into consideration, changes in costs that touch on logistics as the technological infrastructure to be used in the extraction and production costs. This is to the effect that Hotelling’s theory assumes that the marginal cost of production will always increase, independent of the stock that is being produced, meaning that there is no consideration of the cumulative effect of nonrenewable assets that is being produced. Oil producers and economists such as Lee and Mirowski, (2008, 267) are categorical that the cost of production, particularly the extraction costs must increase, as oil fields are dug deeper in order to access the ever-diminishing supply. In a closely related wavelength, it is clear that Harold Hotelling does not factor the changes that are taking shape on technology and logistics, and how these changes affect price and production cost. Carilus (2010, 12) divulges that the theory also fails to factor in, the introduction, reality and dynamics of sources of renewable energy, their prices, and the manner in which they affect nonrenewable energy sources. Technological inroads and improvements through innovation are supposed to improve and make cheaper, producers’ extraction capacity over time. Likewise, the advent of wind, solar and other substitutes for oil are bound to affect prices by either providing these resources profitably and competitively with oil products or by reducing demand for the same. However, Hotelling unfortunately disregards all these realities (Lasserre, 2002, 11 and Kronenberg, 2007, 27). Another drawback that accosts Hotelling’s theory is Hotelling’s failure to consider the fact that all resources, oil and all other nonrenewable resources included vary in quality. Economic reality and dynamics of the real business world have it that less expensive grades are always produced first, and thereby leading to heightened extraction costs, together with the reduction of stock supplies. In the two cases, the cost and future price of the resources do not subscribe to a predictable or/ and gradual path. References Anderson, L. R. et al. 2007. A Classroom Demonstration of the Hotelling Model. Massachusetts: University of Massachusetts, 54. Bulte, E. 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Decontrolling natural Gas Prices and the Theory of Nonrenewable Resources Extraction under Discontinuous Price Policy. Massachusetts: MIT Press, 41. Kandelaars, P. P. 1999. Economic Models of Material-Product Chains for Environmental Resources. London: SAGE Publications, 70. Kronenberg, T. 2007. Reconciling Environmental Conversation with Economic Prosperity. Cambridge: Cambridge University Press, 27. Lasserre, P. 2002. Long term Control of Exhaustible Resources: Harwood Fundamentals of Pure and Applied Economics. London: Harwood Academic Publishers GmbH, 11. Lee, K. S. & Mirowski, P. 2008. “The Energy behind Vernon Smith’s Experimental Economics.” Cambridge Journal of Economics, 32 (2), 257-271. Litzenberger, R. H. & Rabinowitz, N. 1995. “Backwardation in Oil Future Markets: Theory and Empirical Evidence.” Journal of Finance, 50 (5), 58. Per-Olov, J & Karl-Gustav, L. 2000. “Comparative Dynamics in Health Economics: Some Useful Results.” Stockholm School of Economics Working Paper Series in Economics and Finance 17 (2), 78. Renz, A. & Weber, C. 2012. “A Hotelling Model for Fixed-Cost Driven Power Generation.” EWL Working Paper, 6 (2), 21. Sanders, A. 2011. “A Critical Look at the Hotelling’s Theory.” Journal of International business and Theory, 34 (12), 25. Sun, Y. & Kaplan, D. 2010. A New Asymptotic Theory for Vector Autoregressive Long-run Variance Estimation and Autocorrelation Testing. California: University of California, 75. Toman, A. M. Intertemporal Optimisation, the Hotelling’s theory and Nonrenewable Resources Market. Rochester: University of Rochester, 1982, 483. Read More