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H.F. Campbell

AN INTRODUCTION TO MINERAL ECONOMICS

No. 260 September 1999

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ISSN 1033-46f51

AN INTRODUCTION TO MINERAL ECONOMICS

H.F. Campbell

Department of Economics The University of Queensland Brisbane Qld 4072 Australia

September 1999

Discussion Paper No 260

© Campbell, 1999

This discussion paper should not be quoted or reproduced in whole or in part without the written consent of the authors.

AN INTRODUCTION TO MINERAL ECONOMICS

1. INTRODUCTION

In this discussion we will be concerned with the time-path of the prices of mineral products, and with the economic viability of individual mining projects. Mineral products may be final demand goods, such as gold, but more commonly they are intermediate goods, such as copper, aluminium and coal, which are used in the production of final demand goods. This means that the demand for these products is a derived demand. Commodities such as copper, aluminium and coal are produced from mineral deposits using other factors of production such as labour and capital. Figure 1 illustrates the production processes of intermediate mineral products and final demand goods. We will use the term "metal" to refer to the output of this process, even though some mineral products such as coal and oil are nonmetallic, and the term "deposit" to refer to the natural resource stock from which the "metal" is produced. Our concern is with the factors determining metal prices over time, and with the economics of individual mines which produce metals from deposits.

In a competitive market the price of a commodity is determined by supply and demand. As already noted, the demand for metal is a derived demand. The supply depends upon the cost of producing the metal from a deposit, and on the price of the deposit. Figure 2 shows the effect over time of the interaction of the demand for and supply of one mineral product in particular - that of mercury. It can be seen from Figure 2 that over the period 1860 - 1960 the price of mercury, in common with other minerals as discussed in Case Study 1, has followed a U-shaped path which should be explained by our analysis. It can also be seen from Figure 2 that over any short period of time, such as a decade or two, the price of mercury is quite variable in response to economic fluctuations and political events. This means that short-term price behaviour rather than the long-run U-shaped trend is important in the analysis of the economic viability of individual mining projects which commonly have ten to twenty year time horizons. Case Study 4 is devoted to the analysis of an individual mining project.

The paper begins by analysing the long-run path of the price of a metal over time. The effect of supply changes upon price depends on the elasticity of the derived demand for the metal. The nature and extent of changes in supply depend on changes in the price of deposits and other inputs in the production process, and on the technology employed. Once the issues- of demand, production, cost and supply have been analysed, the discussion turns to individual mining projects. Here the relevant issues will be those of project appraisal - short-term price forecasts, capital and operating costs, environmental costs, optimal scale, and differences between private and social benefits.

2. THE DERIVED DEMAND FOR METALS

A rise in the price of an intermediate good such as a metal has two effects: first, producers of final demand goods try to substitute other factors of production for the now more expensive metal; and, second, as the rise in metal price results in an increase in the price of the final demand goods, consumers try to substitute other goods for the now more expensive final demand goods. We will consider each of these influences on the elasticity of demand for a metal in turn.

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Suppose that a final demand good is produced according to some production function. For simplicity, assume that there are only two inputs, capital, K, and metal, M, which is an intermediate input. The combinations of capital and metal which can produce a given quantity of the final demand good are described by an isoquant as illustrated in Figure 3. The leastcost combination of capital and metal consistent with production of the given quantity of the good is illustrated by point E. A rise in the price of metal causes the producer to substitute capital for metal in the production process and thereby achieve a new least cost combination illustrated by point E' in Figur .3. The less convex to the origin is the isoquant the larger will be the fall in the ratio of metal to capital in the production process.

G(M) = G(K) - s G(PM),

(2.2)

The ease with which capital can be substituted for metal is measured by the elasticity of substitution which is the ratio of the percentage change in the factor ratio over the percentage change in the factor price ratio:

s = (% change in M/K)/(% change in PK /PM ),

(2.1)

where M and K are the quantities of metal and capital, and PM and PK are the prices. The reason that metal is included in the numerator of the factor use ratio, and the price of metal as the denominator of the factor price ratio is to ensure that the value of the elasticity of substitution is non-negative. Assuming that the price of capital does not change, the following relation can be obtained from the elasticity formula:

where G(.) represents a growth rate. To understand the meaning of this expression, consider the two extreme values of s: when no substitution is possible G(M) = G(K), implying fixed proportions; and when M and K are perfectly substitutable, implying that s tends to infinity, a rise in the price of M results in that input being abandoned altogether.

Assuming constant returns to scale in the production of the final demand good, the following relation holds between the growth of capital and the growth of metal along an isoquant:

. (l-a)G(K) + aG(M) = 0,

(2.3)

where a is the share of metal in the total cost of production of the good. This relation can be substituted into equation (2.2) to give:

G(M) = -(1-a)sG(PM),

(2.4)

which implies that a percentage rise in the price of metal will result in a percentage fall in the quantity used to produce a fixed amount of the final demand good, and that the percentage fall in the quantity of metal used will be higher the higher is the elasticity of substitution of capital for metal, and the lower is the share of metal in the cost of producing the final demand good.

So far the analysis has considered the effect of a rise in metal price on the quantity of metal used to produce a fixed quantity of the final demand good. One effect of the increase in the price of metal will be to increase the price, and hence reduce the quantity demanded, of the

G(M) = -{(1-a)s + ae}G(PM)'

(2.8)

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final demand good. The percentage reduction in the quantity demanded of the good is given by:

G(Q) = -eG(P),

(2.5)

where e is the elasticity of demand for the final demand good, defined as a positive number, and G(P) is the growth rate of its market price. Assuming that the good is produced by a perfectly competitive industry, the growth rate in market price will be the same as the growth rate in the unit cost of production which is given by:

(2.6)

This expression says that the growth rate in price of the good is given by the share of metal in the unit cost of production multiplied by the growth rate in metal price. Assuming that G(M) = G(Q), and combining equations (2.5) and (2.6), we get:

G(M) = -eaG(PM).

(2.7)

We can now combine the effects of substitution in production and substitution in final demand use on the change in the quantity of the metal demanded in response to a change in price. Adding equations (2.4) and (2.7) gives:

An expression for the elasticity of the derived demand for metal, eM , can be obtained by dividing both sides of equation (2.8) by -G(PM):

eM = {(1-a)s + ae}.

(2.9)

This expression indicates that the derived demand for metal is more elastic the more easily metal can be substituted for capital in the production of final demand goods, and the more elastic is the demand for final demand goods produced from metal. It implies that both producers and consumers can adjust to higher metal prices through substitution.

3. THE COMPETITIVE METAL MARKET

3.1 Dynamic Equilibrium with Zero Production Costs

Our concern is with the way the competitive market allocates a scarce mineral resource over time. The essentials of the analysis can be accommodated in a model in which there are no costs of production. This means that a "metal" is the same as the "deposit" from which it is supplied. In this discussion we will refer to the mineral as the "resource" or as a set of individual "deposits". We start the analysis by noting the fairly extreme assumptions of the simple model. The implications of dropping each of these will be considered in later Sections of the Paper.

In point form, the assumptions of the simple intertemporal mineral resource allocation model are:

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(1) the demand curve for deposits (or the metal), an intermediate demand curve as discussed above, is static, meaning that it does not shift over time in response to changes in population or per capita income. Shifts in response to other factors, such as changes in technology or tastes, are also excluded. Every participant in the market for deposits knows the quantity which will be demanded at each price. We will start the analysis with a linear demand curve which intersects the price axis at a price P, which is the choke price, the price at which all demand for the mineral is choked off. This price is the price at which a perfect substitute for the mineral becomes available in perfectly elastic supply;

(2) there is perfect, or complete, information about the size of the total resource stock;

(3) there are no costs of production associated with supplying the resource to the market. This means that deposits must be identical since differences in size, grade or location would result in differences in cost;

(4) there is no recycling of the resource after its use in the production of final demand goods;

(5) the market in deposits is competitive. This means that ownership of deposits is distributed among a wide range of individuals and firms, no one of which can affect market price by changing the quantity it supplies;

(6) there is a complete set of futures markets in the resource. This is equivalent to assuming that all the individuals or firms who will ever buy or sell units of the resource at any point in time are brought together in a market and allowed to trade until an equilibrium price is established for the resource at each point in time. An equilibrium set of prices is a set which equates supply and demand at each point in time.

There are two kinds of buyers in the market for deposits: firms which need the resource as an intermediate input in production; and investors, or speculators, who wish to hold the resource as an asset. Many mining firms fall into both categories, being both holders of mineral stocks and producers of mineral products. Since arbitrage ensures that there can be only one price of the resource at any point in time the equilibrium time-path of the price of the resource must be consistent with the behaviour of both groups. As far as firms are concerned this means that the price/quantity combination established in the market must lie on the demand curve for the resource as an intermediate input. Since speculative demand for the resource simply involves change in ownership rather than use, it generates no additional net demand over and above that of users. However it does play an important role in setting price as investors must obtain the same rate of return from holding the resource as they would obtain from an alternative investment. This rate of return is given by the market rate of interest.

Consider price/quantity combinations in successive years, t and t+ 1. Could these lie on the equilibrium time-path of the price of the resource? Assume that they are points on the demand curve so that they are consistent with equilibrium as far as firms are concerned. Are they consistent with the requirements of investors? The rate of return to an investor who holds a unit of the resource for one period is the ratio of the capital gain to the purchase price: r = (Pt+! - Pt)/Pt• If this ratio exceeds the market rate of interest investors will wish to buy more of the resource stock in period t, thereby driving the initial price up and the rate of return down; if this ratio is less than the interest rate, investors will wish to sell off holdings in period t to take advantage of alternative investment opportunities, thereby driving the resource price down and the rate of return up. Thus a pair of prices which form an

6

equilibrium from the viewpoint of investors is one for which the resource price rises at the rate of interest. Since this argument holds for any two successive periods, the price of the resource must rise over time at the rate of interest for the market to be in dynamic equilibrium. This result is known as the "Hotelling Rule" after Harold Hotelling who brought it to the attention of resource economists in a famous 1931 journal article.

We have concluded that dynamic equilibrium requires that the market price of the resource moves up the resource users' demand curve over time at a rate equal to the market rate of interest. However our analysis is not yet complete as we have not established a starting point for market price, nor have we discussed what happens when the choke price is reached. Since the choke price is the highest possible price, any investor who is holding the resource stock when this price is reached cannot earn a positive rate of return on his investment. This means that equilibrium from the viewpoint of investors implies that the resource stock will be exhausted at the price Pc.

In principle any price could be a starting point for the process which we have described. Each starting point would determine market price, and quantity supplied to firms, in all subsequent periods. This means that each starting point implies a complete schedule for the supply of the resource right up to the price Pc, at which point sales fall to zero. Consequently each starting point implies a certain amount of cumulative production of the resource; however only one starting point implies a level of cumulative production which equals the initial quantity of the resource which was actually available. That starting point is the initial price in the dynamic equilibrium.

