Strategic Resource Extraction and Substitute

Development
Thomas Michielsen

Tilburg University
Abstract
We analyze a dynamic game between a buyer and a seller of an ex-
haustible resource. The buyer can invent a perfect substitute for the re-
source at any time. In Markov perfect equilibrium, the buyer adopts the
substitute when the resource is exhausted. Resource consumption benets
the buyer because it enables him to put o costly investments. The seller
induces the buyer to delay investment because the buyers reservation
price goes down when the substitute arrives.
JEL-Classication: O30, Q30
Keywords: exhaustible resource, substitute, innovation, Markov perfect equilib-
rium
1 Introduction
The oil market has avours of a bilateral monopoly. The largest exporters have
united themselves in OPEC, a cartel that controls more than 75% of proven
reserves and actively manages supply. Importing countries coordinate on energy
policy and energy security issues through various international organizations
such as the IEA, OECD and EU, and cooperate in the development of renewable
alternatives. Consuming countries are vulnerable to monopoly power because of
their heavy dependency on oil, but also have the means to end this dependency
through developing a backstop: a substitute that can replace oil as the dominant
energy source.

CentER, Department of Economics and Tilburg Sustainability Center, Tilburg Uni-

versity, P.O. Box 90153, 5000 LE Tilburg, The Netherlands. t: +31 (13) 4663077. e:
t.o.michielsen@uvt.nl
1
To prolong consumers dependence on their resource, oil exporters have an
incentive to prevent prices from becoming too high. Indeed, one of OPECs
aims is to secure an ecient, economic and regular supply of petroleum to con-
sumers. Conversely, importing countries realize that investment in renewables
is not only a remedy to the physical scarcity of oil, but also aects exporters
supply decisions. The resulting strategic interaction is the subject of this paper:
we ask how exhaustible resource sellers can adjust the supply path to preserve
their monopoly, and how buyers can use the threat of a substitute to obtain
favourable prices.
This issue was rst dealt with in Dasgupta et al. [1983] and Gallini et al.
[1983]. In their model, a buyer solves for the optimal open-loop arrival time of a
perfect substitute. The resulting strategy is not credible when the buyer cannot
commit [Olsen, 1986, 1993]; we explore this time-inconsistency in section 2. It is
unnatural to suppose that sellers are suciently rational to calculate dynamic
equilibria, but naive enough to believe announcements that are not credible.
We therefore analyze resource supply and investment strategies in a Markov
equilibrium setting.
We use a simple model and a highly stylized representation of the innovation
process. In each period, a monopolistic seller makes a supply oer to a buyer.
After observing the sellers oer, the buyer can decide whether to pay a xed
investment cost and develop a perfect substitute. Upon investment, the substi-
tute can immediately be produced at constant marginal cost and competes with
the resource. We abstract from uncertainty, capacity constraints, R&D exter-
nalities and other factors that are important in order to focus on the strategic
aspects of the resource supply and innovation decisions.
We nd that in equilibrium, the seller induces the buyer to delay the adoption
of the substitute until the resource is exhausted. The resource provides value
to the buyer directly through consumption and indirectly through saving him
the interest on the investment cost. When the buyer adopts the substitute, he
loses the second source of surplus. Moreover, the seller reduces supply when
the buyer invests and sells a larger part of his stock at the buyers reservation
price. Both eects make the buyer worse o after investment. The buyers
indierence condition only becomes binding when the remaining resource stock
is suciently small.
Two papers close to ours are Harris and Vickers [1995] and Gerlagh and Liski
[2011]. In Harris and Vickers [1995], the buyer has a probability to achieve a
breakthrough that will end the resource dependence, which depends on his R&D
eort. As the buyers eort increases when the stock dwindles, the seller has
2
an incentive to slow down depletion, possibly giving rise to non-monotonous
supply paths. In our deterministic setting, supply is non-increasing through-
out. In Gerlagh and Liski [2011], the substitute is not available immediately
following investment, but after an exogenous transition period. Resource con-
sumption in the pre-investment phase reduces the amount that is left for the
transition period. The time-to-build delay acts as a commitment device, whose
value decreases as the resource is depleted. To compensate the buyer, supply
is increasing over time during an interval before investment. Gerlagh and Liski
[2011] assume that investment costs are zero and focus on a model without dis-
counting, whereas the buyers motive to delay incurring the investment costs
plays an important role in our paper.
2 The time-consistency problem
Olsen [1993] sketches why equilibria in which the buyer can commit to the
investment time are not consistent. In the social optimum, investment and
resource exhaustion coincide. Suppose that the arrival time of the substitute
T

