FREC 424 -- Finite Resources and the Future

The traditional "big questions" in resource economics are about the future of the earth: How long can a growing human population continue to enjoy rising standards of living with finite natural resource reserves? What will happen to society when we run out of reserves?

We begin by reviewing two contradictory models of the future: a pessimistic model that predicts eventual economic and social collapse, and an optimistic model that predicts potentially unlimited growth in wealth and standards of living.

The pessimist model

The traditional pessimist model derives from Thomas Malthus's Essay on the Principle of Population (1798). Malthus observed that population can grow exponentially while the natural resource base (which Malthus implicitly assumed was homogeneous) is fixed, thus it is only a matter of time before the human population outgrows the carrying capacity of the Earth. At that point, humans will be reduced to bare subsistence living. (Malthus cited population figures from America to prove his point, but overlooked the fact that much of the American population increase was due to immigration rather than births.)

[Exponential growth: if you could take a piece of paper and fold it in the middle 10 times, how thick would it be? (Assume paper is 0.1 mm thick.)]

The Malthusian model is widely believed because it is simple and logical, and its predictions are clear and dramatic--just do the math! There are numerous modern variants of it:

In 1968 Paul Erlich published The Population Bomb, "The battle to feed humanity is over. In the 1970s, the world will undergo famines. Hundreds of millions of people are going to starve to death in spite of any crash programs embarked upon now. Population control is the only answer." Demographers called for "Zero Population Growth," and China established a one-child-per-couple law to control its population growth. Other quotes from Erlich: "We've already had too much economic growth in the United States. Economic growth in rich countries like ours is the disease, not the cure." (1990) "Giving society cheap, abundant energy would be the equivalent of giving an idiot child a machine gun." (1992).

Dennis and Donella Meadows and Jay Forrester published The Limits to Growth in 1972, calculating interdependent extrapolations of exponential growth in resource use, population and pollution, all culminating in sudden collapses of industrial output and food production, resulting in worldwide famine and population collapse, occurring in the next 30 to 100 years. Until recently the Meadowses were still publishing occasional updates and refinements on this model, although their main predictions to this point (like Malthus's) were pretty consistently wrong.

Garrett Hardin's 1968 article "The Tragedy of the Commons" (Science, 162:1243-1248) discusses the problem of a pasture on which anyone may graze his or her sheep. Since no one owns the common, and it is open to all, every herder has an incentive to enlarge his or her own flock even though it reduces grazing for everyone else's flocks. Unless all its users can agree among themselves to maintain the productivity of the common by limiting the size of their flocks, the common will be overgrazed and ruined. (We will analyze problems of property rights and negative spill-over effects such as these later on in the course.) By analogy, the Earth is a common at risk of ruin from the freedom to pollute or have as many children as we want. Hardin believes that long-term survival requires progressive elimination of freedom and growing reliance on "mutual coercion."

Malthus was not the first writer to worry about unrestrained population growth. Jonathan Swift's famous essay "A Modest Proposal" (1729) explains the demographic problems of early 18th-century Ireland before introducing his tongue-in-cheek population control strategy: "I have been assured by a very knowing American of my acquaintance in London, that a young healthy child well nursed is at a year old a most delicious, nourishing, and wholesome food, whether stewed, roasted, baked, or boiled; and I make no doubt that it will equally serve in a fricassee or a ragout."

People probably evolved to be natural pessimists: the worriers survived which the careless got eaten by saber-tooth tigers. Here are some particular resource depletion stories that show how pessimism is not always warranted. (Jared Diamond's book Collapse explores a number of other resource depletion crises at length, some with tragic outcomes, some with happy outcomes.)

In the 19th century many households used whale oil lamps for lighting, but as the US whaling industry expanded and the technological efficiency of whaling improved, whale stocks were seriously depleted, and whale oil prices rose sharply. But rather than sit home in the dark, people switched to gas and electric lighting and the whaling industry faded into obsolescence. Most whale species are now protected via international treaty. It's not just because people feel warm and fuzzy about whales; it's because modern whaling isn't really profitable.

In 1908 Teddy Roosevelt shared widespread concern that the US was rapidly running out of trees: "If the present rate of forest destruction is allowed to continue, a timber famine is obviously inevitable. Fire, wasteful and destructive forms of lumbering, and legitimate use are together destroying our forest resources far more rapidly than they are being replaced.... Unless the forests can be made ready to meet the vast demands which...growth will inevitably bring, commercial disaster is inevitable." This didn't happen, obviously. Instead, the US timber industry developed more efficient growth management, harvesting and processing technologies, and the nation switched from wood to coal, and then to other fuels, for energy.