A dynamic equilibrium consistent with buyer and investor equilibrium can be illustrated by means of Figure 4. Quadrant 1 illustrates the demand curve for mineral deposits by resource users; Quadrant 2 shows the price of deposits rising at the rate of interest from its initial level

Po to the choke price Pc; Quadrant 3 records the path of mineral output over time, with the area under the output curve measuring cumulative production; and Quadrant 4, which is redundant, simply transfers output levels from Quadrant 1 to Quadrant 3 by means of a ray from the origin with a slope of unity. The possible dynamic equilibrium illustrated in Figure 4

is the actual equilibrium if cumulative production, as measured by the shaded area in Quadrant 3, is equal to the initial resource stock. If proposed cumulative production exceeds the initial resource stock then the proposed set of prices would reduce sales to zero before the choke price was reached; investors would have lost an opportunity to earn an above market rate ofreturn by holding back some of the resource to sell at the choke price. Alternatively, if - proposed cumulative production is less than the initial resource stock investors will be left with holdings of the resource when price can no longer rise. Thus in principle the equilibrium can be found by a trial and error process of looking at the consequences of alternative values

of the starting price.

In summary, there are three conditions for competitive equilibrium illustrated by the three non-redundant Quadrants of Figure 4. The demand curve in Quadrant 1 records all price/quantity combinations consistent with equilibrium in the market which supplies the resource to users. Quadrant 2 records all price paths which are consistent with dynamic equilibrium in the speculative market, while Quadrant 3 illustrates the resource balance equilibrium condition: total quantity mined during the life of the industry must equal initial reserves.

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The competitive market process described above rations out a limited mineral resource over time. If the derived demand for the mineral is inelastic, implying that there are no close substitutes for it in production, and no close substitutes for the final demand goods which it is used to produce, then the initial price of the resource will be relatively high and the rate of decrease in the quantity supplied to the market will be relatively low. Conversely, if the derived demand for the mineral is elastic, initial price will be relatively low and the rate of decrease in quantity supplied will be relatively high. The larger the initial resource stock is, relative to the demand for it, the lower is the initial price, and the larger is the amount that is used in the present.

The competitive market rations out a scarce resource stock over time, but is the outcome efficient from an economic viewpoint? Economic efficiency requires that no one can be made better off by rearranging the time-path of extraction without making someone else worse off by at least the same amount. The competitive extraction equilibrium is clearly efficient from the viewpoint of investors, but what about buyers of the resource? The area under the demand curve up to the quantity of the mineral traded measures the total willingness of buyers to pay for the resource in any year. The present value of these areas is maximized if the discounted value of marginal willingness to pay is equalized for all periods in which the resource is marketed. Since marginal willingness to pay is given by market price, the competitive equilibrium maximizes the present value of buyers' willingness to pay by ensuring that price rises at the rate of interest.

. We conclude this Section by considering the effect of alternatives to Assumption (1) of the model about the demand for the resource. Suppose that there was no finite price high enough to choke off demand for the mineral. An example might be the case of oil: as price rises substitutes for oil as a source of heat energy appear; further price rises prompt the introduction of substitutes such as electricity for powering transportation facilities; eventually rises in price may eliminate all uses of oil except as a source of chemicals for the pharmaceutical industry, and then for especially highly valued drugs and so on. This situation is represented by a demand curve which is asymptotic to the price axis: quantity demanded approaches but never reaches zero as price increases. In these circumstances all the findings of the model with the choke price hold except that mineral price continues to rise at the rate of interest for ever. The resource stock is not exhausted in finite time but the rate at which quantity is supplied to the market continually gets smaller as price increases.

If, instead of being static, the demand curve for the mineral shifts to the right over time because of economic and population growth the results of the analysis still hold. The equilibrium consistent with investor behaviour requires that mineral price rises at the rate of interest. Since demand shift will result in price increases even in the absence of reductions in quantity supplied, the effect of introducing a dynamic demand model is to moderate the decline over time in the quantity of the mineral supplied. This type of demand structure is considered in Case Study 2 on the tin cartel at the end of the Paper.

3.2 The Effect of a Mineral Royalty

In order to gain some experience in using the model of dynamic equilibrium in the competitive mineral market we consider how the equilibrium would be affected if the government introduced a specific royalty on mineral production. A specific royalty is a sum of money to be paid on each tonne of the mineral supplied to users at the time it is supplied. The effect on producers is equivalent to a downward shift in the demand curve for the mineral

8

by the amount of the royalty. While transfers of ownership of the resource stock among investors do not attract the royalty, the private value of the resource is ultimately determined by the net of royalty price which can be obtained by selling it to resource users.

The simplest way to approach the problem is to ask why the original equilibrium extraction path would be inconsistent with equilibrium in the changed circumstances of effective demand facing suppliers. The original path involved a starting price Po. If that path is maintained when the royalty, R, is imposed, the new starting price received by sellers becomes (Po-R). If the price paid by buyers, P. , rises at the rate of interest as in the preroyalty equilibrium, then the price received by sellers, (Pt -R), rises at a faster rate since the royalty is constant over time. This would encourage speculative demand for the resource thereby driving up its current gross of tax price. An increase in the price paid by resource users would reduce the quantity demanded thereby increasing the time to exhaustion. Thus the effect of imposing a royalty in this model is to raise the initial price paid by resource users, to cause the supply price over time to rise at a rate less than the rate of interest, and to lengthen the time to exhaustion.

The argument is illustrated in Figure 5. The solid line in Quadrant 1 indicates the gross of royalty demand curve, and the dotted line the net of royalty demand curve facing resource owners. The time-paths of the equilibrium prices paid by resource users in the pre- and postroyalty regimes are illustrated in Quadrant 2 by solid and dotted lines respectively, and the time-paths of quantities supplied to resource users are illustrated in the same manner in Quadrant 3. The areas under the solid and dotted lines in Quadrant 3 are equal to the original endowment of the resource. The dash-dotted curve in Quadrant 2 illustrates the net of royalty price received by resource suppliers rising over time at the rate of interest.

The introduction of a royalty represents a reduction in the degree of one of the characteristics of property rights enjoyed by resource owners; their share of the benefits from exploiting the resource is now less than 100%, and in general this can be expected to lead to economic inefficiency. In Section 3.1 it was argued that a time-path of mineral price and quantity such as that illustrated by the solid lines in Figure 5 was efficient in that it maximized the present value of willingness to pay for the resource stock. It follows that the alternative time-path under the royalty regime is inefficient: the starting price to users is too high and the use of the resource is prolonged beyond the time when the switch should have been made to the perfect substitute at the choke price.

Initially the burden of the royalty is shared between buyers and sellers since the price paid by buyers rises and that received by sellers falls. However as can be seen from the time-path of the gross of royalty price, Pr, in Quadrant 2 of Figure 5, the price paid by buyers eventually falls below what it would have been in the absence of the royalty.

3.3 Mineral Discoveries

We now consider the consequences of dropping Assumption (2) of the model relating to the size of the resource stock. This assumption implies that at the time the dynamic equilibrium price path is established in the futures market all buyers and sellers know exactly how much of the resource is available to be rationed out over time. In reality all participants in mineral markets expect exploration to result in increases in mineral reserves. Since we defer consideration of costs to the next Sub-section, we will assume for the mpment that mineral

PM =Po+ C.

(3.1)

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exploration is costless. This is equivalent to assuming that additional stocks of the resource simply manifest themselves.

A single unanticipated increase in the total mineral stock available would prompt a revision of the equilibrium price path as illustrated in Figure 6. In effect the futures market would have to reconvene at the time of the unexpected discovery, denoted by t in Figure 6, to renegotiate all contracts. Investors holding stocks of the resource would suffer a capital loss on each unit measured by the difference between the original price at time t, Pt, and the new price, PEt , The market would then embark on its new equilibrium price path starting at PEt, with price rising at the rate of interest until the new exhaustion date is reached. The solid lines in Figure 6 illustrate the original equilibrium and the dotted lines the new equilibrium.

Since speculators lose money when a mineral discovery occurs they will take this possibility into account when entering into contracts. The futures market will form a view about the likelihood of additions to the resource stock and this will tend to pull current prices down and to smooth out the time-path of price illustrated in Figure 6. Dynamic equilibrium in this uncertain world requires that the expected price of the mineral rises at the rate of interest. Variations around this price would occur in response to the occurrence of greater or smaller additions to the resource stock relative to market expectations. Thus the introduction of mineral discoveries does not change the essential nature of the conclusions drawn from the model in which the mining industry has no costs.

3.4 Dynamic Equilibrium with Production Costs

In the model with no production costs the metal and the mineral deposit were the same thing, and firms wishing to use the mineral in the production of final demand goods simply purchased units of it from speculators. Once costs are introduced the structure of the mineral industry is as illustrated in Figure 1: mining companies purchase deposits from resource owners, incur mining and processing costs, and then sell the resulting metal to firms which use it as an intermediate input. We will continue to assume that all resource deposits are identical so that all mining companies incur the same costs of supplying metal to buyers.

A mining firm incurs two types of costs: it has to purchase mineral deposits from resource owners, and it needs to hire labour, capital and other inputs to extract the metal from the mineral deposits. For the moment we will not concern ourselves with the mining firm's extraction cost structure but simply assume that it costs $C to extract each unit of metal from - the resource stock. This means that under competitive conditions the price of metal equals the price of deposits plus the unit cost of extraction:

It follows from equation (3.1) that a change in the price of metal is the sum of changes in the price of deposits and the unit cost of extraction:

dPM = dPo + dC.

(3.2)

Dividing both sides of equation (3.2) by the metal price gives:

G(PM) = b.G(Po) + (I-b).G(C),

(3.3)

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and this expression can be rearranged to give:

where G(.) represents a growth rate, and b = PO/PM is the share of the price of mineral deposits in the unit cost of metal production. If the unit cost of extraction is constant, G(C) = o and the growth in the price of metal over time is a proportion, b, of the growth in deposit price. Since dynamic equilibrium requires that the price of deposits grows at the rate of interest, the price of metal grows at some slower rate. This result is the same as that already obtained in Section 3.3 when the introduction of a cost in the form of a constant mineral royalty caused mineral price to rise at a rate lower than the rate of interest.

