Economics of Natural Resources

1. INTRODUCTION
Traditional usage confines the term natural resources to naturally occurring
resources and environmental and ecological systems that are useful to mankind
or could be useful under feasible technological, economic, and social
circumstances. Examples of natural resources are forest land and its multiple
products and services (e.g. timber, wild-life habitat etc.), natural land areas
preserved for aesthetic, recreational, or scientific purposes (e.g. silent valley of
Kerala, wet lands of eastern Kolkata etc.); the fresh and salt water fisheries;
mineral resources that include mineral fuels and non-fuels (e.g. coal, aluminum
etc.); non-mineral energy sources of solar, tidal, wind, and geothermal systems;
water resources; and also the waste-assimilative capacity of the environment
and ecological systems. These examples make it clear that what we perceive as
natural resources depend on the conditions we have inherited from the past,
current or foreseen technologies, economic conditions, and tastes. For instance,
a century ago, not much was known about benefits of wetlands, and uranium
was not known.
Here we deal with the economics of natural resource use. In particular we
analyse how society should exploit a resource efficiently and the rate at which
a rational agents should exploit such resource through time. The rest of the
paper is organized as follows: In Section 2 we adopt a resource taxonomy
(classification system) that is used to distinguish various categories/measures
of resource availability. Section 3 deals with the question of how to allocate
exhaustible resources efficiently over time. It also discusses certain related
aspects of exhaustible resources. Section 3 analyses the basic issues of
economics of renewable resources taking fishery and forestry as examples.
Section 5 discusses certain aspects of water resource management and
concludes.
2. RESOURCE TAXONOMY
Three separate concepts are normally used to classify the stock of
exhaustible/depletable resource. They are (1) current resources, (2) potential
resources, and (3) resource endowment.
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Current reserves are defined as known resources that can profitably be
extracted at current prices. Their magnitude can be expressed as a number. The
amount of potential reserves, on the other hand, depends upon the price people
are willing to pay for those resources – the higher the price, the larger the
amount of reserves potentially available. For example, techniques, more
expensive than conventional ones, generally allow greater amount of a resource
to be recovered. As the price per unit increases, the amount of a resource that
can be economically recovered also increases. Thus, potential reserves can be
defined as a function rather than a number.
The natural occurrence of resources in the earth‟s crust represents resource
endowment. It represents the upper limit on the availability of terrestrial
resources. Since the size of the resource endowment does not, in any way,
depend on the price, it is a geological rather than an economic concept.
These distinctions among the three concepts are important. Failing to take note
of them may lead to erroneous conclusions. We need to remember that data on
current reserves does not represent the maximum potential reserves. We also
need to remember that the entire resource endowment cannot be made
available as potential reserves at some price people will be willing to pay.
Certain mineral resources are prohibitively costly to extract. It is not likely that
any society, current or future, would be willing to pay the price necessary to
extract them. This, then, would imply that the maximum feasible size of the
potential reserves is likely to be smaller than the resource endowment. Box 1
gives us some ideas about the state of a exhaustible resource in India.

Box 1: Exploration and Production of Petroleum in India

India continues to be one of the least explored regions. of the 26
sedimentary basins, only 6 have so far been explored, accounting for only
30 per cent of the country‟s prognosticated reserves. India‟s balance
recoverable crude oil reserves are declining continuously after peaking at
806 million metric tons in 1992. This indicates the need for greater
exploration efforts.
Source: Parikh (1999)

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Natural resources, as we have said before, include renewable resources such as
fish population and forests and non-renewable exhaustible resources such as oil
reserves and mineral deposits. Thus for another useful classification of natural
resources, we adopt the convention that classifies natural resources as
renewable and exhaustible depending on their rates of regeneration. Oil is
exhaustible because its formation requires millions of yearswhich is not an
economically meaningful time frame. Trees and fishes are renewable because
they can grow to maturity within a reasonably short span of time. Thus it is
possible, though not inevitable, that a flow of these resources could be
maintained over time.
It needs to be remembered, however, that for some renewable resources, the
continuation and volume of their flow depend crucially on humans.
Overharvesting reduces the stock of fish, which in turn reduces the rate of
natural regeneration of the fish population. This may even lead to extinction of
the otherwise renewable resource. For other renewable resources, such as solar
energy, the amount consumed by one generation does not reduce the amount
available to the generations that follow.
Managing natural resources of either kind has its own challenge. The challenge
for exhaustible resources involves allocating dwindling stocks among
generations. In contrast, the challenge for managing renewable resources
involves the maintenance of an efficient and sustainable flow over time.
At an analytical level, however, both the resource categories may be thought to
have a common foundation. The stock of natural resources (for example, the
population of fish in a lake or the number of tons of coal remaining in a coal
field) measures the state of a resource. Stocks of renewable resources like fish,
grow through regeneration; while exhaustible resources like coal are available
in fixed quantities. During a particular time period the stock depletes at the rate
of harvesting or extraction per period. These attributes of natural resources
have much in common with man-made capital. Just as investment increases
and depreciation reduces the stock of man-made capital, so growth through
regeneration increases and harvesting or extraction depletes the stock of natural
resources.

