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R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
Non-renewable resource use and other market structures
So far, we have been studying the patterns of exhaustible
resource use only in the case of perfectly competitive market.
Let us study the case of monopoly market now.
We know that, in the case of monopoly, there is only one firm in
the market and the monopolist determines the price.
In a
competitive market the price is not in the control of any buyer or
seller, but is determined exogenously by the market demand
curve. Then, given the demand curve, the firm chooses the
quantity at which its marginal cost equals marginal revenue
(price). However, the case of monopolist is different. In this case
also there is a demand curve. The monopolist also equals his
marginal costs with marginal revenue to determine its optimum
output level. But, this time, price is not equal to marginal
revenue. The monopolist will charge the price that consumers
are willing to pay at this output level.
1
Price P
R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
MC
PM
Pc
Marginal
Revenue
QM
Qc
2
Demand
Quantity Q
R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
A monopolist will choose output QM at which MC = MR, and
will charge the price PM, which consumers are willing to pay for
QM. Thus, marginal revenue, and not price, is an important
parameter for a monopolist for determining the maximum profit
point. In contrast, under perfect competition, the output level
will be QC and the price will be PC (fixed by the market).
A monopolist that controls the entire stock of a non-renewable
resource will act to maximize the present value of its profits
over time. He will choose a time path of quantities to be
extracted accordingly. For selling a quantity qt at time t, let the
marginal revenue realized by the monopolist be denoted at
MR(qt).
It is possible to show, using the arguments for the competitive
market case, that the profit maximization requirement for a
monopolist is given by,
m
m
MRt 1  MRt
 r or mt  t 1 or  r
1 r
m
MRt
where m represents the marginal revenue. Note that MR = price
for perfect competition, which gives rise to the Hotelling rule.
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R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
Consider the requirement, mt 
mt 1
. We know that the MR
1 r
curve is steeper than the demand curve. Hence, to increase MR
by (1+r) every period, it is enough to reduce the quantity by a
smaller level compared to the situation of competitive industry,
who have to decrease output by a larger level in order to set
price along the demand curve. Consider a monopolist moving up
its MR curve and a competitive industry moving up its demand
curve in each succeeding period. For a given discount rate, bot
will have to satisfy their respective versions of the Hotelling
rule. Thus, as MR curve is steeper than the demand curve, the
monopolist will extract resource more slowly than the
competitive industry. In other words, the monopolist will take
longer time to exhaust a deposit compared to a competitive
industry. Due to this slowness in extraction, Hotelling called a
monopolist "a friend of the conservationist." This also implies
that for the same stock size, the monopolist's initial price will be
higher and rise at a slower rate than for the competitive industry.
Monopolist will take more time to exhaust the resource.
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R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
Extraction paths - monopoly and perfect
competition
Price
Competition
p
M
p
c
0
0
Time
5
Monopoly
R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
Note that monopoly prices will be higher and output smaller
initially but the prices become lower and output higher in later
periods (compared to perfect competition). As because of
discounting, we give lesser weight to later periods, the net
benefit to consumers will be smaller in the case of monopoly
than the perfect competition.
Suppose that the monopolist does not have 100% control of the
market, and some very small firms also exist. What will happen
to these firms? Because prices do not rise at the rate of interest,
but at a lesser rate (only monopolist's marginal revenue rises at
the rate of interest), the small firms will find it unprofitable to
hold their stock, and will be forced to extract and dump its stock
on the market. Thus the monopolist can eliminate these small
firms and strengthen its monopoly power.
However, this prediction of the behaviour of monopoly prices is
only on of the three possible behaviour, as we shall see later.
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R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
Let us now derive the relationship between price and marginal
revenue, and hence derive the pattern of movement of prices in a
monopoly market.
We have,
mt 

pqt , t , qt 
q
 p qt , t   qt
p qt , t 
q




1 

 pt 1  dq
 q 
  dp  
  p  

1 
 pt 1 

  qt 
where  is the price elasticity of demand. Let (qt) =1+(1/).
Then, mt  pt t , which means,
dmt
d
dp
 pt t   t t .
dt
dt
dt
Dividing both sides by mt, we have,
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R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
m  p
 