is known. The Hotelling rule stipulates that a monopolistic seller equates

marginal revenue in all periods. Whereas extra supply causes losses on the
inframarginal units before T

, the substitute generates an upper bound on the

price after T

. Marginal revenue is therefore relatively high after the substitute

has arrived, so the seller would like to extract part of his stock during the
post-investment phase. The requirement that the seller is indierent between
extracting an extra unit pre- or post-investment results in strictly lower supplies
just before T

.
Supplying after T

benets the seller but reduces the buyers welfare and

social welfare. By announcing a late T

, the buyer can reduce wasteful extrac-

tion during the post-investment phase. A late T

results in higher cumulative

extraction in the pre-investment phase, and a higher supply in early periods. It
comes at a cost in later periods however: when the resource becomes scarce, the
buyer cannot dispose over the substitute as early as he would like. After having
enjoyed the benets of high supplies early on, the buyer has an incentive to
alleviate the resource scarcity by investing in the substitute earlier than he had
announced. We illustrate this incentive in Figure 1. After

T, when supply drops
below the buyers reservation level q (which is lower than the long-run quantity
q

because of the investment costs), the buyer prefers to invest immediately

instead of at T

.
1
1
When the initial stock is very large, the seller may also have zero stock remaining at
3
Time
R
e
s
o
u
r
c
e

s
u
p
p
l
y

w
h
e
n

b
u
y
e
r
s

c
o
m
m
i
t
s

t
o

i
n
v
e
n
t
i
o
n

t
i
m
e
0
T
T

0
q
q

Figure 1: The buyers time-consistency problem

4
3 Model
Consider a model with a buyer and a seller of an exhaustible resource. We adopt
the notation of [Gerlagh and Liski, 2011]. The buyer derives ow surplus u(q
t
)
from consuming q
t
units of the resource. Let u(.) be increasing and continu-
ously dierentiable. The surplus function is associated with a consumer utility
function u (.) satisfying u (q
t
) = u(q
t
) u

(q
t
) q
t
. The inverse demand function
is (q
t
) = u

(q
t
). A monopolistic seller is endowed with a nite stock s
0
that
is costless to extract. The seller aims to maximize the stream of ow revenues
(q
t
) = u

(q
t
) q
t
. Utility and prots are discounted at rate r.
The buyer can instantaneously develop a perfect substitute for the resource.
By paying an upfront investment cost I, he gains the ability to produce the
substitute at constant marginal cost c. The buyer is then guaranteed a ow
surplus
u u
_

1
(c)
_
There are i = 1, .., N periods of time of length . Time is continuous
but agents can only act at the beginning of each period, i.e. at time points
t
i
= (i 1). They commit to their actions for the entire period. We distinguish
between a pre-investment phase A and a post-investment phase B. In phase A,
the buyer has a discrete decision variable k
t
{0, 1}, where k
t
= 1 indicates
that the buyer develops the substitute. In phase A, each period has three stages:
(1) the seller oers to supply a quantity q
ti
(2) the buyer chooses k
ti
{0, 1}
(3) when k
ti
= 0, the market clears at price p
ti
= (q
ti
), or when k
ti
= 1, the
sellers oer is rejected and the economy moves to regime B
In phase B, the seller is the only mover and chooses quantity q
ti
. The mar-
ket then clears at price p
ti
= min ((q
ti
), c).
Olsen [1993] uses the same setup as our paper, but the buyer moves before
the seller in each period. Because he cannot credibly punish the seller for setting
a high price, the buyer invests very early.
2
We feel our timing better reects
the buyers optimal T

