NATURAL RESOURCES ECONOMICS

T O U L O U S E S C H O O L O F E C O N O M I C S2 0 0 6 - 2 0 0 7

Natural resources economics M1-TSE

OBJECTIVES OF THE LECTURE

The lecture is intended to provide the students with introductory material in natural resources and environment economics. This material is composed of factual description of natural resources management problems and of analytical tools or models that have been developed to explain them. Elementary knowledge in microeconomics (like those exposed in Varian H. Intermediate Microeconomics) is considered as a prerequisite. A good background in multivariate calculus is also needed (non linear programming techniques). At some points, the lecture will use some basic elements of calculus of variation (Euler-Lagrange condition) and the basic skills will be given for that part.

The reading material is composed of

Kolstad C. Environmental Economics (2000), Oxford University Press

Hartwick and Olewiler, (1998) The Economics of Natural Resources, Addison-Wesley.

More references at the end of the lecture notes.

INTRODUCTION

The interaction between human activities and natural environments has a very long historical record. The exploitation of plants and animals in hunter-gatherers societies or in agricultural societies has lasted for millenniums. The same may be said for mineral resources, stone exploitation being the ancestor of the mining industry. The problem of over-exploitation of the natural resources (“unsustainable development” in modern terms) is also a very old one. Archeological record shows that after the human migration in the American continent, about 80% of the indigenous mega-fauna became extinct, due to over hunting, forest burning and so on. When faced with the negative ecological consequences of natural resources over exploitation, human groups moved away to get new resources, a major cause for the human expansion throughout the world. One of the main feature of the so-called “global” environmental problems like global warming is that not only everybody is impacted by them but also that we have no way to escape from them by moving away.

Natural environments provide two main sources of wealth to human communities: raw materials in the broad sense (including plants and animals) and space, either to undertake economic and social activities or as a way to store waste from this activity. Even if one may be rightfully conscious of the necessity to analyse environmental problems at a general scale, including all the existing interactions between man and the environment, it seems more reasonable to concentrate upon specific resources and questions.

As for many fields of applied economics, environmental economics is concerned by two main topics:

1. Allocation problems: efficient rules of management for natural resources, in the short and in the long run, sustainability and growth, valuations rules for natural assets and benefit-cost analysis, natural resources use as part of the general economy (“green” national accounting), uncertainty and risk management ;

2. Implementation problems: markets for natural resources and pricing rules, competition and industry structures, property rights, market failures and externalities, institutions and policies.

During this lecture we shall concentrate mainly: for the allocation part, over efficient management of natural resource, valuation and sustainability ; and for the second part over market performances and externalities. The very important issues of risk and uncertainty will be evoked but without a formal treatment, the same will apply to institutional design problems of sustainable management of natural environments.

A BRIEF HISTORICAL SUMMARY IN RESOURCES ECONOMICS

Concern for natural resources is an old tradition in economic thought. Malthus is usually considered as the prime founder of natural resources economics. In a provocative essay (Malthus T.R., 1803), Malthus pointed out that an exponential increase in population cannot be sustained in

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the long run altogether with a more modest, arithmetic increase of food production. Such a situation should lead to food shortages and death for the excess population with respect to land availability, and hence agricultural production possibilities. We shall come back to that in more precise terms later. What is interesting to remark at that point is that at the times Malthus wrote his famous essay, the west European countries were actually on their way to escape from the so-called Malthusian trap thanks to the Industrial Revolution. Even if perfectly correct for the preceding period in European history, his analysis would fail for the industrial societies emerging at the end of the XVIII century.

For almost a millennium (and probably more, but nowadays historical record is relatively precise from 1000 AC, see Maddison, 2001), the European societies experienced the so-called Malthusian regime. Such a regime is characterized by the following features: a very slow pace of economic growth, an almost constant population with cyclical variations composed of moderate population increases followed by sharp decreases of over-mortality due to food shortages and epidemic diseases, a very slow trend of technical progress, a sustainable population level mainly determined by the land availability with low productivity levels of land and labour, a population mainly living in rural areas. Such a situation was not specific to Europe and characterized the whole range of societies issued from the Neolithic Revolution (5000 BC). Economic activity relied mainly on renewable resources (agricultural crops and cattle for food, wind, watercourses and forests for energy production and space: land). The sustainability requirement was satisfied by dramatic episodes of massive death of the population when some critical thresholds between the resource availability and the population levels were crossed over. This is a situation which may be still observed in some parts of Africa, but you should notice that quick population extinction nowadays is mainly explained by wars or political problems rather than by pure economic considerations. However, bad food conditions affect more than one billion of people today, that is 16% of the world population.

