1 s2.0 S0928765502000210 Main

Resource and Energy Economics 24 (2002) 301325
Comparing tests of the theory of

exhaustible resources
Janie M. Chermak a, , Robert H. Patrick b,1
a
Department of Economics, University of New Mexico, 1915 Roma NE/SSCI, Albuquerque,

NM 87131-1101, USA
b Rutgers Business School, Newark and New Brunswick, Rutgers University,
180 University Avenue, Newark, NJ 07102, USA
Received 8 February 2001; received in revised form 3 January 2002; accepted 29 March 2002
Abstract
The empirical relevance of Hotellings exhaustible resource theory has been tested with primarily
negative results. Tests have been performed on various resources, at different levels of aggregation,
with varying market structures, and over different time periods. Consequently, it is difficult to draw
any general conclusions concerning the theorys applicability in explaining producer behavior,
given the assumptions and restrictions implicit in the data and tests. This paper compares test
results when the implicit restrictions associated with the data are removed. Employing a single data
set we compare the results for four published tests. Even with this uniform data set, two approaches
reject the theory while two do not.
2002 Elsevier Science B.V. All rights reserved.
JEL classification: Q30; L72; D21; C52
Keywords: Hotelling; Econometric tests; Exhaustible resources
1. Introduction
Does the economic theory of exhaustible resources adequately explain producer behavior? A substantial and substantive literature on testing the theory exists that, for the most
part, casts doubt on the theorys usefulness in describing producer behavior. In Chermak
and Patrick (2001), we empirically tested the theory with a micro-level data set and found
producer behavior to be consistent with the theory. While these results were in agreement
Corresponding author. Tel.: +1-505-277-4906; fax: +1-505-277-9445.
E-mail addresses: jchermak@unm.edu (J.M. Chermak), rpatrick@andromeda.rutgers.edu (R.H. Patrick).
1 Tel.: +1-973-353-5247.
0928-7655/02/$ see front matter 2002 Elsevier Science B.V. All rights reserved.
PII: S 0 9 2 8 - 7 6 5 5 ( 0 2 ) 0 0 0 2 1 - 0
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J.M. Chermak, R.H. Patrick / Resource and Energy Economics 24 (2002) 301325
with the results of some studies, they were contradictory to others. This raises a second
question: why do the results vary? Is it simply a matter that some producers and/or industries adhere to the theory, while others do not? Or is it due to other disparities? There are
many differences in the extant tests including: the resource(s) tested; market structure analyzed; aggregation level over time and/or resources, both across resource type (oil, natural
gas, etc.) and deposit (well, reservoir, industry); whether or not and, if so, how the in situ
resource price (which is not directly observable) is estimated; and the type of test employed.
In this paper, we compare the results from four empirical tests with divergent results,
Farrow (1985), Halvorsen and Smith (1991), Slade and Thille (1997), and Chermak and
Patrick (2001), using a uniform data set. These tests varied by resource(s) considered,
levels of aggregation (over resource deposits, resources, and time), period of time covered,
measurement of user cost, and test methodology. If the new results are consistent with each
other, we can draw the conclusion that the different outcomes in the original tests were due
to the implicit data restrictions. We employ the data and econometric results of Chermak and
Patrick and compare their original results to the results we obtain from the other three tests.
This allows us to compare the results without concern for the potential impacts of resource
or aggregation issues. However, even with this unified data set, the test results are mixed.
The new results are consistent with the original Farrow results. That is, neither finds support
for the theory. Whereas the original Halvorsen and Smith results did not find support for
the theory, the new results do support the theory. In the case of the Slade and Thille results,
while the original results found some support for the theory, the new results do not support
the theory. While these results do not allow us to unambiguously address the question at the
beginning of the previous paragraph, they do allow us to say the differences in the original
test results are not solely a product of the implicit data restrictions and variations across the
studies. Further, they do bring to question the measure of user cost employed in the tests
and the power of the test methodologies, and provide direction for future research.
In Section 2, we present the theory of exhaustible resources and develop the theoretical
basis for the extant tests. In this we offer a shorter, more direct route (relative to either
Halvorsen and Smith or Chermak and Patrick) to derive the result that user cost is equal to
the negative of the partial derivative of the final indirect cost function with respect to gross
production, which is used in a class of tests of the theory. Section 3 presents an extensive
review of the extant empirical tests. Section 4 discusses the data we use in this paper.
Section 5 presents the empirical specifications and estimates of the indirect cost functions
used in the tests. Section 6 presents the results of the tests. We also demonstrate the bias
inherent in explicit price path tests that use final rather than gross costs to measure user
cost and develop a data transformation on final costs to alleviate this bias. Section 7 offers
conclusions and directions for future research.
2. The theory of exhaustible resources
The primary test methodologies of the theory of exhaustible resource are:
Modeling the firm as producing the exhaustible resource and directly estimating the
dynamic optimality condition and then testing if the estimated parameters conform to the
theory, which is the predominant test in the literature.
303
Modeling an integrated firm producing and processing the exhaustible resource, estimating an indirect cost function restricted by the dynamic optimality condition, and then
testing whether the parameters of this restricted cost function are consistent with those
of the unrestricted cost function.
Modeling the firm as producing the exhaustible resource with production costs independent of stock and then testing whether price increases at the rate of interest.
We present the theoretic development of these methodologies below.
First, consider a firm that produces and processes a natural resource into a final product.
By relaxing the assumption that the cost function for the integrated firm is separable in final
(z) and gross (q) product, which is maintained in both Halvorsen and Smith (1991) and
Chermak and Patrick (2001), we are able to develop the user cost measure for the integrated
firm in a much simpler and direct fashion. While the results are analogous, the non-separable
cost function development directly leads to this result.
The firms indirect cost function for the final product, C is defined as
C(z(t),
q(t), W , R(t), t) min WX subject to z(t)=f (X f , q, t) and q=g(X g , R, t),
X
where W is the input price vector (for both gross and final product renewable inputs), R(t)
the remaining reserves at time t, q(t) = g(Xg , R, t) is the gross production function, X g =
{xj (t) : j = 1, . . . , j } are inputs into the gross production process, the final production of
natural gas (i.e. the amount that is input into the pipeline to be transported to purchasers) is
given by z(t) = f (X f , q, t), and X f = {xk (t): k = 1, . . . , K} are inputs used to process
gross production to arrive at the final product at each t. Gross product is naturally an input
into the production of the final product and is not necessarily the amount of natural gas that
can be sold by the firm. The removal of non-hydrocarbon gases from the natural gas and
other shrinkage generally prohibit this.2 Naturally, final production can be no greater than
gross production, i.e. z q.
The price-taking integrated firms objective is
T
max =
ert [P (t)z(t) C(z(t),
q(t), W , R(t), t)]dt,
z,q,T
subject to
= q(t),
R(t)
R(0) = R,
R(T ) 0,
the
where P(t) is the price of the final product in time t, r the relevant discount rate, R(t)
change in the resource stock, R(0) the beginning reserves, and R(T) the reserves, if any,
remaining at the terminal time, T. The present value Hamiltonian is
q(t), W , R(t), t)] (t)q(t),