[Olsen, 1986]. The buyers strategy is then inconsistent when the

investment cost is not too large.
2
For small values of the remaining stock, there exists a sequence of trigger zones. The
buyer invests when the remaining stock is inside one of these trigger zones, because he then
cannot credibly prevent the seller from setting a high price. Outside the trigger zones, the
buyer can credibly punish moderately but not very high prices. The seller prefers to price
on the lower rather than the upper bound of this range of moderate prices however. Olsen
5
the mutual dependence of buyers and sellers in natural resource markets and is
more in line with oil exporters concerns about security of supply.
4 Closed-loop equilibrium
When making decisions during phase A, agents take into account their payos
in phase B. We therefore rst turn to phase B. Because a perfect substitute
is available at cost c, marginal revenue

(q
t
) is equal to c for the rst q

1
(c) units and is discontinuous at q

. When increasing supply above q

, the
seller starts incurring losses on the inframarginal units. If the seller practices a
limit pricing strategy, supplying q

in each period until exhaustion, the stock is

exhausted at time s/q

. For small values of the remaining stock, the marginal

revenue

(q
t
) |
qt>q
of supplying a unit in excess of q

is always lower than the

present value of c at time s/q

. The seller then supplies q

in each period until

the time of exhaustion T. When the remaining stock is large, limit pricing takes
so long to exhaust the stock that

(q
t
) |
qt>q
may be higher than ce
rs/q

. It
is then worthwhile to supply q
t
> q

in early periods.
Proposition 1 (post-investment phase, Hoel [1978]). Let
s

r
ln
_
lim
qq

(q)
c
_

s

When the remaining stock s < s

q
t
= q

t (0, T) , T =
s
q

When s > s

q
t
=
1
_
ce
r(Tt)
_
t (0, T )
q
t
= q

t (T , T) (1)
s.t.
_
T
0

1
_
ce
r(Tt)
_
dt + q

= s (2)
The above system implicitly denes the sellers optimal post-investment strategy

I
(s; c).
does not analyze large initial stocks. We speculate that the buyer cannot credibly prevent
the seller from treating his problem as a free-terminal-time-problem with a scrap value (the
scrap value being the discounted prots from selling the last units at the substitute price).
The buyer then invests before the remaining stock reaches the region that Olsen considers.
6
0 T T
0
q

R
e
s
o
u
r
c
e

s
u
p
p
l
y

i
n

t
h
e

p
o
s
t

i
n
v
e
s
t
m
e
n
t

p
h
a
s
e
Time
Figure 2: The sellers optimal supply in the post-investment phase
Figure 2 illustrates the sellers supply path during the post-investment phase.
In the optimum, the seller is indierent between supplying an extra unit in any
period before T and marginally extending the limit pricing period. The
present value of marginal revenue in all periods before T ,

(q
t
) e
rt
, is
equal to that at the exhaustion time T, ce
rT
.
It will be useful to dene the value function for the seller V (s) and buyer U(s)
as a function of the remaining stock during phase A. Denote the buyers and
sellers value at the time of investment by U
I
(s) and V
I
(s), respectively. Let
(s, q) be the buyers investment strategy and (s) the sellers supply strategy.
The value for the seller is the payo from choosing the optimal q for an interval
of length , given the strategic response of the buyer
V (s) = max
{q}
{[(q) + e
r
V (s q)](1 (s, q)) + V
I
(s)(s, q)}. (3)
7
The value for the buyer can be dened analogously
U(s) = max
k{0,1}
{[u((s)) + e
r
U(s (s))](1 k) + U
I
(s)k}. (4)
The value of the resource to the buyer W(s) is the utility it provides on top of
the long-run level
W(s) = U(s)
_
u
r
I
_
The post-investment values U
I
(s) and V
I
(s) are determined by the dynamics
described in Proposition 1.
W
I
(s) =
_
T
0
[u (q
t
) u] e
rt
dt (5)
We can now characterize the buyers optimal strategy. The buyer will delay
investment when
u (q) u rI + qW
I
(s) (6)
Utility from resource consumption must equal a return on the buyers invest-
ment option u rI plus the cost of reduction in post-investment surplus.
3
Be-
cause the seller is impatient, the buyer realizes that resource supply in phase B
will exceed the long-run substitute supply q