m  p

p

r
p

( Price equation)
Let us now consider the following cases.
1. When the price elasticity of demand  is constant. Hence,
 =1+(1/) = constant. Its derivative is then zero. Thus, the
price equation is modified to
p
 r , which is the Hotelling's
p
rule for competitive markets. Thus, at constant price
elasticity of demand, the price path of monopolist will
coincide with that of competition.
2. The price paths will be different if  is a function of q. Now,
 

d dq
dq dt
d 
1  dq
1   
dq    dt

1 d dq
 2 dq dt
We know that so long as there is a positive stock, the quantity
supplied should decline over time in order to ensure rising
marginal revenue (as MR curve is negatively sloped – decreases
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R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
with output). Hence, dq/dt < 0. This means that the sign of the
derivative of  is that d/dt. We can use this information in the
profit equation above.
If
d
 0,
dq
p t
r
pt
If
d
 0,
dq
p t
r
pt
Thus, the manner in which the monopolistic outcome differs
from the competitive one depends entirely on the way in which
the elasticity varies along the demand function.
Consider a linear demand curve, p = A – Bq, (A,B >0). We have,
dp   Bdq
dp
dq
 B
p
p
dq

q
dp
 B q
p
A  Bq
dq
q
dp
p

A  Bq
 Bq
 1
A
Bq
d
A

dq Bq 2
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R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
Then, d /dq > 0. Hence,
p t
 r , or monopoly price rises slowly
pt
compared to perfect competition case.
The other case is when
d
p
 0, making t  r . In this case, the
dq
pt
monopoly price path is steeper than competitive.
In this case, monopoly initial price is lower and rises more
sharply over time then competitive case. However this case does
not have much practical relevance for exhaustible resource
industry. If
p t
 r , the resource will appear to provide a
pt
potential buyer an abnormally high rate of return, and this will
generate large speculative demand, driving prices down. Hence,
the continued maintenance of
p t
 r may not be practicable,
pt
especially when the total supply is limited.
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R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
Extraction paths - monopoly and perfect
competition
Price
Monopoly
p
c
p
M
0
0
Time
11
Competition
R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
Oligopoly
Oligopoly situation arises when a few firms dominate the
industry. In this market, the firms can collude with each other
(collusive oligopoly) or they can follow the price path set by a
dominant firm (dominant firm oligopoly). Exhaustible resource
market has been characterized by dominant firm oligopoly, and
hence we will take it up now.
Where the largest firm controls 60-80% of the market, it has a
number of strategies. The most profitable is often to cede part of
the market to the competitive fringe (CF) (i.e., other small
firms), and act as a monopoly for its share.
Consider the figure in the next page to understand the pricing
behaviour of a dominant firm in a oligopoly market. DD is the
market demand curve, and dd is the demand curve for the
dominant firm (DF). MRDF represents the MR curve for the DF.
The supply curve for CF can be obtained as the horizontal
distance between dd and DD for any price. That is, CF's output
is the difference between market demand and DF's output. Thus,
at point B, DF produces zero output and CF supplies the entire
market demand. At price PDF, DF supplies quantity QDF, while
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R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
CF supplies the remaining quantity equal to QT – QDF to the
market.
Like a monopoly, the DF will equate MC = MR to determine its
optimal output, and will charge a price as per the demand curve.
Thus, A is the point at which MRDF = MC, and the price is PDF.
Note that under competitive conditions, the output and price of
the dominant firm will be determined by the point E, and the
corresponding industry output will be at F. Thus, competition
results in lower prices and higher outputs.
If the market consists of only the dominant firm (without any
CF) (the case of pure monopoly), a new MR curve for the firm
will be made (MRT curve shown in the figure) and the
monopoly price and quantity will be PM and QM respectively.
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R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
Price
Oligopoly
D
PM
MC
B d
PDF
F
PC
E
D
A
d
MRDF
QDF
MRT
QM Q C
14
QT
Quantity
R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
Suppose an exhaustible resource industry consists of a mixture
of firms, some competitive and some acting as a single
monopoly, or cartel. The Organization of Petroleum Exporting
Countries (OPEC) has been viewed as a cartel, and the rest of
the world as the competitive fringe. By cartel, we mean a set of
producers who explicitly consider the effects of their
coordinated supply decision on the resource price.
