Dynamic Efficiency

& Hotellings Rule

[adapted from S. Hacketts lecture notes]

Dynamic efficiency
Recall static notion of Pareto efficient
resource allocation is that one cannot
change how resources are split to
generate larger gains from trade (without
making some one else worse off)

In contrast, dynamic efficient resource allocation is

that one cannot shift production from one time time
period to another and generate a larger present
value of gains from trade summed across all time
periods.

Dynamic efficiency
The notion of dynamic efficiency is
an intuitive concept.
First, lets consider the concept of
present (discounted) value.
Would you rather have $10,000 in
cash right now or 10 years from now?
Why (or why not)?

Dynamic efficiency
Reasons why most people would
rather have $10,000 today instead
of 10 years from now:
If we anticipate inflation (rising prices over time),
then the purchasing power of $10,000 will shrink
over time.
If we take the $10,000 today and invest it in, say,
government bonds, then we will have more than
$10,000 in 10 years.

Dynamic efficiency
Reasons why most people would
rather have $10,000 today instead
of 10 years from now (continued):
Pure rate of time preference: I want good things
now and would rather wait for bad things. I dont
know if I will be alive in 10 years, so why wait?
Strong current needs (e.g., college expenses, health
care expenses, basic food and shelter needs)
heightens ones pure rate of time preference.

Dynamic efficiency
Suppose that you have inherited
$10,000, which will be held in trust
for you for 10 years.
What is the least amount of cash you would accept
from me RIGHT NOW that would make you
willing to sign over the inheritance to me?
Your answer to that question is your present
(discounted) value of that future $10,000 payment.

Dynamic efficiency
As an aside, why might your present
discounted value of a $10,000
payment 10 years in the future
differ from that of someone else?
Different life circumstances, different investment
opportunities. Other?

Dynamic efficiency
Note: The discount rate (like
an interest rate) reflects the
time value of money:
The rate at which the present value
of a payment shrinks as the time of
payment is pushed off further into the
future
The rate at which the future value of current
interest-earning savings grows over time.

Dynamic efficiency
Since different people have different
discount rates, then at the prevailing
market interest rate, some people are
lenders (financial investors), while others
are borrowers.

As with market equilibrium price, the equilibrium

market interest rate reflects a balancing of the
discount rates of those supplying and demanding
loanable funds.

Dynamic efficiency
Finance is an application of economics
that focuses on time value of money. We
will limit ourselves to an elementary
application of the time value of money.

Dynamic efficiency
Suppose that you will receive a single
guaranteed future payment i years from
the present, and your discount rate (interest
rate) is r. Then the present discounted
value (PV) of that future payment (FP) is
given by the following formula:

PVFP = ($ future payment)/(1+r)i

Dynamic efficiency
PV example:
$ future payment is $10,000. i = 2 years
from the present. r = 10% (0.10). Then:
PVFP =

$10,000/(1+0.1)2
=

$10,000/1.21

$8,264.63

Dynamic efficiency
Based on the preceding example,
the person is indifferent between
having $8,264.63 right now and
getting $10,000 two years from now.
Thus, literally, the $8,264.63 is the present
(discounted) value of $10,000 to be received two
years from now.

Dynamic efficiency
Final point on PV: If you will receive a
stream of payments over time (e.g., social
security payments), then the PV of that
stream of payments is found as follows:

PVFP =
i($ future payment, year i)/(1+r)i
Where i = 0, 1, 2, , n years.

Dynamic efficiency
Moving on
Our analysis of dynamic efficiency
will be based on a highly
simplified modeling framework,
which will provide an accessible
introduction to the topic, as well
as important insights, without
overwhelming you with complex

Dynamic efficiency
Simplifying assumptions:
There is a well-functioning competitive market for the
nonrenewable resource in question (no monopolies or
cartels)
Market participants are fully informed of current and
future demand, marginal production cost, market discount
rate, available supplies, and market price
We will look at the most basic dynamic case: two time
periods: today (period 0) and next year (period 1)

Dynamic efficiency
Simplifying assumptions, continued:
Marginal cost is constant
Market demand is steady state, meaning that demand in
period 1 is the same as in period 0 (no growing or shrinking
demand)

Dynamic efficiency
Model:
Demand: P = 200 Q
Supply: P = 10
Discount rate r = 10 percent (0.1)
Total resource stock Qtot = 100

Dynamic efficiency
Case 1: Ignore period 1 while in period
0 (live for today)

Competitive market equilibrium: 200-Q0 = 10

Q0 = 190
Problem! Qtot = 100 < 190. Scarcity-constrained
market equilibrium Q0 = 100;
P = 200 100 = $100.

