CHAPTER- 4

Natural Resources
 Introduction
Classification of natural resources

• Environmental resources can be grouped into either

renewable (when they have a capacity for
reproduction and growth) or non-renewable
(otherwise).

• One fundamental similarity among these two

groups of resources is that both of them are capable
of being fully exhausted.
 That is the stock is driven to zero if too much
harvesting or extraction activity is carried out over
some time period.
 While exhaustibility is a consequence of the finiteness
of the stock in the case of non-renewable resources,
 renewable resources can be driven to zero if the rates
of harvesting continually exceeds their natural growth.
 Non-renewable resources
• Non-renewable resources include fossil-fuel, energy
supplies, oil, gas and coal and minerals(copper and
nickel).

• They are formed by geological processes over millions

of years and so, in effect, exist as fixed stocks which,
once extracted, cannot be renewed again.

• But there is one central question, about the ‘’optimal

extraction path over time for any particular non-
renewable resource stock’’?
• They comprise a set of resources varying in chemical
and physical type (such as oil, gas, uranium, coal, and
the various categories of each of these) and in terms of
costs of extraction (as a result of differences in
location, accessibility, quality and so on).

• Thus, in this chapter we will discuss the efficient and

optimal extraction of one component of this set of non-
renewable resources where substitution possibilities
exist.
Theory of optimal depletion of non-renewable
resources
• Hotelling Theorem
• First we need to ascertain why real prices of non renewable resources should
increase through time.

• This expression is generated by the theory of exhaustible resources,

formulated by Harod Hotelling in 1931.

• Given a finite stock of non- renewable resources, at what rate should that
resource be depleted?

• The answer is that it should be depleted in a manner that the welfare

generated from using the resource is maximized.
• To solve this problem of welfare maximization; assume the following

– consider the planning horizon(path) of two time periods, 0 and 1

– The economy has a fixed stock of known size of non-renewable
resources
– The initial fixed stock is represented by S
– Rt is the quantity extracted in period t,
• The demand for this fixed stock of non-renewable resource at each time is
given by: Pt= a-bRt

• where Pt is the price in period t, with a and b being positive

constant numbers. So, the demand functions for the two periods
will be:
P0=a−bR0
P1=a−bR1
These demands are illustrated in Figure below

Figure, 4.1. the non-renewable resource demand function for the two-
period model

•A linear and negatively sloped demand function has the

property that demand goes to zero at some price, in this
case the price a.
• The shaded area in Figure 4.1 (algebraically, the integral of P with respect to
R over the interval R=0 to R=Rt)shows the total benefit consumers obtain
from consuming the quantity Rt in period t.
• i.e, Rt b 2
B ( Rt )   ( a  bRt )dRt = aRt - Rt
0 2
• From a social point of view, this area represents the gross social benefit(B)
derived from the extraction and consumption of quantity Rt of the resource.
• where the notation B(Rt) is used to make explicit gross benefit at time t(Bt) is
dependent on the quantity of the resource extracted and consumed (Rt).

• However, the gross benefit obtained by consumers is not identical to the net
social benefit of the resource because resource extraction involves costs.
• Accordingly, let’s assume that the marginal cost of extraction is c and total
extraction costs, Ct, for the extracted quantity Rt units will be Ct = cRt
• Therefore, the total net social benefit is;
NSB = Bt- Ct
• where NSB denotes the total net social benefit and B is the
gross social benefit of resource extraction and use. Hence
• NSBt=
= aRt – b/2 Rt2 –CRt
• A socially optimal extraction policy requires that; the extraction
program maximizes social welfare.
• let, two things should be existed to determine this program.
– There should be social welfare function, and
– there should be statement of technical possibilities and constraints
available at any point in time.
• The general two period social welfare functions is given by;
U1
• W=W(U0, U1) takes the particular form; W  U 
1 
0
• where ρ is the social utility discount rate, reflecting society’s time preference.

• Thus, the utility in each period as being equal to the net social benefit in each
period.
NSB1
W  NSB0 
1 

• Only one relevant technical constraint exists in this case: there is a fixed initial
stock of the non-renewable resource, S.