H = ert [P (t)z(t) C(z(t),
2 The US Energy Information Administration (Natural Gas Annuals, various years) distinguishes gross withdrawals from final product as follows. Gross withdrawals are defined as full well-stream volume (excluding condensate separated at the lease), while dry natural gas production, or final product, is defined as gross withdrawals
less gas diverted for re-pressuring, quantities vented or flared, non-hydrocarbon gas removed in the treatment
or processing, and extraction losses. Thus, it is possible to increase final production without increasing gross
production by, for example, lessening diversions or decreasing vented or flared gas.
304
where (t) is user cost. Necessary conditions for an interior solution include;3
Hz = ert (P C z ) = 0,
(1)
Hq = ert C q = 0,
(2)
HR = = ert C R ,
(3)
)] (T )q(T ) = 0,
H (T ) = erT [P (T )z(T ) C(T
(4)
= q(t),
R(t)
(5)
R(0) = R,
R(T ) 0,
and
(T ) 0
(0 if R(T ) > 0).
(6)
Condition (1) is the traditional production result for a firm in a competitive output market; i.e. the firm produces the quantity that equates the output price to marginal cost. The
price-taking firm chooses the optimal level of final output based on (1). Since gross product
is an input into the production of final output and the firm is choosing the optimal final
output level, the firm is then minimizing the cost of producing the required level of gross
production for the optimal z. As such, the shadow value of gross product is determined by
(2), which does not require an explicit expression of the price of gross product. Rearranging
(2) results in;
= ert C q .
(7)
That is, user cost is equal to the negative of the partial derivative of the indirect final cost
function with respect to gross production. Given that C q < 0 (see Chermak and Patrick,
2001), user cost is positive. The shape of the extraction path is found by differentiating (2)
with respect to time, substituting in (3), and rearranging. This yields
q =
r C q C qz z C qR R C qt C R
.
C qq
(8)
As indicated by (7) and (8), neither the measurement of user cost nor the optimal extraction
path depends explicitly on a final product price path, as the producers expected price path
is implicit in the choices of the final output level, z(t), given the indirect cost function, C.
If final and gross production are equivalent (i.e. there is no processing of gross product
into final product), q(t) = z(t), then the relevant indirect cost function can be written as
C(q(t), R(t), W g , t) min
W g Xg ,
g
X
s.t. q = g(Xg , R, t).
This yields the traditional exhaustible resource model. The necessary conditions for an
interior solution include
Hq = ert (P Cq ) = 0,
HR = = ert CR ,
3
(9)
(10)
Subscripts, unless otherwise indicated, denote the partial derivative with respect to the subscripted variable.
305
H (T ) = erT [P (T )q(T ) C(q(T ), R(T ))] (T )q(T ) = 0,
(11)
= q(t),
R(t)
(12)
R(0) = R,
R(T ) 0,
and
(T ) 0
(0 if R(T ) > 0).
(13)
From Eq. (9), user cost at any time is the discounted difference between price and the
marginal cost of extraction, Cq ;
= ert (P Cq ).
(14)
The shape of the extraction path is found by differentiating (9) with respect to time, substituting (10), and rearranging. This yields
q =
rCq + P rP CqR R Cqt CR

.
Cqq
(15)
As indicated by (14) and (15), both user cost and the optimal extraction path depend explicitly on a final product price path.
The initial Hotelling (1931) model includes the restriction that marginal extraction costs
are independent of the extraction rate and stock. This implies
ert P = 0,
(16)
or
P = ert .
Thus, when extraction costs are independent of extraction rate, price is equal to the user
or scarcity cost of the resource. Differentiating (16) with respect to time and rearranging
yields Hotellings r-percent rule,4
r=
P
.
P
(17)
This result indicates that price increases at the rate of interest for an optimally exploited
resource when marginal costs are independent of extraction and extraction costs are not
dependent on remaining stock.
Eqs. (7), (14) and (17) are the basis for the empirical tests of the theory of exhaustible
resources found in the extant literature. Both (7) and (14) can be categorized as shadow
price type tests. While (7) allows for processing of the gross product to a final product and
incorporates a price path implicitly, (14) restricts final product to be equal to gross and
relies on an explicit price path with which to test the theory. Tests based on (17) are price
4 Hotelling relaxes assumptions on both extraction cost and market structure in subsequent portions of the paper.
Results are presented when costs are a function of both the extraction rate and cumulative extraction under both
monopoly and social optimums. The inclusion of cumulative production accounts for increased costs of extraction
as a mine goes deeper and the effects of cumulative production on the demand for durable commodities, such
as gold (p. 152). The inclusion of remaining reserves accounts for extraction cost due to grade changes or, as in
Hotellings case, costs increase due to distance.
306
behavior tests. This type test requires gross product be equal to final product and imposes
the additional restriction that costs are independent of the extraction rate. Empirical tests
from the three test categories are discussed in the following section.
3. Empirical tests in the extant literature

The implications of increased natural resource scarcity and its effect on economic growth
have been discussed since at least the 19th century (Ricardo, 1817; Gray, 1914; Hotelling,
1931). However, the theory was not empirically tested until the second half of the 20th century. The tests presented in this section are grouped according to the theoretic development
of the test.
3.1. Price behavior tests: (r = P /P )
The earliest empirical tests were price behavior tests that, as the name implies, focused
on price paths as indicators of scarcity and were based on (17). Included in this group are
Barnett and Morse (1963), Smith (1979), and Slade (1982). Barnett and Morse (1963) tested
the hypothesis that economic scarcity of natural resources, as measured by the real cost of
extractive output, will increase over time in a growing economy. Observing the annual US
real unit cost trends (18701957) of five aggregate groups of natural resource commodities
(all extractive, minerals, agriculture, forestry, and fishing) they found unit prices declined,
rather than increased. Scrutinizing the data as relative unit prices (relative to non-extractive
output) also found little support for scarcity.
Smith (1979) employed an econometric analysis of annual (19001973) price data of
four aggregated resource groups and found little evidence of upward trends in prices. Slade
(1982) analyzed long run price movements using annual data (18701978) aggregated into
major metals and fuels commodities. Estimating a quadratic functional form, she found
support for three distinct price trends; declining, flat, and increasing. Slade hypothesized
the trends come at different points in the life cycle of the exhaustive resource.
Smiths conclusions (p. 426) concerning his work may be apropos to all of the price
behavior studies: . . . evaluations of resource scarcity without detailed analysis of the character of the markets for the specific commodities, as well as the institutional changes during
the period, do not seem possible. Limitations of these early tests included the level of
aggregation as well as the implicit assumptions of constant technology across the individual commodities within each group and across time.5 Also, the hypothesis that the unit
prices increase over time at the rate of interest implicitly restricts the test to marginal
costs being independent of extraction and costs being independent of cumulative extraction or remaining reserves. Additionally, Ahrens and Sharma (1997) examine deterministic versus stochastic trends in resource price. Their results suggest potential specification
problems in these time series tests. Given the severe restrictions and the fact that the natural gas resources we analyze are subject to stock effects, we do not analyze a price path
test.
5
For a further discussion of difficulties with aggregation, see Blackorby and Schworm (1982).
307
3.2. Shadow price behavior tests