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We will take up next the economics of exhaustible resources. Analytics of both
exhaustible and renewable resources involve some mathematics. However, we
will attempt to explain the basic ideas without developing the mathematics
(other than some simple algebra) that underlies them.
3. MANAGING EXHAUSTIBLE RESOURCES
Exhaustible resources will be depleted so long as the extraction rate is positive.
Are our exhaustible resources being depleted too rapidly? To answer questions
like this we need to know the optimal rate at which to extract/deplete
exhaustible resources. With that in view we will present here some simple and
intuitive results involved in the theory of depletion.
What are the conditions that must hold while depleting an exhaustible resource
over time, that is, along an optimal depletion path? The supply (and extraction)
behavior of a price-taking owner1 of an exhaustible resource such as oil differs
from that of an ordinary good or resource. An exhaustible resource is limited in
quantity and is not producible like an ordinary good. Ordinary goods produced
in the economy using available methods of production can be replicated. Since
exhaustible resources are created by geological processes with geological time
spans, they can be regarded as fixed in quantity, although the total quantity
available may not be known.
A price-taking firm supplying ordinary goods will adjust production in all
periods so that the incremental cost of production of an extra unit of output,
i.e., its marginal cost (mc) of production in each period equals price (p) in that
period. If the mc is less than p, the supplier can raise current profits by
increasing production. However, when the firm is the extractor of an
exhaustible resource, such behavior might require extraction of more stocks
than is available to the firm.
Cases like this, then, require some modifications of the standard theory. Since
an exhaustible resource is limited in quantity and is not producible, extraction
and sales of a unit today, involves an opportunity cost; the value that might
have been obtained for that time at some future date. This opportunity cost is
1
Competitive owner who sells his natural resource in a market where he does not have a large
enough market share to be able to influence market prices.
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usually given the name user cost (uc). The presence of user cost is central to
the economics of exhaustible resources. User cost does not exist for
conventional reproducible goods since the consumption of an amount now
does not reduce the quantity that can be consumed in the future; additional
quantities can always be produced. However, a barrel of oil extracted today is a
barrel unavailable for extraction in the future. In deciding whether to extract
and sell an additional barrel today, the extractor must consider not only the cost
of pumping the barrel, but also the cost of foregoing the highest return that
could have been earned if the oil had instead been pumped and sold in the
future. Hence, it is necessary to have a more inclusive definition of marginal
cost and we call it augmented marginal cost (Salant, 1995). The augmented
marginal cost (amc) is, then, defined as the marginal cost of extraction (mc)
plus the user cost (uc).
When mc is redefined in this way, it is optimal for a competitive resource
owner (firm) to extract the resource in each period to the point where its amc
equals the market price (p). Instead of the usual efficiency condition, price (p)
= marginal extraction cost (mc), we have:
p = mc + uc.
This is the first condition of optimal depletion. As shown in Figure 1, it implies
that less of the resource will be extracted today than if it were a producible
ordinary good or a resource. Given the relation between demand and price p =
p(y), where p is the price and y is the quantity demanded and extracted, only y*
units (rather than y** where p = mc) will be extracted by a resource planner or
a price-taking firm seeking to allocate extraction efficiently over time. This
leaves a positive difference AB (the opportunity cost/user cost) between p and
mc.

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 Figure 1:Optimum Extraction of an Exhaustible Resource.
Beneath the apparent simplicity of this rule lies a wealth of subtlely (Salant,
1995). The rule implies, for example, that the current extraction rate by a
private owner of a natural resource depends not only on the current price, as in
the standard theory, but also on expectation about future prices. These price
expectations determine the opportunity cost of additional current extraction. A
competitive supplier that expects future prices to be sufficiently low compared
with the current price may extract and sell intensively in the current period,
judging the opportunity cost of additional extraction to be small. But if future
prices are expected to be sufficiently high, the same current price may induce
no extraction whatsoever today.
For some further results let us, for simplicity, assume just two periods: the
resource owner either extracts and sells the resource today, in period 0, or
retains it in the ground until the next period 1. Let the price he can obtain for a
unit of the resource today be p0 and the price he expects to prevail for a unit in
the next period be p1. The cost per unit of extracting the resource and
delivering it to the buyer is C, which is not expected to vary between periods 0
and 1, that is C = mc remains constant.
Because the owner has a fixed stock (to be supplied from) of the resource, any
unit sold in period 0 will reduce the quantity that can be sold in period 1. If he
sells the unit in period 0 he will receive net revenue of p0–C but forgo revenue

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of p1-C in the following period. The value in period 0 of the net revenue
foregone is its present value (p1-C)/(1 + r) where r is his discount rate2.
Hence his return from selling a unit today will be:
(p0 – C) – (p1 – C) / (1 + r)
(p1-C)/(1+r) is the opportunity cost of his decision to sell a unit today. It is the
user cost of his decision. It arises because he is faced with the alternative of
selling it in the following period. If
(po – C) > (p1 – C) / (1 + r)
he will be better off selling his resources in the current period. If, on the other
hand,
(po-C) < (p1-C) / (1 + r)
he will be better off by leaving it in the ground. His optimum amount of
current extraction is given where
po-C = (p1-C) / (1 + r) (1)
This implies that po = C + (p1 – C) / (1 + r) (1a)
Equation (1a) states our earlier result that the current price of the resource
when it is extracted optimally, should be equal to the mc plus the user cost (uc).
With reproducible resources there is no element of user cost since resources are
produced in each period to satisfy the demand in that period and there is no
carry over from period to period. Hence, as we have seen earlier, for a
reproducible resource the optimum output is given where po = C.

2
The present value (PV) of a stream of net benefits Bo …., BT received over a period of T years is
T

computed as PV (Bo ……. Bt) = B

t0
t
1  r  t
where  is the summation, r is the appropriate

interest rate, Bo is the amount of net benefits receivers immediately, and Bt is the amount of net
benefits received t years from now. The process of calculating the present value is called
discounting and the rate r is referred to as the discount rate. One rupee received in period t is
equivalent to 1/(1 + r)t1 rupees in period 0. At a discount rate of 10 per cent, a firm will be
equally well off if it earns Rs. 100 today (which can generate Rs. 10 of interest income) or if it
earns Rs. 110 one year from now.

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 Transposing equation (1a) we have
(p1 – C) = (po – C) (1 + r) (2)
Equation (2) is the second condition of optimal depletion and is usually
described as the fundamental equation (due, originally, to Hotelling, 1931) of
exhaustible resource extraction. It says that along the optimum extraction path,
where the resource owner is indifferent as to the options of extracting or
leaving the resource in ground, the price of the resource, net of marginal
extraction costs, that is, the user cost has to rise at a rate equal to the discount
rate. A numerical example may help to illustrate this fundamental condition.
Suppose the interest rate is 10 per cent and the net price (p – mc), that is, user
cost per unit of the resource is Rs. 20. If the net price (user cost) is not
expected to grow by 10 per cent to Rs. 22 next year, it pays to extract more of
the resource in the current period, because the resulting income from sales will
earn 10 per cent interest if invested in interest bearing assets. If the net price is
expected to go above Rs. 22 that is, to grow faster than the rate of interest – the
producer will have no incentive at all to extract in the current period. This is
because any unit extracted today will (even after interest earning) be worth less
in a year than a unit extracted and sold a year from now.
If mc of extraction is small relative to the price of the resource, equation (2)
approximates to
p1/po = 1 + r or p1 = po (1 + r).
Thus along the optimum path resource prices grow at the discount rate. The
higher the discount rate the faster the rise of resource price along the optimum
path. A higher discount rate reduces the user cost of the resource and causes
mine owners to deplete their resource at a faster rate. In reality, of course,
extraction costs are never zero. Whenever they are positive, a price increase
equal to the interest rate would cause the net price to rise by more than the
interest rate. For example, suppose the price per unit of a resource is Rs. 30 and
the net price is Rs. 25. A 10 per cent price rise (in the rate of interest) would
boost the net price from Rs. 25 to Rs. 28, or by more than 10 per cent. This
difference would give every extractor an incentive to postpone extraction