The cost structure of the mining firm will depend on its production technology and the prices of the inputs it uses. The inputs other than mineral deposits - labour, capital, energy - can be thought of as producing "mining effort" which is used in fixed proportions with mineral deposits to produce metal. This assumption allows us to separate the unit cost of metal into the unit deposit cost and the unit effort cost. If the mining firm's production of effort is subject to the usual assumptions about technology, the firm will have a U-shaped long-run average cost of effort curve, as illustrated in Figure 7. Adding the unit cost of deposits to that curve gives the firm's U-shaped long-run average cost of metal curve. In long-run equilibrium competition will force all firms to operate at the minimum point of the long-run average cost curve. This means that when the price of deposits is Po ,as illustrated in Figure 7, each firm will produce OQ units of metal per period at a unit cost of Po+C, where C is the minimum point of the average cost curve. Competition ensures that the price of metal equals the unit cost of production. A rise in the price of deposits will not affect the output level of each firm, but it will reduce the industry output through the effect of the higher metal price on quantity demanded. The reduced industry output is achieved by the exit of extraction firms from the mining industry.

To this point it has been implicitly assumed that the cost structure of extraction firms remains unchanged over time. In fact there have been considerable technological advances in mining and in the recovery of metal from are. This can be allowed for in the model by allowing the long-run average cost curve of mining effort to shift downwards over time, thereby reducing the level of C, the minimum average cost. In shifting downwards, the long-run average cost curve may also shift to the right or left, indicating an increase or decrease in the optimal size

of mining firm. According to equation (3.3), the effect of a fall in C will be to slow or even - reverse the rate of increase in metal price. For example, it is easy to construct a scenario which is consistent with the U-shaped time-path observed for the prices of many metals: in the early stage of the industry deposit price is low and mining effort cost is high; this means that the share of deposit price in unit cost, denoted by b in equation (3.3), is low in the early stage; as a consequence the time-path of metal price is dominated by falls in the unit cost of mining effort; as the industry matures and deposits become more scarce, the share of deposit price in the unit cost of metal rises and the rising price of deposits comes to dominate the time-path of metal price.

3.5 The Effect of Varying Quality of Deposits

We now introduce to the analysis variations in characteristics across deposits. Some deposits contain a higher grade of ore than others, some are closer to the surface, and some are closer to the market. The effect of these variations in characteristics is to vary the amount of "mining

11

effort" which must be combined with each unit of a deposit to produce a unit of metal; and variations in the amount of effort translate into variations in unit mining cost across deposits. Since the deposit price is the metal price less the unit mining cost, deposits with more favourable characteristics will sell for a higher price per unit of the metal they contain. This higher price is a rent similar to the higher price paid for agricultural land with more favourable soil fertility, rainfall or location.

Equilibrium in the market for mineral deposits requires that the unit price of "deposits" rises at the rate of interest. However we now have different kinds of deposits in existence and we need to form a view as to how the market determines which deposits are produced and which are held as investments. Suppose that there are two deposits, each one unit in size, one of high quality and one of low quality. Since quality is ultimately a matter of extraction cost, we will assume that one deposit has a high, and the other a low extraction cost. Consider two successive periods in time over which use of the deposits is to be allocated. The options are:

(1) use the low cost deposit this year and the high cost deposit next year;

(2) use the high cost deposit this year and the low cost deposit next year.

We now consider which of these options is consistent with dynamic equilibrium.

In a competitive market the price of a unit deposit is given by the metal price less the unit extraction costs. Under Option 1 the capital gain to investors from holding the high cost deposit for a year is: (P2-CH) - (PI-CH), where PI and P2 are the metal prices in years 1 and 2, and CH is the unit extraction cost of the high cost deposit. The rate of return on holding the high cost deposit for one year is: rH = (P2-PI)/(PI-CH). Similarly the one year rate ofreturn on holding the low cost deposit is given by: rL = (P2-PI)/(PI-CL). Since CH>CL it follows that rH>rL. For Option 1 to be a dynamic equilibrium rH >r >rL, where r is the interest rate, so that investors are willing to sell low cost deposits in year 1 and retain high cost deposits until year 2. This is consistent with the relationship established between the one year rates of return for the two types of deposit. On the other hand, for Option 2 to be consistent with dynamic equilibrium it would be necessary that rL>rH. In other words, the forces of speculation will ensure that the lower cost, higher quality, deposits are used first.

Is the market outcome consistent with economic efficiency? Efficiency would require that the mineral stock is allocated so as to maximize its net present value in a competitive market. We can calculate the net present values of the two options as follows:

NPV(l) = (PI-Cd + (P2-CH)/(l +r);

Since NPV(l) - NPV(2) > 0, the market solution is efficient.

A consequence of the market allocation of deposits over time is that, in the absence of technological change, the unit extraction cost of deposits rises as lower quality deposits are brought into production. This phenomenon is sometimes included in more advanced models by making the unit cost of extraction a positive function of cumulative extraction (or a negative function of remaining stocks). The rise in extraction cost will counter the effects of technical change in lowering mining costs. This means that the proportionate change in unit cost, denoted by G(C) in equation (3.3), could be either positive or negative depending on

12

which effect predominates. It might be thought that in the early stages of the life of the industry high quality deposits would be plentiful and technical change rapid, so that G(C)<O, whereas the reverse would be true in the later stages. This view would tend to reinforce the prediction of a U -shaped path for the price of a metal over a long period of time.

The assumptions of the above analysis imply that the deposits being mined in any given year are of uniform quality, whereas in practice we observe differences in quality and corresponding differences in value among the cross-section of deposits in production. Since mining projects generally have a life of several years, variation in the quality of deposits currently under production is not inconsistent with the higher quality deposits coming on stream first. Also in a world of imperfect information about mineral stocks the mineral exploration industry will not necessarily find deposits in order of their quality even although there is an incentive to do so. The picture which emerges from our abstract model is of a set of deposits waiting to be exploited; the lower the quality of the deposit the higher is its rate of return to investors; over time the rate of return in any given deposit falls; once the rate of return on a deposit falls to the rate of interest it is no longer profitable to hold and it is released to buyers for use in production. Of course there is also an exploration industry engaged in augmenting the stock of deposits and its role will be analysed in the next Section.

3.6 Exploration

If additional mineral stocks can be found by exploration there are two ways of supplying deposits to mining firms: they can be supplied from an existing inventory held by speculators, or by firms which explore for and find mineral reserves. Supply from the former source is costless apart from the forgone opportunity for speculative gain, whereas the latter source involves the additional costs of exploration. Thus, in terms of the discussion in the previous Section, reserves in speculators' inventories tend to be high quality (low cost) deposits, whereas reserves yet to be found are low quality (high cost). This suggests that the speculators' inventory will be used first and that exploration will commence once the initial inventory has been used up. This means that our analysis should treat exploration as the only source of mineral reserves.

Mining firms generally hold reserves equivalent to several years' production. Since we have ruled out speculative holdings, these reserves must play some role in production. A mining company needs to ensure that its capital equipment and expertise will have a continuous supply of deposits to work with. Some models incorporate this feature of the mining production process by making the unit cost of extraction depend on the size of the firm's reserves; the higher reserves are, the lower the unit cost of extraction.

Two main influences on the cost of acquiring reserves through exploration are the stock of geological information available and the stock of reserves waiting to be discovered. The more information that is available the lower the unit cost of discovery, and the lower the stock of reserves waiting to be discovered the higher the unit cost of discovery. As exploration progresses the stock of information increases, but the stock of undiscovered reserves declines. The net effect is likely to be an eventual rise in the unit cost of discovery.

Consider first the case in which unit extraction costs are unaffected by changes in the level of reserves. If the current level of reserves was the entire stock of the mineral available to the industry the market would establish a price path for the metal over time .as analysed in Section 3.5. Exploration introduces the possibility of additional reserves becoming available.

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The effect is to lower the initial price of the metal, but not to affect the rate of change of price over time. In other words, introducing exploration results in a downward shift in the metal price path as described in Figure 6.

If the level of reserves affects unit extraction costs the situation is much more complicated; firms can trade off exploration costs against extraction costs. The net effect on metal price depends on the size of initial reserves. If reserves are initially relatively high the prospect of additional discoveries will have little impact on the price path described in the previous paragraph. However, if initial reserves are relatively low exploration can increase reserves and reduce extraction costs significantly. Since exploration costs are low in the early stages of the life of the industry the decline in unit extraction costs can be larger than the unit exploration cost, thereby leading to a decline in metal price in a competitive minerals industry. However; as the industry matures unit exploration costs rise and eventually exceed any benefit of lower unit extraction costs resulting from additional reserves. The overall result in the case in which initial reserves are relatively low is a U shaped price path for the metal, similar to that illustrated in Figure 2.

3.7 Recycling

Mining firms supply metals for use as intermediate inputs in the production of final demand goods. When these goods have been consumed the metals then become scrap; examples are iron in the form of scrapped cars, copper in the form of scrapped piping, and aluminium in the form of scrapped cans. The existence of these stocks of scrapped materials creates a possible alternative source of supply of raw material for metal production through recycling.

We know from the analysis of Section 3.6 that when deposits of different quality can be marketed, the lower cost deposit will be employed in production first. We observe that unit extraction cost is currently lower than unit recycling cost. This suggests that all deposits will be exhausted before the stocks of scrap are exploited. However this conclusion fails to take into account the other component of the cost of production - the price of deposits or of scrap.

If we assume that the same set of futures markets exists for scrap as for deposits, we can treat the stock of scrap material as a "deposit" in the standard analysis. In the early stage of the industry'S life deposits are plentiful and relatively low cost, whereas stocks of scrap are scarce and relatively high cost. Thus stocks of scrap are equivalent to low quality (high cost) deposits during this stage. As we have already seen, production from high cost deposits, such as scrap, will be deferred until the low cost deposits have been exhausted. However as extraction progresses the stock of scrap will grow relative to that of deposits, the quality of the remaining deposits will decline, and at some point the unit cost of production of metal from scrap will fall below that from deposits. At this point the industry shifts from reliance on deposits to reliance on scrap.

According to our analysis, production will shift to scrap as a source of raw materials when that becomes the cheaper source. However the stock of scrap is exhaustible because of processes such as rusting and wear, and as the stock of scrap declines its price rises until eventually the cost of production of metals from scrap will again exceed the cost of extraction from deposits. This suggests that we should observe a period of no recycling, followed by a period of no mining, followed in tum by period of no recycling. What we have actually observed so far in the case of the metals referred to is a period of no recycling, followed by the current period of combined recycling and mineral extraction. However, as we have

G(M) = -{(l-a)s + ae}.{br + (l-b)G(C))

(3.4)

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already noted in Section 3.6, deposits of differing quality are extracted at the same point in time for reasons which are not covered by our abstract model, and the co-existence of mining and recycling can be explained in the same way.

What effect will the possibility of recycling have on the time-path of the price of a metal? The prospect of acquiring additional stocks of materials through recycling will have a similar effect as the prospect of acquiring them through exploration. In our discussion of exploration it was suggested that the prospect of mineral discoveries would reduce current deposit prices. Furthermore, if undiscovered reserves were thought to be large relative to discovered reserves, metal prices might actually fall for a period of time before adopting the characteristic upward trend. In the same way we would expect the possibility of recycling to reduce current prices. In addition, if the decay rate on scrap is low, we might expect that the prospect of the availability of relatively large stocks ofrecyclable material in the future would tend to cause metal prices to decrease over the initial period of time when extraction is the only source of supply.

