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Fundamental Economics of Depletable Energy Supply - page 6 / 30

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Resources for the Future

Krautkraemer and Toman

The foregoing does not imply that energy producers are omniscient or free of forecast error. That is prima facie not the case. Later in the article we discuss how the theory of depletable energy supply has been extended to incorporate various kinds of uncertainties. Those extensions emphasize the key role that expectations play in influencing supply behavior. What is assumed in the economics of depletable energy supply, however, is that producers are capable of avoiding systematic and persistent errors over time. This assumption can and sometimes is questioned, but we know of no persuasive economic theory based on alternative assumptions that has been formulated.

It is worth noting in this regard that the calculation of a present value involves the choice of discount rate(s) to deflate future returns relative to current returns. In characterizing producer behavior in depletable energy supply theory, the appropriate discount rates would reflect the competitive rate of return capital invested in the energy industry could earn in other uses, including adjustments for various kinds of financial risks. Since in practice market-based rates of return put disproportionate weight on returns in the first few years of an activity, the assumption that producers are not systematically biased in their expectations of future returns is not as difficult to swallow as it might first seem.

The standard theory of depletable energy supply can be extended well beyond a simple description of a single competitive firm. In addition to uncertainty, already noted, the theory can be extended to incorporate a number of market distortions, including property rights problems, environmental spillovers, taxes, and market power. However, efforts to describe the exercise of market power by energy producers like the Organization of Petroleum Exporting Countries (OPEC) and its members have been especially unsuccessful. A number of political and other factors must be incorporated to properly treat market power.

2. The Simple ‘Cake-Eating Model of Resource Extraction

In the simplest case, it is assumed that a known, finite stock of the energy resource is being allocated over some number of time periods to maximize the present value of net returns. Producers calculate returns to extraction in different periods based on price expectations (in the simple model expectations are assumed always to be realized), and knowledge of costs based on

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