Resources and Environmental Economics

ECON F471

Lecture 5.3-5.4

Dynamic Efficiency
BITS Pilani Sustainable Development
K K Birla Goa Campus
Swagat Kishore Mishra
 Dynamic Efficiency (cont.)
• Dynamic efficiency: allocate resource use over time so
that the present value of the net benefits are
maximized.
• We will start with a two period model:
• Assumptions:
– fixed supply of resource to allocate over 2 periods
– Demand (marginal willingness to pay) function is
constant, i.e., the inverse demand function, is given by : P
= 8 -0.4q
– marginal cost of extraction is constant $2/unit
– interest rate is 10%
• Dynamic efficiency balances present and future uses of a
depletable resource by maximizing the present value of the
net benefits derived from its use.
• According to the dynamic efficiency criterion, the
efficient allocation is the one that maximizes
the present value of the net benefit. The present value
of the net benefit for both periods is simply the sum of
the present values in each of the two periods.

• To take a concrete example, consider the present value

of a particular allocation: 15 units in the first period
and 5 in the second.
 How would we compute the present value of
that allocation?
• The present value in the first period would be that
portion of the geometric area under the demand
curve that is over the supply curve—$45.00
• The present value in the second period is that portion
of the area under the demand curve that is over the
supply curve from the origin to the five units produced
multiplied by 1/(1 + r).

• If we use r = 0.10, then the present value of the net

benefit received in the second period is $22.73, and
the present value of the net benefits for the two
years is $67.73.
 Having learned how to find the present value of net
benefits for any allocation, how does one find the
allocation that maximizes present value?

• The dynamically efficient allocation of this

resource has to satisfy the condition that the
present value of the marginal net benefit from
the last unit in Period 1 equals the present
value of the marginal net benefit in Period 2
More insights
 Two Period Model
– Note if total supply is greater than 30, the efficient
allocation would be 15 units/period, regardless of
interest rate.
– In this case static efficiency is sufficient.
– One period’s consumption does not affect the other
period’s consumption. In this sense, they are
independent.
Fig. 5.1 (modified, not shown in text) An arbitrary allocation of an limited depletable
resource (q1=15, q2=5)

9.0 9.0

8.0
8.0
P.V. Net Benefits= Net Benefits=
0.5*(6)*15=$45 7.0 0.5*(6+4)*5=$25
7.0
P.V.=25/(1.10)=$22.73
6.0 6.0

Price ($/unit)
Price ($/unit)

5.0 5.0

4.0 4.0

3.0 3.0

2.0 2.0

1.0 1.0

0.0 0.0

0 5 10 15 20 25 0 5 10 15 20 25

Quantity Quantity

(a) Period 1
P.V. Total Benefits (b) Period 2
= $67.73
 Two Period Model
– How do we find the allocation that gives us maximum
present value net benefits? We could guess or have a
computer search iteratively.
– But the best way is use economic logic (and/or math)
– Dynamically efficient allocation requires that the present
value of the marginal net benefit (PVMNB1) in period one
equals the present value of the marginal net benefit in period
two (PVMNB2).
– Fig. 5.2 shows the PVMNB for each period. Period 1 is read
from left to right and period 2 is read from right to left. Note
that the intercept for period 1 is $6 ($8-$2), but intercept of
period 2 is $5.45 (=$6/1.1)
 Fig. 5.2 The optimal allocation of a limited depletable resource

P.V.MNB1
P.V.MNB2
P.V.NB1 =
0.5*(6+1.905)*10.238= 5.45
$40.466 P.V.NB2 =
0.5*(5.45+1.905)*9.762=
$35.90

MUC 1.905

Quantity in
Period 1
20 19 18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0 Quantity in
Period 2

q1=10.238, q2=9.762
 Two Period Model
– The solution set is q1=10.238 and q2=9.762. The Total PV of
the net benefits equals $40.47 in period 1 plus $35.90 in
period 2, i.e., $76.37. This is the maximum PVNB. Recall for
example, that in the q1=15 and q2=5 allocation, PVNB =
$67.73
– This solution occurs where the two PVMNB curves cross. The
vertical distance where they cross is referred to as the
marginal user cost.
– marginal user cost (MUC) is the present value of the
foregone opportunities at the margin.
– in this example the MUC is $1.905, indicating that use of the
resource today will reduce the present value of future net
benefits by $1.905
 Two Period Model
– Thus, the PVMNB of the last unit used in period 1 should
be worth $1.905. If it is worth more in period 1, than we
should consume more in period 1 until the PVMNBs are
equal. If it is worth more in period 2, than we should
consume more in period 2 until the PVMNBs are equal.
– Price in period 1 should be $3.905 = 8-.4*10.238.
– Price in period 2 should be $4.095 = 8-.4*9.762.
– The actual marginal user cost rises at the rate of
interest. $1.905*(1+.1) = $2.095.
 Measuring economic scarcity. . .

• Economic scarcity is NOT a measure of how many physical

units of a good exist: it is NOT a measure of physical
abundance

• It is marginal user cost