During the initial extraction-only period the value of deposits increases at the rate of interest, as required for dynamic equilibrium, and this tends to pull the metal price up. However the effective price paid by the buyer is the price charged by the mine less the scrap value, and dynamic equilibrium requires that the scrap value increases over this period at a faster rate than the rate of interest, otherwise investors would not be willing to withhold scrap from the market. The net result is a decline in the effective price over the initial period. Thus, as in the case of exploration, an analysis of recycling suggests that a U-shaped time-path for the price of a metal might be expected.

3.8 Supply and Demand

This Section has developed various time-paths for metal prices which are consistent with competitive dynamic equilibrium in the mining industry. The price paths considered are the product of supply and demand interactions on an intertemporal basis. Each price path has a consequence for the rate at which scarce mineral resources are used up and we now consider this issue briefly.

We saw from equation (2.8) that, when demand is static and there is a fixed stock of the resource, the growth rate in metal use over time is negative in response to a positive growth rate in metal price. Equation (3.3) indicated that the growth rate of metal price would depend on the growth rates of the two components of production cost - the price of depos-its and the unit cost of extraction. Substituting the dynamic equilibrium condition that the growth rate of the price of deposits equals the rate of interest into equation (3.3) and combining the two equations yields an expression which relates the growth in metal consumption to the characteristics of market demand and supply:

The first thing to note from equation (3.4) is that the growth rate of metal consumption is predicted to be negative. The rate of decline will be larger the higher the elasticity of substitution, s, the higher the demand elasticity, e, the higher the rate of interest, r, and the higher the positive growth rate of unit extraction cost. In other words, if a metal has close substitutes, if present consumption is given a higher weight relative to future consumption, and if unit extraction costs are expected to rise rapidly, then the working of the competitive

15

market will result in the mineral stock being used up fairly rapidly. If, on the other hand, there are no close substitutes and unit extraction costs are increasing slowly, or even declining, then the decline in metal consumption will be relatively small over time implying that substantial stocks of the mineral will be conserved for future use.

For most minerals the direct issue is one of cost rather than of scarcity. Increasing scarcity could be expected to manifest itself in higher metal prices rather than in a cessation of supply.

3.9 Increasing Scarcity

From time to time the concern has been expressed that we might "run out" of minerals. David Brooks (1973) has responded to this view as follows:

"In literal terms, the notion of running out of mineral supplies is ridiculous. The entire planet is composed of minerals, and man can hardly mine himself out, though one of the most amusing applications of exponential growth curves indicates that if sand and gravel production continue to expand at rates typical of the past 20 years the whole earth will soon be consumed.

Specifically, except for a few substances, notably crude oil and natural gas, which are discretely different from the rock masses that contain them, the quantities of mineral materials in even the upper few miles of the earth's crust approaches the infinite. A single cubic mile of average crustal rock contains a billion tonnes of aluminium, over 500 million tonnes of iron, 1 million tonnes of zinc, 600,000 tonnes of copper. "

The basis of the concern that we might "run out" of minerals is the comparison of estimated levels of recoverable resource stocks with current rates of production. The problem with this comparison is that the current state of knowledge about resource stocks is based on information derived from exploration. As suggested in Section 3.7, the level of exploration effort is determined by the effect of the level of reserves on extraction costs. Exploration is driven by the desire to keep extraction costs down rather than by any need to know the size of the ultimately recoverable resource stock.

There are various market observations which might serve as indicators of increasing resource scarcity. However the interpretation of market data depends on the view that is taken on how well the market functions. For example, in Section 3.1 a complete set of perfectly competitive markets succeeded in rationing out a fixed stock of deposits until a perfect substitute was available. In practice only limited futures markets exist and we cannot assume that future scarcity is adequately reflected in present prices. Furthermore minerals such as oil, uranium, bauxite and copper are produced by industries dominated by cartels or marketing arrangements which tend to raise current prices above competitive levels. Nevertheless market data are likely to provide the best information about future scarcity.

Market data provide information about the price of deposits, the cost of extraction, and the price of metals. The price of deposits appears to be the most directly related variable to the scarcity of resources. The price of deposits is determined by the forces of supply and demand: on the demand side, mining firms purchase deposits to extract, and the net demand of speculators depends on their view as to future prices. On the supply side, additional deposits are located and proved through exploration. As long as speculators engage in arbitrage the expected price of deposits, and hence the marginal cost of finding deposits, will rise at the

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rate of interest. If we observed any different price path we would tend to question the relevance of our model rather than draw conclusions about resource scarcity. Thus deposit price information is of limited value in this context.

Movements in the level of extraction costs provide information about the rate at which the mining industry is shifting to production from lower quality (higher cost) deposits. This information does reflect increasing scarcity but is usually regarded as commercially sensitive and is not readily available. However higher extraction costs will be reflected in higher prices of mineral products and these prices are widely recorded and published. It will be recalled that in competitive equilibrium the price of metal is equal to the price of deposits plus the unit cost of extraction. Since we assume that the price of deposits rises at the rate of interest, movements in metal prices directly reflect changes in extraction costs. This conclusion needs to be modified if metal prices are generated by a noncompetitive industry: prices reflect monopoly rents as well as the basic conditions of supply.

As time progresses a mineral industry turns to lower grade (higher cost) deposits to maintain supply. The tendency towards higher metal production costs may be offset by a number of factors such as technical improvements in mining and mineral processing, discovery of additional deposits through exploration, and exploiting opportunities for recycling. Customer resistance will mitigate the effect of higher costs on prices: firms which use metals as intermediate products will substitute other materials for them; and consumers will substitute other goods for those containing the high priced metals. As noted earlier, a U-shaped price path is to be expected in the long-run, with the rising portion of the curve reflecting "resource scarcity".

Case Study No. 1 at the end of the Paper examines the price paths displayed by several commonly used minerals. Gold is excluded from this analysis because for much of this century its price has been regulated by central banks. However it has been observed that over the centuries an ounce of gold buys you one good man's suit. Leaving aside the question of the changes which have occurred in a "man's suit", what this adage conveys is the view that the effects on production cost of moving to lower grade deposits over the millennia have been roughly offset by technical progress, leaving the price of gold constant in real terms. In this sense, gold has not become more scarce over a substantial period oftime.

4. THE MONOPOLY MINERAL MARKET

Suppose that a single supplier owns the entire stock of a mineral resource, and that he can sell some of it this year and some next year. Suppose also that there are no costs of production and that demand is the same in each year. We can use this simple model to isolate the important influences determining the time-path of mineral prices under monopoly: the rate of interest, and scarcity.

However large the stock of the resource, the monopolist will never find it advantageous to sell a quantity in either year beyond that which maximizes total revenue. In Figure 8 the total revenue functions in years 1 and 2 are illustrated in Quadrants 2 and 4 respectively. Quantity supplied in each period will not be greater than Qm. If there is no scarcity of the resource, Qm will be supplied in each period and this is illustrated by point A in Quadrant 1.

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If the total stock of the resource is less than 2Qrn the monopolist has to make a decision about how to allocate sales of the scarce resource between the two periods. The resource constraint in Quadrant 3 illustrates a set of combinations (QJ,Q2) such that QJ+Q2 < 2Qrn. Corresponding to these supply combinations is a set of total revenue combinations illustrated by RR' in Quadrant 1; note that RR' is truncated at the revenue levels corresponding to Qrn. The curve RR' is a revenue possibilities curve which summarizes the choices open to the monopolist.

G(MR) = G(P) + G(e)/(e - 1).

(4.1)

It can be assumed that the monopolist wishes to maximize the present value of his profit. If the rate of interest is zero, this is accomplished by allocating supply equally between the two periods so as to equate marginal revenues as illustrated by point B in Quadrant 1. This result can also be expressed in terms of present value analysis: at a zero rate of interest the slope of the net present value line is unity, and net present value is maximized by choosing a point on RR' at which -dRJ/dR2 = 1. The slope -dRJ/dR2 is equal to the ratio of the marginal revenues MRJ/MR2, and hence maximizing present value at a zero rate of interest requires that marginal revenue is equalized in the two periods. This occurs at point B.

Now suppose that the rate of interest is positive. The slope of the net present value line is given by 1/(1 +r) < 1. A point on RR' with a slope less than one must be to the left of B. In other words, when the rate of interest is positive, and scarcity exists, the supply profile is tilted towards the present. A higher level of output in period 1 as compared with period 2 corresponds to a lower marginal revenue in period 1. When the ratio of MRJ/MR2, as given by the slope of the revenue possibilities curve, is set equal to 1/(1 +r) marginal revenue rises at the rate of interest between the two periods. This result extends to a multi-period analysis: provided there is scarcity and a positive rate of interest, the present value maximizing monopolist will adjust his supply of a mineral over time so as to ensure that his marginal revenue rises over time at the rate of interest. If costs were introduced to the analysis, then net marginal revenue (marginal revenue net of marginal cost) would rise at the interest rate.

The following simple relationship can be established between price, P, and marginal revenue, MR:

MR = P(1 - lie),

where e is demand elasticity defined as a positive number:

e = - (dQ/dP)(P/Q).

The growth in marginal revenue can be expressed as:

Since a profit maximizing monopolist never operates where marginal revenue is negative demand elasticity cannot be less than unity, and hence the term (e - 1) cannot be negative. Furthermore, since the production profile is tilted towards the present, the monopolist is moving up the demand curve over time and this means that demand elasticity is increasing. Since G( e) > 0, it follows than G(P) < G(MR). In other words, under monopoly, with zero extraction costs, the price of the mineral rises at less than marginal revenue, and hence at less than the rate of interest.

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Figure 9 compares the time-path of the price of a mineral supplied under conditions of zero cost from a fixed total quantity of reserves under competitive and monopoly market conditions respectively, when there is a perfect substitute for the mineral available in unlimited supply at a known price. The solid lines illustrate the competitive equilibrium and the dotted lines the monopoly equilibrium. As compared with competition, the effect of monopoly is to raise the initial price of the mineral and to delay the time to exhaustion. Thus by restricting supply to raise price, the monopolist contributes to resource conservation. However this degree of conservation, as compared with that determined by the competitive market, reduces economic welfare since consumers lose more by postponing the use of the perfect substitute than the amount of the monopoly profit.