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rather than satisfy current demand. If such imbalances are to be avoided, the
price in successive years must rise by less than the interest rate.
We will see that this analysis may illuminate many questions of practical
policy. Let us consider for illustration, the following questions (Salant, 1995):
 Suppose a state-owned or controlled enterprise say Coal India Limited
(CIL) is entrusted with selling an exhaustible natural resource (in this
example coal) on the world market. For a small country3 can it be right
to extract it to the point where the mc of extraction equals the world
market price? Is it ever prudent to refrain from extracting a resource,
even though it is profitable to begin with that is, current price exceeds
the mc of extracting the first unit?
 Credit may be more tightly rationed (and interest rates higher) in one
country than in another. How does this affect the former country‟s
relative rate of resource extraction?
 Suppose a government decides to restrict the extraction of a resource
that is privately owned and extracted because the resource is
considered highly valuable (such as gold in India) or because the
extraction process generates pollution (such as gold mining which uses
mercury or arsenic). Is it right in such cases to give the extractor a
grace period before the restrictions are effectively imposed to
overcome the dislocations that such policies will cause?
Each of the questions raised above ceases to be puzzling once attention is
properly refocused on the opportunity cost of current extraction and how that
cost changes when a new policy is anticipated.
Expanding short-run coal production based on the equality of mc of extraction
and market price is excessive because it fails to account for the future net
return (profit) foregone, when an additional ton of coal is extracted. Moreover,
if this opportunity cost is sufficiently high, no amount of the resource should

3
A small country is one that sells on the world markets but that does not have a large enough
market share to be able to influence world prices (a price-taker).
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be extracted today even though the current price exceeds the current mc of
extracting the first unit.
As regards the second problem, when the real interest rate rises, the uc of
extracting another ton declines because the future profit (from the ton that must
be foregone) is worth less today (that is discounted profit is low today). Hence,
even if mc does not shift, the augmented mc (amc) in early periods will fall. As
a result, the same sequence of prices would generate an initial expansion in
extraction. This outcome can be used to explain differences in the behavior of
two countries selling the same natural resource on the world market. Assume
that both countries have approximately the same underground reserves and
costs of extraction. If credit is rationed more tightly in one country, that
country should extract more rapidly in the short-term in order to maximize
national wealth.
In the third problem where (say) it is proposed to shut down a highly valued
or/and polluting gold mine but the mine operator is permitted a grace period to
mitigate the dislocations caused by the closure, during the grace period
premature closing lowers the uc of an additional unit. Consequently, the amc in
each period before the date of closing is lower than it was before the policy
was announced. If the sequence of world price is unchanged, the mine operator
will find it profitable to intensify mining throughout the grace period.
3.1 Towards a Substitute (Backstop)
Our discussion so far considered optimal depletion of an exhaustible resource
when we implicitly ruled out availability of any substitutes or „backstop‟ as it
is sometimes called, of the resource concerned. However, it may so happen that
a substitute resource, possibly a renewable resource, is available at a constant
marginal cost. This scenario could pose the problem of optimal depletion of
say oil or natural gas with a solar substitute. What would be the optimal
depletion rules in these circumstances?
We note that the amc for the exhaustible resource cannot exceed the mc of the
substitute. The society could always opt for the use of a renewable resource
instead, whenever it appears cheaper to do so. Thus, although the maximum
willingness to pay (the „choke price‟) sets the upper limit on amc and for that
10
matter on p when no substitute is available, the mc of extraction of the
substitute sets the upper limit when a substitute resource is available at amc
that is lower than the choke price.
3.2 Exploration and Technological Progress
In principle, extraction costs may rise over time as lower-cost reserves are
depleted and higher-cost reserves remain to be exploited. The search for new
resources involves costs. As more easily accessible resources are exhausted,
we must move into less accessible areas, such as the bottom of the ocean or
high slopes of the mountain. This suggests that the marginal cost of
exploration, which is the marginal cost of finding an additional unit of the
resource, should be expected to rise over time, just as marginal cost of
extraction does.
Rising augmented marginal cost of a resource induces society to exploration
activities. Some of this exploration would be successful. If the mc of extraction
of the newly found resources is sufficiently low, this could lower, or at least
moderate, the increase in amc and price.
Technological progress, in the present context would be manifested as
reductions in the cost of extraction. However, with a finite amount of a
particular exhaustible resource, the fall in amc would not last indefinitely,
because ultimately it would have to rise. This period of transition could last
quite a long time though.
3.3 Resource Extraction and Environmental Cost
Extraction of a natural resource may impose an environmental cost on society.
In situations like this property-rights are not usually well-defined and hence
this cost is not internalized by the extractors. The aesthetic costs of strip
mining, the occupational health hazards associated with coal mining, and the
acids leached into streams from mine operations are all examples of associated
environmental costs. The cost of extraction and sale (including user cost) is
borne by the resource owner and taken account of (internalized) in the
calculation of how much of the resource to extract. The environmental damage,
however, is an external cost and is not borne by the owner and as such it will