We categorize shadow price behavior tests by the implicit or explicit incorporation of a
price path, as developed in Section 2.6 Eqs. (7) and (14) are the basis for this distinction.
Eq. (7) results from modeling the producer as an integrated firm that produces and processes
the resource, while (14) results from modeling the firm as producing the exhaustible resource. Both require either an estimated indirect cost function, which, of course, embodies
the production technology of the firm (or industry), or an estimated production function,
which, in turn, allows the cost function to be derived. The existing empirical tests are also
differentiated by the resource tested, the level of aggregation in the data, market structure,
and time. The explicit price expectations tests directly estimate the transition equation,
which requires an explicit price path through time in order to measure user cost. Included in
this test class is research by Stollery (1983), Farrow (1985), Young (1992), and Slade and
Thille (1997). Also included in this category are the tests of Miller and Upton (1985a,b).
3.2.1. Explicit price expectations ( = ert (P Cq ))
Stollery tests the theory using a time series of in situ prices for nickel. He extends the basic
Hotelling model to account for the effects of depletion, possible technological change, and
exogenous discoveries. Employing a price leadership model, with the International Nickel
Company (INCO) as the price leader, Stollery estimated a log-linear demand function and
a CobbDouglas production function, using annual data (19521973), supplied by INCO.7
Stollery finds the resource rent for nickel rose over the time period at a rate compatible with
a 15% discount rate. Employing a capital asset pricing model (CAPM), Stollery argues that,
given market conditions over the period in question, a 15% discount rate is consistent for
INCO.
Farrow tests the exhaustible resource theory using monthly price and cost data (January
1975 to December 1981) from an underground hard rock mineral mine that produced several
joint product metal commodities. Weighted averages are used for the joint production as well
as output prices.8 Due to lack of data concerning the remaining reserves, an approximation
is used.9 The basic theoretical model is analogous to the Hotelling extension with costs
being a function of extraction, reserves, and input prices.
Farrows cost function was estimated using company accounting record data. Income
statements were supplemented by information from invoices to obtain output prices, inventory records, and other operating costs. The coefficients were restricted to be homogeneous
of degree one in input prices. Employing information from the cost function, he directly
estimates the transition equation and then tests the appropriate restrictions on the transition
equation parameters. In an AR(1) model, the parameter estimates are significant. However,
Farrow points out the weak link between the theory and the data, in that the sign on the
parameter that coincides with the firms discount rate is negative. Farrow derives a number
6 This distinction between the tests is recognized, for example, by Halvorsen and Smith, Slade and Thille, and
Chermak and Patrick.
7 Given this market power assumption, the appropriate measure for user cost in the Stollery work is =
ert (MR Cq ).
8 Due to the available data, the test performed is actually on the final product, rather than gross product.
9 See Farrow for a complete discussion of the reserve estimate.
308
of alternative tests including; (1) a dynamic discount rate model, (2) a price expectations
model, and (3) an output constraint model. In all cases, the theory of exhaustible resources
is rejected at the level of a single mine with joint outputs.
Young estimates a translog cost function for 14 Canadian copper mining firms that operated between 1956 and 1982. The annual data, from government records, consists of prices
and quantities of inputs, outputs, and ore grades. Employing this data, Young estimates the
production cost function for the copper mines. The cost function is then restricted to comply
with the theory of exhaustible resources. The results do not find support for the theory.
Slade and Thille integrate the theory of exhaustible resources with the capital asset pricing
model (CAPM) to develop their theoretic model. With this model they perform a variety of
tests, including a test of the basic Hotelling model. They employ the cost function estimated
by Young. In addition to the price and cost information, the test requires a rate of return
for a risk free asset. The 90-day Canadian Treasury bill rate is used. They estimate user
cost as the difference between price and marginal extraction costs under several different
restrictions including certainty as well as risk. Slade and Thille directly estimate the transition equation and test the statistical significance of the restrictions. While the test of the
basic Hotelling model does not reject the theory, the parameter estimates with which the
test is made are not significantly different from zero and as the authors suggest, the model
has little explanatory power. The authors further suggest the result of failure to not reject
the theory under the basic model to be vacuous (p. 702). Additional tests that incorporate risk and/or financial variables into the model improve the explanatory power of the
model.
Miller and Upton (1985a,b) formulate a test incorporating a variation of estimating the
transition equation. The test is based on an alternative implication derived from Hotellings
analysis. It is essentially, . . . the value of a unit of reserves in the ground is the same as
its current value above ground less the marginal cost of extracting it (p. 24), regardless of
when the reserves are extracted. This formulation, sometimes called the Hotelling Valuation
Principle, was in part a response to lack of adequate time series data with which to test the
more traditional implications of the theory.
Miller and Upton test the valuation principle by regressing the market value of oil and gas
reserves (based on a firms stock market prices) on their estimated Hotelling values (based
on wellhead prices, extraction costs, and estimated reserves extracted from Securities and
Exchange Commission data). The panel data set includes data for several publicly traded
firms. The 1985a results are robust under a variety of specifications, while the 1985b results
are not. Lack of data variation is suggested as a factor in the 1985b results.
It is important to note the differences and similarities between the tests. While Farrow
tests the theory at the level of a single mine, he uses aggregated commodity prices due to
joint production within the mine. This aggregation implies restrictions on the producers
decision-making. Stollery employs data aggregated across mines for an individual firm,
considered the price leader in the nickel industry. Young employs a panel data set of Canadian
copper mines. Slade and Thille also employ the Young data, extended with additional
information for various tests of the theory. Miller and Upton aggregate over deposits in
their test. All of these efforts incorporate explicit prices into the tests and all the tests are
based on direct estimation of the transition equation and testing the appropriate hypotheses
concerning the parameter estimates.
309
3.2.2. Implicit price expectations ( = ert C q )

Two empirical tests in the literature explicitly allow for processing of gross product into
final product and, thus, allow for differences, i.e. z(t) q(t). The theoretic development
of the Halvorsen and Smith (1991) and Chermak and Patrick (2001) tests are based on (7).
The empirical test of Halvorsen and Smith, however, incorporates explicit prices into the
test, while the Chermak and Patrick test implicitly incorporates prices.
Halvorsen and Smith test the integrated Canadian metals industry that not only produces
the resources, but also processes the resources. Thus, the distinction between gross and final
product is included in the theoretical development. Furthermore, the theoretical development
of the Halvorsen and Smith test is based on the implicit incorporation of price expectations
through the restrictions imposed restrictions of the indirect final cost function. That is, the
role of prices is incorporated through production choices. Although the theoretical basis of
the test incorporates implicit price expectations, the empirical test explicitly incorporates
output price in that they measure output as a unit dollar value of production as opposed to
the physical quantity of the resource. It appears this is done due to the aggregate nature of
the data that are used. By transforming final commodity products to values, a potential unit
problem is alleviated.
Employing aggregate annual data from the Canadian metals industries (19541974),
they estimate a system of equations for the indirect average cost function. The system is
restricted by the dynamic optimality condition and the consistency of the parameter estimates from the unrestricted and restricted systems are tested. They test the theory under
different discount rate levels held constant through time, as well as under varying discount
rates. Support for the theory at the industry level across these aggregated commodities is not
found. However, as Halvorsen and Smith state (p. 137); the data used to estimate the econometric model are at a high rate of aggregation, the empirical results should be considered
as only tentative. . . data for individual exhaustible resources, or preferable, individual resource firms is required to confirm the finding that the theory of exhaustible resources is not
empirically valid.
Chermak and Patricks theoretic development is for a price taking firm that produces
and refines a resource. Monthly production and cost data for 29 individual, tight-gas sand,
natural gas wells (located in three geographic areas in the US, and owned by five firms) are
employed to estimate the final indirect cost function (May 1987 to June 1991). An indirect
final cost function is econometrically estimated using these data, as are gross and average
production cost functions. The dynamic optimality condition is used to restrict each of
these indirect cost functions. The results of the tests of the parameter estimates between the
restricted and unrestricted functions indicate that these natural gas wells were produced in
a manner consistent with the theory. That is, the production decision is effectively taking
into account the opportunity cost of current production (the in situ resource price) and the
path is optimal according to the theory.
The Halvorsen and Smith and the Chermak and Patrick tests employ similar test techniques, i.e. restrict the indirect cost function by the dynamic optimality condition and then
test the consistency of the parameter estimates of the restricted and unrestricted indirect
cost functions. The differences in these tests include the resource tested, the level of aggregation (over time, deposits, and resources), and the explicit specification of the final
price path.
310
3.3. Summary of extant test results