The model of oligopoly is important for the study of exhaustible
resource use because, for most part of its history, OPEC
behaved as a dominant firm monopolist.
To analyze the behaviour of oligopoly over time, let us assume
that both the cartel and the CF have the same, constant
extraction cost. The cartel determines its price over time using
the monopoly version of Hotelling's rule [MRt = MRt+1/(1+r)],
and exhaust its resources. If CF can wait, they can hold their
stock till cartel exhausts its reserves, and enjoy capital gains for
selling its stock. However, if no capital gains are foreseen (e.g. a
backstop may be possible before cartel's reserves are exhausted),
CF will exhaust its reserves ahead of the monopolist because the
prices will rise (as fixed by the Cartel) at a rate lower than the
rate of interest (only MR will rise at the rate of interest).
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R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
Price
Extraction paths - Oligopoly
p0
Constant cost
Cartel
Fringe
Time
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R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
Price
Extraction paths - Oligopoly
p0
Constant cost
Fringe
Cartel
Time
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R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
If the extraction cost for CF (denoted as Cf) is higher than that of
the cartel (denoted as Cd), extraction begins with the cartel with
some initial price. The price will rise such the PV of MR are
equal. Once the price becomes larger than Cf, CF begins
production. At this stage, price must rise at the rate of interest.
Because, if price rise follows MR rule, prices will not rise at the
rate of interest, and CF will dump its stock for buying other
assets whose value rises at the rate of interest. This will pull
prices down to zero, which will not be in the interest of Cartel.
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Price
Extraction paths - Oligopoly
cf
p0
cd
Cartel
Fringe
Time
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R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
Effect of backstop in a dynamic environment – The phenomenon
of limit pricing
Let the cartel has zero extraction cost. Let p' be the cost of the
backstop.
If the cartel agrees to sell all its resource at a price lower than p',
it faces no competition. If it sets a price above p', it will find no
buyer, since the backstop producers will undercut it. Thus the
demand curve of cartel has the following shape.
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Price
p'
q1
Quantity
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R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
Assume zero extraction costs and iso elastic demand curve, with
elasticity greater than 1. We know that optimal monopoly prices
will increase at the rate of interest (MR and prices are
proportional as proved earlier). But now the cartel faces the
constraint pt > p'. One might think that the cartel will set its
initial price such that when pt reaches p', its resources are
exhausted. However, while it is optimal for a competitive
market, it is not so for the cartel. Cartel will benefit by setting a
higher initial price, and can increase the present value of its
profits. This means that the cartel will have some resources left
at the date pt = p'. It would ideally like to allow the price to rise
beyond p', but it is not possible. Hence, it will sell its remaining
resources at the constant price p', and backstop will take over
after cartel's resources are exhausted (at t2).
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R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
Limit pricing by oligopoly
Oligopoly case
Competitive case
Price
p'
p0
p
c
0
t1
Time
23
t
c
1
t2
R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
Obviously, competitive conditions will begin with a lower price
pc0 and proceed to exhaustion such that price pt = p' at tc1.
Because initial price of oligopoly is higher, initial quantity
extracted is smaller than the competitive case. Also, presence of
oligopoly delays the appearance of backstop as tc1 < t2.
How will the cartel ensure that backstop does not enter the
market during t1 – t2? This is done by what is called the limit
pricing behaviour of the cartel. It will charge a price marginally
less than p', thus positioning itself just below the kink in the
demand curve. This strategy is called limit pricing or entry
deterrent pricing.
This limit pricing policy has interesting implications. Suppose,
due to a new technology, p' reduces to p''. Now the cartel simply
establishes a new price just below p''. This will discourage
technological innovations by backstop producers though
consumers benefit because of these innovations. (They can have
a positive social return but little private return.)
It is recognition of this limit pricing possibility that lies behind
many of the arguments in support of the establishment of a