11
not be part of the extraction decision. It is important to know how the market
allocation, based on only the former cost would differ from the optimal
allocation (depletion), which is based on both.
The inclusion of environmental costs results in higher resource prices, which
tend to lower demand. All other things being equal, it would allow the resource
to last longer. On the other hand when environmental side-effects are ignored
by the resource extracting firm, the price of the exhaustible resource would be
too low, demand too high, and the resource would be extracted too rapidly over
time.
3.4 Resource Scarcity
Are resources getting scarce? We will consider two economic measures of
resource scarcity, namely cost and price to confront the question raised.
Nineteenth century economist David Ricardo views the increasing costs
associated with depletion as a limit to growth. In principle, extraction costs
may rise over time as lower-cost reserves are depleted and higher-cost reserves
remain to be exploited. Certainly resources have been extensively depleted
over the last century and more. How have costs behaved?
The predictions of Ricardian scarcity were examined empirically for the USA
in a famous study by Barnett (1979). The authors considered two versions of
the scarcity hypothesis: a strong version, that unit costs of extractive
(exhaustible material) industries should rise through time; and a weak version,
that costs in extractive industries should rise relative to non-extractive
industries. The latter version recognizes the impact of technical progress in
lowering costs of production in modern economies. For all true extractive
industries, costs over the long term declined relative to the costs in non-
extractive industries.
These studies also examined the proposition, derived in the earlier sections,
that because of the influence of user cost, prices of exhaustible resources
should rise relative to those of reproducible resources. This proposition is also
rejected by the evidence.

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 There are four basic reasons for the failure of the scarcity hypothesis
(Bowers, 1997).
1. As higher grade resources are exhausted, lower grade resources are
found in greater abundance. Furthermore, the difference in grades
diminishes as the known stock expands.
2. As a particular resource becomes scarce, price rises are offset by
switches in demand to substitutes (backstop). That is, scarcity is offset
by decline in demand.
3. Increases in prices stimulate exploration for new deposits and induce
increased recycling.
4. Technical progress influences supply by reducing extraction costs and
by making possible the exploitation of previously uneconomic
deposits. It also reduces demand by encouraging efficiency in resource
use.
4. MANAGING RENEWABLE RESOURCES
The line dividing exhaustible resources and renewable resources is not always
clearly drawn. Just as exhaustible resources, in a sense, can be renewed
through exploration and technology, renewable resources can be exhausted. In
fact, much of the current concern about resource exhaustion involves
renewable resources (Fisher, 1981). However, renewable resources are
different from exhaustible resources because of the fact that they are naturally
regenerated on time frame that is relevant to human exploitation. Catching a
fish or cutting a tree does reduce the population of fish or tree in any period.
But unless the population has already been reduced to the point of the critical
threshold, natural growth will replenish the loss of biomass due to the harvest
within a relatively short period. So, although it is true that a renewable resource
can exhausted, it need not be.
Mankind shares the planet earth with many other living species. When
biological species become commercially valuable they are subjected to two
opposing human objectives. On one hand, the value of the species to humans
provides a reason for human concern about its future. On the other hand,

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commercially exploitable biological resources can also be pushed to the brink
of extinction if not managed sensibly.
In case of biological resources the size of the resource stock (population) is
determined jointly by biological factors and by actions taken by society. The
size of the population, in turn, determines the availability of resources for
future. As the flow of these resources over time is not purely a natural
phenomenon, a crucial issue is the optimum (efficient) rate of resource use
over time and over generations. A related question is: can the market be relied
upon to achieve and sustain this rate? Using the fisheries as an example of a
renewable resource we will address these issues here.
4.1 Biological Dimension: Growth Curves
Unlike exhaustible resources, renewable resources can be reproduced. Thus,
even though available stocks are affected by human intervention via their
levels of exploitation, the economics of renewable resources depends,
crucially, on assumptions about their population dynamics.
Figures 2 and 3 show the population dynamics of a hypothetical renewable
resource, which we assume to be a single fish species. The stock of fish (or
biomass) is supposed to follow growth through time as shown in Figure 2. This
shows cumulative growth, or the size of the stock, as a function of time. At low
levels of stock the fish multiply, but as they begin to compete for food their
rate of growth slows down and eventually the stock converges on some
maximum level Xc, the ecosystem‟s carrying capacity for that species (in the
absence of human intervention). The cumulative curve, thus, takes the general
logistic shape with at first successively larger increments, then successively
smaller ones. Note that the curve, as we have drawn, begins at Xmin – the
critical minimum level of population. If the size goes below this level the
species is driven to extinction (X0).
It is useful for our purposes to look at the information contained in Figure 2 in
a somewhat different way. Figure 3 shows the growth in the resource stock on
the vertical axis and the level of stock (X) on the horizontal axis. The solid
curve relates this growth of the species, measured as the net annual increment
to the population or weights thereof (births minus death), to the stock level.
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Left to nature and in the absence of human predation, Xc is the population level
that willprevail. Xc is known as natural equilibrium because at Xc stock is just
replacing itself. Reductions in the stock because of mortality or predator
species or (in the case of fish) out-migration would be exactly offset by
increase in the stock because of births, growth of the resource (weight) in the
remaining stock, and in-migration (of fish).
This natural equilibrium would persist because it is stable. A stable equilibrium
is one in which movements away from this equilibrium stock level set forces in
motion to restore it. If, for example, the stock temporarily reduces below Xc
then it will recover because for all stock levels below Xc growth is positive.
Thus if the stock is reduced to X1, it will increase in the first year by G(X1). In
the next year the population level of X1 + G(X1) will grow by less than G(X1),
but the growth will still be positive and the process will continue until the stock
is back to Xc. If, on the other hand, the stock temporarily exceeds Xc, it would
be exceeding the capacity of its habitat (carrying capacity). As a result,
mortality or out-migration would increase until the stock settles down within
the confines of the carrying capacity of its habitat at Xc.