• We assume that society wishes to have none of this resource stock left at the
end of the second period.

• Then the quantities extracted in the two periods, R0 and R1, must satisfy
the constraint: R0+R1=S

• To determine the optimal social welfare program using the

Hotelling rule, it needs to optimize social welfare subject to the
constraint.
• The optimization problem can now be stated as follows.
• Resource extraction levels R0 and R1 should be chosen to maximize social
welfare, W, subject to the constraint that total extraction of the resources
over the two periods equals S. Mathematically, this can be written as;
• Max W  NSB0 
NSB1
R0 , R1 1 

• Subject to R0+R1=S
• There are several ways of obtaining solutions to constrained optimization
problems of this form.
• We can use the Lagrange multiplier method. First step is to form the
Lagrangian function, L

L  W   ( S  R0  R1 )
 NSB1 
 NSB0      S  R0  R1 
 1   
 b 2 
b 2  aR1  R 1  cR1 
 aR0  R 0  cR0   2    ( S  R0  R1 )
2  1  
 
• Where, λ is a ‘Lagrange multiplier’. Remembering that R0 and R1 are choice
variables (variables whose value must be selected to maximize social
welfare)
• The necessary conditions includes: L  a  bR0  c    0
R0
L a  bR  c  
 0
R1 1 
• Since the right-hand side terms of the above equations both equal to zero,
implies that, a  bR1  c
a  bR0  c 
1 
• Using the demand function Pt =a−bRt, the above equation can be written as,
P1  c
P0  c 
1 
• where P0 and P1 arePgross   )  Pand
0  c (1 prices 1  c P0 −c and
P1 −c are net prices. A
resource’s net price is also known as the resource rent or resource royalty.
Rearranging this expression, we obtain

( P1  c)  ( P0  c)

P0  c
• If we change the notation used for time periods so that P0 =Pt−1,
P1 =Pt and c=ct=ct−1, we then obtain Hotelling rule.
Pt  Ct  ( Pt 1  Ct 1

Pt 1  Ct 1

• The left-hand side of the above equation, ρ, is the social utility

discount rate, which represent some view about how future utility
should be valued in terms of present utility.

• The right-hand side is the proportionate rate of growth of the

resource’s net price.
• For example, society chooses a discount rate of 10%, then Hotelling’s
rule states that an efficient extraction programme requires the net
price of the resource can grow at a proportionate rate of 10% over
time.
• Does market economy yield an optimal and efficient allocation
of resource?
• Yes (both optimal and efficient) under certain circumstances.

• The efficiency of the market mechanism intuition:

• In a competitive market economy, profit maximisation requires
that firms take proper account of their revenue and cost
functions.

• The utility function provides appropriate information about the

market demand curve, and so provides appropriate information
about firms’ revenues.
• Any costs of production and extraction will be taken into
account by businesses.
 The marginal utility function tells us about willingness to pay (WTP)
and so corresponds to a demand function in a market economy

MUt

MU1 = P1

C1 Ct
• A market economy will probably not deliver an efficient and optimal
allocation of non-renewable resources because:
• The existence of Monopoly which makes depletion too slow.
• Social costs of resource depletion not considered. (e.g. pollution
externalities).
• Private (market) interest rate above the social discount rate.
• There may be other forms of market failure:
– Presence of public goods
– Absence of well-defined and enforceable property rights
– Incomplete information
– And some of the agents’ functions may depend upon
environmental quality:
– Utility depends on environmental quality
– Quantity depends on environmental quality
Renewable resources
• Environmental resources are described as renewable when they have a
capacity for reproduction and growth.

• The class of renewable resources is diverse.

• It includes populations of biological organisms such as fisheries and forests
which have a natural capacity for growth, and water and atmospheric
systems which are reproduced by physical or chemical processes.

• We may also consider more broadly defined environmental systems (such

as wilderness areas or tropical moist forests) as being sets of interrelated
renewable resources.

• A broad concept of renewable’s would also include flow resources such as

solar, wave, wind and geothermal energy.

• These share with biological stock resources the property that current
harnessing of the flow does not mean that the total magnitude of the
future flow will necessarily be smaller.
• It is important to distinguish between stocks and flows of the renewable
resource.