The extant tests discussed in the above sections are summarized in Table 1. It is clear
from these results that not only do the test mechanisms vary across tests, time units, aggregation levels, and commodities, but also market structure. Given these differences, it
is difficult to assess whether the results of these tests are artifacts of the resources tested,
levels of aggregation, type of test employed or other differences. To remove any data related
differences, we employ the Chermak and Patrick data, which is disaggregated to individual
natural gas wells, to the test methodologies of Farrow, Slade and Thille, Halvorsen and
Smith, and compare them to the Chermak and Patrick results. While Farrow, and Slade and
Thille performed more than one test to ascertain the impact of various assumptions, we
focus on their tests of the basic Hotelling Theory, so that the results are comparable across
the four tests. While results for other specifications are of interest, they are not directly
comparable and lend little to our basic inquiry of the impact of aggregation, resource type,
etc. on the results.10
4. Data
The data are 443 monthly observations from May 1987 to June 1991 for 29 tight gas sand
wells.11,12 Seventeen wells are located in Wyoming, ten in west Texas, and the remaining
two in east Texas. The wells vary in, among other things physical characteristics, age,
and completion technology. Four companies13 provided individual well information. The
processing of the gas, resulting in final product, is the separation of condensate and/or
non-hydrocarbon bases, as well as gas diverted for re-pressuring, or gas vented or flared.
Data were not available for final production for all wells. To avoid the discarding of pertinent
information, missing final product observations were estimated with existing data.14 For a
complete description of the data, see Patrick and Chermak (1992). In order to perform the
Farrow, as well as the Slade and Thille tests, output price data were also required. These
data were obtained from the Energy Information Administration Natural Gas Annual.15
10
Due to the extreme restrictions found in the price path tests and the fact that the resource we consider is subject
to stock effects, this test type is not considered further. Additionally, the Hotelling Valuation test is not considered
in this research under conditions of anonymity required by the firms that supplied the data.
11 A tight-gas sand well is physically distinguished by the physical characteristic of low permeability, which
hinders flow through the reservoir. This inhibits interaction between wells. Thus, well interactions need not be
considered in this research.
12 Not all wells have data for the entire time period.
13 One company allowed two different divisions to provide data. Given the data were for different divisions, located
in different states, the divisions were treated separately to allow for the possibility of behavioral differences in the
econometric specification.
14 Final production is a function of, among other things, gross production. Missing final production were estimated
employing full feasible generalized least squares from the available data according to z = z q zq t t , where t refers
to production month and final production is restricted to be less than or equal to gross production (see Griliches
(1986) or Greene (2000) for further detail on the estimation technique). The econometrically estimated relationship
between final and gross production is ln z = 0.312 + 1.035 ln q 0.023 ln t.
15 Various years.
311
312
The Slade and Thille test also required a risk free discount rate. Analogous to the Slade and
Thille test, the US 3-month Treasury bill rate was used.
Employing these data, three econometrically estimated indirect cost functions from Chermak and Patrick are presented. The first function is the final cost function (i.e. recognizes
processing of the resource), the second is the gross cost function (i.e. does not recognize
any processing of the raw resource), and the third is the average final cost function. These
functions are employed to perform the Farrow, Halvorsen and Smith, and Slade and Thille
tests and to reproduce the Chermak and Patrick results. The following section presents the
econometric specification of the indirect cost functions.
5. Specification and estimates of the indirect cost function

The indirect final cost function is specified in the form of a Generalized CobbDouglas,
are hypothesized to be a function of gross producwhere monthly final production costs, C,
tion, q, final production, z, and remaining reserves, R. Production month, t, is also included
to account for differences in the wells across their respective production horizons.16 A
fixed effects model, which stratifies the panel data by firm and by year, is employed. The
specification for the indirect final cost function is
ln C =
N

i=1
i D i +
Y
y Dy + q ln q + z ln z + R ln R + t ln t + e,
y=2
where i = 1, . . . , N firms (N = 5), y = 1, . . . , Y years (Y = 5), and e: the customary

error term, a random number with zero mean.
Chermak and Patrick (2001) examine a number of specifications of the indirect final cost
function. Here, we use the specification they determine to be the best representative of the
data generating process. Briefly, their rationale is as follows. Their theoretical development
demonstrates that C z 0 and C q 0, which implies that the s on z and q should be
of opposite sign. Further, a Wald test, used to test the hypothesis H0 : z = q versus
z = q , resulted in a Wald value of 0.000049, which is less than the critical 2 value.
Thus, the null is not rejected. Given this theoretic and statistical support, the final cost
functional form is restricted to z = q .
In addition to the final cost specification, we also present the reduced form of the indirect
gross cost function, C, which does not recognize processing of the resource by the extractive
firm and we present an average final cost function estimation, AC. The parameter estimates
are presented in Table 2. These results are employed in the empirical tests of the theory
presented in the following section.
16 Unfortunately, we do not have price data for the firms inputs. Given that we do not observe the actual input
prices into the production processes of the firms comprising the data set, rather than introduce potential bias
through price indices that may not adequately capture the individual firms input prices, we have not explicitly
included measures to represent input prices. However, using well dummy variables, depth, thickness, and time
trend for instruments, we performed Hausman specification tests on our estimated models and found no significant
indication of bias and inconsistency in our specifications.
313
Table 2
Estimated indirect cost functions
Parameter
Final cost (C)

Estimate
q
z
R
t
Firm1
Firm2
Firm3
Firm4
Firm5
1988
1989
1990
1991
Log-L
0.863a
0.863a
0.048b
0.056a
7.351a
6.926a
8.823a
9.222a
8.849a
0.157
0.383b
0.449c
0.326
0.731a
62.61
Gross cost (C)

S.E.
0.032
0.032
0.029
0.023
0.508
0.488
0.493
0.465
0.480
0.224
0.231
0.229
0.237
0.032
Estimate
0.038a
0.053b
0.041b
7.057a
6.647a
8.525a
8.91a
8.114a
0.147
0.366
0.432b
0.305
0.726a
60.55
Average cost (AC)