Figure 2: Logistic Growth Curve of a Renewable Resource where Stock

Size is a Function of Time

15
 Figure 3: Relationship between Resource Stock and Growth
Xmin, in the diagram, is known as the minimum viable population and
represents the level of population below which growth in population is
negative (i.e., deaths and out-migration exceed births and in-migration). The
reader can check that in contrast to Xc, this equilibrium is unstable. Here, once
the stock moves away from Xmin no forces act to bring back the resource stock
to a viable level.
With human intervention when catch (yield) level equals the growth of the
stock, it is known as sustainable yield. Here the stock size, the growth rate and,
hence, the catch all remain constant. Thus, in terms of Figure 3, G(X1) is the
sustainable yield for resource stock X1.
Figure 3 helps to identify a concept widely used (particularly by biologists).
This is the maximum sustainable take (MSY), which occurs when the growth of
the resource is at a maximum. In Figure 3 it is G(Xm) corresponding to the
MSY stock Xm. The apparent attraction of MSY should be obvious: if we
harvest the renewable resource in such a way that we take MSY from the stock,
it will regenerate itself and we can get MSY again in the next time period, and
so on. If it takes one year to regenerate, MSY can be harvested each year. If it
takes ten years, we must harvest MSY every tenth year only. MSY is the most
we can harvest from the resource and maintain its sustainability without
reducing its long term stock. We get the maximum from it each period. Herein

16
lies attraction in the idea of setting our rate of harvest equal to MSY4. However,
we shall see shortly that, MSY is unlikely to be an economically optimal policy.
4.2 Efficiency and Sustainable Yield
Allocation to be efficient has to equate marginal costs of harvest with marginal
benefit (that is, maximize net benefits) and hence must include the costs as
well as the benefits associated with harvests. For our present purpose we ignore
discounting and define the static-efficient sustainable yield. It is the catch
(harvest) level that, if maintained perpetually, would produce the largest annual
net benefits. Dynamic-efficient sustainable yield will incorporate discounting.
Initially we concentrate on static concepts and properties.
Our analysis, for simplicity will assume that: (1) The resource (fish) price is
constant; (2) the marginal cost of fishing effort (to be explained subsequently)
is constant; and (3) the amount of harvest (Y) per unit of effort E expended is
proportional to the size of the resource stock (that is, the smaller the fish
population, in our present example, the fewer fish caught per unit of effort).
We now introduce the level of exploitation or harvest or yield of the resource.
Following assumption (3) above, we write
Y = EX (3)
Then, the rate of harvest can be shown on Figure 3. To keep the diagram
simple, we assume that Xmin = Xo. The choice of E will determine the
equilibrium harvest Y and the stock level X, that is, where EX is equal to the
growth of the resource and this is shown in Figure 4 where E = E1. This gives
the harvest Y* and the stock X*. Any harvest level above Y* along the line E1X
will mean that harvest is greater than the sustainable yield Y* and the stock will
decline to X*. A harvest level below Y* along E1X will be less than the yield
through natural regeneration (growth), and the stock will grow to X* again.
It is easy to see that Y*, though sustainable, is not MSY. However, by
manipulating E we could set Y equal to EmX at Ym, the MSY. Introducing the

4
It is to be noted that catches (harvests) larger than growth would be possible in the short-term,
but these could not be sustained. They will lead to reduced stock size and, eventually, if the stock
were drawn down to a level less than Xmin, to the extinction of the species.
17
effort level, thus, helps us to determine the harvest and stock level. But it does
not allow us to indicate the efficient sustainable yield. For that we need to
introduce costs and benefits (revenue) into the picture.

Figure 4: Effect-Growth Equilibriums

To introduce costs and revenues we transform figure 4 into Figure 5 showing
the relationship between the harvest (yield) and the level of effort, that is,
moving from (X, Y) plane to (E, Y) plane.
Figure 5 shows various equilibrium levels of yield (like Y*, Ym, etc.)
corresponding to various levels of effort (like E1, Em etc.), where Em > E1
and so on. A little reflection will show that every effort level on this figure
corresponds a stock level in Figure 4 and Eo corresponds to Xc, and Emax to
Xo. Note that increasing fishing effort (a movement from left to right in Figure
5) would, in Figure 4, result in smaller resource stock and would be recorded
as a movement from right to left.

18
 Figure 5: Effort-Yield Function
Now, the effort-yield curve depicted in Figure 5 can be translated into costs
and revenue. In Figure 6, revenues (benefits) and costs are shown as functions
of harvesting (fishing) effort. Because the price (p) of the harvested resource
(fish) is assumed to be constant, total revenue (R) from harvest (Y) is
R = pY,
and the shape of the revenue function has the same shape as that of the effort-
yield function of Figure 5.
As sustainable levels of effort are increased, eventually a point is reached (Em
in Figure 6) where further effort reduces the sustainable catch (yield) and
revenue for all years. That point corresponds to the MSY (Ym in Figure 5).
The net benefit is shown in Figure 6 as the vertical difference between the
benefit R = pY and costs, C = cE (the constant marginal cost of effort times the
units of effort expended). The efficient (optimum) level of effort is Ee, where
the vertical distance between benefits and costs is maximized. In other words,
Ee is an efficient level of effort, because it is where the marginal benefit (slope
of the total benefit curve) is equal to the marginal cost (the constant slope c of
the total cost curve). Once the efficient level of effort is determined we can
determine the efficient level of yield from Figure 5.

19
 Figure 6: The Efficient (Optimum) Sustainable Yield for a Renewable
Resource (Fishery)
Is, then, the MSY efficient? The MSY is efficient (in a timeless static world)
only if the marginal cost of effort is zero. At the efficient level of effort this
(zero) marginal cost has to be equal to (zero) marginal benefit and marginal
benefit is zero at the MSY level only. Because this is not generally true, the
efficient level of effort (Ee) is less than that necessary to harvest MSY (Em).
Hence, the static efficient level of effort leads to a larger resource (fish) stock
than does the MSY yield level of effort and MSY does not appear to be a
socially desirable objective to strive for.
4.3 Market, Free (Open) Access and Common Property Resources
Having identified an efficient allocation of a renewable resource (fishery), we
can now consider a competitive market allocation and compare these two
allocations. A competitive sole owner is supposed to have well-defined
property rights to the resource. A sole owner would want to maximize his
profit. This will occur (ignoring discounting again) at an effort level where
marginal revenue equals marginal costs. Clearly, this is effort level Ee, the
static-efficient sustainable yield. This will provide positive profits equal to the
difference between R(Ee) and C(Ee). In the absence of any externality,
maximizing net profits and maximizing net social benefits may be assumed to
be the same thing, and hence lead to the same result.
20
While it is not difficult to think of privately owned fishing rights in lakes,
private owners are not normal in ocean fisheries. Ocean fisheries may typically
be international common-property; resources, no single fisherman exercises
control over. Because no sole property rights to the fish belt are conferred to
any owner, no single fisherman can restrict others from exploiting the resource.
This characterizes free (open)-access resources.
What could be the consequences when access to the resource (fishery or
forestry) is completely unrestricted? Free-access resources generate two kinds
of externalities (Titenberg, 2001): (1) a contemporaneous externality, which is
borne by the current generation. It involves congestion due to over-
commitment of resources to fishing – too many boats, too many fishermen, too
much effort. As a consequence, current fishermen earn a substantially lower
rate of return on their effort5. (2) An inter-generational externality, which is
borne by the future generations. It occurs because over-fishing reduces the
stock of fish, which in turn lowers future profits from fishing (once, in the
process, effort level exceeds that associated with the MSY).
When access to the fishery is free, an incentive to expend effort by each
fisherman beyond Ee reduces profit to the fishery as a whole. Every one
imposes a burden on everyone else. At the efficient level, each fisherman
(boat) will receive a profit equal to its share of the scarcity rent. However, this
rent serves as a stimulus for new fishermen to enter, driving up costs and
eliminating the rent. Hence, open access results in overexploitation of
resources.
In a free-access resource, as stated above, the individual fisherman has an
incentive to expend further effort, until profits are drawn down to zero. This
occurs at effort level Ef in Figure 6, where net benefits are zero (R = C).
Contemporaneous externality manifests in too much effort being expended to
catch too few fish, and cost (C) is substantially higher than it would be in an
efficient allocation. In fact, many fisheries and forests in different parts of
India and elsewhere are currently plagued by these kinds of problems.