Fig 1 : world GDP per capita from 0 to 2000 AC, in 1990 thousand ppp$ (purchase parity index)

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However, this impression of overall sustainable stagnation is misleading. The long run dynamics of timber acreage and the loss of agricultural land by erosion show a tendency to a reduction of the resource base of the economy. The price effect of deforestation was one cause of the substitution for coal in England at the end of the XVIIIth century. The critical problem of land availability and productivity was not a concern only for Malthus. Several economists of this time stressed the importance of land shortage and low land fertility as a limit to the standard of living of human population (Quesnay, Turgot).

Actually, international trade, the industrial and agricultural revolution and the move of many European people towards North America helped Great Britain to avoid such a Malthusian trap. By the middle of the XIXth century, an agricultural crisis was no more seriously considered at least in Western Europe. But now a new concern emerged, following the Industrial Revolution. In the pre industrial era, the natural resources base in the economy was mainly composed of renewable resources (land, forests, water, wind). But in the industrial era, the resource base of the economy is primarily composed of non renewable (or exhaustible) resources, coal especially. Hence the question of the consequences upon economic growth and welfare of the irreversible exhaustion of the natural resource base of industrial societies runs into the public debate. In a famous book, (Jevons, 1865), S. Jevons tries to anticipate the future of the Great Britain, faced with an increasing scarcity of its main mineral resource, coal. Due to the cost and ore quality competition with the US coal mines, Jevons predicted a progressive fading out of the English coal mines, a movement ending at the end of the XXth. He also described an impoverished England, facing moreover the pollution from coal burning. This was the official beginning of the fear about the so-called “unsustainability” of our industrial development model. We shall come back later to this problem.

Fig 2 : Trends of coal price and production between 1899-1999 (in $ 2000 on left scale) and (in billions tons on right scale)

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By the end of the XIXth century, we see the emergence of the environment in the political arena with the so-called “conservationist movement” in the United States. This movement has been at the origin of the national parks in the U. S. It was an ancestor of the today ecological political parties. A second important point, correlated with the first, is the creation of Civil Engineers Corps in charge of the management of natural resources (mainly mines, land, water and forests) in many industrial countries. This shows that it believed at this time that the problem of natural resources management was in fact a problem of ill-management. A 'rational' management of the natural resource, based upon the knowledge of nature coming from the natural sciences, was seen as the solution to both protect the natural assets and allows for the exploitation of natural resources for economic benefits. Engineers were in charge of implementing such 'rational' policies. The old concern of economists for the natural resources turned into a more specialized and applied research field. Many further achievements in resources economics borrow from initial engineers works in economic management.

Economic analysis suffered from this competition with the engineering management techniques for the natural resources. During the first half of the XXth century, most natural resources issues were treated as management problems and not as real economic problems (that is involving markets, prices, trade and economic growth). During the second half of the XXth century, the globalization of the trade of primary materials and energy sources upon international markets create a revival of the economic analysis of the natural resources. However the main breakthroughs in resources economics occurred before 1950. The principles of the valuation of the mines are set up by Gray (1914), the seminal treatment of the economics of exhaustible resources being Hotelling (1931). Pigou (1920) developed the concept of externality in connection to social welfare. This concept will allow to give strong microeconomic foundations for the public management of the environment.

During the post war era, the research field of environment and resources economics became more and more organized : specialized research centres like RFF (Resources for the Future), dedicated reviews, academic societies, faculties and teaching. Specialization of matters also occurred : energy economics, water economics, land economics, forest economics, fisheries economics... Greater political concern for environmental issues provoked the apparition of dedicated public offices, agencies or ministries of environment in the industrialized countries. This created a demand for environmental economic studies, sustaining the growth of the profession. These tendencies applied both in the theoretical strand of research and in applied research.