minimum price of oil. In the absence of such a price floor,
investors might not be willing to commit funds for the
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development of alternative energy sources because of the risk of
the final product being undercut by the low cost oil producers.
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Organization of Petroleum Exporting Countries (OPEC)
The organization of Petroleum Exporting Countries (OPEC) was
founded in 1960 with five members – Iran, Iraq, Kuwait, Saudi
Arabia and Venezuela. Some more members joined later on.
Qatar joined in 1961, Indonesia and Libya in 1962, Abu Dhabi
(later known as United Arab Emirates) in 1967, Algeria in 1969,
Nigeria in 1971, and, Ecuador and Gabon in 1973. By 1973,
OPEC had 13 members, and controlled more than 60% of oil
production. This grew to 68% in 1974 and there was virtually no
excess capacity outside OPEC. This meant that OPEC could
unilaterally increase oil price to any extent, and still sell large
quantities. The first oil price rise was effected in 1973, followed
by a series of rises for nearly a decade.
The sudden price rise in 1973 brought the hard reality of
vulnerability of oil importing countries and what the oil
exporting countries could achieve by withholding supplies.
OPEC was able to unilaterally increase oil prices and withhold
supplies. Between 1973 and early 1980s, the world held its
breath before every meeting of the oil ministers of OPEC
countries. Many appeared to believe that OPEC had to simply
name a price; the market would take anything they could come
up with.
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R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
This was the time when research on energy started gaining an
impetus. People estimated energy price and income elasticities,
and started to consider energy as another factor of production, in
addition to the usual factors such as capital and labour.
Generally the short run price elasticities are much smaller, while
even the long run values are not much higher, indicating relative
inelasticities. Also, the effects on analyzing the behaviour of
OPEC were on, so that it can be manipulated to achieve desired
results. In fact, there were at least two schools of thought; some
people claimed that OPEC was a cartel, while others contested
it. Obviously, OPEC's behaviour differes in important ways
from the classical text book example of a monopoly, though
OPEC could influence the market significantly with its actions.
Those who contested the hypothesis that OPEC was a cartel
pointed to the fact that it did not set production quotas,
something that an effective cartel will have to do. Yet the
hypothesis of absence of a cartel power was difficult to
reconcile with the apparent sway OPEC held over oil prices.
Several theories have been put forward to claim and counter
claim OPEC as a cartel, and published in research journals.
How OPEC could behave as a cartel but still did not set any
production quotas in the 1970s became apparent in the 1980s,
when OPEC became a victim of its own success.
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The oil price rise that happened twice in the 1970s triggered
worldwide recession. The demand for oil was high, and
substitution and conservation possibilities were low in the
1970s. This created a price inelastic situation and hence demand
for oil did not come down as prices increased. Because of the
inelasticity, though price rise was sharp, production cuts were
not needed to support the higher price. Also, at that time, the
sudden increase in foreign exchange could meet more than their
needs and no further increase in foreign exchange was needed.
The capacity to absorb imports through the sudden influx of
foreign currency earnings was high.
This however did not last long. The growth in world oil demand
slowed immediately after the first oil price rise. From 19401970, oil demand of the world grew at around 7% per year. But,
after that, especially after the second price rise around 1980, the
demand for oil stagnated; in 1994, it was virtually the same as in
1979. (There was a slight increase in demand even after the first
price rise in 1973, which reflected the low short-run elasticities;
but the stagnation in the 1980s reflected the higher long-run
price elasticity of oil.)
The years from the late 1970s to mid 1980s can be characterized
not by OPEC as a successful cartel, but rather by Saudi Arabia
(which is the largest single producer within OPEC, controlling
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R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
about one third of its oil) as a swing producer (a producer that
tempers its own production as needed to maintain the price).
When the Iranian production fell dramatically after the
revolution of 1979, Saudi met the reduction by increasing its
production. Because of the continued high oil prices, oil from
