RENT AND EXTRACTION COST AS ALTERNATIVE MEASURES OF NATURAL RESOURCE SCARCITY

3.5 RENT AND EXTRACTION COST AS ALTERNATIVE MEASURES OF NATURAL RESOURCE SCARCITY

One important concept that is often associated with a discussion of the supply of a particular factor of production is rent. As we shall see shortly, this concept can be used as an alternative measure of natural

resource scarcity. In Figure 3.7 let r e and C e represent the market equilibrium price and quantity of coal respectively. Following an approach that we have already used in Chapter 2 , area OC e M (an area under a

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Figure 3.6 Long-run price trend for coal

supply curve) represents the total cost of production or extraction. In an ideal market setting, this cost would represent the opportunity costs of all factors of production (labor, capital and other resources, such as the

capitalized value of land, etc.) that are used to extract the equilibrium level of coal, C e . On the other hand, area 0r e MC e represents the total receipt (income) to the owners of the coal mines. The difference between what the owners receive as income and the cost of extraction is a rent which is represented by the area of triangle 0r e M. It represents the total payment to owners of a factor of production in excess of the minimum price necessary to bring the resource into the market. In other words, it is the payment above a resource owner’s minimum acceptable price. To what could this payment be attributed?

Close observation would indicate that rent is a payment (value) to a resource as it exists in its natural state (with zero value-added). In other words, rent is received by owners purely for owning the resource under consideration. Owners play no part in the creation of this resource. Hence, rent is intimately related to the value of natural resources in situ. The implication of this is that rent can be used as a measure of physical scarcity. This is demonstrated below using a specific concept of rent known as differential rent.

3.5.1 Differential rent

For most extractive resources, such as coal, gold, aluminum and even agricultural land, the normal pattern tends to be to utilize or mine these resources sequentially in accordance with quality and accessibility. Mines containing higher-quality ores or agricultural land with high natural fertility are put to use first. To illustrate this point, in Figure 3.8 the supply of coal has three segments. The first segment is the horizontal

line P 0 –A. This supply curve relates to the amount of coal forthcoming to the market from the highest- quality and most easily accessible coal mines. Since the quality of this resource is assumed to be uniform, the horizontal supply curve, P 0 , represents the constant unit production cost (extraction and transportation costs) of coal from such mines. The second segment of the supply curve is represented by another horizontal line, B–C. This parallel upward shift of the supply curve from P 0 –A to B–C reflects the change in the quality of the coal mines, from mines containing high-grade ore to those whose ore is of lower grade.

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Figure 3.7 The concept of rent

Figure 3.8 The case of differential rent

Thus, for the coal forthcoming from this second tier of mines, the unit cost is assumed to be uniform and higher than from the first tier of mines. The supply curve for the coal forthcoming from the third and last tier of coal mines, line E–F, can be interpreted in a similar way. What is evident from the discussion so far is the simple fact that the unit cost of production (in terms of extraction, refinement, transportation, etc.) of coal increases as mining is extended towards a fringe area containing a progressively poorer quality of ore.

How does the above discussion concern rent? To answer this, let us incorporate the demand side of the issue. In Figure 3.8 ,D 0 ,D 1 and D 2 represent three different levels of demand condition for coal. For

a demand curve at or below D 0 , the market price for coal will be P 0 . Since the supply curve is horizontal, P 0 –

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A, in this situation rent will be zero. This is because P 0 represents both the market price and the unit cost of coal. Thus, owners of coal mines are not receiving anything in excess of their cost of production. However, suppose the demand for coal increases to D 1 .In this situation the market price for coal will increase to P 1 . Now, as a result of this development, owners of the coal mines from the first tier will start to earn rent since their production cost is still P 0 , while the market price for coal is now P 1 . On the other hand, owners of coal mines from the second tier will realize no rent —since there is no difference between the market price they receive and their unit cost of production, in this case P 1 . Hence, from this discussion it is evident that the total rent received by the owners of coal mines from the first tier, area P 0 P 1 BA (or the area of the rectangle I), is attributable to differences in the quality (grade) of coal—hence the term differential rent.

It should be noted that differential rent increases with an increase in demand. In Figure 3.8 , if the demand further rises to D 2 , the rent obtained by owners from the first tier of mines also increases from area P 0 P 1 BA to area P 0 P 2 GA (or the combined areas of rectangles I and II). In addition, the owners of mines from the second tier are now able to realize rent which is measured by the area BCEG (or the area of rectangle III). Thus, as a result of the shift in demand from D 1 to D 2 , the total rent has increased from area P 0 P 1 BA (the area of rectangle I) to area P 0 P 2 ECBA (or the area of rectangles I+II+III). Another example that could have been used to illustrate the concept of differential rent is agricultural land. Agricultural land varies in its natural productive capacity—fertility. In Figure 3.8 , then, the horizontal line P 0 –A represents the supply curve of available farming land that is of high and uniform quality (in terms of fertility). The rent accruing from this farmland will be negligible provided the demand for farmland remains at or below D 0 . This is because, over this range, the market price of a unit of farmland (P 0 ) is the same as the cost per unit of making the farmland available for cultivation. However, as demonstrated earlier, owners of this type of land start to earn rent as soon as the demand for farmland exceeds D 0 . Similarly, the lines B–C and E–F represent the supply curves for marginal and submarginal farmland, respectively. From Figure 3.8 it can be easily observed that rent increases as demand for farmland grows and progressively inferior land is brought into cultivation. Note here that what causes rent to increase is not, as such, the existence of absolute scarcity of farmland. Instead, it is the rise in the cost of harvesting resulting from the progressive decline in the quality of farmland. This phenomenon was first articulated by one of the most celebrated classical economists: David Ricardo (1772– 1823). As a result of this, modern economics literature classifies this particular phenomenon as Ricardian scarcity.

Finally, one important implication of the above discussion is that an increase in rent is intimately associated with a growing scarcity of natural resources. Since the increase in rent is intimately associated with the physical condition (decline in quantity and/or quality) of the resource under consideration, it could in some way be taken as a measure of physical scarcity. This was shown to be the case both for coal mines and for farmland. For this reason, some economists have advocated using rent as a preferred measure of natural resource scarcity (Brown and Field 1979).

However, it is not difficult to show that rent could also be significantly affected by technological changes. What this does is to obscure or diminish the effectiveness of rent as a measure of physical scarcity. If technological elements are not carefully factored out, it is possible to observe a declining trend for rent while the physical condition of a natural resource (in terms of quality and/or quantity) is diminishing. It should also be noted that, as discussed above, rent depends on demand and supply conditions, and for that reason it is not a purely physical measure of resource scarcity. Furthermore, because of the lack of easily observable and consistent market information concerning rent, its practical value as measure of natural resource scarcity is rather limited (Brown and Field 1979).

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3.5.2 Extraction cost

Finally, another possible measure of natural resource scarcity is extraction cost. In some cases, extraction costs could account for a major portion of the total value of many natural resources. In such cases, increasing extraction costs over time could be used as a signal of emerging natural resource scarcity. To some degree, compared to market price, extraction cost may be a better measure of physical resource scarcity to the extent that the rising cost indicates the degree of difficulty of extracting this resource from its original natural habitat. Furthermore, it is much easier to obtain information on extraction cost than on rent. However, even in this case, technology may bring about a distortion in the normal association between extraction cost and the ease, in physical terms, by which a natural resource is being extracted.