Temp1 Essay

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Oil Prices, Exhaustible Resources, and Economic Growth* James D. Hamilton Department of Economics University of California, San Diego email: jhamilton@ucsd.edu October 18, 2011 ∗ Prepared for Handbook of Energy and Climate Change 1 Abstract This chapter explores details behind the phenomenal increase in global crude oil production over the last century and a half and the implications if that trend should be reversed. I document that a key feature of the growth in production has been exploitation of new geographic areas rather than application of better technology to existing sources, and suggest that the end of that era could come soon. The economic dislocations that historically followed temporary oil supply disruptions are reviewed, and the possible implications of that experience for what the transition era could look like are explored. 2 1 Oil prices and the economics of resource exhaustion. One of the most elegant theories in economics is Hotelling’s (1931) characterization of the price of an exhaustible natural resource. From the perspective of overall social welfare, production today needs to be balanced against the consideration that, once consumed, the resource will be unavailable to future generations. One option for society would be to produce more of the commodity today, invest the current marginal benefits net of extraction costs in some other form of productive capital, and thereby accumulate benefits over time at the rate of interest earned on productive capital. An alternative is to save the resource so it can be used in the future. Optimal use of the resource over time calls for equating these two returns. This socially optimal plan could be implemented in a competitive equilibrium if the price of the resource net of marginal production cost rises at the rate of interest. For such a price path, the owner of the mine is

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