S.E.
0.011
0.029
0.022
0.494
0.474
0.482
0.452
0.468
0.222
0.229
0.227
0.236
0.033
Estimate
0.996a
0.052b
0.059b
7.383a
6.957a
8.842a
9.241a
8.449a
0.161
0.382b
0.451c
0.329
0.728
62.64
S.E.
0.011
0.028
0.022
0.497
0.478
0.485
0.455
0.472
0.223
0.230
0.228
0.237
0.033
S.E.: standard error.

a Level of significance: 0.01.
b Level of significance: 0.10.
c Level of significance: 0.05.
6. Empirical test results

Employing the estimated cost functions presented in Table 2, the basic Hotelling test
results of Farrow, Slade and Thille, Halverson and Smith, and Chermak and Patrick (2001)
are presented.17 The single data set results are compared to the original results and across
test methodologies. The Farrow, and Slade and Thille tests, both explicit price path tests, are
presented first, followed by the implicit price tests of Halvorsen and Smith, and Chermak
and Patrick (2001).
6.1. Explicit price path tests
The explicit price path tests of Farrow, and Slade and Thille are analogous to the traditional
model. Costs are a function of current extraction, remaining reserves, and input prices.
Necessary conditions include (9) through (13). Eqs. (10) and (14) form the basis for the
consistency test between the theory and the data. Converting (10) and (14) to current value
results in
m = P Cq ,
(18)
m
= rm + CR ,
(19)
and
17
In each of these papers a variety of tests are performed. We perform tests that are comparable across the papers.
314
Table 3
Farrow results
Parameter
1
2
OLS
AR(1)
Estimate
S.E.
Estimate
S.E.
0.10
402.26
0.06
559.24
0.22
1340.99
0.10
862.64
where
m(t) = ert (t).
The current value shadow price (or user cost) is m, Cq is the partial of the indirect gross
cost function,18 with respect to extraction and CR is the partial with respect to remaining
reserves. P is the exogenous unit output price of the resource (hence, the explicit price expectation). Eq. (19) is the dynamic efficiency condition with which data and theory consistency
are tested.
6.1.1. Farrow test
Farrow tests the theory of exhaustible resources using data from an underground hardrock
mine that produces several joint products, as discussed in Section 3. A translog functional
form is empirically estimated. The coefficients are restricted to be homogeneous of degree
one in input prices. From this cost function, Cq and CR are estimated, m(t) is then estimated
using (18). These estimates form the date set required to test the theory via the dynamic efficiency condition, (19). The discrete form of (19) is employed for the empirical test. That is,19
$m(t) = rm(t 1) + CR (t)
(20)
If the data are consistent with the theory, the following restrictions on (20) must hold;
(i) r: the firms discount rate for the time period, i.e. the parameter estimate on m(t 1)
equals the firms discount rate, and
(ii) the implicit parameter estimate on the stock effect, CR , equals 1.
Explicitly;
$m(t) = 1 m(t 1) + 2 CR (t)
is econometrically estimated. The restrictions, (i) and (ii), imply testing the hypotheses
H0 : 1 = r and 2 = 1
versus HN : 1 = r and/or 2 = 1.
These restrictions are tested with F-tests. If H0 is not rejected, then exhaustible resource
theory is consistent with the data.
Farrows basic test results are reproduced in Table 3. Initial test statistics indicated the
OLS errors were autocorrelated, consequently the model was rerun using a Hatanaka (1974)
18
19
Input price coefficients were restricted to homogeneous of degree one.

Time arguments are included in parentheses in the discrete forms.
315
estimator in order to obtain consistent and efficient parameter estimates. Farrow derives a
number of alternative tests. In all cases, the theory of exhaustible resources is rejected at
the level of a single mine for this data set.
To perform the Farrow test the new data set (the Chermak and Patrick data augmented
with an explicit price path) is employed. Given that expected prices received by each firm
were not available, an estimated monthly price per thousand cubic feet of natural gas was
used. This use of an ex post price path is analogous to Farrow. The gross cost function (see
Table 2) is the basis for the test. Cq and CR are estimated, as is m(t). Analogous to Farrows
single firm test, we allow for variations across the firms. Thus, we estimate
$mi (t) = 1i mi (t 1) + 2i CRi (t),
(21)
where i = 1, . . . , 5 are the individual firms. The results are presented in Table 4.
The first subscript number refers to the variable and the second refers to the firm. The
signs on the parameter estimates for the 1i s are consistent with Farrows results. However,
this result implies each of the five firms has a negative discount rate. Thus, all 1i = r.
The restriction of all 2i = 2 is tested with an F-test. The result indicates acceptance of the
restriction. However, given the negative signs on the 1i s, we would reject the theory based
on the results of this test. These results are also consistent with Farrows original research.
6.1.2. Slade and Thille test
Slade and Thille test the theory using the cost functions estimated by Young (1992) for 14
Canadian copper mining firms. This research tests the original Hotelling model as well as
additional specifications, including the CAPM. The theoretical development incorporates
a dynamic CAPM model into the dynamic efficiency condition, (19). The dynamic CAPM
provides a relationship, over the life of the asset, between the rate of return on a risky asset,
the risk-free rate of return, and the expected rate of return on the market portfolio (see, for
example, Merton, 1973). Specifically
ri (t) = r(t) + i (rm (t) r(t)),
(22)
where ri (t) is the rate of return on asset i at time t, r(t) is the risk free rate of return at time
t, i is the beta coefficient for the ith asset that determines the risk premium and rm (t) is
Table 4
Farrow test with new data
Parameter
Estimate
S.E.
11
12
13
14
15
21
22
23
24
25
0.1932E01
0.1194
0.9779E01
0.3122E01
0.1305E01
6415.1
0.1240E+07
0.5206E+06
0.2199E+06
1477.9
0.8388E02
0.3380E01
0.4943E01
0.3737E01
0.1536E01
29754.0
0.3560E+06
0.2796E+06
0.2474E+06
4628.3
F-test to restrict
i = 1 (i = 1, . . . , 5), Fcalc = 3.3067, Fcrit (3, 599) = 3.78 ( = 0.0061).
316
the expected rate of return for the market portfolio. Substituting this into (19) yields the
stochastic differential equation;
E(m(t))
= [m(t)(r(t) + i (rm (t) r(t)))] + CR (t).
(23)
Rearranging (23) yields;