for large values of the remaining

stock. Resource consumption in phase A reduces this post-investment surplus
by qW
I
(s). We are now ready to derive the main result.
Proposition 2. There is a subgame-perfect equilibrium in pure strategies. The
buyers equilibrium strategy is
(s, q) = 1 q : u(q) < u rI (7a)
(s, q) = 0 o.w. (7b)
The sellers equilibrium strategy is (s) =
I
_
s,
_
u
1
( u rI)
__
, with
I
(s; c)
as dened in Proposition 1.
Because the buyer can guarantee himself the long-run surplus u rI by
investing, the buyers strategy maximizes his value of the resource W(s). The
buyers reservation utility in the post-investment phase is u(q

), the utility he
can attain by consuming the substitute. The seller always supplies q q

,
because there is no loss on the inframarginal units for smaller q. The buyers
3
This indierence condition is similar to the one in [Gerlagh and Liski, 2011]. In their
paper, the buyer must be compensated for the fact that current resource consumption reduces
the amount that is left for the transition period. In our setting, the buyers indierence is
driven by post-entry competition and the discount rate.
8
reservation utility before investment is u( q) = u rI, reecting that resource
consumption allows him to delay investment. The sellers best response to the
buyers equilibrium strategy is to supply at least q q, because he would trigger
investment for smaller q.
Although the motivation diers in the pre- and post-investment phase, the
seller always supplies at least the buyers reservation quantity. From the sellers
perspective, the threat of the substitute is therefore equivalent to an existent
substitute with a higher marginal cost. Adopting the substitute does not change
the equilibrium dynamics except for raising the buyers reservation utility from
u rI to u. This is not accompanied by an increase in actual utility, as the
buyer pays interest rI on the sunk investment costs. The increase in the buyers
reservation utility has two eects, as we show in Figure 3. Firstly, the buyers
surplus from the resource (u(q) minus the reservation utility) is lower for any
given supply path. Secondly, the seller decreases supply in early periods [Hoel,
1978, 1983] when the buyer invests. The maximum price for the resource de-
creases after investment; to compensate for this, the seller increases the price
in early periods. Combining these eects, the buyers surplus from the resource
decreases when the buyer invests.
Figure 4 depicts the sellers supply as a function of the remaining stock. For
s < s, a seller who is constrained to supply at least q would supply exactly q
until exhaustion. When the buyer invests, supply increases from q to q

. The
increased utility from consumption exactly osets the interest on the investment
cost, so the buyer is indierent whether to invest or not. For intermediate values
of s ( s < s < s

), the resource provides no surplus after investment (as the seller

marginally undercuts the substitute until exhaustion), but a positive surplus
before investment: the dierence in consumption utility is less than rI. For
s > s

, the resource provides a positive surplus after investment, but an even

larger surplus if the buyer abstains from investing.
In the Appendix, we derive the same result when the buyer can invest a con-
tinuous amount in each period and the marginal cost of the substitute depends
on cumulative investment. The buyer invests the amount that maximizes con-
sumption utility minus the interest on the investment costs in one go when the
resource is exhausted. Similarly, the seller supplies at least the buyers long-run
utility until exhaustion.
9
Figure 3: Resource supply before and after investment as a function of time
10
Figure 4: Resource supply before and after investment as a function of the
remaining stock
11
5 Conclusion
When the buyer cannot commit to the arrival time of a substitute for oil, the
seller can induce the buyer to delay adoption until exhaustion. Though the
model is highly stylized, the results accord with the slow technological progress
in renewable energy and oil exporters eorts to stabilize prices.
A Proof of Proposition 1
The seller supplies q

