Chapter 19.f
Exhaustible Resources
“The world will run out of oil by 1991” (Club of Rome's Limits to Growth, 1972)
Julian Simons documented a series of authoritative predictions dating back to 1885, all
documenting that the U.S. would soon run out of oil.
1) 1885, U.S. Geological Survey: "Little or no chance for oil in California."
2) 1891, U.S. Geological Survey: Same prophecy by USGS for Kansas and Texas as in
1885 for California.
3) 1914, U.S. Bureau of Mines: Total future production limit of 5.7 billion barrels of oil,
at most a 10-year supply remaining.
4) 1939, Department of the Interior: Oil reserves in the United States to be exhausted in
13 years.
5) 1951, Department of the Interior, Oil and Gas Division: Oil reserves in the United
States to be exhausted in 13 years.
“BP's Statistical Review of World Energy, published yesterday, appears to show that the
world still has enough "proven" reserves to provide 40 years of consumption at current
rates. The assessment, based on officially reported figures, has once again pushed back
the estimate of when the world will run dry.” (The Independent, June 2007)
People have been predicting for a long time that the world will run out of oil. They
have been proven wrong again and again. In fact, economic analysis tells us that we
will never run out of oil, for the simple reason that oil has a price. As oil becomes
scarcer, its price rises. The rise in price has both demand effects and supply effects.
On the demand side, high prices encourage consumers to conserve and to look for
substitutes for oil. On the supply side, high prices encourage more extensive drilling,
as well as production of oil substitutes, like natural gas and nuclear energy.
Suppose that you own an oil well, and suppose that there is a widely-believed
prediction that the world will run out of oil in the year 2047. If you believed that
prediction, you would put a cap on your well today and wait for the year 2048 when,
according to the prediction, oil will be extremely scarce, and you can sell your oil for
fantastic prices. But your actions would have delayed the running-out date beyond
2047. Furthermore, there will be other oil well owners who will save their oil until
2049, 2050, etc. Thus, profit-seeking oil well owners will be forever pushing back the
running-out date, so that the date never actually arrives.
Figure 19.f.1 puts this idea into graphical form. Suppose that the world has a total of
100 units of oil, and that no more oil can ever be produced. To keep the graph simple,
assume that this oil is fixed in amount and costlessly available, so that the supply
curve of oil can be drawn as a vertical line. There are people who want to consume oil
this year, next year, and every year into the foreseeable future. Let the demand curve
D0 represent oil demand by this year’s people. If there were no future generations of
people, so that D0 is the only source of demand for oil, then the equilibrium price of oil
would be zero, and 85 units of oil would be consumed. Oil would be a free good, like
air, and people would consume 15 units less than the available supply of 100.
Now let a second generation of people pop into existence. Their demand for oil is
given by D1. Note that D1 is a future demand curve. It shows what next year’s people
will pay next year for oil delivered next year.
What will be the new equilibrium price of oil, now that people from years 0 and 1 are
both bidding for that oil? One might think that we could find that price by horizontally
summing D0 and D1, and then finding where that combined demand curve crossed the
vertical supply curve in figure 19.f.1. But that would be forgetting that D0 is stated in
terms of this year’s dollars and D1 and is stated in next year’s dollars. Before we can
add the demand curves, they must both be stated in the same year’s dollars. The
easiest way to do this is to take the present value (PV) of D1. For example, suppose
that if 40 units of oil are offered for sale next year, then next year’s people will pay
$55 per unit next year. If those same people were asked to pay one year in advance of
delivery, then assuming a market interest rate of 10%, next year’s people would pay
$50 (10% less than $55) per unit today, for oil to be delivered in 1 year. Repeating this
process for various quantities of oil yields the present value of next year’s demand, or
PV(D1). Note that when the interest rate is 10%, PV(D1) is found by tilting D1 down
by 10%.
The correct way to combine the demands of both year’s people is to horizontally sum
D0 and PV(D1). This yields the combined demand curve shown. The intersection of the
combined demand with the supply curve yields an equilibrium price of $50. This is the
price that this year’s people will pay to have a unit of oil delivered this year, and it is
also the price that next year’s people will pay today, to have a unit of oil delivered
next year. The two prices must be the same, or it would pay producers to divert oil to
whichever period has the higher price.
Figure 19.f.1
P
S
PV(D1)
D1
55
50
D0+PV(D1)
(Combined demand)
D0
40
60
75
85
100
Q
Once the price of oil is set at $50, the demand curve D0 shows that this year’s people
will buy 60 units of oil, while PV(D1) shows that next year’s people will buy 40 units. If
these are the only people that exist, their combined quantities (40+60) will exactly use
up the 100 units of oil available. The remarkable result of this model is that this year’s
people do not blindly use up the oil and leave nothing for future generations. Instead,
they will conserve 40 units of oil for next year’s people. They don’t conserve this oil
out of concern for next year’s people, but rather because the market forces them to
conserve. The demand of next year’s people drives the price of oil up to $50, and when
this year’s people face this price, they decide in their own interest to consume only 60
units. The invisible hand is efficiently allocating oil across time periods.
P
Figure 19.f.2
S
PV(D1)
B
50
A
D0
C
40
45
60
D0+PV(D1)
(Combined demand)
75
85
100
Q
55
Once we understand that the invisible hand is alive and well in the oil business, it
becomes clear that government efforts to conserve oil are an undesirable interference
with the operation of the market. Various government programs, from automotive fuel
economy standards to building insulation standards, are attempts to be more
“conservationist” than good economic sense would dictate.
Figure 19.f.2 reproduces some key parts of figure 19.f.1. As before, the market reaches
equilibrium at a price of $50, with this year’s people consuming 60 units and next
year’s people consuming 40 units. But suppose that this year’s people are forced by
some government program to reduce their consumption from 60 units to 55 units. The
loss to them is equal to the areas (B+C), below their demand curve. If those 5 conserved
units are then made available to next year’s people, the present value of their gain will
be equal to area A, below the present value of their demand curve. It is clear from the
diagram that the loss (B+C) is bigger than the gain (A). The conservation of those 5
units has made the world poorer, and the government’s attempt to save resources has
actually wasted resources. The same can be said of most programs aimed at conserving
resources. When the government forces people to recycle plastic, rather than putting
that plastic in a landfill, the aim would have been to conserve landfill space. But the
invisible hand is already at work conserving landfill space for us, and any attempt to
force us to conserve landfill space today will only create losses bigger than gains, just as
in the case of oil.