Mexico and North sea became more profitable, and their market
share increased. This put a further slide in prices. In 1982,
production quotas could no longer avoided within OPEC.
However, it has been observed that some OPEC members
exceeded their quotas. In these circumstances, to keep prices
high, Saudi cut its production.
This led to a situation where Saudi's production shrunk from
about 10 million barrels a day in 1979-80 to just about 3 million
in 1985. This coupled with reduction in prices from $40 per
barrel to less than $30 in 1985, led to a massive reduction in
their export earlings from 119 billion dollars in 1981 to 27 in
1985. Because of these developments, Saudi decided to export
more oil. This created more supply of oil in 1985, resulting in a
very sharp fall in prices, to as low as $10 per barrel in 1986.
Since 1986, oil prices were relatively steady for the next ten
years, though there was an increase momentarily to more than
$30 per barrel during Gulf war. This period is characterized by
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R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
the waning power of OPEC. In 1970, OPEC's share was 50%,
which fell to 30% in 1985, and was around 40% in 1996. During
this period, several member countries opted out of OPEC.
Ecuador left OPEC in 1993 and Gabon in 1995. Also, Iraq does
not supply oil after the UN sanctions following invasion of
Kuwait in 1991.
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Factors influencing the behaviour of OPEC
We have seen that cartelization of the oil suppliers was very
effective in the 1970s, but not so much in the eighties and after
that. Why? Were the conditions which made it profitable unique
to oil, or can it be extended to other natural resources – energy
(coal) or other minerals (say bauxite)? To answer these
questions, we must isolate those factors that made cartelization
possible. There can be several factors. We shall discuss some of
them.
1. World economic growth and the income elasticity of demand
for oil
Over time, the major force shifting world oil demand outward is
the rate of world economic growth. This income growth is
translated to oil demand via the income elasticity o demand. For
the major oil consuming countries, the income elasticity for oil
products averages around 1.0. This means that as the world
economy grew at about 4% in the 1970s, the oil demand also
grow at this rate. The continual increase in demand fortified the
ability of OPEC to raise prices. High income elasticity of
demand also supports cartelisation. All other things being equal,
the higher the income elasticity of demand, the higher the price
would have to rise to bring demand to zero (in the absence of
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substitutes) or more rapidly it would rise to the level of backstop
price.
The rate of economic growth affects OPEC pricing in two ways.
First, the more rapid the growth in demand and oil consumption
are, ceteris paribus, the more rapid will be the rate of depletion.
This will also increase the user costs, thus increasing the price.
Second, as OPEC s the residual supplier, an increase in demand
or decrease will directly affect the amount demanded from
OPEC. In 1970s, OPEC benefited due to increasing demand, but
in 1980s it had to cut production due to the recession.
2. Price elasticity of demand
It determines how responsive demand is to price. Normally,
price elasticities are less than unity indicating that demand will
reduce by a smaller amount when oil prices are increased by a
given amount. The short-run values will be much lower. The
long run price elasticity depends upon the opportunities for
conservation as well as the availability of substitutes.
3. Non-OPEC suppliers (Competitive Fringe)
If the cartel is able to prevent new suppliers, not part of the
cartel, from entering the market and undercutting the price, it
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can remain stable. If CF can increase their supply at the high oil
prices, they can decrease oil demand and hence the prices. If this
response were large enough, the allocation would approach the
competitive allocation.
The impact of CF on OPEC's behaviour was dramatically
illustrated by the events in the 1985-86 period. OPEC's share
was two-thirds in 1973, which reduced to 50% in early 1980s,
and further to 30% by the mid 1980s.
4. Compatibility of member interests
Note that OPEC is a cartel consisting of several member
countries, and not a monopoly. The interests of each member
may be different from the interests of the group as a whole.
Cartel members have a strong incentive to cheat. A cheater, if
undetected, could surreptitiously lower its price and steal part of
the market away from the others. Thus, successful cartelization
presupposes a means for detecting cheating and enforcing the
collusive agreements.
In the 1970s, cartel members did not have any need to cheat as
they got excess revenue. However, in the 1980s, because of the