• The stock is a measure of the quantity of the resource existing at a point in time,
measured either as the aggregate mass of the biological material (the biomass) in
question (such as the total weight of fish of particular age classes or the cubic
metres of standing timber), or in terms of population numbers.

• Renewable stock resources includes,

– living organisms: fish, cattle and forests, with a natural capacity for growth
– inanimate systems (such as water and atmospheric systems): reproduced
through time by physical or chemical processes
– arable and grazing lands as renewable resources: reproduction by biological
processes (such as the recycling of organic nutrients) and physical processes
– They are fully depletable.
• Renewable flow resource includes,
– solar, wave, wind and geothermal energy.
– These energy flow resources are non-depletable.
– But bring about costs in harnessing them as usable energy
resources
Biological dimension renewable resource(fisheries)

• In order to investigate the economics of a renewable resource, it is first

necessary to describe the pattern of biological (or other) growth of the
resource.

• To fix ideas, we consider the growth function for a population of some

species of fish. We suppose that this fishery has potential growth rate
denoted by ‘g’.

• This is the proportional rate at which the fish stock would grow when
its size is small relative to the carrying capacity of the fishery, and so
the fish face no significant environmental constraints on their
reproduction and survival.

• The intrinsic growth rate ‘g’ may be thought of as the difference

between the population’s birth and natural mortality rate.
• Suppose that the fish population stock is ‘S’ and it grows at a
fixed rate of ‘g’.
• Then, in the absence of human interference the rate of change
of the fish stock over time is given by:
S 
 S  gS
t
• By integrating this equation, we obtain an expression for the
stock level at any point in time:
St  S0 e gt
• in which S0 is the initial stock level. In other words, for a positive
value of g, the population grows exponentially over time at the
rate g and without bounds.
• This is only credible over a short span of time.
• A simple way of representing this effect is by making the actual
(as opposed to the potential) growth rate depend on the stock
size.
• Then we have what is called density-dependent growth. Using
the symbol χ to denote the actual growth rate, the growth
function can be written as:

S   ( S )S
• where χ(S) states that χ is a function of S, and shows the
dependence of the actual growth rate on the stock size.

• If this function has the property that the proportionate growth

rate of the stock declines
S / S as the stock size rises then the


function is said to have the property of compensation.

• let us suppose that under a given set of environmental conditions there is a
finite upper bound on the size to which the population can grow (its carrying
capacity).
• A commonly used functional form for χ(S) which has the properties of
compensation and a maximum stock size is the simple logistic function:
S
 ( S )  g (1  )
S Max
• Where, Smax is the maximum stock
• in which the constant parameter g>0 is what we have called the intrinsic or
potential growth rate of the population.

• Where the logistic function determines the actual population


growth
S  rate,
S  we
S  t  g 1  SMax S
may therefore write the biological growth function as

• But as we want to use the notation dS/dt net effect of natural changes and
human predation, we shall use the alternative symbol G to refer to amount of
biological growth.

• (More completely, we shall use the notation G(S) to make it clear that G
 S 
g 1 this change
G ( SS)) With
depends on  S the logistic biological growth function is given
by:  Smax 
Steady-state harvests of fish
• Consider a period of time in which the amount of the stock
being harvested (H) is equal to the amount of net natural
growth of the resource (G).

• Suppose also that these magnitudes remain constant over a

sequence of consecutive periods.
• We call this steady-state harvesting, and refer to the (constant)
amount being
 harvested as a sustainable yield.
S
• Defining as the actualS rate of change of the renewable


resource stock,
S

with = G−H, it follows that in steady-state
harvesting =0 and so the resource stock remains constant
over time.
• There is one particular stock size (SMSY) at which the quantity of
net natural growth is at a maximum (GMSY)
• If at a stock of SMSY harvest is set at the constant rate HMSY, we
obtain a maximum sustainable yield(MSY) steady state.

• A resource management programme could be formulated to

make MSY overtime.

• It is sometimes thought to be self-evident that a fishery, forest

or other renewable resource should be managed so as to
produce its maximum sustainable yield(MSY).
• HMSY is not the only possible steady-state harvest.

