What Is Hotelling's Theory?
Let me explain Hotelling's theory, also known as Hotelling's rule, directly to you. It states that if you own nonrenewable resources, you'll only produce and sell basic commodities from them if that action gives you a better return than putting your money into financial instruments like U.S. Treasury bonds or other interest-bearing securities. This assumes markets work efficiently and that you're driven purely by profit.
Economists use this theory to forecast prices for things like oil and other nonrenewable resources, tying it all to current interest rates. The rule comes from Harold Hotelling, an American statistician.
Key Takeaways
- Hotelling's Theory sets the price or yield point where a nonrenewable resource owner decides to extract and sell instead of waiting.
- It compares that to returns from U.S. Treasury bonds or similar secure investments.
- Harold Hotelling, the American statistician, created this rule.
Understanding Hotelling's Theory
As an owner of a nonrenewable resource, you're faced with a key choice: leave it in the ground hoping for a higher price next year, or pull it out now, sell it, and invest the money in something that earns interest. That's the core of Hotelling's theory, and I'll walk you through it.
Take an iron ore deposit owner as an example. If you expect iron ore prices to rise by 10% in the next year, but the real interest rate you can get on investments is only 5%, you'd hold off on extracting. Hotelling ignores extraction costs here. Flip it—if prices rise by 5% but interest is 10%—you'd mine, sell, and invest for that 10% return. At equal rates, say 5% each, you'd be neutral.
Theory and Practice
The gap between marginal extraction costs and the resource's price is what we call Hotelling rent. According to the theory, the price change rate for a depletable resource should match the discount interest rate used by the extractor—this is the Hotelling r-percent growth rule. When extraction costs are zero, prices for extracted and unextracted resources align, and the rule holds for both. But if costs rise over time, resource prices should increase slower than the interest rate.
So, if everything else stays the same, a higher discount rate means a pricier unextracted resource, pushing faster extraction. In theory, prices of nonrenewables like oil, copper, coal, iron ore, zinc, or nickel should follow real interest rate trends.
But in reality, a 2014 study from the Federal Reserve Bank of Minneapolis found the theory doesn't hold up. They looked at basic commodities, and their price growth rates were all below—sometimes way below—the average U.S. Treasury rates. The researchers pointed to extraction costs as the likely culprit.
Who Was Harold Hotelling?
Harold Hotelling lived from 1895 to 1973 and was an American statistician and economist. He worked at Stanford and Columbia Universities early on, then at the University of North Carolina-Chapel Hill until retiring. Beyond his theory on nonrenewable resource prices, he's recognized for Hotelling's T-square distribution, Hotelling's law, and Hotelling's lemma.
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