The effect of imposing a royalty on monopoly output is illustrated in Figure 10. The imposition of the royalty shifts the monopolist's marginal revenue curve downwards by the amount of the royalty and lowers the value of marginal net revenue corresponding to the choke price. The gross of royalty demand and marginal revenue curves are illustrated by solid lines in Quadrant 1 and the net of royalty marginal revenue curve by a dotted line. Suppose the monopolist attempts to follow the original time-path of marginal revenue which is illustrated by a solid curve in Quadrant 2: if marginal revenue rises at the rate of interest, then net marginal revenue (marginal revenue minus the constant royalty) will rise at more than the rate of interest. Since dynamic equilibrium requires that net marginal revenue rises at the rate of interest, the monopolist will wish to slow the rate of growth of gross marginal revenue. However this will extend the life of the deposit beyond the original terminal date, To. In order to lengthen the life of the industry without violating the resource constraint it will be necessary to reduce the initial level of sales. This is done by raising initial price. The dotted lines in Quadrant 2 show the equilibrium time-paths of net marginal revenue, and mineral pnce.

The initial price to buyers rises from Po to Pr, and the seller receives P, less the royalty. It can be shown that in the case of a linear demand curve the rise in the initial price charged by the seller is less than half of the amount of the royalty. Thus the seller bears more than half of the initial burden of the tax. As in the competitive case the time to exhaustion is extended and buyers eventually receive the mineral product at a lower price than in the absence of the royalty. Since prior to the imposition of the royalty the monopoly was contributing to inefficient use of the mineral stock by retarding the rate of extraction, the effect of the royalty is to cause a further reduction in the net present value of the mineral stock.

5. THE MINERAL CARTEL

We have examined dynamic equilibrium under the two polar forms of industrial organization - perfect competition and monopoly. However supplies of some minerals are derived from industries which are characterised by an intermediate form of industrial organization: in this form there is one dominant firm which provides a significant portion of industry supply and which is able to influence market price by its rate of output; the output of each of the remaining firms is small in relation to industry output and these firms act as perfect competitors or price takers. In world mineral markets the dominant firm often takes the form of a resource cartel: examples are OPEC (oil), CIPEC (copper), IBA (bauxite), the diamond cartel operated by de Beers, and the uranium cartel operated by Australia, Canada, France and South Africa which succeeded in raising yellowcake prices from under $10 to over $40 per pound in the 19701s. Resource cartels became the subject of a significant amount of research

... ~

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effort following the substantial rise in crude oil prices apparently achieved by OPEC following the Yom Kippur War in 1967: as can be seen from Figure 11, the real (inflation adjusted) price of oil jumped from under $5 per barrel to over $30 per barrel in the space of a decade.

As in our analysis of monopoly we will make the simplifying assumption that there are no extraction costs and that demand is characterized by a choke price. Dynamic equilibrium in a cartelized industry needs to accommodate the requirement of the dominant firm that its marginal revenue rises at the rate of interest, and the requirement of the competitive fringe that price rises at the interest rate. We can establish the nature of the equilibrium by excluding extraction paths which are inconsistent with these two requirements.

P = a - b(Qm + Qc),

First, it is clear that neither side of the industry will wish to withhold its stocks from production until the other side has exhausted its reserves. Given a free hand in the market each side would ration out its stocks over time until the choke price was reached. If the other side then entered the market with a finite rate of supply, price or marginal revenue would have to fall. This would be inconsistent with dynamic equilibrium since it would have been better to have sold earlier at a higher price or marginal revenue. Hence we conclude that both sides of the industry operate from the beginning, just as we observe in the case of the world oil industry and other cartelized industries.

Secondly, could one side of the industry exhaust its stocks before the other? If the cartel exhausted its stocks and left the industry, the competitive fringe would act so as to increase mineral price over time at the rate of interest. As indicated by equation (4.1), when price rises at the rate of interest, and demand elasticity rises as a consequence of the higher price and lower quantity demanded, marginal revenue rises at a faster rate than the interest rate. If the cartel were to abandon the industry to the competitive fringe it would forgo the opportunity to hold mineral stocks during a period in which they yielded a higher marginal rate of return than alternative investments. On the other hand, the competitive fringe would have no regrets if it exhausted its stocks and exited the industry, leaving the cartel in a monopoly position: marginal revenue would then rise at the rate of interest and price at a slower rate.

A possible dynamic equilibrium seems to involve both sides of the industry supplying the market to start with, and the competitive fringe exhausting its stocks first. However this begs the question of how in the initial stage of the industry's life price and the cartel's marginal revenue can both rise at the rate of interest. As indicated by equation (4.1) the growth in price and the growth in the cartel's marginal revenue can be equal only when the growth in the elasticity of the demand curve facing the cartel is zero. If the industry inverse demand curve is given by:

the demand curve facing the cartel is given by:

and the cartel's marginal revenue is given by:

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where Qm is cartel output and Qc competitive output.

Competitors respond to price rising at the rate of interest by reducing their quantity supplied over time. This means that the demand curve facing the cartel shifts outwards over time. To satisfy the dynamic equilibrium condition that G(P) = G(MR) = r the cartel must operate along a ray, such as OR in Figure 11, which maintains a constant elasticity of demand for the cartel's product. Of course there is an infinite number of such rays but only one is consistent with the cartel exhausting its reserves just as the choke price is reached. As illustrated in Figure 12, as the competitors reduce their rate of output over time the cartel increases its rate of output. Once the competitors have exhausted their stocks the cartel has achieved a monopoly position which it can then exploit.

The time-paths of mineral price resulting from the costless exploitation of a given initial stock of a mineral under the three forms of industrial organization are compared in Figure 12. We have already illustrated the competitive and monopoly time-paths in Figure 9. As expected the dominant firm model yields an intermediate price path: the initial price and the terminal date lie between the competitive and monopoly outcomes. In the initial phase of the industry when the cartel and competitors co-exist price rises at the rate of interest; during this period the cartel gradually increases its rate of output to compensate partially for the reduction in the competitors' output. Once the competitors exit from the industry the price path flattens, reflecting the fact that the cartel has become a monopoly and that marginal revenue, computed from the market demand curve, is now rising at the rate of interest. Dynamic equilibrium requires no discontinuity at the point of transition from the dominant firm to the monopoly structure: a fall in price at this point would impose a capital loss on the dominant firm which it could have avoided by extracting more in earlier periods; and a rise in price would offer the possibility of a capital gain to competitors which they could have obtained by delaying extraction.

The dominant firm model was used by Cremer and Weitzman (1976) in the mid 1970s to forecast oil prices into the next century. They made an assumption about the choke price and then used information about reserves and extraction costs to work out a dynamic equilibrium price path. As can be seen from Figure 11, their forecasts of dramatically lower oil prices than those which were observed at the time of their research were borne out by events. Case Study

2 at the end of this Chapter describes another application of the dominant firm model, this time to the question of the viability of the international tin cartel. The research of William Low (1981) conducted in the early 1980s used the competitive and dominant firm models to - predict that the gains from cartelization were not large enough to outweigh the costs of organizing and maintaining a tin cartel. His prediction was also subsequently supported by events.

6. THE EFFECT OF A RISE IN THE INTEREST RATE

Some researchers have suggested an alternative explanation for the substantial rise in oil prices in the 1970s. This explanation is based on a property rights model of exhaustible resource extraction. Prior to the establishment of nationalist governments in the oil producing countries of the Middle East the industry was controlled by a group of multinational oil companies, known as "The Seven Sisters". These companies, it is argued, sensing the growth of nationalist sentiment kept extraction rates high in the belief that they would eventually lose control of the oil reserves. Once the oil fields were nationalized production reverted to a

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lower rate consistent with long-run net present value maximization, thereby forcing an upward adjustment of world oil prices.

Fully to understand this argument we need to establish a simple model of the way in which oil companies might react to the risk of confiscation of their reserves. Suppose that a company expects to earn $V from oil extraction at time t, but that there is a probability, p, in each year between now and t that the oil reserves will be confiscated. The expected value of the earnings in year t is given by: $V(1-p)\ and the expected present value is given by: $V(1- p )t/(l +r)\ where r is the appropriate rate of interest. Since it is approximately true that (1- p )/(1 +r) = 1/(1 +r+p), the expected net present value can be calculated by adding the annual probability of confiscation to the rate of interest. In other words, the argument is that the foreign oil companies were using higher than market rates of interest to decide about the extraction time-path of their reserves.

Whether the foreign oil companies operating in the Middle East acted as price takers or price makers, their use of a high rate of discount because of the risk of confiscation would have led them to adopt a relatively high rate of extraction. We can use our model of dynamic equilibrium to demonstrate this result under either of the two polar forms of industrial organization. Figure 13 compares the time-paths of oil price and extraction rate for the competitive case with no extraction costs under a low- and high- interest rate regime. If the threat of nationalization of the Middle East oil fields resulted in oil producers using a relatively high discount rate to evaluate their oil reserves they would have been operating along the more rapid extraction path in Figure 13. Once the oil fields came under local control the threat of confiscation would have disappeared and the producers would have reverted to using the market rate of interest as the discount rate, and the slower path of extraction as illustrated in Figure 13. The shift from the faster to the slower extraction path is accompanied by a significant upward revision in the price of oil, such as occurred in the period following the Iranian revolution.

We have considered two explanations for the substantial rise in oil prices which occurred in the 1970s - the cartel model, and the risk adjusted discount rate model. Another explanation which has been put forward is that the oil production of the major oil owning countries is determined by the need to finance their budgetary requirements from oil revenues. This is a "needs driven" strategy towards exploiting oil reserves which would be necessitated by the absence of alternative sources of funds such as the international capital market. Yet a further explanation is that the so called "oil price shock" was the result of loose monetary policy - adopted by the oil purchasing countries.

7. MINERAL RENT AND TAXATION

One outcome of Cremer and Weitzman's research on the effects of the cartelization of the world oil industry was an estimate of the relative importance of the various factors which make up the price of Middle East oil. The production cost is very low - around $1.15 per barrel at the time of their research - and yet the predicted dynamic equilibrium world price was in the order of $9.80. The difference between marginal production cost and price constitutes a rent which has three sources:

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(1) scarcity rent: this is the price per barrel which oil deposits could command in a competitive market because of the prospect of the eventual exhaustion of world oil reserves. The factors determining this value were examined in Section 3;

(2) monopoly rent: this is the premium which the oil owning countries can exact by exercising their monopoly power - withholding supplies in order to increase price. This process was analysed in Section 4;

(3) Ricardian rent: this is the premium which Middle East oil can exact because of its relatively low cost of production. The price of a primary product needs to be high enough to cover the costs of the highest cost, or marginal, supplier. All other suppliers are inframarginal and their land or mineral reserves earn a return termed a Ricardian rent.

Cremer and Weitzman's estimate of the dynamic equilibrium price of OPEC oil in 1975 US$ and its breakdown was as follows:

Production Cost:

Ricardian Rent:

Monopoly Rent:

Scarcity Rent:

$1.15 $2.87 $4.88 $0.90

Total Price:

$9.80

This figure is based on an estimated annual OPEC supply of 5 billion barrels of oil.