• Indeed, Figure below shows that any harvest level between zero
and HMSY is a feasible steady-state harvest, and that any stock
between zero and SMAX can support steady-state harvesting.
Figure below shows Steady state harvest

For example, H1 is a feasible steady-state harvest if the stock size is

maintained at either S1L or S1U.

Which of these two stock sizes would be more appropriate for attaining a
harvest level of H1.
An open-access fishery Model
• The open-access fishery model shares two of the characteristics of the
standard perfect competition model.

• First, if the fishery is commercially exploited, it is assumed that this is done by

a large number of independent fishing ‘firms’. Therefore, each firm takes the
market price of landed fish as given.

• Second, there are no barrier to entry into and exit from the fishery.
• But the free entry assumption has an additional implication in the open-
access fishery, one which is not present in the standard perfect competition
model.

• The open-access model has two components:

1. a biological sub-model, describing the natural growth process of the fishery;
2. an economic sub-model, describing the economic behaviour of the fishing
boat owners.
 Biological sub-model

• In the absence of harvesting and other human interference, the

rate of change of the stock depends on the prevailing stock size
 S 
dS/dt=G(S)= gS 1 
 S

Max 

• we assume that the particular form taken by this growth

function is the simple logistic growth model.

• Economic sub-model
• Many factors determine the size of the harvest, H, in any given period.
• These include the number of boats deployed and their efficiency, the
number of days when fishing is undertaken and so on.
• For simplicity, assume that all the different dimensions of harvesting activity
can be aggregated into one magnitude called effort, E
• Hence, other determinants of harvest size, including random influences, we
may take harvest to depend upon the effort applied and the stock size. That
is: H=H(E, S)
• This relationship can take a variety of particular forms. H=eES
• where e is a constant number, often called the catch coefficient.
H
• Dividing each side by E, we have  eS
E
• which says that the quantity harvested per unit effort is equal to some
multiple (e) of the stock size.

• We have already defined the fish-stock growth function with human

predation as the biological growth function less the quantity harvested. That
is, 
S  G(S )  H

• The total cost of harvesting, C, depends on the amount of effort being

expended C=C(E)
• For simplicity, harvesting costs are taken to be a linear function of effort,
C=wE
• where w is the cost per unit of harvesting effort, taken to be a constant
• Let B denote the gross benefit from harvesting some quantity of fish.
• The gross benefit will depend on the quantity harvested, so we have:
B=B(H)

• Assuming that fish are sold in a competitive market, each firm takes the
market price P as given and so the revenue obtained from a harvest H is
given by B=PH.
• Therefore, fishing profit is given by; NB =B−C

Entry into and exit from the fishery

• To complete our description of the economic sub model, it is necessary to
describe how fishing effort is determined under conditions of open access.

• A crucial role is played here by the level of economic profit prevailing in the
fishery.

• Economic profit is the difference between the total revenue from the sale
of harvested resources and the total cost incurred in resource harvesting.
• Given that there is no method of excluding new firm into the
industry, nor is there any way in which existing firms can be
prevented from changing their level of harvesting effort,
• and effort applied will continue to increase as long as it is
possible to earn positive economic profit.

• Conversely, individuals or firms will leave the fishery if

revenues are insufficient to cover the costs of fishing.

• A simple way of representing this algebraically is by means of

the equation: dE/dt=δ·NB
• where δ is a positive parameter indicating the responsiveness of
industry size to industry profitability.
• When economic profit (NB) is positive, firms will enter the
industry; and when it is negative they will leave.
Bioeconomic equilibrium

• We close our model with two equilibrium conditions that must be satisfied jointly.
• Biological equilibrium occurs where the resource stock is constant through time
(that is, it is in a steady state).
• This requires that the amount being harvested equals the amount of net natural
growth: G=H

• Economic equilibrium requires that the amount of fishing effort be constant

through time.

• Such an equilibrium is only possible in open-access fisheries when rents have been
driven to zero, so that there is no longer an incentive for entry into or exit from
the industry, nor for the fishing effort on the part of existing fishermen to change.
• We express this by the equation; NB =B−C=0

• In an open-access economic equilibrium, profit is zero, so PH =wE.