at time t when the MR of supplying an additional unit is

lower than the discounted MR at the time of exhaustion, i.e.
lim
qq

(q) ce
r(Tt)
Solve for T t
T t
1
r
ln
_
lim
qq

(q)
c
_
(8)
The seller supplies q

in each period until exhaustion when this inequality holds

for all t
_
0,
s
q

_
. We can calculate the threshold stock s

such that the seller

practices limit pricing until exhaustion for all s s

by substituting T =
s
q

and solving for the s such that (8) holds with equality for t = 0
s

=
q

r
ln
_
lim
qq

(q)
c
_
When s > s

, the seller extracts the last s

units in a period of length =

s

. While extracting the rst s s

units, marginal revenue rises at the rate

of interest and is equal the present value of marginal revenue at the time of
exhaustion

(q
t
) = ce
r(Tt)
q
t
=
1
_
ce
r(Tt)
_
Let (.) = (

)
1
be the sellers supply as a function of marginal revenue. The
stock constraint determines T
_
T
0

_
ce
r(Tt)
_
dt + q

= s (9)
B Proof of Proposition 2
We make use of Proposition 3 in Hoel [1983].
12
Lemma 1 (post-investment phase, Hoel [1983]). When s > s

,
I
(s; c) is
increasing in c.
Because of the buyers investment option, the resource is exhausted in nite
time. This means there exists a subgame-perfect equilibrium in pure strategies.
We assume that the number of periods N is suciently large, such that the
optimal strategies are not aected by the length of the game. The buyers
strategy maximizes U(s) with respect to k. His value from investing is
U
I
(s) =
_

T
ue
rt
dt I +
_
T
0
u (q
t
) e
rt
dt
=
_

0
( u rI) e
rt
dt +
_
T
0
[u (q
t
) u] e
rt
dt, q
t
s.t. u (q
t
) u t (0, T)
=
_

0
( u rI) e
rt
dt + W
I
(s; c)
Let

U (s) denote the payo when the buyer adopts the equilibrium strategy, and
denote the corresponding exhaustion time by

T. We have

U (s) =
_

T
ue
rt
dt e
r

T
I +
_
T
0
u (q
t
) e
rt
dt
=
_

T
( u rI) e
rt
dt +
_
T
0
u (q
t
) e
rt
=
_

0
( u rI) e
rt
dt +
_
T
0
(u (q
t
) [ u rI]) e
rt
dt, q
t
s.t. u (q
t
) u rI t
_
0,

T
_
Then there exists a c c such that

U (s) =
_

0
( u rI) e
rt
dt + W
I
(s; c)
In order to prove that

U (s) U
I
(s), it is sucient to show that W
I
(s; c) is
increasing in c when W
I
(s; c) > 0. By Lemma 1,
I
(s; c) increases in c for
s > s

. Moreover, u decreases in c. Then T increases in c. Therefore,

W
I
(s; c) is increasing in c.
The seller always supplies at least q given that the buyer only invests when
q < q. When the seller chooses a q
t
< q, he triggers immediate investment
and is subject to the more stringent constraint q
t
q

for the remainder of the

game. Choosing q
t
< q therefore cannot be optimal, provided the period length
is suciently small.
13
C Continuous Investment
In this section, we generalize the buyers problem: rather than making a discrete
investment decision, the buyer can invest a continuous amount in each period.
The marginal cost of the subsitute is a decreasing function of cumulative invest-
ment
c = c (I) , c