In their comprehensive survey, Barnett and Morse (1963) provided the first complete attempt to present an historical record of the trends in natural resources use, cost and prices since the beginning of the industrial revolution. Their conclusions were rather optimistic. The resource prices fell continuously in the long run, reflecting a non increasing scarcity of the natural resources. The pattern of exploitation of exhaustible resources shows a sharp increase for the last centuries but discoveries of new reserves and technical progress alleviated the exhaustion process. Regarding markets behaviour, no concern for the ultimate exhaustion of the resources appears. This optimistic view has been seriously challenged by the famous report of Meadows and alii, the so called “Club de Rome” report (1974). Based upon observed trends of resource use, the report predicted a quick exhaustion of the main non renewable resources (oil, gas, iron, copper) within a thirty years range. None of these predictions realized, but the Club de Rome report has been until today a constant reference for environmentalist people promoting a radical change of the pattern of economic development. The failure of the Club de Rome predictions was due, as usual in this kind of pure extrapolation exercise, to the lack of consideration for economic forces : markets, investments and technical progress.

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Fig 3 : Oil prices (in 2000 $ left scale) and consumption (in billions barrels, right scale)

This is reflected in the number of years left before exhaustion of our main mineral resources at current consumption levels. Despite an increasing consumption rate, these durations have increased or remained constant. For example the consumption of copper has been multiplied by a factor five between 1950 and 2000. Long historical records shows an even more dramatic increase. The world production of copper was about 15 000 tons per year at the beginning of the XIXth century. It is nowadays about 30 000 tons per day, that is a multiplication by a factor 700 in two centuries. However the number of years before exhaustion has slightly increased form 42 years in 1950 to 50 years in 2000. This is the consequence of a continuous discovery process and of the technical progress in ore extraction and refinement.

Other economic forces may explain the “inexhaustibility” paradox. The first one is substitution. The replacement of copper wires by optical fibres in the telecommunication industry allowed for a huge expansion of communication networks without exhausting the copper reserves. When political problems in Congo at the end of the seventies created a cobalt shortage with high prices hikes, substitution of cobalt by manganese in paints, and by ceramic in alloys inverted the tendency and the price of cobalt fell quickly during the eighties. Another reason is simply raw material saving. A modern car contains half the steel contained in a 1970 car for example. A third one is recycling. Today about 70% of a car parts are recycled. The car production has evolved to lower the costs of dismantling and recycling car parts. Recycling amounts for 33% of steel production, 25-30 % of aluminium production, 25% for nickel, 45-50% for silver and lead, 35-40% for copper. Newspapers have described the secondary steel shortage in Europe in 2005 because of the explosion of China demand for scrap materials. Technical progress can also change completely the demand pattern for raw materials. The substitution from silver films for photographs to digital photograph is expected to lower by 50% the silver consumption level at the world scale.

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Fig 4 : Copper prices (in 2000 thousand $ on left scale) and production (in millions tons)

This does not mean that we should not bother about the future availability of natural resources. For example, there have been no major discovery of oil fields since forty years and the today high levels of oil prices reflect the difficulty of current supply to meet the high energy demands of emerging countries like China and India. It seems difficult to imagine that a six billions world population could enjoy the living standard of an US citizen, consuming as much natural resources and energy than he does. But the historical record shows that the economic system has been able throughout the last centuries to continuously postpone the exhaustion process of raw material despite a dramatic increase in their consumption pattern.

ENVIRONMENTAL ECONOMICS

Beginning with the Conservation movement, concern for Nature itself became more and more important in policy making. So alongside the classical concern for natural resources, emerged progressively a new field of research in natural resources economics, namely the environmental economics. Two important economic concepts are at the heart of this approach : externalities and public goods. An externality is the physical consequence of the behaviour of one or many economic agents overs the behaviour spaces of one or many other economic agents. Here 'physical' means an effect which does not come from the market system. Environmental issues provide a very good field of applications for this concept. The car emissions of greenhouse gas, water pollution, are well known examples of physical effects of some agents behaviour (industrials or households) over the welfare of other agents (industrials or households). Pollution problems may be seen as primarily externalities problems.