• Notice that when this condition is satisfied, dE/dt =0 and so effort is constant at its
equilibrium (or steady-state) level E=E*.
Open-access steady-state equilibrium
• We can imagine an open-access fishery steady state equilibrium
by means of what is known as the fishery’s yield–effort
relationship.
• To obtain this, first note that in a biological equilibrium H=G.
• Then, by substituting the assumed functions for H and G respectively
we obtain,  S 
gS 1    eES
 S Max 

• Which can be rearranged to give  e 

S  S Max 1  E 
 g 
• In the above equation, is one equation in two endogenous
variables, E & S(with parameters g, e and SMAX).
• It implies a unique equilibrium stock at each level of effort.
• Next substitute (H=eES) in the equation above gives,
 e 
H  eES Max 1  E 
 g 
• In an open-access economic equilibrium, profit is zero, so PH=wE

• The above Equations constitutes two unknowns (H and E); these can
be solved for the equilibrium values of the two unknowns as
functions of the parameters alone.

• This solution method can also be represented graphically, as shown

in Figures blow

• Figure ‘a’ below shows equilibrium relationships in stock–harvest

space.
• The inverted U-shape curve is the logistic growth function for the
resource.
Figure a, steady-state equilibrium fish harvests and stocks at various effort levels

•Three rays emanating from the origin portray the harvest– stock relationships (from the
function H=eES) for three different levels of effort.

•If effort were at the constant level E1, then the unique intersection of the harvest–stock
relationship and biological growth function determines a steady-state harvest level H1 at
stock S1.

•The lower effort level E2 determines a second steady-state equilibrium (the pair {H2,
S2}).
• The particular point on this yield–effort curve that corresponds to an open-
access equilibrium will be the one that generates zero economic profit.

• The zero economic profit equilibrium condition PH=wE can be written as

H=(w/P)E.

• For given values of P and w, this plots as a ray from the origin with slope w/P
in Figure ‘’b’’.

• The inverted U-shape curve here shows the steady state harvests that
correspond to each possible effort level, describes the fishery’s yield–effort
relationship.

• The particular point on this yield–effort curve that corresponds to an open-

access equilibrium will be the one that generates zero economic profit.
 Figure ‘b’ Steady-state equilibrium yield–effort relationship

For given values of P & w, this plots as a ray from the origin with slope w/P in figure ‘b’. The
intersection of this ray with the yield–effort curve locates the unique open-access
equilibrium outcome.
Alternatively, multiplying both functions in Figure ‘’b’’ by the market price of fish, P, we find
that the intersection point corresponds to PH=wE.

This is, of course, the zero profit condition, and confirms that {EOA, HOA} is the open-access
effort–yield equilibrium.
Open access and species extinction
• The extinction of renewable resource stocks is a possibility in conditions of
open access, but open access does not necessarily result in extinction of
species.

• Open access enhances the likelihood of catastrophic outcomes because:

– Incentives to conserve stocks for the future are very weak.
– Free riding once a bargain has been struck
– Crowding diseconomy effects

• There are many reasons why human behaviour may cause species
extinction. These include:

– Even under restricted private ownership, it may be ‘optimal’ to the owner

to harvest a resource to extinction.
– Ignorance or uncertainty about current and/or future conditions results in
unintended collapse or extinction of the population.
– Shocks or disturbances to the system push natural species below
minimum threshold survival levels.
Forest Resources
• A forest is a form of natural capital. It is a renewable resource
that lies on both natural regeneration and replanting by forest
managers to produce new generation of trees.

• Land covered by forests can provide a sustainable flow of a

variety of products and services. These include:
– Timber , serve as raw material for housing and wood products
– Serve as an important source of fuel
– Clean the air by absorbing CO2
– Shelter for wild life
– Water protection /maintain water sheds
– Tourism and recreation.
 Characteristics of forest resources
• some of the key characteristics of forest resources which differ from fish are;
• forests are multi-functional. They directly provide timber, fuel wood, food,
water for drinking and irrigation, stocks of genetic resources, and other
forest products.