There are two main reasons for arguing that mineral rent should be subject to taxation. First, in many jurisdictions the State is the owner of the subsurface minerals. A company exploiting these minerals may be required to pay for what they take. The simplest way for the government to obtain a return from the resource might be to put mineral deposits up for auction. There are two main problems with this approach. First, exploration for and production of many minerals is dominated by a few firms which would be able to collude to keep the auction price of deposits low. Secondly, a considerable amount of risk is attached to the location and development of a mineral deposit; an auction system involves the mining firms bearing all of the risk. Some people argue that the government is better placed to bear risk than private companies and that a royalty system results in a more efficient spreading of risk. For example, an ad valorem royalty is paid only on extraction and only as a percentage of the actual price of the mineral product at the time of extraction.

The second argument for taxing mineral rent is based on the notion that a rent is a payment to a factor of production in excess of that required to keep the factor in its present use. For this reason the taxation of rent does not, in principle, affect the allocation of resources in the economy, thereby leading tax reformers like Henry George to advocate that all government revenue should be derived from a single tax levied on land, or natural resource, rent. In practice most taxes aimed at collecting mineral rent for the State are distortionary. For example, we have seen that a royalty imposed at a fixed rate distorts the time-path of extraction of a mineral stock. This problem can be addressed by having the royalty increase at the rate of interest. However if the mineral stock is heterogeneous in terms of grade, depth and location - all factors affecting extraction cost and hence rent - a different level of royalty is required on each unit of the stock if some units are not to be priced out of production by the royalty.

23

In Australia and Canada the States or Provinces are currently prohibited from levying direct taxes, such as personal and company income taxes. These jurisdictions own the mineral resources within their borders and are entitled to levy severance taxes or royalties on mineral production. Royalties can be levied on the quantity of mineral produced (a specific royalty) or on the value of production (an ad valorem royalty). Table 1 reports the royalties levied by the Australian States on various mineral products.

For various reasons State and Provincial governments have sought to extend their mineral tax systems beyond the imposition of simple severance taxes. For example, if a simple royalty system is not to impose significant costs in terms of distortions it may have to be imposed at a level that raises little revenue; the effects of a royalty on iron ore output in Western Australia are examined in Case Study 3, and the nature of the trade-off between efficiency and equity is examined in Case Study 4. Some jurisdictions have tried to overcome this problem by designing more complicated royalty systems: for example, the Saskatchewan mineral royalty described in Case Study 4 was actually a progressive rate of return tax. The simple royalty offers little opportunity to influence the structure of the mining industry. Some jurisdictions have introduced more complicated systems with lower royalty rates for minerals which are subject to further processing within the State or Province: for example, in Western Australia the royalty rates are 10% ad valorem on material ex-mine, 7.5% on crushed and screened, 5% on concentrates, and 2.5% on metals. Many States and Provinces have been involved in disputes of various kinds with their federal governments and this has sometimes led to unusual taxation measures: for example, Queensland collects some of its royalties in the form of excess freight charges on the State owned railways.

While they do not own the on-shore mineral reserves, federal governments have sought in various ways to obtain a share of the revenues derived from the exploitation of these resources. The simplest method is through an export tax which reduces the price to the domestic producer and results in revenue to the federal government: for example, coal and oil exports from Australia are subject to a levy. In Queensland, export coal is subject to an implicit specific royalty in the form of an excess state railway freight charge, and to the federal coal export levy. Cassing and Hillman (1982) have modelled this situation as a noncooperative game, with each level of government attempting to maximize its own revenue given the actions of the other level, and without consideration for the effect on the level of coal production and exports.

The objective of a mineral royalty system is to obtain a reasonable proportion of the value of the mineral in the ground for the resource owner. A royalty system which does not discourage mineral extraction contributes to this aim. Royalties levied on a specific or ad valorem basis delay the extraction of mineral reserves, and render marginal resources uneconomic. Royalties levied on pure profits, on the other hand, will not affect the extraction decision. An attempt to design a non-distortionary mineral tax system resulted in the resource rent tax which is levied on mineral projects under federal jurisdiction in Australia. The tax is levied on a project (rather than a firm basis) and is not payable until such time as the project has achieved the required rate of return for its investors.

The resource rent tax (RR T) operates by specifying the rate of return which investors require to cover the cost of capital. This rate is the rate of return which could have been earned on a similar project elsewhere. The initial project investment is compounded forward at the required rate to give an indication of the funds that would have accumulated from an alternative investment. These funds can be thought of as a "capital recovery bank" - a

24

measure of the amount of money the investors need to recoup to receive the required rate of return. Invested funds are recouped from the operating profits of the project - the revenues less the operating costs. Each year annual operating profits are subtracted from the capital recovery bank to reflect the repayment of capital, and the balance is compounded forward at the required rate of return. When the balance has fallen to zero the investors have achieved the required return on the project. Any further operating profits constitute a rent - a payment in excess of that required to commit capital to the project. The rent is then taxed at a reasonably high rate - 40% in the Australian case.

A disadvantage of a profits based royalty system, such as the RRT, is its complexity; firms' accounts do not record profits on a project basis. Furthermore, since profits tend to be more variable than output, the revenues obtained from a profits tax will be more variable than those obtained from a specific or even an ad valorem royalty. A compromise between the two types of system was suggested by the Mineral Revenues Inquiry of Western Australia: all mining projects would pay an ad valorem royalty, and large projects would also pay a tax on net value or profit.

8. EVALUATING MINING PROJECTS

In evaluating a mineral prospect a firm has to decide how much to invest in gathering information prior to making a decision about extraction. Information should be gathered to the point at which the expected marginal benefit equals the marginal cost. The expected marginal benefit of information depends partly upon the expected net present value of the deposit, if extracted. The firm needs a way of working out the net present value of the proj ect corresponding to known and anticipated characteristics of the deposit, such as configuration and size of ore body and grade of ore. In this Section we first consider a model which can be used to determine the net present value of a mineral deposit. We then analyse the exploration decision.

8.1 The Net Present Value of a Deposit

In practice mining firms are both resource owners and resource extractors. A competitive mining firm is faced with the same kind of problem as that of the investor selling reserves to a competitive mining industry as described in Section 3: allocating the reserves over time so as

to maximize the present value of the asset. If the same extraction cost conditions are assumed - as in the industry analysis, the same result should be obtained for the firm as for the industry - that the rate of supply of the mineral product declines over time. Some researchers such as Miller and Upton (1985) have examined the extraction profile of mining firms to test this hypothesis. However there is a significant difference between the structure of a mining project and the industry model of Section 3: the mining project has an initial irreversible investment in productive capacity. Once this investment has been undertaken the value of the mine will be maximized by operating it at full capacity for most of its life. This point was recognized by Paish (1938) and has been demonstrated by Campbell (1980).

Paish's approach was to choose a constant rate of extraction that maximized the net present value of the mine, subject to the resource constraint presented by the limited size of the deposit. It is useful to distinguish between capital costs, which vary positively with the extraction rate, and operating profits which are the project revenues less the variable costs. An increase in extraction rate increases the scale of the project and raises capital costs; it also

25

raises the level of operating profit and shortens the life of the mine because of the resource constraint. Generally an increase in project scale raises the present value of the operating profit. The optimal scale is where the marginal increase in present value of operating profit falls to equal the. marginal capital cost of the increase in scale. This point is illustrated in Figure 14.

A realistic model of a mineral project will recognize that several processes are being undertaken: ore is extracted from the mine, and then processed in a mill before being transported to market; and employees of the mine and mill may be housed in a town. The capital and operating costs of these processes need to be included in the model. Furthermore, it is desirable to incorporate the geology of the resource in the model so as to generate a "geoeconomic" model. This can be done simply by specifying the size and grade of the depost, or alternatively by taking its physical configuration into account.

Figure 15 is a two-dimensional representation of a hypothetical mineral deposit which is to be exploited by means of an open-pit mine. The deposit is assumed to be a cylinder of a certain radius, b, commencing a certain depth below the surface. Mining consists of removing the overburden, which involves a capital cost, and then removing successive layers of waste in order to mine the ore. This representation assumes away many of the questions which confront mining engineers. For example, the radius of the deposit and its terminal depth are choice variables which depend on ore grades and mining costs; and the slope of the pit is a choice variable which is governed by the risk and cost of a collapse of the pit wall. Nevertheless the geoeconomic model can be used as the basis of a net present value maximizing model to work out the optimal extraction rate.

The key variable to determining the terminal depth of the pit is the stripping ratio - the ratio of waste to ore. As can be seen from the two dimensional model of Figure 15, the stripping ratio at depth dt is given by: set) = dt/b sin(a). As the depth of mining increases the stripping ratio rises. lfthe operating cost of mining a tonne of material is $c, it costs $c (l+s(t)) to mine a tonne of ore. Ore will be mined only as long as the mining operating costs are covered by the minehead price of ore. Hence the terminal depth of the pit can be obtained by solving the equation: p'" = C (1 + dt/b sin(a)), where pm is the minehead price. The three dimensional version of this equation is derived in a paper by Campbell and Scott (1980) which analyses the costs of different scales of operation of three uranium mines in the Alligator Rivers region of the Northern Territory of Australia.

The minehead price of ore is the market price of the processed material obtained from one tonne of ore less the unit transportation and milling costs. The unit mining and milling operating costs depend on the scale of the project: generally economies of scale are expected so that unit operating costs fall as scale increases. This means that a large scale project will operate to a greater terminal depth than a small scale project because pm will be higher and $c lower. If a royalty is imposed it will have the same effect as a rise in unit mine operating cost: a rise in $c will reduce the terminal depth of the pit with the result that some ore which would have been worth extracting in the absence of the royalty will be abandoned.

If estimates of mining, milling and other cost structures are available, the mining project can be simulated at various scales. It is convenient to use the milling rate as the measure of scale as the rate of mining material has to adjust to the needs of the mill for ore. As project scale increases the amount of ore to be mined may rise because of scale economies,-but the life of the mine may nonetheless decline because of the higher rate of extraction. The optimal

".

26

milling rate is the one associated with the highest net present value of the mine. This model can be used to determine the extraction rate which a firm will choose to maximize the present value of its profits net of taxes and royalties. The effect of the tax and royalty regime can be estimated by comparing this rate with the rate which would be chosen in the absence of taxes and royalties. Case Study 4 describes the use of this model to analyse the effects of the Saskatchewan mineral royalty system.

The model can be used more generally to assess the viability of a mining project under alternative marketing, procurement and financing arrangements. Emerson (1984) describes a mineral processing project evaluation model which takes these issues into account. In his model the rate of output of the project is held constant throughout the analysis. The advantage of a geoeconomic model as described in this Section is that decisions about taxation and other arrangements can be allowed to impact on the design of the mine and mill complex thereby taking account of a wider range of possible outcomes of government policy decisions.

