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Resources for the Future

Krautkraemer and Toman

increases with the extraction rate, or if extractive capacity is fixed.

The current pattern of petroleum extraction obviously violates the rule of exploiting lower- cost deposits before higher-cost deposits. The cost of extraction from petroleum reserves in the Middle East is much lower than the cost of extraction from reserves in the United States. This suggests that the simple modeling device of incorporating resource inventory in the extraction cost relationship probably aggregates over and therefore blurs some important distinctions. The case of petroleum is further complicated by the actions of large oil producers in OPEC using market power to restrict their output to levels below what would occur under perfect competition. The higher-than-competitive price that results provides the incentive for higher-cost producers to extract from their reserves. The higher noncompetitive price also distorts the capital investment decision, as the marginal cost of investment in capacity varies widely from $343 in Saudi Arabia to over $10,000 in the United States. Efficient allocation would result in the equalization of marginal investment cost across geographical regions.

3.2 Exploration and New Resource Development

Exploration is an economic activity and, like other economic activities, marginal benefit and marginal cost play a key role in determining how much exploration occurs. Again, a key paper in the development of this analysis is Pindyck (1978). Expenditures on exploration and development reduce current profit with an expected return of adding valuable reserves for future exploitation. The efficient level of exploration activity balances the expected marginal cost of exploration with the expected benefit of exploration.

The expected marginal benefit of exploration is not just the discovery and development of new reserves per se; in a model of incomplete resource exhaustion, the quantity of the resource stock is not determinative. The marginal benefit of exploration comes from the discovery of reserves whose cost of development and extraction is less than or equal to the cost of the reserves currently being depleted. In other words, the marginal value of new reserves equals the user cost of current resource depletion along an efficient time path of extraction and new reserve development.

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