5
Some areas of deltaic West Bengal and coastal Kerala are experiencing this phenomenon.
21
A resource owner with exclusive property rights would balance the use value
against the asset value of the resource (that is, would consider future flow of
returns also). When access to the resource is unrestricted, exclusivity is lost. It
is then rational for the individual fisherman to ignore the asset value, as he can
never appropriate it. This process will dissipate all the scarcity rent.
However, free-access harvesting may or may not lead to the extinction of the
species. It depends on the nature of the species and the benefits and costs of
harvesting below the minimum viable stock (Xmin in Figure 2 or 3). The
condition under which extinction will occur are: (a) that effort is costless –
effort is at Emax in Figure 5 and the stock goes to zero; or (b) harvesting takes
place at levels above the natural rate of regeneration, that is, the harvest is non-
sustainable. The risk of resource extinction is high if there is a critical
minimum size of the population (Xmin).
Are free-access resources and common-property resources synonymous
concepts? Do they imply identical equilibra? The answer is generally no. We
have seen that free-access means that no one owns the resource and access is
open to all and unrestricted. A common-property resource, however, is one that
is owned by a defined group of people – say a community. It is possible that
within this group members may have free-access to the resource. But it is very
likely that the group will develop rules and norms of use, restricting the use
that any one individual is allowed to make of the resource. These rules are
widespread where common property exists; tribal control of woodlands in
Arunachal, community controlled irrigation systems in many parts of India and
so on. The reason that such rules emerge is the cognizance of the fact that
unrestricted use by each individual is more likely to lead to resource extinction,
adversely affecting the welfare of everyone and perhaps imposing an
irreversible damage (cost) on future generations. In terms of Figure 6 we might
expect a common-property solution to be generally between the profit-
maximizing solution and the free-access solution. However, common-property
solutions can break down if, for instance, the defined group gets larger and
larger because of population growth and in-migration. It may then pay any one
individual to defect, breaking ranks and maximize individual benefit at the

22
expense of the resource and the community‟s overall interests (Pearce and
Turner, 1990).
4.4 Another Renewable Resource: Forests
Forests provide multiple benefits (goods and service) to humans. Forests are
the source of timber which serves a variety of human needs (including fuel
needs of people of the less developed world). Forests protect us from floods
and soil erosion, cleanse the air, and act as the natural habitat of wildlife. They
play a crucial role in the ecology of watersheds that supply much of our useful
water.
Although forests share many attributes with other renewable resources, they
also exhibit some unique features. Trees are commercially valuable when they
are cut and sold. However if not cut, like a capital asset, standing forests also
provide a stream of non-timber environmental services (as mentioned in the
preceding paragraph). Each year, the forest manager has to decide about when
to cut (harvest) a particular forest stand. Unlike many other renewable
resources, the time period between initial investment (planting) and recovery of
that investment (harvesting) may be quite long. Intervals of 25 years or more
are common in forestry. Furthermore, most of the environmental benefits
provided by the forest are positive externalities which normally cannot be
captured by the resource managers. This leads to inefficient management.
Economics can be combined with forest ecology to arrive at an efficient
management of this important natural resource. The standardThe starting point
is to model the efficient decision to cut an even-aged homogeneous single
stand (or cluster of trees). Here we assume that the forest provides only
commercial value of timber. This model could then be used to indicate how the
multiple values of the forest resource should influence the harvesting decision.
4.5 Tree Growth and Harvest
Data, based on measurement of volume, suggest that when even-aged trees are
very young growth is rather slow in volume terms, though the tree may
increase sufficiently in height. Then a period of sustained rapid growth follows.
Ultimately, with the aging process growth slows down, stops or even reverses.

23
When should such a stand be cut (harvested)? Foresters adopt a biological
approach to answer this question. They suggest a measure known as mean
annual increment (MAI). The MAI is obtained by dividing the cumulative
volume of the stand at the end of each decade by the cumulative number of
years the stand has been growing up to that decade.
The biological decision rule then is: cut (harvest) the stand at the age when the
MAI is maximized.
4.6 Economics of Forest Harvesting
To an economist, however, the above rule would appear somewhat arbitrary.
This rule ignores the factors that seem to play a crucial role in an efficient
harvesting decision. Some of these factors are, for example, the value of the
timber, the time value of money, the costs of planting and harvesting. An
economic model of the harvesting decision would, however, incorporate the
basic biology of tree growth as shown in Figures 2 and 3 in Section 4.
Economic efficiency would imply that the optimal time to harvest a stand
would be that age that maximizes the present value of the net benefit from
wood. .
In this framework, it can be shown that discounting (incorporated in time value
of money) shortens the age when the stand is harvested. The use of zero
discount rate implies that the opportunity cost of capital is zero; therefore, it
pays to leave the money invested in trees as long as some growth is occurring
and the value of timber is increasing in the process. With a positive discount
rate, however, the trees will be harvested as soon as more will be earned from
the money from the sale invested in a financial asset at rate r. Is economic
efficiency compatible with sustainable forestry? According to one approach,
sustainable forestry would imply harvesting limited to the growth of the forest,
leaving the volume of wood unchanged over some specified period of time.
Efficiency is not necessarily compatible with this definition of sustainable
forestry. Efficiency requires maximizing the present value. Maximizing the
present value, in turn involves, as shown above, an implicit comparison
between the increase in value from delaying harvest (basically because of the
growth in volume) and the increase in value from harvesting the timber and

