Bryan Caplan  

Friedman Extends Hotelling

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David Friedman re-explains Hotelling's analysis of natural resources, then argues that - due to insecure property rights - Hotelling's rule underestimates how fast prices will rise:

Suppose I own underground oil, but I believe there is a substantial chance, say ten percent each year, that someone else will seize control over it. I will only leave the oil in the ground if the expected rise in oil prices is enough to compensate me not only for the interest I could have earned on the money I would get by selling the oil now but also for the risk of losing the oil. So insecure property rights result in producing more oil now, less later, and a price pattern that rises faster than in the Hotelling model.

Essentially all property rights in underground oil are insecure. It has surely occurred to the current rulers of Kuwait and Saudi Arabia that money in a Swiss bank account is a safer asset than oil under the desert. The government of Norway is unlikely to fall to a coup or an invasion—but the politicians who control it today cannot be confident of controlling it ten years from now, so have an incentive to pump now and use the money to maintain their political power.

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COMMENTS (9 to date)
Tom writes:

Wouldn't that lead to an over supply now, and lower prices?

Kevin writes:
Wouldn't that lead to an over supply now, and lower prices?

I think that's the point. The arguement is that oil prices don't accurately reflect the amount of oil in reserve.

I disagree for another reason, increasing capacity requires new equipment and equipment is a long term investment. Oil extracted down the line is more likely to pay off the investment better than oil extracted now.

The premise of pumping as much oil as possible now brings to mind images of Captain Kirk calling down to the engine room and values being turned on full blast and guages flying into the red.

Barkley Rosser writes:

The real problem with Friedman's argument is that he falls for the same mistake his dad made back in 1973 when he forecast an impending death of OPEC. While it has not always been able to exercise market power, OPEC certainly has been able to do so for extended periods. In such cases, they do seem to coordinate to reduce production to increase short-term prices. This can clearly more than offset the argument given, at least for substantial periods of time.

Marc Shivers writes:

In the longer term, the opposite could actually be true as a result of reduced incentive to invest in production capacity... [More]

T.R. Elliott writes:

All very interesting from a speculative perspective. And I'm not discounting or making light of the intellectual merit of his statements when I say that they are of little more value than "metaphysics: an introduction" by Bahm sitting to my right on the bookshelf. No analysis. Just speculation.

I look at supply. I look at demand. I see them closing in one another another. I look at estimates of future production. I look at the instability in regions producing oil. I look at how quickly investment can be transformed into new production. I look at the depletion of existing fields. I study the analysis at theoildrum.com and James Hamilton's blog.

Humans are not that rational. Or for those who think they are, rational just is defined to be whatever humans do. E.g. Saddam Hussein torching oil fields in Kuwait. Al Qaeda's desires to do the same.

The ideas put forth by Friedman are compelling intellectually but I'm not sure of the value beyond that.

James writes:

If only every libertarian could communicate ideas as clearly as Friedman... (Not a dig at the hosts, just a compliment to DF)

T.R.,

While you may find an intellectually compelling case to be less than (compelling?), many people, including myself, feel the same way about a methodology specified so inexactly that it's impossible to even determine if one is actually using it correctly (or incorrectly). Looking is great. Inferring is better. Making clear one's assumptions about how to get from the former to the latter is the best.

T.R. Elliott writes:

James: I'm not following your point. What I'm saying is the following: Friedman's extensions to Hotelling are sound. They might apply to the real world of oil production. An economist might get a few papers out of it. All well and good. It provides a us with some speculation amunition to postule gaps in our understanding of oil production. But I'll focus on production and consumption, the geology and the technological possibilities that exist for alternatives and efficiency.

So what is it that you are saying?

Lauren writes:

David Friedman indeed has a wonderfully clear summary of Harold Hotelling's insights and a weak point in Hotelling's analysis.

In case you happen to be looking for more background on this interesting subject, here are some excellent discussions:

"Natural Resources" by William J. Baumol and Sue Anne Batey Blackman in the Concise Encyclopedia of Economics

"Property Rights and Natural Resource Management" by Richard Stroup and John Baden

"The Economics of Exhaustible Resources" by Harold Hotelling. JPE, Vol. 39, No. 2, Apr., 1931. The original article is available online through JStor (hat-tip to Marc Shivers above for the JStor link)

The Coal Question. William Stanley Jevons's original 1865 work on exhausting a natural resource--coal--which set off what is now almost 150 years' worth of concerns.

bartman writes:

I look at supply. I look at demand. I see them closing in on one another.

That's odd - I see them as being the same, all the time. Such is the nature of an accounting identity.

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