8.2 The Value of Information about a Deposit

Mineral exploration takes many forms, ranging from general exploration of a territory, identifying specific areas of high mineralization, locating deposits, estimating the size and grade of deposits, and establishing the configuration of deposits prior to preparing a pit design. The benefits of exploration may be widely distributed, as in the case of a published geological survey of a region, or, at the other extreme, may accrue only to the firm which holds the mining rights to the deposit. The findings of the former kind of exploration are a public good, which is why government is usually involved in this kind of activity. In this Section we are concerned with the latter kind of exploration which is undertaken privately for the benefit of the individual firm.

Exploration provides information about a mineral deposit, and the value of that information can be assessed using the economic theory of information. Information theory argues that the value of information is the excess of the expected value of the decision that is made with the information over the value of the decision which would be made without the information. To choose the optimal amount of information to acquire, the firm must estimate the value of information prior to exploration. This involves taking a view about what the information is likely to contain. In other words, the firm asks itself three questions: where are we now? where are we likely to be after undertaking exploration? and, following from the first two questions, how much better off are we likely to be after exploration?

In the example which follows we abstract from two factors which affect the value of information: one is the degree of risk aversion of the firm, and the other is the quality of the information which can be obtained. Exploration will alter the firm's beliefs about the value of a deposit if mined. The firm's beliefs can be summarized by a probability distribution, and exploration may either raise or lower the mean, but will certainly lower the variance of that distribution. The variance of the distribution is a measure of the risk the firm faces, and a lower variance provides a benefit to the firm in the form of a reduction of the cost of risk. To exclude this benefit from our example, we assume that the firm is risk neutral. The value of information to the firm depends on how reliable the information is believed to be. If information is thought to be unreliable it will have little effect on the firm's beliefs and hence little chance of affecting the firm's decision. Since the value of information lies in its potential to contribute to a better decision, the better the quality of information is~ th~ught to be the

27

higher its value. In our example we assume that the information which can be obtained from exploration is perfect, meaning that it is completely accurate.

Suppose that on the basis of the initial survey of potentially oil bearing structure the firm has decided that it will cost $20 million to exploit, and that the value of the recovered oil will be either +$40 million, with probability 0.6, or zero, with probability 0.4. This means that the firm's prior beliefs about the net present value of the prospect are summarized as: +$20 million with probability 0.6, and -$20 million with probability 0.4. Suppose that the firm can obtain perfect information about the state of nature: an exploration well will either be "wet", in which case the prospect is worth +$20 million if extracted, or "dry", in which case it is worth -$20 million, if developed. If after drilling the well the firm receives the message "wet" it will mine the prospect, and, conversely it will abandon the prospect if it receives the message "dry". If it does not undertake the exploratory well it will exploit the deposit because its expected net present value is +$4 million; the latter figure is termed the value of the prior optimal act.

The limited set of options which we have allowed the firm are illustrated by the decision tree in Figure 19. If the firm takes the "don't explore" option the prospect has an expected net present value of $4 million as explained above. If it takes the "explore" option it expects to receive the message "wet" with probability 0.6, and the message "dry" with probability 0.4: these expectations are derived from its prior belief that the probability of the structure containing commercially recoverable oil is 0.6. If the firm receives the message "wet" it will develop the prospect and gain a net present value of +$20 million; if it receives the message "dry" it will abandon the prospect. The expected net present value of following the "explore" option is +$12 million, which is $8 million higher than the expected value of the "don't explore" option. We conclude that the information to be gained from exploration has an expected value of +$8 million. If the cost of an exploratory well is less than this amount, then the expected net value of exploration is positive and the firm should act to acquire it prior to making a decision about the prospect.

Campbell and Lindner (1987) expand this example to include risk aversion on the part of the firm, which tends to raise the value of information, and less than perfect information, which tends to lower its value. They also distinguish between uncertainty, exploration risk and development risk. In our example we considered only the value of information in reducing uncertainty about the value of the prospect if exploited. Exploration also reduces the risk associated with developing the prospect, but carries with it the risk that the project may-be - abandoned. The decision tree of Figure 19 can be expanded to include these considerations.

9. SUMMARY

This paper has reviewed the main factors which determine the course of mineral prices in the long-term. They can be divided into two main groups - demand factors and supply factors. Demand for minerals is a derived demand, depending on factors such as income, population, tastes and relative prices which determine the demand for the consumption goods which use minerals in their production processes.. Minerals are intermediate goods which enter the production processes of final demand goods. Changes in the technology of those processes affect the degree of substitutability of other inputs for minerals, thereby affecting elasticities of demand for minerals and the associated price responses to changes i~ mineral outputs.

28

Changes in technology elsewhere in the economy can lower the cost of substitute products for minerals, thereby limiting the potential for mineral price increases in the future.

While demand factors are important, the main focus of the paper is on the effect on mineral prices of changes in supply factors. Supply factors can be divided into two main groups: cost factors and institutional factors. Cost factors include: actual or anticipated changes in scarcity, as a result of the combined effects of exploration and depletion, which alter the amount of the scarcity rent component of unit cost; changes in the quality of deposits which influence the cost of extraction; and changes in mining technology which lower cost by making more efficient use of mineral deposits and other inputs to the mining process. Perhaps the most important institutional factor is the industrial structure of the mining sector; the formation of a mineral cartel can result in a substantial increase in mineral price, and in prices being held above the competitive level for a considerable period. Incomplete property rights to mineral deposits are another important influence: insecure or short-term tenure of mineral deposits encourages higher extraction rates and lower mineral prices than in a perfectly competitive environment; and a reduced share of the benefits of mineral exploitation, as a result of an increase in royalty rate or other forms of mineral taxation, may provide an incentive to slow down the rate of extraction, thereby tending to drive mineral prices up. While the real rate of interest is an important underlying factor which influences the supply of deposits for extraction, it is relatively constant over time, exerting a steady upwards pressure on mineral prices which, in the recent past, has generally been more than offset by changes in other supply factors.

29

CASE STUDIES

CASE STUDY 1:

THE TIME-PATH OF MINERAL PRICES

The models discussed in Section 3 suggested that reductions in extraction cost because of improved technology, or the prospect of additional sources of a mineral being obtained through exploration or recycling, would lead to the time-path of mineral price being Ushaped. Margaret Slade published a study in 1982 entitled "Trends in Natural Resource Commodity Prices: An Analysis of the Time Domain" which tests this hypothesis for the following range of commodities and periods: aluminium (1890-1978), copper (1880-1978), iron (1880-1978), lead (1880-1978), nickel (1910-1978), silver (1880-1978), tin (1880-1978), zinc (1880-1978), coal (1880-1978), natural gas (1920-1978), and petroleum (1880-1978).

Slade's approach was to estimate the following regression equation for each commodity:

Pt = a + bt + ct2 + Ut

where Pt is the real price of the commodity at time t in 1967 US dollars, t is the year, Ut is a disturbance term, and a,b, and c are constants. If the commodity price follows aU-shaped time-path, the fitted value of the coefficient b will be significantly different from zero and negative, and that of c positive. An insignificant value for c, together with a positive value for b would indicate that the commodity price trend is consistently positive over the period, as predicted by the simple model of Section 3.1. If neither b nor c were found to be significantly different from zero, then the commodity price has no time trend, only cyclical fluctuations.

Slade found that the signs of the estimated band c coefficients were consistent with the hypothesis of a U-shaped time-path of price. For aluminium, copper, iron, silver and natural gas the evidence was very strong with the coefficients band c being significantly different from zero at the 99% confidence level. For zinc, coal and petroleum the confidence level was 95%, and for nickel, 90%. For tin the estimate of the b coefficient was not significantly different from zero, although the c coefficient was significant at the 95% level. Lead was the only commodity for which no significant evidence of a price trend of any kind could be found. The base of the U -shaped curve marks the time at which resource scarcity starts to have an impact on commodity prices. This occurred in different decades for different minerals: aluminium (1960), copper (1940), iron (1920), nickel (1940), silver (1940), tin (1900), zinc (1930), coal (1900), natural gas (1950), and petroleum (1910).

CASE STUDY 2:

PROSPECTS FOR AN INTERNATIONAL TIN CARTEL

Prior to the Second World War the major tin producing countries, such as Malaya and Thailand, had managed to exercise some influence on the world price of tin. Following the War the International Tin Council, consisting of major producing and consuming countries was formed to determine a range for the price of tin, and to maintain the price within that range by the use of a buffer stock. Since both producers and consumers were represented on the ITC it was not a cartel as defined in Section 5. This Case Study describes an analysis of the prospects for an international cartel of tin producers similar to that of oil (OPEC), copper (CIPEC) or bauxite (IBA) producing countries. The major tin producing countries in the 1970s were Malaysia, Thailand, Indonesia, Bolivia, Nigeria and Zaire. Together these

Competitive Industry Cartelized Industry

85.6 66.6

161.4 176.6

247 245

30

countries had about two-thirds of the world's reserves and supplied around 80% of output. The analysis was conducted by William Low in 1981 at the University of British Columbia.

Low's approach was to use the competitive model of Section 3 and the cartel model of Section 5 to determine alternative dynamic equilibrium price paths for the world tin industry. These competitive and cartel industry price paths have different implications for the net present value of profits of the major producing countries. Low argues that a significantly higher net present value of the resources of the major producers in a cartelized industry will be necessary to cover the costs of negotiating and enforcing output levels of its members. Other researchers, such as Pindyck (1978), have suggested that an improvement of around 30% in net present value is necessary to provide sufficient incentive for the formation and operation of a cartel.

Using published estimates of world supply and demand elasticities, Low constructed the linear demand and supply curves illustrated in Figure 17. The supply curves are obtained by summing the marginal cost of production from identical deposits. Since the cartel would control more deposits than the competitive fringe, its supply curve would lie below that of the fringe; and if all deposits were exploited by competitive firms, the supply curve of the competitive industry would lie below that of the cartel. The demand curve has a choke price of$18.30 per lb, in 1975 US dollars, as compared with the 1978 price of$6.30.

The demand and supply information in Figure 17 is used to solve for alternative solutions to the dynamic equilibrium price path of the world tin industry starting in 1978 and using a real rate of interest of 5% per annum. These solutions are illustrated in Figure 18. In the competitive case, initial price is estimated at $6.83 per lb, which is slightly higher than the observed 1978 price. The world's reserves are predicted to last for 82 years. Under a cartel, initial price is significantly higher at $8.93 per lb, and the world's reserves last for 141 years. The competitive producers drop out of the industry after 65 years beyond which point the cartel acts as a monopoly.