In 1920, US consumption of petroleum was a half-billion barrels/year, and the USGS estimated total reserves to be 7 billion barrels--about 15 more years of petroleum left even if consumption didn't increase! But 15 years later, although consumption had increased dramatically, total reserves were up to 12 billion barrels--enough to last about 15 more years. Today the US consumes over 7 billion barrels/year, about 40% of this is produced domestically, and current US petroleum reserves are estimated to be about 22 billion barrels--enough to last about 9 years-- but that's not the whole story. In 2008, world oil consumption was about 64 billion barrels/year from global reserves now estimated to be about 1.2 trillion barrels--enough to last over 50 years.

The total volume of oil deposits in the earth is certainly finite. "Reserves" are defined as deposits that are currently proved and economical to extract. Over time, oil companies discover more deposits, and develop more efficient extraction technologies that make previously sub-economic deposits profitable to extract. For most of the past 100 years global oil reserves have been increasing on the production end at least as fast as they were being depleted on the consumption end.

From demography to economics

During the 19th century various economists refined and elaborated on the theories of Malthus. David Ricardo observed that some farmland is more productive than other farmland, but the owners of the more productive farmland can hire workers for the same wages that owners of less productive farmland pay their workers. Thus a resource "rent" accrues to the owners of high-quality farmland. As population grows, the excess supply of labor drives wages lower, and successively poorer quality land is brought into production. As the relative scarcity of land increases, rents on higher quality land rise. Ricardo's theory implies that society will become polarized into two classes: a large population of landless, impoverished workers scraping out a bare living on rented land (which Karl Marx termed the "proletariat") and a small landowner elite who collect the rents (Marx's "capitalists"). Unrestrained population growth would keep wages at subsistence level, and the peasant population is fully exploited by the capitalists who capture all of society's wealth.

The Ricardian model troubled many 19th century economists, because the concentration of wealth in fewer and fewer hands seemed to imply eventual "secular stagnation," an inadequate aggregate demand leading to economic collapse: how much consumption can a dwindling number of super-rich capitalists maintain? Who will buy all the stuff their farms and factories produce? This logic convinced Karl Marx that capitalism would necessarily fail, so that the proletariat (workers) would finally overthrow the system, seize the means of production and establish a socialist state in which everything is communally owned.

The Ricardian concept of a resource rent is fundamental to the economic models we will study that predict how competitive markets allocate resources through time. The marginal rent earned on a unit of resource is the difference between its market price and its marginal extraction cost. Since the market price reflects the scarcity of the resource, the marginal rent does too. In fact resource rents are sometimes called "scarcity rents." The marginal resource rent is equivalent to a marginal profit or resource investment value. As the resource gets scarcer, marginal rent rises in line with price, which is what investment values are supposed to do.

The flip-side equivalent of marginal rent is the marginal opportunity cost of not using the resource in its next-best use or in the next-best time period. This is why resource rents are sometimes referred to as "marginal user costs."

The optimist model

The Malthusian model has the advantage of simplicity and clarity, but its predictions of worsening poverty and hunger have been mostly wrong (at least so far!), and there is a solid body of economic theory to explain why:

In 1931 Harold Hotelling formalized the standard economic model of exhaustible resource depletion, explaining why profit-maximizing behavior in competitive resource markets causes efficient allocations of resources through time. This is the fundamental principle behind the exhaustible resource depletion theory taught in this course.

Hotelling explains that competitive resource owners all compare the discounted resource rents they could expect to receive in different time periods, and try to sell their resource stocks in the time period(s) when the discounted rents are maximized. If resource owners expect that resource rents will rise faster than the rate of discount, they withhold the resource from the market (viewing them as high-return investments), and the current price of the resource immediately rises to a level from which rents then grow at the rate of discount. If resource owners expect that resource rents will rise slower than the rate of discount, they sell off their resources (as low-return investments), and the current price of the resource immediately falls to a level from which rents will grow at the rate of discount. So market consensus expectations about future rents are reflected in current resource prices. Resource markets exhibit foresight! They anticipate future scarcity, and reflect it (discounted) in today's prices. Over the long term, marginal rents from an exhaustible resource will rise at the rate of discount through time. We will revisit these concepts in detail over the next few weeks.