Case 1: Consume All in Period 0

250

Price

200
150
100
50

Demand
Supply

0
0

20

40

60

80

100
Quantity

120

140

160

180

200

PV of total gains from trade

over periods 0 and 1:
Period 0:

CS0 = (200-100)*100/2 = $5000

PS0 = (100-10)*100 = $9000
TS0 = $14,000
PVTS0 = $14,000/(1+0.1)0 = $14,000

Period 1: Since all of the resource was consumed in

period 0, there are no gains from trade in period 1.
PVTS = $14,000

Case 1: Consume All in Period 0

250

Price

200
150
CS = $5000

100
PS = $9000

50

Demand
Supply

0
0

20

40

60

80

100

120

Quantity

PV of total gains from trade = $14,000

140

160

180

200

The theory of dynamically efficient

resource markets

Case 2: Divide Qtot equally over

periods 0 and 1:
Period 0: Q0 = 50, P0 = 200 50 = $150.
Period 0 gains from trade:
CS0 = (200-150)*50/2 = $1,250
PS0 = (150-10)*50 = $7,000
TS0 = $8,250

Case 2: Consume Half in Period 0 and Half in Period 1

250
200

Price

CS = $1,250

150
100
PS = $7,000

50

Demand
Supply

0
0

20

40

60

80

100

120

140

160

Quantity

PV of total gains from trade, period 0, = $8,250

180

200

Case 2: Divide Qtot equally over

periods 0 and 1:
Period 1: Q1 = 50, P1 = 200 50 = $150.
Period 1 gains from trade:
CS1 = (200-150)*50/2 = $1,250
PS1 = (150-10)*50 = $7,000
TS1 = $8,250
PV TS1 = $8,250/(1+0.1)1 = $7,500

Case 2: Consume Half in Period 0 and Half in Period 1

250
200

Price

CS = $1,250

150
100
PS = $7,000

50

Demand
Supply

0
0

20

40

60

80

100

120

140

Quantity

PV of total gains from trade, period 1, = $7500

160

180

200

Case 2: Divide Qtot equally

over periods 0 and 1:
Sum of the PV of total gains from trade over periods
0 and 1:
$8,250 + $7500 = $15,750
Note that $15,750 in PV of total gains from trade from
dividing the resource equally over periods 0 and 1
EXCEEDS the $14,000 in total gains from trade when we
consumed all of the resource in period 0. Thus equal
division is closer to being dynamically efficient.

Methods for solving for the

dynamically efficient allocation of the
fixed stock of resource over time:

Hotellings rule: The dynamically efficient

allocation occurs when the PV of marginal profit
(also known as marginal scarcity rent or marginal
Hotelling rent) for the last unit consumed is equal
across the various time periods.

Hotellings rule
(P0-MC)/(1+r)0 = (P1MC)/(1+r)1
Marginal profit,
period 0

Marginal profit,
period 1

Hotellings rule

Less math-intensive solution method:

1. Select an initial way to divide the resource stock
over time (hint: usually more in period 0, less in
period 1, due to time preference)
2. Derive prices in both periods using these
quantities
3. Calculate PV of marginal profit in both periods

Hotellings rule

Less math-intensive solution method:

4. If you are not very close to satisfying
Hotellings rule, then change the way you
allocated the resource stock. Increase Q in the
time period that had the larger PV of marginal
profit, and decrease Q in the other time period.
Note: Profit maximizing firms will automatically
have this incentive to redistribute production.
Why?

Hotellings rule

Less math-intensive solution method:

5. Re-derive prices in both periods using these
new quantities
6. Re-calculate PV of marginal profit in both
periods
7. See if you are closer to satisfying Hotellings
rule. Repeat steps as needed until you are within
a reasonable approximation of satisfying
Hotellings rule.

Optional Hotellings rule

More math-intensive solution method
(optional):
In the simple two-period case considered here,
let demand be given by P = a bqi. The integral of
demand is total benefits, aqi bqi2/2. Likewise total
cost is cqi (c is constant MC). If the available
resource stock is Qtot, then the dynamically efficient
allocation of a resource over n years is the
solution to the following maximization problem:

Optional Hotellings rule

The dynamically efficient allocation solves the
following maximization problem:
i (aqi bqi2/2 cqi)/(1+r)i + [Qtot - i qi],
where i = 0, 1, 2, , n. If Qtot is constraining, then
the dynamically efficient solution satisfies:
(a bqi c)/(1+r)i - = 0, i = 0, 1, , n.
[Qtot - i qi] = 0