recession, OPEC's production had to be cut to maintain high
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price, and hence each member had to be allocated fixed
production quotas. this have a ripe situation for cheating. To
detect cheaters, OPEC hired a specialized Dutch accounting firm
in 1985. However, even if some body is found cheating, strong
disciplinary measures are needed to arrest this behaviour, but
these measures may lead to disintegration of the cartel itself.
The incompatibility of member interests became clear while
assigning production quotas. The interests of members having
smaller reserves is different from those having large reserves.
For example, Saudi Arabia has approximately 33% of OPEC's
proved resources. Hence, it has an incentive to preserve the
value of these resources. If price is set so high that investment in
substitutes and backstop is encouraged, the value of its holdings
will reduce. It would like to keep prices sufficiently low so that
substitutes are not made available for a long enough time till it
uses its reserves. On the other hand, countries having lower
reserves would like to set higher prices so that they gain the
maximum as early as possible before backstop technologies
became viable and affect oil prices.
Political situation also plays an important role in cartel's
stability. For example, OPEC is dominated by Arab countries –
Saudi Arabia, Kuwait, Libya, Algeria, Iraq, Qatar and the UAE.
They have about 75% of the cartel's reserves. Their degree of
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hostility towards Israel is much higher than the non-arab
members. Compatibility is affected by the degree of closeness of
the members with Israel and the US, and other western
countries. Also the recent Iraqi invasion of Kuwait has affected
OPEC's stability.
5. Policy actions of crude buyers
It is also possible that crude byers unite and take coordinated
action to counter the threats of cartel. For example, in 1983, US
(23%), Japan (22%) and France (11%) bought about 56% of
OPEC oil, and they can together influence OPEC's decisions.
However, because of the low short run price elasticity, the threat
of disruption to their economic was so great that no such action
could be taken.
Some countries tried to block exports to OPEC as a counter
measure of oil price increase. But, this too was unsuccessful, as
western imports of OPEC were mostly luxuries that can be
dispensed with.
Another policy action can be imposing tariffs for OPEC oil.
However, tariffs require concerted implementation by all
importing countries. If country A imposes tariff, its energy
prices increase, its growth will be affected, and it can lag behind
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others. Hence, all countries should cooperate. There may be
opposition within the country for such an artificial price increase
(over and above the already high oil prices). This will affect
smooth cooperation by all concerned countries.
Finally, the usual policy options such as conservation and
research and development in substitutes for oil are generally
taken by all oil importing countries. Obviously, we have seen
that, backstop influences heavily OPEC's price decisions.
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Natural Resource Scarcity
Substantial research in the 1980s has been devoted to
determining just how scarce exhaustible resources have become
over time. People have tried to define and "measure" the natural
resource scarcity.
By natural resource scarcity, we mean what must be given up to
obtain an additional unit of the resource – the opportunity cost
of exploiting the resource.
Factors mitigating resource scarcity
1. Exploration and discovery
A profit maximizing firm will undertake exploration activity
until the marginal discovery cost equals the user cost of the last
resource sold. Larger levels of discovery can counter resource
scarcity.
2. Technological progress
This reduces the cost of the ore by discovering new ways to
extract, process and use the ore. Howerver, the rate and type of
technological progress is influenced by the degree of resource
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R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
scarcity. Rising extraction costs create new profit opportunities
for the development of new technologies. In places where labour
is abundant, new technologies tend to use more labour and save
capital. When fossil fuels were abundant and cheap, newly
discovered technologies relied heavily on them. As fossil fuel
supplies decline, new technologies have been developed which
conserve the use of these fuels and substitute them using other
renewable forms of energy and other factors of production.
3. Substitution
Adverse consequences of resource scarcity can be countered by
substituting abundant resources for scarce ones. The easier the
substitution is, the smaller will be the impact of declining
availability and rising costs.