Robert Solow's 1974 article "The Economics of Resources or the Resources of Economics" (American Economic Review) expands on Hotellling's hypotheses and provides a good explanation of how rising resources prices signal scarcity, stimulate conservation, new discoveries, new recovery technologies, development of substitute resources, etc. Solow's growth models demonstrate that we can have limitless economic growth with a limited physical resource base as long as we maintain adequate capital investment.

Alfred Kahn's The Next 200 Years is another rebuttal of the Limits to Growth model, and projects that technology will keep food production ahead of population growth. As long as the economy continues to develop technological efficiencies and substitute capital for raw materials, we will be fine.

Julian Simon's The Ultimate Resource (1981) takes the most contrarian, optimistic view of the future. Simon's "ultimate resource" is people, and the imaginations and ever-increasing stock of knowledge they possess. He argues that per-capita incomes and living standards have been rising pretty steadily in line with population for 500 years and will likely continue to do so indefinitely. Efficient markets naturally signal impending scarcities with rising prices. But long-term prices for most resources have declined. It's not the quantity of reserves we have left that indicates resource scarcity, but the real (inflation-adjusted) prices of resources.

(Simon had some high-profile debates with Paul Erlich over resource scarcity, and in 1980 they made a bet. Erlich would track the inflation-adjusted value of a $1,000 portfolio of five metals for ten years (Erlich chose copper, chrome, nickel, tin and tungsten, $200 of each at 1980 prices). If the real value of the portfolio had increased by 1990, indicating rising economic scarcity, Simon would pay Erlich the increase in value. If the real value of the portfolio had fallen, indicating reduced economic scarcity, Erlich would pay Simon the decrease in value. Simon won the bet handily. By 1990 the inflation-adjusted value of the metals portfolio had fallen by more than half, and Erlich sent Simon a check for $576.07.)

Technologies continue to enhance the productive efficiencies of finite resources. The quantity of farmland is pretty stable, but technologies have increased yields per acre dramatically and food prices keep falling. Today's cars get about twice as many miles per gallon as cars built in 1970 got.

Pollution has actually declined as population and per-capita incomes increased. The US has significantly cleaner air and water today than it had 30 years ago. This demonstrates that environmental quality is a luxury good, which simply means that its income elasticity is greater than one. In other words, as incomes increase, demand for environmental quality increases proportionately more. Note that the term "luxury good" does not imply the good is frivolous or high-priced or just for rich people. Other "luxury" goods include safe water, sanitation, education, health care and even longevity.

Most modern economists would argue that the pessimist models are gross over-simplifications--mechanistic and myopic, because they ignore the capacities of people and markets to adapt to changing resource endowments. The pessimist models generally assume that the carrying capacity of our environment is fixed, that people will keep reproducing at the same constant rate, and that there will be no market adjustments to resource scarcity; so resource depletion will be sudden and catastrophic. There is no differentiation of land qualities, or human abilities, no capital or wealth accumulation, no technological improvements in resource use efficiency--in short, no economics! The pessimist models yield clear predictions, but they turn out to be wrong.

The optimist models are somewhat more technical, and their predictions are less specific. They recognize that the world is more complex, and human societies (market democracies, at least) are more responsive and adaptable to change than the pessimist models allow.

In general, the pessimist models imply that the free market system will ultimately fail or betray us. The implication is that markets and behaviors must be controlled to insure society's survival. We may need to restrict peoples' reproductive rights (as Hardin suggested and China has done), ration their consumption, control their choices, etc.

In contrast, the optimist models argue that the free market system generally does allocate resources efficiently. Market interventions are only necessary to correct identifiable market failures such as externalities or undersupply of public goods. Government failure leading to the imposition of unnecessary market distortions may represent a more significant risk to our future welfare than market failure.

Although economics has been termed "the Dismal Science," economists are typically optimistic about the abilities of efficient markets to protect us from "overshoot and collapse" scenarios in the future. Unfortunately, public confidence in market efficiencies is not so strong. Public mistrust of markets can easily foster wasteful and even counter-productive government policies to correct perceived economic problems.

In the policy realm, the resource economist's primary mission is to distinguish truly inefficient resource markets from efficient markets, and argue for limiting policy interventions to inefficient markets only. Please keep in mind that political processes are not necessarily more efficient than market processes. Government interventions in markets often create bigger problems than they solve. That is why this course includes a large amount of political economy theory to complement the standard resource economics theory.