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One of the well-known consequence of externalities is that the first welfare theorem remains no longer true in an economy with externalities. In other words, a competitive market system will in general not decentralize a Pareto optimum of the economy. Externalities are a case for the so-called 'market failures', that is the free market system will pick up an equilibrium price system not reflecting the impacts of pollution over economic agents. The pollution emissions will get a zero price level, but this cannot be a social optimum, since one can find people in the economy willing to pay for a reduction of the polluting emissions, because they harm their welfare. Hence there is an excess supply of pollution the free markets cannot take into account by lack of active markets for pollution allowances. 'Market failures' are in fact a matter of 'missing markets'.

One can see that the idea of negative externalities like pollution is in fact an extension of the notion of an economic 'good'. A standard consumption good increases welfare and hence has a positive value (or a positive 'price' at a competitive equilibrium). A pollution good decreases welfare and hence should get a negative price at an equilibrium, the value of the good being here corresponding to a social cost of pollution. In other words, 'missing markets' can be described equivalently as reductions of the possible tradable 'goods' space. By increasing the goods space, that is including as tradable goods the pollution goods, it should be possible to restore the optimality of the competitive equilibrium in this 'extended' abstract economy. And we shall see that it is effectively the case.

The failure of the free markets system makes a case for public intervention, only a public body being able to take care about the environmental amenities (or services). By imposing a pollution tax, or 'ecotax' upon pollution, based upon the social cost of pollution, the policy maker can restore the optimality of the competitive equilibrium. Such a tax scheme is called a 'Pigouvian tax', from Pigou, the first economist to fully describe the economic externality problem.

One of the main difficulty in policy definition is the determination of a socially optimal pollution level. Such an optimal level will rarely be equal to zero, since a complete abatement of the existing pollution would imply an excessive cost burden. Actually, such an optimal level can be determined at the point where the marginal social benefit from a decrease of the pollution level would be just offsetted by the marginal cost to obtain it. On practical grounds, this means that an environmental policy should be designed on the basis of cost-benefit analysis. If costs are more or less easy to measure, the same cannot be said from the benefits of an improvement in the quality of the environment. An important part of these benefits are not coming through the market, and their evaluation cannot be derived from market prices. Environmental economists have developed a battery of measurement methods for these 'non market' benefits. The so called 'environmental valuation' methods play today an important role in environmental policy design and in the evaluation of the performances of these policies..

An alternative to the 'externality story' is the 'property rights and transaction costs story'. If the 'externality story' explains what are the externalities and how to correct them, it does not explain where the externalities come from. Instead of speaking of 'missing' markets, we could alternatively say that pollution problems come from the lack of a well defined property rights system. There does not exist an entitlement of property rights for pollution, or more precisely, nobody wants to hold a property right upon pollution. A better definition of the property right system, making for example the car owner the sole owner of the gas emissions from his car, would reduce the amount of externalities in the economy. In fact it is possible to show that without transaction costs, a complete assignment of private property rights would restore the optimality of the competitive equilibrium by completely 'internalizing' the externalities (the so-called Coase theorem).

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What prevents the realization of a complete property right system in this story is the existence of transaction costs. Try to figure out what could be a contract between the car owner and other people suffering from car pollution. It would very difficult (and costly) to get a precise measure of the fraction of the global impact of air pollution upon the health of the pollution victims which can be attributed to the specific car emission from this given car owner. In this case, a complete assignment of the property rights of the car owner upon the air pollution impacting negatively the health of some specific people would be almost impossible, due to the nature of the polluting good. This is an example of how too high transaction costs would prevent the emergence of a complete private property rights for air pollution. Many examples of this kind may be given in the environmental domain. Environmental externalities arise generally from the lack of well defined property rights due to excessive transaction costs between economic agents.