E(m(t))
CR (t)
= r(t) +
+ i (rm (t) r(t)),
m(t)
m(t)
where E(m(t))/m(t)
is the average expected rate of change of the shadow price. This is

the basis for the Slade and Thille Hotelling CAPM test. If there is certainty in the extraction sector, the shadow price is not random, therefore, i = 0, and a standard Hotelling
relationship results;
m(t)
CR (t)
= r(t) +
.
m(t)
m(t)
(24)
This differs from the Farrow specification in that (i) the use of the ratio of change in user
cost to last period user cost and (ii) the use of the risk free discount rate, rather than the firm
discount rate.
From Youngs estimated translog cost function and an explicit price path, Slade and
Thille derive the user cost, change in user cost, and the marginal cost of remaining reserves.
This data, coupled with the risk free interest rate (the 90-day Canadian Treasury bill rate),
is used to estimate the discrete function;
$m(t)
CR (t)
= 0 + 1 r(t) + 2
.
m(t 1)
m(t 1)
(25)
The restrictions on the parameter estimates that are consistent with the theory of exhaustible
resources imply the hypotheses test;
H0 : 0 = 0, 1 = 1, and 2 = 1 versus HA : at least one restriciton does not hold.
The restrictions are jointly tested using a Wald test.
A generalized method of moments estimator is used with lagged values of the variables
plus year, rate of change of producer price index, and the rate of growth of aggregate
consumption included as instruments. Variables from two-time periods prior are used, due
to the rate of growth variables in the regression. Table 5 presents the original Slade and
Thille results for the Hotelling variables from the general model. The general model is then
restricted so that all parameter estimates are zero except for the Hotelling variables. The Wald
Table 5
Slade and Thille results
Parameter
Estimate
S.E.
0
1
2
..
.
0.04
3.5
6.7
..
.
0.08
2.45
5.06
..
.
317
Table 6
Slade and Thille test with new data
Parameter
Estimate
S.E.
0
1
2
0.1
18.5
131.0
0.1
16.2
3359.1
2 statistic of 1.08 (P-value = 0.58) indicates the basic Hotelling model is not rejected.
However, note the parameter estimates, 1 and 2 are not statistically significantly different
from zero. The parameter estimates for the restricted Hotelling model are not reported in
the original paper. Additional tests are conducted by restricting the appropriate variables in
the general model (including a CAPM and a Hotelling CAPM). The addition of financial
variables leads to a model with some empirical support.
Employing the indirect gross cost function, the Slade and Thille test under certainty is
executed. To conduct the test, the data is augmented with the same price path as utilized
in the Farrow test and a risk free asset rate of return. In keeping in line with the Slade and
Thille test, the risk free rate of return is proxied by the 3-month US Treasury Bill. The
indirect gross cost function is used in the new Slade and Thille test. We econometrically
estimate (25), following the same lag and econometric procedures as Slade and Thille. The
restrictions on the parameter estimates (0 = 0, 1 = 1, and 2 = 1) are statistically tested
with a Wald test. The results are presented in Table 6. The Wald statistic of 20.5 is in excess
of the critical 2 of 7.82 (at 1% level of significance). Thus, the results do not indicate
support for the theory.
Both the Farrow and the Slade and Thille tests estimate the transition equation and test
their respective restrictions on the parameter estimates of the estimated transition equation.
The basic Hotelling test of Slade and Thille is more restrictive than the Farrow test given
the use of the risk free interest rate but less restrictive in that Farrow maintains 0 = 0. The
use of the new data set did not result in support for the theory under either of these tests.
6.1.3. Caveats, further considerations, and additional tests
There are two points to note about bias in these tests. The first is in regard to bias in the
tests in general. The second source of bias is particular to the data used by Farrow, and Slade
and Thille, and in the tests presented above. In this section, we discuss these sources of bias
and their implications for testing the theory, develop a data transformation to ameliorate the
second source of bias, and perform revised explicit price tests using the transformed data.
First, the empirical test of efficiency is based on consistency between the data generating
process and the necessary conditions for efficiency; Eqs. (18) and (19). Farrow originally
makes this point (p. 461) in his analysis. The test requires a measure of user cost and since
user cost is not directly observable, necessary condition (18) is used for this estimate. The
result of both conditions being necessary for efficiency, and one of them being imposed to
measure a variable required in the test of efficiency, results in the test being biased towards
not rejecting the theory.20 This direction of bias strengthens our results in this section.
20 This argument also holds in regard to the implicit price tests of the next section in that the theory is being
imposed to measure the unobservable user cost, which is then used in testing the Hotelling theory.
318
Second, Farrow, and Slade and Thille, and the replications of their tests presented above,
all use cost data for the final product when the theoretically relevant data for the tests would
measure gross costs. In our dataset, we observe only final costs, which we then use as a proxy
for gross costs in estimating the indirect gross cost function above. Thus, the dependent
variable is systematically overstated, which may imply a measurement error problem. While
it is generally accepted that measurement error in the dependent variable can be absorbed
by the error term (e.g., Greene, 2000), the error in this situation would not conform to
the textbook case, i.e. where the error in the dependent variable is normally distributed
with zero mean and constant variance. Any parameter bias resulting from this systematic
over-measurement of the dependent variable may result in the overestimation of marginal
gross costs, which is the necessary cost function for carrying out explicit price tests of the
theory. The implications of this are that (18) would underestimate user costs and that the
partial of indirect gross costs with respect to remaining reserves would be overestimated
in (19).21 To illustrate, let C = C + C be the cost data vectors, where C and C are final
and gross costs, as defined above, and C represents processing costs. Additionally, let X be
the data matrix for all explanatory variables relevant to the gross cost model and is the
vector of associated parameters. Consider, for simplicity, the OLS estimator using the data
we observe, which would imply the parameter estimates,
= (X X)1 X C = (X X)1 X (C + C).
(26)
Theoretically, we require data to estimate gross costs of, for example, the form C =
X + u , where u is the traditional vector of errors with the properties E(u ) = 0

and E(u u ) = 2 I . This implies that = (X X)1 X C. Substituting for C in (26) and
rearranging leads to
= + (X X)1 X (u + C).
(27)
Rearranging (27) and applying the expectation operator leads to
E( ) = (X X)1 X C,
(28)
which indicates biases of (X X)1 X C in parameter estimates due to the fact that final cost
data is used as a proxy for gross cost data. At this level of generality no definitive inferences
can be made regarding the effect of these biased parameter estimates on rejection of the
theory.
However, we are able to circumvent the fact that we do not observe production costs,
thereby mitigating this second source of bias (although the first remains), by applying some
of the theoretical results developed in Chermak and Patrick (2001) in order to predict the
indirect gross costs from our estimated indirect final cost function. Chermak and Patrick
(2001) demonstrate that m = C q (Lemma 1, p. 93), m = C z fq Cq (Lemma 2, p. 94),
and C R = CR (p. 93). The two Lemmas can be used to show that marginal gross cost equals
the sum of the value (in terms of the marginal final cost of z) of marginal product of q and
the marginal final cost of q, i.e. Cq = C z fq + C q .22 Using this result, the estimated indirect
21
22
We would like to thank an anonymous referee for making these points.