24
investing the sale-proceeds to earn r. If the growth rate in volume is small (as
with slow-growing species), maximizing the present value may imply harvest
volumes higher than the net growth of the forest.
It is interesting to note that the search for sustainable forestry that is also
economically efficient has led to the emergence of rapidly growing tree species
and plantation forestry (for example, eucalyptus). These species raise the
attractiveness of replanting, because the invested money is tied up for a shorter
period of time. These species are raised in plantations.
Plantation forestry, however, has raised many questions and has become
controversial. It involves a single species of tree, endangering biodiversity so
essential for many purposes including wildlife habitat. It also requires large
chemical inputs and water, endangering growth of other species around. In
Karnataka, a few years back, a popular movement developed against planting
eucalyptus.
It is instructive to note that thus far we have abstracted from the amenity values
of a forest while determining optimal rotation length. If standing trees provide
amenity services in proportion to their volume, it can be shown that efficient
rotation will be longer (Snyder and Bhattacharya, 1990). However, when
amenity values are large and cannot be captured by the forest owner, the
private rotation decision may fail to take account of these values, leading to
inefficiently short rotation periods.
In India, soon after independence, in the first flush of industrial growth, vast
stretches of bamboo forests were leased to paper and pulp mills. The
agreements required the mills to pay a royalty to the government for the
quantities of bamboo extracted. This royalty was fixed at a highly subsidized
rate. Generous subsidies were also offered to forest-based industries for forest
clearance and harvest. All these prompted destruction of the forest resource
base. Lease of forest lands without creation of any stake in the future
productivity of these lands has adversely affected the regeneration potential of
these areas. Such policies have not only deprived the government of revenue,
but also encouraged unsustainable, indiscriminate exploitation of the country‟s
forest wealth.

25
Dense forests once covered India. As of 2010, the Food and Agriculture
Organization of the United Nations estimates India‟s forest cover to be about
68 million hectares, or about 20 percent of the country‟s area. In qualitative
terms, however, the dense forest in almost all the major Indian states has been
reduced. Forest degradation is a matter of serious concern. India is the world‟s
largest consumer of fuelwood. India‟s consumption of fuelwood is about five
times higher than what can be sustainably removed from forests.
5. ECONOMICS OF WATER RESOURCE
Water is one of the essential elements of life. We humans depend not only on
an intake of water to replace the continual loss of body fluids but also on food
sources that themselves need water to survive. This resource deserves special
attention.
The earth‟s renewable supply of water is governed by the hydrologic cycle, a
system of continuous water circulation. Enormous quantities of water are
cycled each year through this system, though only a fraction of circulated water
is available each year for human use.
Available supplies are derived from two rather different sources – surface
water and groundwater. As the name implies, surface water consists of the
fresh water in rivers, lakes, and reservoirs that collects and flows on the earth‟s
surface. By contrast, groundwater collects in porous layers of underground
rock known as aquifers. Though some groundwater is renewed by percolation
of rain or melted snow, most has been accumulated over geologic time and,
because of its location, cannot be recharged once it is depleted.
In many parts of the world, water scarcity is already upon us, and that of other
areas, including several parts of India, can be expected to experience water
scarcity in the next few decades.
The problem with groundwater is even more severe. Groundwater levels have
been declining in some areas of the country as a result of intensive pumping,
and significant depletion of groundwater supplies has occurred in several
regions. Around 29 per cent of ground water blocks in India are semi-critical,
critical or overexploited and the situation is deteriorating rapidly. By 2025, an
estimated 60 per cent of ground water blocks will be in a critical condition.
Climate change will further strain ground water resources.
26
India is the largest user of ground water in the world, with an estimated use of
230 cubic km of ground water every year – more than a quarter of the global
level. Now, ground water supports around 60 per cent of irrigated agriculture
and more than 80 per cent of rural and urban water supplies.
Though the discussion thus far has focused on the quantity of water, that is not
the only problem. Quality is also a problem. Much of the available water is
polluted with chemicals, radioactive materials, salt, or bacteria. It is important
to keep in mind that water scarcity has an important qualitative dimension that
further limits the supply of potable water.
This brief survey of the evidence suggests that in certain parts of India
groundwater supplies are being depleted to the potential detriment of future
users. Supplies, which for all practical purposes will never be replenished, are
being “minded” to satisfy current needs. Once used, they are gone. Is this
allocation efficient, or are there demonstrable sources of inefficiency? In order
to answer this question we must be quite clear about what is meant by an
efficient allocation of surface water and groundwater.
5.1 The Efficient Allocation of Scarce Water
What efficiency means for the allocation of water depends crucially on whether
surface water or groundwater is being tapped. In the absence of storage, the
problem with surface water is to allocate a renewable supply among competing
users. Intergenerational effects are less important, as future supplies depend on
natural phenomena (e.g., precipitation) rather than on current withdrawal
practices. For groundwater, on the other hand, withdrawing water now does
affect the resources available to future generations. In this case, the allocation
over time is a crucial aspect of the analysis. Because it represents a somewhat
simpler analytical case, we shall start by considering the efficient allocation of
surface water.
Surface Water
An efficient allocation of surface water (1) must strike a balance among a host
of competing users, and (2) must supply an acceptable means of handling the
year-to-year variability in surface water flow. The former issue is acute,
because so many different potential users have legitimate competing claims:
27
Some (e.g., municipal drinking water suppliers or farmers) withdraw the water
for consumption; others (e.g., swimmers or boaters) use but do not consume
the water. The latter challenge arises because surface water supplies are not
constant from year to year or month to month. Because precipitation, runoff,
and evaporation all change from year to year, less water will be available to be
allocated in some years than in others. Not only must a system for allocating
the average amount of water be in place, above-average and below-average
flows must also be anticipated and allocated.
With respect to the first problem, the dictates of efficiency are quite clear – the
water should be allocated so that the marginal net benefit is equalized for all
uses. If marginal net benefits have not been equalized, it is always possible
to increase net benefits by transferring water from those uses with low net
marginal benefits to those with higher net marginal benefits. By transferring
water to the users who value the marginal water more, the net benefits of the
water use are increased; those losing water are giving up less than those
receiving the additional water are gaining. When the marginal net benefits are
equalized, no such transfer is possible without lowering net benefits.
Groundwater
When withdrawals exceed recharge from a particular aquifer, the resource will
be mined over time until supplies are exhausted or until the marginal cost of
pumping additional water become prohibitive. The marginal extraction cost
(the cost of pumping the last unit to the surface) would rise over time as the
water table drops. Pumping would stop either (1) when the water table run dry
or (2) when the marginal cost of pumping was either greater than the marginal
benefit of the water or greater than the marginal cost of acquiring water from
some other source.
Abundant surface water in proximity to the location of the groundwater could
serve as a substitute for groundwater, effectively setting an upper bound on the
marginal cost of extraction. The user would not pay more to extract a unit of
groundwater than it would cost to acquire surface water. Unfortunately, in
many parts of the country where groundwater overdrafts are particulars severe,
the competition for surface water is already keen; a cheap source of surface
water doesn‟t exist.
28
In efficient groundwater markets, the water price would rise over time. The rise
would continue until the point of exhaustion, the point at which the marginal
pumping cost become prohibitive or the marginal cost of pumping becomes
equal to the next-least-expensive source of water. At that point the marginal
pumping cost and the price would be equal.
5.2 Common Property Problems.
The allocation of groundwater must confront one additional problem. When
many users tap the same aquifer, that aquifer becomes a common-property
resource. Tapping a common-property resource will tend to deplete it too
rapidly; users lose the incentive to conserve. The marginal scarcity rent will be
ignored.
The incentive to conserve a groundwater resource in an efficient market is
created by the desire to prevent pumping costs from rising too rapidly and the
desire to capitalize on the higher prices that could reasonably be expected in
the future. With common-property resources, neither of these desires translates
into conservation, for the simple reason that water conserved by one party may
simply be used by someone else because the conserve has no exclusive right to
the water that is saved. Water saved by one party to take advantage of higher
prices can easily be pumped out by another user before the higher prices ever
materialize.
For common-property resources, pumping costs would rise too rapidly, initial
prices would be too low, and too much water would be consumed by the
earliest users. The burden of this waste would not be shared uniformly.
Because the typical aquifer is bowl-shaped, users on the periphery of the
aquifer tend to be particularly hard hit. When the water level declines, the
edges go dry first, whereas the center can continue to supply water for
substantially longer periods. Future users would also be hard hit relative to
current users.
In conclusion we may say that we touched upon here some of the basics of the
economics of natural resources using some representative resources. However,
we need to remember that this is just a very brief introduction of a much larger
issue.
29
 BIBLIOGRAPHY