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R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
Y
y2
F1
y3
O1
y0
F2
y1
S1
O2 < O1
x1
x0
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S2
x'
X
R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
Consider the adjacent figure. F1, F2, S1, and S2 are called
isoquants. An isoquant portrays all possible combinations of
inputs that can produce a given level of output. We have
assumed the product can be produced by using only to inputs, X
and Y. F1 and F2 represent the fixed proportion technologies, a
case in which no input substitution is possible. F2 represents a
fixed proportion combination to produce a lower level O2 output
than F1 (O1). S1 admits some possibility for input substitution,
and is drawn produce the same output level (O1) as F1. Because
S1 is asymptotic to the axes, perfect substitution is not possible.
S2 represents a case where perfect substitution of inputs is
possible for the output O1. This is because S2 cuts the axes at x'
and y', meaning that O1 quantity of output can be produced with
a combination (x0, y0), or with (0, y') or (x', 0).
The significance of input substitution can be illustrated as
follows. Let X be the depletable resource. Let its supply be
reduced from x0 to x1. If the technology involved is
characterized by S1, the constant output level O1 can be
maintained by increasing the amount of the other resource from
y0 to y2. Thus, the increase in y by (y2 –y0) compensates for the
reduction in x1 leaving the output unaffected. However, note that
it is not possible to completely dispense with the resource X
with this technology.
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R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
If production process is characterized by F1 instead of S1, the
reduction in the availability of X from x0 to x1 will necessitate a
reduction in the output from O1 to O2, where O2 < O1.
No
substitution of Y for X is possible. In addition, because inputs
must be used in fixed proportions, the amount of Y needed in the
process is reduced to y1, leading to the abundant supply of Y by
(y0 – y1).
Note that there are several factors such as population growth,
world economic growth, and catastrophes, which can lead to
increasing natural resource scarcity.
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R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
Criteria for an ideal scarcity indicator
1. Foresight
The indicator should help to anticipate scarcity and should not
merely be a record of the scarcity once it has occurred. Thus, it
should incorporate future demand patterns, availability of
substitution, changes in extraction cost, and so on.
2. Comparability
The indicator should allow comparisons among different
resources (coal, oil, etc.) for the purpose of identifying the most
serious problems.
3. Computability
It should be calculated readily from reliable, published sources
of information or should depend on information that can be
readily collected.
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R. Ramanathan/ Energy and Environmental Economics / HUT/ January-April 2001
Measures of natural resource scarcity
1. Unit costs (marginal extraction costs)
For a given technology of extraction, as lower grade ores are
extracted after higher-grade ores, an increase in marginal costs
of extraction is expected. Hence, this can reflect resource
scarcity. However, the indicator does not fulfill the foresight
criterion. It provides no indication of future changes.
2. Resource prices in real terms
This measure is a better indicator of resource scarcity than unit
costs. As prices incorporate future expectations, foresight
criterion is fulfilled. It also satisfies the comparability criterion
generally. The values are readily available in the form of long
time series. However, there are some problems with this
measure. Prices can vary depending on some temporary events
that do not pertain to resource scarcity. Also prices are subject to
market distortions – by government policies such as taxes,
subsidies, quotas and other factors such as market structures,
influence of labour unions, etc. Also presence of externalities
that are not efficiently handled by markets (such as pollution)
can affect the true value of prices.
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3. User costs
This measure is forward looking. User costs are zero if future
did not matter! It adusts itself to impending depletion, presence
of backstop, uncertainty, extraction costs, discount rates, etc.
However, the main problem is that user costs are firm specific,
and are difficult to measure because they require substantial
amount of firm-specific data. This also makes comparisons
among scarcity of several resources difficult.
Thus, natural resource scarcity of a resource should be studied
using a variety of indicators, and their behaviour over a long
period of time.
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