Chermak and Patrick (2002), among other things, formally develop this relationship.
319
Table 7
Farrow test with revised data
Parameter
11
12
13
14
15
21
22
23
24
25
F-test to restrict
Estimate
0.3552E02
0.2390E02
0.5846E02
0.4889E02
0.2731E02
24.85
599.83
41.78
17.06
0.2218
S.E.
0.1975E02
0.8929E02
0.3185E01
0.1880E01
0.3114E01
61.928
1028.5
311.63
128.14
2.123
i = 1 (i = 1, . . . , 5), Fcalc = 0.1372, Fcrit (3, 599) = 3.78.
final cost function can be partially differentiated with respect to z and q, and the final product
production function can be partially differentiated with respect to q, to obtain the measures
for Cq . Differentiating the indirect final cost function with respect to remaining reserves
provides our measure for CR . Thus, even though we do not directly observe gross costs, we
are able to develop the theoretically correct gross cost variables necessary to perform the
explicit price path tests.
Even when we remove this data bias from the tests performed above, the explicit price
tests do not find support for Hotellings theory. The results from the Farrow and the Slade
and Thille tests with the estimated gross cost measures are presented in Tables 7 and 8,
respectively. For the Farrow test, the parameter estimates representing the discount rates
are not significantly different from zero. In addition, the F-test restricting the 2i s = 1
is rejected. Thus, the results do not find support for the theory. For the Slade and Thille
test, the parameter estimates are not significantly different from zero. Additionally, the
estimated Wald statistic of 290.4 (critical 2 = 7.82) rejects the restrictions at a 1% level
of significance. As before, this test does not find support for the theory.
6.2. Implicit price path tests
The implicit price path tests of Halvorsen and Smith and Chermak and Patrick are analogous to the general natural resource model that recognizes at least partial processing of the
gross product. The indirect final cost function is employed. Necessary conditions include
(1) through (6). Eqs. (2) and (7) form the basis for the consistency test. Converting (2) and
Table 8
Slade and Thille test with revised data
Parameter
Estimate
S.E.
0
1
2
0.3627E04
0.3225
0.5106
0.1326E01
2.1398
2.3601
320
(7) to current value results in;

m(t) = C q (t)
(29)
and
m(t)
= rm(t) + C R (t),
(30)
or
C q (t) C q (t 1) = r C q (t) + C R (t).
Eq. (30) is the dynamic optimality condition employed in the test of the theory of exhaustible
resources.
6.2.1. Halvorsen and Smith test
Halvorsen and Smiths econometric test is based on the estimation of a system of equations for the average final indirect cost, AC, with a translog specification. Specifically, AC
(q(t), W (t), R(t), t) where AC is the ratio of costs to final product, z. Due to the aggregate
nature of the resources, Halvorsen and Smith use a dollar value of ore concentrate. Additionally, R(t) is cumulative extraction, rather than remaining reserves.23 The input price
vector, W (t), explicitly refers to the inputs, capital and labor.24 Linear homogeneity in prices
is imposed by restricting the coefficient on input prices to be equal to one and the coefficients on input price/gross production and input price/remaining reserves cross products
to be equal to zero. Hicks neutral technical change (with respect to inputs) is achieved by
restricting the coefficients on input price/time equal to zero. To increase the efficiency of
the parameter estimates, the cost shares of reproducible inputs were estimated jointly with
the cost function.
From this system, user cost is estimated by the negative of the partial of the indirect total
cost function with respect to gross output;
ln C(t)
C(t)
m(t) = C q =
.
ln q(t) q(t)
This, coupled with
ln C(t)
C(t)
C R =
ln R(t) R(t)
allows the empirical estimation of the dynamic optimality condition.25 That is
1) C(t
1) ln C(t)
1
C(t)
ln C(t)
C(t)
ln C(t
. (31)
=
+ (1 + r(t))
R(t)
ln q(t) q(t)
ln q(t 1) q(t 1)
ln R(t)
The average final cost function is restricted by (31). A Hausman (1978) specification test is
used to test the null hypothesis that (31) is satisfied by the parameter estimates of the average
23
Cumulative extraction, rather than remaining reserves was used due to data availability.
The dollar value is apparently used in order to alleviate problems of aggregating different metal unit outputs.
25 Due to the use of cumulative extraction, instead of remaining reserves, the sign on the partial with respect to
R is the opposite of what we would normally expect. For a formal treatment see Chermak and Patrick (2001).
24
321
Table 9
Halvorsen and Smith results
Discount rate
Hausman statistica
0.02
0.05
0.10
0.15
0.20
58.2
48.8
69.3
291.8
102.8
The critical value of the test statistic is 24.7 at a 0.01 level of significance.
final cost function, versus the alternative that it is not. The test statistic is asymptotically
2 distributed with degrees of freedom equal to the number of parameters being tested.
Halvorsen and Smith employ data that is an annual time series from the Canadian metal
mining industry from 1954 through 1974 supplied by the Ontario Ministry of Natural Resources. Final output, z, is the dollar value of ore concentrate deflated by the wholesale
price index. Thus, while the theoretic development of this test is an implicit price path formulation, data availability resulted in price explicitly being incorporated into the empirical
test. It is this specification of z that places the empirical Halvorsen and Smith test in the
explicit price path category. The price of capital is a modified Christiansen and Jorgenson
(1969) service price index reflecting acquisition cost, the rate of interest, and the depreciation rate. The price of labor is the average wage plus indirect benefits for the industry.
Gross extraction is the aggregate total tons of metallic ore extracted in a given time period.
Cumulative extraction is total tons of metallic ore extracted from 1949.26 The time variable
is normalized to equal zero in 1964. Halvorsen and Smith perform the test for constant
discount rates, r, and varying discount rates. Table 9 reports results for constant discount
rates.
The null hypothesis (the data conform to the Hotelling theory) is rejected at all discount
rates, and so the test does not find empirical support for the theory of exhaustible resources.
However, as the authors state in their results (p. 137), the data used to estimate the econometric model are at a high rate of aggregation, the empirical results should be considered
as only tentative. . . data for individual exhaustible resources, or, preferable, individual resource firms is required to confirm the finding that the theory of exhaustible resources us
not empirically valid.
We run the Halvorsen and Smith test employing the average, indirect final cost function.
The data are for natural gas only. Thus, z is the actual units of natural gas, rather than
the dollar value. Also, remaining reserves, rather than cumulative extraction is used as the
measure of R. We restrict the indirect average (with respect to z) final cost function by
ACq (t)z(t) = (1 + r)ACq (t 1)z(t 1) ACR (t)z(t).
Employing three stage least squares estimation, we restrict the parameter estimate on
the average cost function by the dynamic optimality condition over the same range of
26
1949 is the first year for which data was available.
322
Table 10
Halvorsen and Smith test with new dataa
Discount rate
Hausman statistic
0.02
0.05
0.10
0.15
0.20
6.62
6.36
6.05
5.86
5.76
a Distributed with 2 with three degrees of freedom. The critical value of the statistic, at the 0.05 level of
significance is 7.815.
discount rates as Halvorsen and Smith. The Hausman test statistic is computed to test the
null hypothesis. Results are reported in Table 10.
Contrary to the original test results, we find support for the theory at all discount rates
tested. The primary differences between this test and the original test include; (i) different
resource, (ii) disaggregated data, (iii) no explicit price path, and (iv) the use of remaining
reserves, rather than cumulative production.
6.2.2. Chermak and Patrick test
The Chermak and Patrick test employs the final cost function, C(z(t),
q(t), R(t), t). Mulrt
tiplication of (30), the dynamic optimality condition, by e , followed by integration and
rearrangement yields;
t
erx CR dx.
m(t) ert m(0) =
0
The discrete time version, with the substitutions of m(t) = C q (t), produces the form of
the dynamic optimality condition with which the parameter estimates of the indirect cost
function are restricted. That is;
ert [C q |t=0 ] C q =
t
(1 + r)tx C R ,
(32)
x=0
Specifically the test is of the null hypothesis that (32) is satisfied by the parameter estimates
for the indirect final cost function, versus the alternative hypothesis that the dynamic optimality condition is not satisfied by these parameter estimates. The hypothesis is tested with
a Hausman specification test. The dynamic optimality condition is tested under a range
of discount rates. The test results are reported in Table 11. The theory is not rejected at
the 0.05 significance level, which implies that the natural gas resources are produced in a
manner consistent with the theory. That is, the production decision is effectively taking into
account the opportunity cost of current production (the in situ resource price) and the path
is economically optimal according to the theory.
Both the Halvorsen and Smith and the Chermak and Patrick tests estimate a restricted
indirect final cost function to test the restricted versus unrestricted forms. The original
Halvorsen and Smith test incorporates explicit prices to estimate a weighted value across
the products. Also, the original Halvorsen and Smith test employed cumulative extraction as
323
Table 11
Chermak and Patrick results
Discount rate
Hausman statistica
0.02
0.05
0.10
0.15
0.20
3.828
1.799
0.993
2.571
2.958
Distributed with 2 with three degrees of freedom. The critical value of the statistic, at the 0.05 level of
significance is 7.815.
a
a proxy for remaining reserves, whereas the new test employs estimated remaining reserves.
These restrictions are relaxed in the new test, as well as any implied restriction associated
with aggregation across resources and deposits.
7. Summary and conclusions

