Fundamental Economics of Depletable Energy Supply Jeffrey Krautkraemer and Michael Toman∗
The economic principles governing the efficient production of depletable energy resources (oil, natural gas, and coal) have been a subject of interest and controversy for over 70 years. The pathbreaking article on the subject by Hotelling (1931) was motivated by then-current concerns about scarcity of energy and other natural resources that have a remarkably familiar ring to contemporary ears. More recently, the “energy crisis” of the 1970s motivated new concerns about the availability of sufficient energy resources and the capacity of economic markets to effectively allocate those resources over space and time.
In this article, we first present and discuss the basic logic underlying all neoclassical economic theories of “optimal” energy resource provision: maximization of the present value of some stream of economic returns. We then discuss how the economic theory of optimal resource depletion has evolved since Hotelling's article. We consider in turn theories of economically efficient energy resource extraction and new resource development. After presenting the basic theoretical framework, we discuss extensions incorporating investment in fixed production capacity, uncertainty, and various market distortions, as well as extensions incorporating nondepletable “backstop” energy resources.
The utility of an economic theory is to be found not merely in its conceptual elegance, but also in its power to support improved empirical understanding of actual behavior. Our discussion of empirical literature indicates that this work has so far provided only limited empirical understanding of observed energy supply behavior.
∗ Krautkraemer: Professor of Economics, Washington State University. Toman: former Senior Fellow, Resources for the Future; adjunct faculty member, Nitze School of Advanced International Studies, Johns Hopkins University. This paper was prepared for the forthcoming Encyclopedia of Energy to be published by Academic Press (Cutler Cleveland, ed.). Responsibility for the content of the paper is the authors’ alone.