(I) 0, I =
_

0
idt
We can write u (I) u
_

1
(c (I))
_
. The timing in each stage is
(1) the seller supplies a quantity q
ti
(2) the buyer chooses i
(3) the market clears at price p
ti
= min ((q
ti
), c (I))
Prots and utility depend on the stance of technology I in addition to the sup-
ply q. Let (s, I) denote the sellers supply strategy and (s, I, q) the buyers
investment strategy. The value functions are given by
V (s, I) =max
{q}
_
(I, q) + e
r
V (s q, I + (s, I, q))
_
(10)
U (s, I) =max
{i}
_
(u (I, (s, I)) i) + e
r
U (s (s, I) , I + i)
_
(11)
Analogously to the previous section, we can express the value of the resource to
the buyer as
W (s, I) = U (s, I)
_
u (I)
r
I
_
Utility from the substitute is a bounded and concave function of cumulative
investment.
Assumption 1.
u
I
0,

2
u
I
0,

I :
u
I
= 0 I

I
The equilibrium is similar to the one in Propostion 2. The buyer selects the
cumulative investment level I

that yields the highest long-run utility u rI,

and invest this amount in one go when the resource is exhausted.
Proposition 3. Let I

be the solution to
u
I
= r. There is a subgame-perfect
equilibrium in pure strategies. The buyers equilibrium strategy is
(s, 0, q) = I

q : u (q) < u(c (I

)) rI

(12a)
(s, I, q) = 0 o.w. (12b)
14
and the sellers equilibrium strategy is
(s, I) =
I
_
s; min
_
c (I) , u
1
( u(c (I

)) rI

)
__
(13)
with
I
(s; c) as dened in Proposition 1.
Proof. First, we show that given the sellers strategy (13), the buyers strat-
egy must satisfy

I
_

0
idt = I

. Suppose that for a certain buyers strategy

I < I

. Then by Assumption 1, the buyer can marginally improve his welfare

by choosing
_
0,

I, 0
_
> 0. Suppose that

I > I

. Then the buyer must either

invest a positive amount when cumulative investment already exceeds I

, or
invest a large amount when I < I

such that cumulative investment overshoots

I

. We discuss both cases in turn. Firstly, suppose there exists an I such that
I

I and (s, I, (s, I)) > 0 for some s. Let I

denote the largest such I. Then

the buyer can marginally improve his welfare by choosing (s, I

, (s, I

)) = 0.
By Assumption 1, this increases the long-run utility u rI, and by Proposi-
tion 2, it increases the value of the resource W (s, I). Secondly, suppose there
exists an I < I

such that (s, I, (s, I)) > I

I for some s. Let I

be the
largest such I. Then the buyer can marginally improve his welfare by choosing
(s, I

, (s, I

)) = I

. Again, this improves long-run utility by Assump-

tion 1 and increases the value of the resource by Proposition 2. By induction it
follows that cumulative investment

I must equal I

.
Secondly, we show that given the sellers strategy (13), it is optimal to invest
I

in one go when the resource is exhausted. When the resource is exhausted,

it is optimal for the buyer to reach the long-run optimal level I

as quickly as
possible. Suppose that the buyers strategy entails i
1
= (0, I
1
, 0) > 0, i
2
=
(0, I
2
, 0) > 0 for some 0 < I
1
< I
2
< I

. Then by Assumption 1, the buyer

can marginally improve his welfare by choosing (0, I
1
, 0) = I
2
I
1
+ i
2
. By
induction it follows that the buyer invests I

I when the resource is exhausted.

When the resource is not yet exhausted, it is optimal to delay investments until
exhaustion. Suppose there exists an s > 0 such that (s, I, (s, I)) > 0 for
some I. Let s
3
be the lowest such s. Then the buyer can marginally improve
his welfare by choosing (s
3
, I, (s
3
, I)) = 0 and increasing the investment
at exhaustion by the same amount. This does not aect the long-run utility
u(c (I

)), but increases W (s, I) by Proposition 2.

Thirdly, the proof that the sellers strategy (13) is optimal given buyers
strategy (12) is analogous to the last part of the proof of Proposition 2.
15
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16