Optional Hotellings rule

Now lets apply the parameters from our
problem (a = 200, b = 1, c = 10, r = 0.1, 2
periods). the dynamically efficient solution
satisfies:
(200 q0 10)/(1+0.1)0 =
(200 q1 10)/(1+0.1)1 =
100 = q0 + q1

Optional Hotellings rule

(200 q0 10)/(1+0.1)0 = (200 q1 10)/(1+0.1)1.
Since q1 = 100 - q0, substitute (100 - q0) for q1 and
simplify:
190 - q0 = (190 - (100 - q0))/(1.1)
-q0(1+0.9091) = 0.9091*90 190
q0 = 108.182/1.9091 = 56.667
q1 = 100 56.667 = 43.333

Optional Hotellings rule

Test:
P0 = 200 56.667 = 143.333
(P0 MC)/(1+0.1)0 = $133.33
P1 = 200 43.333 = 156.667
(P1 MC)/(1+0.1)1 = $133.33

Therefore, Hotellings rule is satisfied.

Dynamically Efficient Market

Allocation
Period 0 gains from trade:
CS = (200 - 143.333)*56.667/2 = $1,605.55
PS = (143.333-10)*56.667 = $7,555.56
PV(TS) = $9,161.11

Dynamically Efficient Market

Allocation
Period 1 gains from trade:
CS = (200-156.667)*43.333/2 = $938.87
PS = (156.667-10)*43.333 = $6,355.48
PV(TS) = $7,294.35/1.1 = $6,631.23
Sum of PV of total gains from trade, periods 0 and
1: $9,161.11 + $6,631.23 = $15,792.34.
This is $42.34 larger than a 50/50 split in Case 2.

Dynamically efficient equilibrium

Intuition
If the PV of marginal profit is equal across time
periods (Hotellings rule), then firms have no
incentive to re-arrange production over time. This
solution also generates the largest PV of total gains
from trade over time.

Dynamically efficient equilibrium

Intuition
When a resource is abundant then consumption today does
not involve an opportunity cost of foregone marginal profit
in the future, since there is plenty available for both today
and the future. Thus, when resources traded in a
competitive market are abundant, P = MC and thus
marginal profit is zero.
As the resource becomes increasingly scarce, however,
consumption today involves an increasingly high
opportunity cost of foregone marginal profit in the future.
Thus as resources become increasingly scarce relative to
demand, marginal profit (P-MC) grows.

Dynamically efficient equilibrium

Intuition
The profit created by resource scarcity in competitive
markets is called Hotelling rent (also known as resource
rent or by the Ricardian term scarcity rent). Hotelling rent
is economic profit that can be earned and can persist in
certain natural resource cases due to the fixed supply of the
resource.
Due to fixed supply, consumption of a resource unit today
has an opportunity cost equal to the present value of the
marginal profit from selling the resource in the future.

Dynamically efficient equilibrium

Intuition
How will the dynamically efficient allocation of the
fixed resource stock change if the discount rate r
becomes larger? Explain

Dynamically efficient equilibrium

Intuition
Suppose that the discount rate remains the same,
but the resource stock increases or decreases. How
will this affect the dynamically efficient allocation
of the resource stock?

Dynamically efficient equilibrium

Intuition
Under the dynamically efficient solution in our
simplified modeling framework, what is the
trend of price over time? Why?

Dynamically efficient equilibrium

Intuition
Real world: Natural resource commodity prices may rise or
fall over time because:
Marginal production cost might decrease (technology
improves) or increase (exploit cheapest sources first).
Demand may grow over time unless a new technology
displaces this demand (e.g., coal replaced firewood, natural
gas replaced coal, alt. energy replaces natural gas?),
Future demand and marginal cost cannot be known with
certainty.

Dynamically efficient equilibrium

Further Study
In a graduate natural resources economics class you could
evaluate dynamically efficient resource allocation for these
more complex and real-world cases:
more than 2 time periods
varying and/or uncertain demand
increasing and/or uncertain marginal cost of production,
and
"backstop" technologies allowing for substitutes.

Practice Problem Dynamic

Efficiency
Demand: P = 200 Q
Supply: P = 10
Discount rate r = 20 percent (0.2)
Total resource stock Qtot = 100
1. Solve for the dynamically efficient allocation (within $1 of
marginal profit)
2. How does this increase in the discount rate affect the
dynamically efficient allocation?
3. Now suppose that r = 0.1 but Qtot = 60. Solve for the
dynamically efficient allocation (within $1 of marginal profit).
How does a reduction in resource stock affect the dynamically
efficient allocation?