• Moreover, as ecosystems, forests also provide a wide variety of services,

including removal of air pollution, regulation of atmospheric quality, nutrient
cycling, soil creation, habitats for humans and wildlife, watershed
maintenance, recreational facilities and aesthetic and other amenities.

• Woodlands are capital assets that are intrinsically productive.

• Trees typically exhibit very long lags between the date at which they are
planted and the date at which they attain biological maturity. The length of
time between planting and harvesting is usually at least 25 years, and can be
as large as 100 years. This is considerably longer than for most species of
fish.
• Unlike fisheries, tree harvesting does not involve a regular cut of
the incremental growth. Forests, or parts of forests, are usually
felled in their entirety.

• Plantation forestry is intrinsically more controllable than

commercial marine fishing. Tree populations do not migrate
spatially, and population growth dynamics are simpler, with less
interdependence among species and less dependence on
relatively subtle changes in environmental conditions.

• Trees occupy potentially valuable land. The land taken up in

forestry often has an opportunity cost.

• The growth in volume or mass of a single stand of timber,

planted at one point in time, resembles that illustrated for fish
populations.
 The Economics of Forest Harvesting Model

• Suppose there is a stand of timber of uniform type and age.

• All trees in the stand were planted at the same time, and are to
be cut at one point in time.

• Once felled, the forest will not be replanted. So only one cycle or
rotation plant, grow, cut is considered.

• For simplicity, we also assume that,

– the land has no alternative uses so its opportunity cost is zero;
– planting costs (k), marginal harvesting costs (c) and the gross price of felled
timber (P) are constant in real terms over time;
– the forest generates value only through the timber it produces, and its
existence (or felling) has no external effects

• Looking from the point of view of the forest owner (landowner), what is the
optimum time at which to fell the trees?
• The answer is obtained by choosing the age at which the present
value of profits from the stand of timber is maximized.

• Profits from felling the stand at a particular age of trees are given by
the value of felled timber less the planting and harvesting costs.

• Notice that because we are assuming the land has no other uses, the
opportunity cost of the land is zero and so does not enter this
calculation.
• If the forest is clear-cut at age T, then the present value of profit is;
P  C ST eiT  K  pST eiT  K
• Where; ST= is the volume of timber available for harvest at time T
p= is is the net price of the harvested timber
i= is the private consumption discount rate (which is equal to
the opportunity cost of capital to the forestry firm).
• The present value of profits is maximized at that value of T
which gives the highest value for pST e  iT  K

• To maximize this quantity, we differentiate the above equation

with respect to T, using the product rule, set the derivative
equal to zero and solve for T.
 
T
 pST e iT  K  
T
 pST e iT 

iT S e iT
 pe  pST
T T
S
 pe iT  ipST e iT  0
T
S
pe iT  ipST e iT
T
S
p  ipST
T
S
i / ST
T
• The above equation states that the present value of profits is
maximized when the rate of growth of the (undiscounted) net
value of the resource stock is equal to the private discount rate.
• Note that when i =0, present values are identical to
undiscounted values.

• The interest rate to a forest owner is the opportunity cost of the

capital tied up in the growing timber stand.

• When the interest rate is zero, that opportunity cost is zero.

Renewable resources policy

• When the use of resources is economically inefficient, there are potential

welfare benefits to the community from policy which leads to efficiency gains.

• This suggests that policy may be directed towards removing externalities,

improving information, developing property rights, removing monopolist
industrial structures, and using direct controls or fiscal incentives to alter
rates of harvesting.
• 1. Command and control regulations
– regulations aimed at reducing fishing effort. Examples inc lude restrictions on
the boat size or other capital equipment used by fishermen, closed
fishery seasons, limits on days of fishing permitted per boat; etc.
– restrictions on fishing equipment and net size, aimed at controlling the
qualitative nature of the catch.
– reducing environmental damage associated with harvesting;
– spatial restrictions on harvesting activity, aimed at reducing conflict
among fishing and forest operators;
– quantity restrictions on catches and cutting of trees.
2. Incentive-based policies:
– Restrictions on open access/property rights
– Fiscal incentives with money to apply conservation activity
– Establishment of forward or futures markets
– Marketable permits (‘individual transferable quotas’, ITQ)