Fig 5 : Externalities, optimality and trade

In some sense, pollution may be seen as some kind of a natural resource, lowering the social welfare. This approach is interesting for the case of stock pollution, that is a pollutant which accumulate over time. Greenhouse gas like CO2 (Carbon dioxide) accumulate in the atmosphere as a stock. This is not the flow emission of CO2 by economic activity which is reducing welfare but the whole stock of carbon. The historical trends of the main pollutants is of course of primary importance in this strand of literature. One can observe two kinds of patterns for pollutants. Most of the time, pollutants increase with economic growth. But in some cases, one can observe a first increasing and then decreasing pattern of pollution emissions. This kind of pattern is called and 'Environmental Kuznets curve' by analogy with the pattern of income inequality over time described by S. Kuznets. Such inverted U shaped curves may be explained by technical progress, substitution from polluting resources to cleaner resources (form coal to oil and gas for example) and depollution efforts due to environmental policies. The following example gives an EKC for air pollution in London since the XVIIth century.

Externalities

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Missing markets

Extension of the space of tradable

goods

:Public Intervention

Pigouvian Tax

Entitlement of property

rights

MARKETS

PRICES

GOODS

Direct internalization of the externalities

« Green » Taxes

Permits Markets

Norms

Markets failures

Lack of prices signals

Sub optimality

of the competitive equilibrium

Fig 6 : Smoke and sulfur dioxide (SO2) concentrations in London from 1600-2000

Note that these concentrations are today at their XVIIth century levels. The peak was reached at the end of the XIXth century when coal use for industry and house heating was at a maximum.

A SUMMARY OF THE LECTURE

We shall begin by considering simple problems of resource valuation in a static context (that is without time consideration). Land and water will be treated as examples of renewable resources. Then we turn to the case of exhaustible (non renewable) resources (like coal or oil). For these resources, we shall need to introduce time into the analysis. We shall first consider the problem of the optimal exhaustion of a non renewable resource. Then we shall look at the effect of industry structure upon the extraction pattern of an exhaustible resource, contrasting the competitive case, the monopoly case and a simple oligopolistic industry structure.

Then we shall turn to the study of the relations between economic growth, natural resource exploitation and pollution. This will give us some preliminary statements for the sustainability problem, the modern saying for the “Limits to growth” debate.

Next we shall consider some classical issues in environmental economics. We shall discuss environmental degradation as some kind of externalities and we shall apply to environmental policy the classical treatment of externalities in public economics. We study shall three kinds of policy instruments : markets for pollution permits, taxation and norms. We shall show that in a first best context, all these instruments can be made equivalent in their effects upon welfare and all of them

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allow to restore the optimality of the market system. We shall conclude with some material about environmental valuation and environmental cost benefit analysis.

Last, we shall come back to the case of renewable resources and consider the cases of forests and fisheries, which are particular cases of renewable resources that can accumulate over time. Hence we should also introduce an intertemporal framework to study the optimal management of such resources. These resources are well known examples of the possibility of 'tragedies of the common'. That is, lack of well defined property rights (open access regimes) can lead to over exploitation of the resource base (deforestation, fish species erosion, biodiversity losses).

References in the text

• BARNETT H, and C. MORSE, (1963), Scracity and Growth : The economics of natural ressources availability, John Hopkins Press, Baltimore.

• GRAY L.C., (1914), Rent under the assumption of exhaustibility, Quarterly Journal of Economics, 28, p 497-519.

• HOTELLING Harold, (1931), The economics of exhaustible ressources, Jouranl of Political Economy, 39, p 137-175

• JEVONS Stanley, (1865), The Coal Question: An inquiry concerning the progress of the nation and the probable exhaustion of our coal mines, 1865.

• MADDISON Angus, (2001), L'économie mondiale, une perspective millénaire, Éditions OCDE

• MALTHUS T. Robert, (1803) An Essay on the Principle of Population; or a View of its past and present Effects on Human Happiness; with an Inquiry into our Prospects respecting the Removal or Mitigation of the Evils which it occasions , 1803, revised and expanded 2nd edition of 1798.

• MEADOWS D.L. And alii, (1974), Dynamics of Growth in a finite world, Wright Allen, Cambridge, Massassuchets.

• PIGOU Arthur Cecil, (1920), The Economics of Welfare,

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