The purpose of this paper is to review existing tests of the theory of exhaustible resources,
which yield conflicting results, and compare four of these tests using a single data set, thereby
removing any data related artifacts of previous tests. We find alternative approaches to testing
the theory result in conflicting conclusions when we analyze the same resource. In addition,
we show biased user cost estimates are inherent in the explicit price path tests because of the
use of final cost data rather than the theoretically correct gross cost data to measure in situ
resource price. We develop a data transformation to remove this bias. However, removing
the bias does not change the test results. Finally, we show a shorter more direct approach
(relative to Halvorsen and Smith or Chermak and Patrick) to derive user cost equal to the
negative of the partial derivative of final cost with respect to gross production condition,
which is used in the implicit price tests.
Employing a micro data set, we perform four tests of the theory of exhaustible resources
found in the literature. The single data set, removes any restrictions or assumptions due to
different; resources, levels of aggregations (across deposits, resources, and/or production
periods), and time horizons. Characteristics and results for the original and new tests are
summarized in Table 12.
Table 12
Comparison across tests and results
Test
Farrow
Slade and Thille
Halvorsen and Smith
Chermak and Patrick
Estimate
Transition equation
Transition equation
Restricted cost function
Restricted cost function
Price
Original
New
Explicit
Explicit
Explicit
Implicit
Explicit
Explicit
Implicit
Implicit
Test
statistic
F-test
Wald
Hausman
Hausman
Results
Original
New
Reject
Do not reject
Reject
Do not reject
Reject
Reject
Do not reject
Do not reject
324
As can be seen from the results, the Halvorsen and Smith and the Chermak and Patrick
tests find support for the theory with the unified data set. The Halvorsen and Smith result
is contrary to the original. Additionally, the new results are consistent with the original
Farrow results. However, the original Slade and Thille results did not reject the theory,
but the new results reject the theory. From these results, we conclude the inconsistency
in results cannot entirely be attributed to aggregation or time horizon issues. While the
disaggregated data may have played a part in the switch in the Halvorsen and Smith test,
it obviously did not alter the results for the Farrow test and most likely did not contribute
to the change in the Slade and Thille results. Do these results then suggest more acceptance for the theory or do they suggest the theory is not consistent with practice, since
all four tests do not either find support or not find support for the theory? In order to discern anything more definitive, we must analyze the factors that are consistent between the
Halvorsen and Smith and Chermak and Patrick tests, but inconsistent with the remaining two
tests.
Perhaps the most notable characteristic in Table 10 is that when we remove the necessity
of an explicit price path and the proxy of cumulative extraction for remaining reserves from
the Halvorsen and Smith test, the results indicate that the firms production behavior is
consistent the theory. In the new tests, the two with prices implicitly included find support,
while the two with explicit prices do not find support. Does this mean that explicit prices
present a problem for theoretical relevance? If so, it may be due to the fact that the prices
used in both the original and the new tests are ex post. However, production decisions
would be based on ex ante, or forecast prices. Simply put, the econometrician does not
observe the price forecasts on which the firm makes its production decision. If the prices
used by the firm to make production decisions are significantly different from the prices employed by the econometrician in the test, the empirical tests should not find support for the
theory.
The second observation that can be made from Table 10 is that the two tests that directly estimate the transition equation and test restricted parameter estimates do not find
support, while the two that restrict the indirect cost function by the dynamic optimality
condition do find support. Although this may be due to the use of inappropriate price paths,
it could also be due to the test methodology. Measuring user cost as the difference between
price and the marginal cost of gross extraction may not be consistent between the two
methodologies and may not adequately incorporate other important factors, for example,
the shadow value of capacity, if any. If the optimal extraction path is constrained by capacity
(as suggested by Farrow), then the difference between price and marginal cost would also
include a shadow value of capacity. The restricted cost function tests alleviate this potential problem. In addition, this test does not require explicit prices to incorporate producer
behavior.
More definitive results concerning the theory of exhaustible resources can only be made
after further research is completed concerning the ex post and ex ante price paths, the
consistency between the measures of user cost employed in the alternative tests,27 and
the performance of the statistical estimators as they apply to the empirical tests of the
theory.
27
See Chermak and Patrick (2002).
325
Acknowledgements
We would like to thank participants at the First World Congress of Environmental and
Resource Economists for helpful comments on a previous draft. We would also like to thank
three anonymous referees for their insightful comments and suggestions. The usual caveat
applies.
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Resource and Energy Economics 24 (2002) 301325

Comparing tests of the theory of

Department of Economics, University of New Mexico, 1915 Roma NE/SSCI, Albuquerque,

q(t), W , R(t), t)] (t)q(t),

(0 if R(T ) > 0).

s.t. q = g(Xg , R, t).

H (T ) = erT [P (T )q(T ) C(q(T ), R(T ))] (T )q(T ) = 0,

(0 if R(T ) > 0).

rCq + P rP CqR R Cqt CR

3. Empirical tests in the extant literature

3.2. Shadow price behavior tests

3.2.2. Implicit price expectations ( = ert C q )

3.3. Summary of extant test results

5. Specification and estimates of the indirect cost function

where i = 1, . . . , N firms (N = 5), y = 1, . . . , Y years (Y = 5), and e: the customary

Final cost (C)

Gross cost (C)

Average cost (AC)

S.E.: standard error.

6. Empirical test results

Input price coefficients were restricted to homogeneous of degree one.

i = 1 (i = 1, . . . , 5), Fcalc = 3.3067, Fcrit (3, 599) = 3.78 ( = 0.0061).

= [m(t)(r(t) + i (rm (t) r(t)))] + CR (t).

Rearranging (23) yields;

is the average expected rate of change of the shadow price. This is

= (X  X)1 X  C = (X X)1 X  (C + C).

Rearranging (27) and applying the expectation operator leads to

We would like to thank an anonymous referee for making these points.

i = 1 (i = 1, . . . , 5), Fcalc = 0.1372, Fcrit (3, 599) = 3.78.

(7) to current value results in;

1949 is the first year for which data was available.

7. Summary and conclusions

See Chermak and Patrick (2002).

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= (X X)1 X C = (X X)1 X (C + C).