What is Hotelling’s Theory?
Hotelling’s theory states that nonrenewable resource owners will only manufacture essential commodities if they can earn more than from existing financial instruments like the U.S. Treasury or other interest-bearing securities. The idea implies efficient markets and profit-driven nonrenewable resource owners. Using current interest rates, economists utilize Hotelling’s theory to anticipate oil and nonrenewable resource prices. The rule was named after American statistician Harold Hotelling.
Understanding Hotelling’s Theory
Hotelling’s thesis questions whether a nonrenewable resource owner should keep it in the ground and hope for a better price next year or extract and sell it and deposit the money in interest-bearing security.
Imagine owning iron ore. If this miner anticipates iron ore to appreciate 10% in 12 months and can only spend 5% per year, he will not extract it. His hypothesis ignores extraction expenses. With a 5% price appreciation forecast and a 10% interest rate, the owner would mine, sell, and invest the iron ore sales revenues at 10%. Miners will be indifferent at 5% and 5%.
Theory and Practice
Hotelling rent is the gap between marginal extraction costs and pricing for natural resources. The hotelling-percent growth rule states that the price change of a depletable resource must match the interest rate miners or extractors use to discount the future. When marginal extraction costs are zero, the Hotelling rule applies equally to stock and unmined resource prices. However, if extraction costs grow, the resource price should rise less than the discount interest.
Thus, everything else being equal, a more significant discount rate suggests a higher price for the unextracted resource and encourages quicker extraction. The price rises of nonrenewable resources like oil, copper, coal, iron ore, zinc, nickel, etc. should mirror actual interest rate hikes.
A 2014 Federal Reserve Bank of Minneapolis investigation found Hotelling’s premise flawed. The authors found that all fundamental commodity price appreciation rates fell short—some significantly short—of the yearly average rate of U.S. Treasury securities. The authors thought extraction costs caused the variance.
Who was Harold Hotelling?
Harold Hotelling (1895–1973) was an American statistician and economist who worked at Stanford and Columbia Universities in his early and mid-career. Then at UNC-Chapel Hill until his retirement. In addition to his theory on nonrenewable resource pricing, Hotelling is notable for his T-square distribution, rule, and lemma.
Conclusion
- A nonrenewable resource owner will sell it rather than wait for Hotelling’s Theory’s price or yield.
- It compares prices using U.S. Treasury bonds or other interest-bearing securities.
- American statistician Harold Hotelling invented the rule.
