What is Hotelling’s Theory?
Hotelling’s theory proposes that the only time holders of nonrenewable resources should produce their commodities is when the revenue generated from them can exceed that from other financial instruments.
Also known as Hotelling’s rule, the theory makes several assumptions. First, that markets are efficient. Second, that owners of the respective resources are motivated only by profit.
- Hotelling’s theory is used by economists to predict the price of an exhaustible resource based on prevailing interest rates.
- The theory assumes that events take place in an efficient market.
- Factors that will affect the supply of the exhaustible resources, such as new discoveries and technology, are non-existent.
Hotelling’s Theory Explained
The prices of nonrenewable resources have fluctuated dramatically over the past few years. It has raised a lot of concern not only among policymakers and economists but also business owners.
Oil prices are a good case in point. Pricing soared in the 2000s but dropped sharply in 2008 due to the Great Recession. Once the economy recovered from the financial crisis, prices increased again. They are currently on another downward trend.
So why do prices of such exhaustible resources fluctuate so dramatically? More importantly, how does the supply of such a resource that has a fixed quantity vary?
American mathematical statistician Harold Hotelling sought to answer the above questions in 1931, giving rise to what is now known as Hotelling’s theory.
His proposition starts with the trade-off that owners of nonrenewable resources face. These individuals have two options. They can choose to leave the resources at their places of origin, where commodity remains a physical asset. Or, they can extract the resources, sell them, and use the resulting proceeds to invest in a financial asset.
According to Hotelling, owners should always consider the current interest rates and projected prices of their resources before making a decision.
For illustration purposes, consider one barrel of oil. Let’s assume that its current price is $100, the annual interest rate is 5%, and the expected price for next year is $110. If the owner opts to extract the oil and sell it, he/she will earn $105 (5% * $100) per barrel by the end of the year.
However, if they prefer to wait and extract in the coming year, they’ll be able to sell the barrel for a much higher price of $110. The smarter play here would be to sell the oil in the following year.
In summary, Hotelling was trying to show how the forces of competition between owners of exhaustible resources affect supply. The forces will always ensure that a resource’s projected price will be equal to its current price and the expected interest earnings.
From the illustration, if the price of one barrel will rise to $110 next year, and the annual interest rate is 5%, then it should be retailing at $105 today.
Assumptions of Hotelling’s Theory
A competitive market
As we mentioned earlier, one assumption that Hotelling made was that nonrenewable resources would be traded in a competitive market, or there would be perfect competition among the owners of these resources. It means that all traders sell an identical product (exhaustible resource) and buyers have complete knowledge of the commodity in question.
No technological advancements
Another assumption is that no technological advancements take place within the estimated period. If we were to account for technology, it would result in a reduction in the production cost. As a result, the commodity’s supply would increase, paving the way for a decline in prices.
A constant supply of the renewable resource
Hotelling’s theory assumes that the supply of the nonrenewable resource does not change. For example, if an oilfield owner were to discover another valuable spot for mining the same resource, it would change the dynamics significantly.
Chances are, the individual would prefer to sell a portion of the resources now and extract the rest in the following year. It means they would earn a profit either way.
Hotelling’s theory is a simple and straightforward concept. It clearly illustrates the trend that prices of exhaustible resources are likely to take in the future. After adjusting their prices and interest rates for inflation, then it’s likely that the price of a non-renewable resource will vary parallel to the change in interest rate.
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