The important question is the relative net present value of the reserves of the six cartel members under the alternative industry structures. The net present value estimates corresponding to the alternative price paths are reported in the following Table. It can be seen that the net present value of the reserves of the six main producers rises from $161.4 billion to $176.6 billion as a result of forming a cartel. This rise of around 9% is judged to be an

Value of the World Tin Industry Under Alternative Industry Structures Net Present Value of Deposits

(Billions of 1975 US Dollars)

owned by

Competitive Frin e

Cartel

Total

31

insufficient incentive for the formation of a cartel. It is interesting to note that, contrary to the prediction of the cartel model with no production costs, the competitive fringe is actually worse off under a cartelized industry structure. This can be attributed to higher rates of production by the competitive fringe early in the industry's future life. These higher production rates bring forward in time higher extraction costs which would have been postponed under a competitive industry structure.

Low's study offers two predictions which can be tested against the facts. First, he predicts that the major world tin producers will not be able to collude to raise tin prices in the way that the OPEC and uranium cartels were apparently able to do in the post 1970 period. In addition to predicting the existence of an essentially competitive industry, Low also predicts the future path of the world price of tin under that form of industry structure. It can be seen from Figure 17 that, under a competitive industry structure, the net price of tin (the price less marginal cost) will need to rise to $16.87 per lb after a period of 82 years from 1978. Since net price rises at the rate of interest, we can tell what the predicted net long-run equilibrium price is in any year. The observe price may differ from the predicted price because of short-run fluctuations in the world economy.

Low's model omits many factors which determine the future price of tin. It makes no allowance for outward shifts in demand over time as a result of economic growth, or for increases in supply due to new discoveries. Nevertheless it gives some important insights into the effect of market structure on the price of an exhaustible resource.

CASE STUDY 3:

THE EFFECT OF A ROYALTY ON WESTERN AUSTRALIAN IRON ORE PRODUCTION

In the 1983-84 financial year the State of Western Australia collected $71 million dollars in royalties from the iron ore industry, representing around 5% of state government revenue from all sources. The royalty system is of the kind discussed in Section 2.7: export lumps are charged at a 7.5% ad valorem rate (with a minimum of 60 cents per tonne), export fines at 3.75% (with a minimum of 30 cents per tonne), and ore used in Australia at 15 cents per tonne. Williams and Fraser (1985) have used supply analysis to estimate the effect of this royalty system on the level of output or iron ore.

In Williams and Fraser's model mining firms choose a desired level of output to maximize profit, which is defined as revenue less costs and royalty payments. Assuming the cost function is of the form c(q) = aq«l+b)/b>, the first-order condition for profit maximization, net price equals marginal cost, yields the following expression for desired rate of output:

In qt * = S + b In R,

where qt* is desired rate of output at time t, R, is the net price of iron ore (price less the specific royalty) at time t, In denotes the natural logarithm, and sand b are constants. Actual output may be different from the desired level because of technological, management, industrial relations, and environmental constraints on output which take time to overcome. These constraints are summarized by the following equation:

32

where qt represents the actual level of output, c is a constant reflecting long-run growth plans, and d < 1 is a constant reflecting the speed of adjustment of actual output to its desired level.

The two equations of the model can be combined to give a single equation determining the level of actual output:

In qt = (sd + c) + bd In R, + (I-d) In qt+1.

CASE STUDY 4:

TAXATION AND SASKATCHEWAN URANIUM MINING

This equation was estimated using data for the period 1961-62 to 1981-82, and an estimate of 0.61 was obtained for the value of bd. This suggests that in the short-run a 1 % reduction in net revenue per tonne caused by a rise in the iron ore royalty would reduce output by 0.61 %. In terms of royalty rates and receipts, a 1 % reduction in net revenue per tonne is equivalent to an 18.18% increase in the royalty rate which would increase royalty receipts by 17.57% in the short-run. The long-run elasticity of supply is given by the value of the constant d, which can be estimated to be 4.36. As expected, the higher value of the long-run elasticity of supply indicates that the long-run effect on output of an increase in royalty would be more significant than the short-run effect. In the long-run an 18.18% increase in the specific royalty rate would raise government revenue by less than 14% and would reduce output by 4.36%.

A study by Campbell and Wrean (1984) used the open-pit mine model of Section 8 to analyse the effect of the Saskatchewan Uranium Royalty (SUR) on the extraction decision of mining firms and on the net present value of deposits. The SUR consists of a basic royalty in the form of an ad valorem tax on production, plus a graduated royalty in the form of a graduated rate of return tax. The graduated rate of return tax is a form of the RR T described in Section 8: once the project's capital recovery bank has been exhausted the operating profits are taxed at a rate which is determined by the project's rate of return as measured by the ratio of operating profit to initial capital investment. The higher the rate of return the higher the rate of tax on operating profit. In addition to the SUR projects were liable to the normal federal and provincial corporation income taxes.

Campbell and Wrean used a hypothetical mine similar to the proposed Key Lake Mine for their analysis. The Key Lake proposal was an open-pit mine as illustrated in Figure 15 and the mining model incorporated pit data consistent with the dimensions of the Key Lake deposit. The cost data were obtained by adjusting to reflect Canadian conditions the cost structure used by Campbell and Scott (1980) in their study of the Ranger, Pancontinental and Nabarlek uranium mines in Australia.

The privately optimal extraction rate under the SUR was found to be around 60% of the optimal rate in the absence of taxation. Despite this significant difference the gross value of the mine - its value to shareholders plus the value of the tax revenues paid to government - was only 3 % lower under the tax system than in the absence of taxation. This suggests that the NPV(Profit) curve of Figure 15 has very little curvature in the case of the Key Lake project. Depending on the price of uranium the tax share of the value of the project was predicted to be between 45 and 67% of the gross value of the mine. This represents a very favourable trade-off of efficiency against equity since the efficiency cost of the SUR is estimated at less than 5% under all price conditions considered.

33

While the Campbell and Wrean study was concerned with the performance of the mineral tax system from a social viewpoint, their model could have been used to undertake a detailed assessment of the social benefits to be obtained from the project. In a benefit-cost analysis of a hypothetical mineral processing project in Australia, Emerson (1984) takes account of foreign equity participation and the repatriation of profits, tax effects, overseas borrowing and the choice of discount rate, future prices of output and inputs, and possible environmental effects. This kind of study can be conducted on a spreadsheet and can be used to determine the sensitivity of the net benefits to the host country of alternative tax and financing arrangements and alternative price outcomes.

REFERENCES

Brooks, D.B. (1973) Minerals: an Expanding or Dwindling Resource? Mineral Bulletin MR 134, Ottawa, Department of Energy, Mines and Resources, pp. 17.

Campbell, H.F. (1980) "The Effect of Capital Intensity on the Optimal Rate of Extraction of a Mineral Deposit", Canadian Journal of Economics, Vo1.13, No.2, pp. 349-356.

Campbell, H.F. and Scott, A.D. (1980) "Costs of Learning about the Environmental Damage of Mining Projects", Economic Record, Vol. 56, No. 152, pp. 36-53.

Campbell, H.F. and Wrean, D.L. (1980) "Tax Neutrality and the Saskatchewan Uranium Royalty", Resources Policy, Vol. 10, No.1, pp. 31-36.

Campbell, H.F. and Lindner, R.K. (1987) "Does Taxation Alter Exploration: the effect of uncertainty and risk", Resources Policy, December, pp. 265-278.

Cassing, lH. and Hillman, A.C. (1982) "State-Federal Resource Tax Rivalry: the Queensland Railway and the Federal Export Tax", Economic Record, Vol. 58, pp. 235-241.

Cremer, J. and Weitzman, M.L. (1976) "OPEC and the Monopoly Price of World Oil", European Economic Review, Vol. 8, pp. 155-164.

Emerson, C. (1984) "Economic Evaluation of Mineral Processing Projects" in P.J. Lloyd (ed.) Mineral Economics in Australia, pp. 253-272, Sydney: Allen and Unwin.

Hotelling, H. (1931) "Economics of Exhaustible Resources", Journal of Political Economy, VoL 31, pp. 137-175.

Low, W. (1981) "Viability of an International Tin Cartel: a Nash-Cournot Model", Department of Economics, University of British Columbia, unpublished Honours Dissertation, pp. 64.

Miller, M.H. and Upton, C.W. (1985) "A Test of the Hotelling Valuation Principle", Journal of Political Economy, Vol. 85, No.1, pp. 1-25

Paish, F.W. (193"8) "Causes of Changes in Gold Supply", Economica, Vol. 5, pp. 379-409.

34

Pindyck, R.S. (1978) "The Optimal Exploration and Production of Non-renewable Resources", Journal of Political Economy, Vol. 86, No.5, pp. 841-861.

Pindyck, R.S. (1978) "Gains to Producers from the Cartelization of Exhaustible Resources", Review of Economics and Statistics, Vol. 60, No.2, pp. 238-251.

Salant, S. W. (1976) "Exhaustible Resources and Industrial Structure: a Nash-Cournot Approach to the World Oil Market", Journal of Political Economy, Vol. 84, No.5, pp. 1079- 1093.

Schulze, W.D. (1974) "The Optimal Use of Non-renewable Resources", Journal of Environmental Economics and Management, Vol. 1, pp. 53-73.

Slade, M.E. (1982) "Trends in Natural Resource Commodity Prices: an analysis of the Time Domain", Journal of Environmental Economics and Management,Vol. 9, pp. 122-137.

Williams, K.G. and Fraser, R.W. (1985) "State Taxation of the Iron Ore Industry in Western Australia", Australian Economic Review,lst. Quarter, pp. 30-36.

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DISCUSSION PAPERS IN ECONOMICS PUBLISHED IN 1999

(A complete list of Discussion Papers in Economics is available upon request.)

251. Dragun, A.K., Environmental Institutional Design. Can Property Rights Theory Help?, January 1999.

252. Jun Wang, Entrepreneurship, Institutional Structures and Business Performance of the Overseas Chinese, March 1999.

253. Araya, B. and Asafu-Adjaye, J., Returns to Farm-Level Soil Conservation on Tropical Steep Slopes: The Case of the Eritrean Highlands, April 1999.

254. Purcell, T., Beard, R. ~lDd McDonald, S., Walrasian and Marshallian Stability: An Application to the Australian Pig Industry, April 1999.

255. Karunaratne, N.D., The Yield Curve as a Predictor of Growth and Recession in Australia, May 1999.

256. Cage, R. and Foster, J., Overcrowding and Infant Mortality: A Tale of Two Cities, June 1999.

257. Lougheed, A., Economic Liberalism, Economic goals, and Economic Policy.

Towards Utopia, Brave New World, or Hell on Earth?, June 1999

258. Evans, E., Economic Nationalism and Performance: Australiafrom the 1960s to the 1990s, June 1999. (Ninth Colin Clark Memorial Lecture)

259. Campbell, H.F., Natural Resource Economics: An Introduction, July 1999.