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Fundamental Economics of Depletable Energy Supply - page 5 / 30

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Resources for the Future

Krautkraemer and Toman

Throughout the article, we cite some key examples in which the theory and application of depletable energy supply are developed in the literature. Some relatively recent surveys provide more detailed references (Cairns 1990, Walls 1992, Epple and Londregan 1993, Toman and Walls 1995, Krautkraemer 1998).

1. Basic Hypotheses in the Economics of Depletable Energy Supply

The fundamental assumption underlying all of mainstream economic theory is that economic actors are motivated to make choices by the goal of maximizing some measure of economic returns. The textbook model of commodity supply is a simple case in point. In that model, competitive producers (producers lacking any market power, taking prices of inputs and outputs as given) seek to maximize profit, the excess of gross revenue over their opportunity cost of production, including returns to capital and entrepreneurial effort. Profit is maximized when the market price of output, a measure of incremental gain from expanding production, equals the incremental cost of output expansion taking into consideration all possible technological possibilities for cost-effectively combining various inputs.

The same assumption underlies the economics of depletable energy supply. However, in that theory, the measure of returns assumed to motivate behavior is a present value of current and future net revenues that accrue over time from a sequence of production decisions. A present value metric is used in depletable energy economics because, for reasons explained further below, the act of producing or developing more or less resource today has unavoidable consequences for future potential returns because of the interplay of economics, geology, and technology. If these future consequences were ignored by totally myopic producers, their cumulative effects would come as an unanticipated and unwelcome surprise later. Since there is every reason to assume that producers are aware of these intertemporal connections and, being aware, are motivated to account for them, it makes more sense from the standpoint of theoretical logic to suppose that producers systematically account for them in evaluating the present value of a sequence of decisions over time.

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