The Interaction of Scale Economies and Energy Quality

Ubiquitous in the natural resources literature is that resource scarcity is associated with high resource prices that incentivise the exploitation of marginal resources and the usage of alternatives. In this paper, this incentive is higher protability in the extractive sector, rather than simply a higher price for its output. Since energy is an essential input to the economy, its supply aspects the marginal products of other factors, and in general equilibrium its supply aspects the costs that the extractive industry faces. Energy sector protability is therefore ambiguously affected by the quality of available energy resources. There are conditions related to the returns to scale in the economy which can cause lower energy sector protability with lower energy quality. This means that marginal resources may be abandoned as high quality resources are lost. An economy which exhibits constant, or weakly increasing, returns to scale can operate at any level of energy quality, since protability rises with falling energy quality and we observe results consistent with the usual Hotellings Rule. However an economy which exhibits strongly increasing returns to scale cannot operate with only low quality energy resources and protability may fall with falling energy quality. It is therefore possible that an energy quality shock disincentivises, rather than incentivises, the use of marginal resources and alternatives. Ultimately, a strongly increasing returns to scale economy may have no steady state equilibrium under a decentralised market allocation, despite such an allocation being technologically feasible.