Agarwal, A. (ed.) (1992), The Price of Forest, Delhi: CSE.

Barnett, H.J. (1979), „Scarcity and Growth Revisited‟, in V. Kerry Smith (ed.),
Scarcity and Growth Revisited, Baltimore: Resources for the Future,
pp. 163-217.
Bhattacharya, R.N. (ed.) (2001), Environmental Economics : An Indian
Perspective, Delhi, Oxford University Press.
Bowers, J. (1997), Sustainability and Environment Economics : An Alternative
Text, UK: Addison Wesley Longman.
Fisher, A. (1981), Resource and Environmental Economics, Cambridge:
Cambridge University Press.
Hanley, Nick, N.J. Shogren, and B. White (1997), Environmental Economics in
Theory and Practice, UK: Macmillan Press.
Hotelling, H. (1931), „The Economics of Exhaustible Resources‟, Journal of
Political Economy, 39, pp.137-75
Parikh, K.S. (ed.)(1999), India Development Report, 1999-2000, Delhi: Oxford
University Press.
Pearce, D. and R.K. Turner (1990), Economics of Natural Resources and the
Environment, New York: Harvester and Wheatcheef.
Salant, S.W. (1995), „The Economics of Natural Resource Extraction: A
Primer for Development Economists‟, The World Bank Research
Observer, February, pp.93-111.
Snyder, D. and R.N. Bhattacharya, (1990), „A More General Dynamic
Economic Model of the Optimum Rotation of Multiple-use Forests‟,
Journal of Environmental Economics and Management, 18, pp. 168-
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Titenberg, T. (2001), Environmental Economics and Policy, 2nd ed., USA:
Addison-Wesley.

30
Centre of Excellence in Environmental Economics

The Ministry of Environment and Forest, Government of India has

designated Madras School of Economics as a Centre of Excellence in the
area of Environmental Economics. The Centre carries out research work
on: Development of Economic Instruments, Trade and Environment, and
Cost-Benefit Analysis. The Centre is primarily engaged in research
projects, training programme and providing policy assistance to the
Ministry on various topics. The Centre is also responsible for the
development and maintenance of a website (http://coe.mse.ac.in), and for
the dissemination of concept papers on Environmental Economics.

Madras School of Economics

Madras School of Economics was founded in 1993 as a private post-

graduate institution for teaching and research in economics. MSE offers a
two-year Master's program in Economics, Financial Economics, Applied
Quantitative Finance, Actuarial Economics and Environmental Economics
affiliated to the Central University of Tamil Nadu, and a Ph.D. programme
affiliated to Madras University. MSE has undertaken a large number of
research projects since its inception, including the World Bank sponsored
Capacity Building Programme in Environmental Economics. The World
Bank project involved research, training, curriculum, and overseas
fellowship components which were coordinated by MSE. Subsequently, the
Ministry of Environment and Forests approved the proposal to set up a
Centre of Excellence in Environmental Economics at MSE. MSE has also
served as an ENVIS Centre in Environmental Economics under the
Environment Information System (ENVIS) of the Ministry of Environment
and Forests, Government of India. A dedicated program on Trade and
Environment, with support from the Ministry of Environment and Forests,
Government of India, has been initiated at MSE.