Tuesday, November 25, 2008

Explaining the Ehrlich-Simon wager

In 1980, prominent environmentalist, and author of the book The Population Bomb, Paul Ehrlich, entered into a wager with the late cornucopian economist Julian Simon. Ehrlich saw resource scarcity as a major problem, and that with time, resource prices would begin to rise as a reflection of physical limits. On the other hand, Simon predicted that with increased human population and ingenuity, the prices of resources would continue to decline indefinitely. Based on this logic, he challenge Ehrlich with “a public offer to stake US$10,000… on my belief that the cost of non-government controlled raw materials (including grain and oil) will not rise in the long run.” They designated September 29th 1990 as the cut off date for the wager, and bet on five metals – chromium, copper, nickel, tin and tungsten. The result was that the price of all five metals dropped in inflation adjusted terms, and Ehrlich sent Simon a cheque in October 1990.

So why did Ehrlich lose the bet, when we know for a fact that there are long run physical limits to natural resources? The first reason raised by many environmentalists is that his timing was a little off. Maybe he was a few decades early in his prediction. I believe this explanation is entirely incorrect.

The second reason is Ehrlich ignored economic principles. The price of a good at any point in time only reflects its relative scarcity compared to the availability of other goods – not the absolute scarcity. If the rate of supply (aka the rate of extraction) of these metals was high, the price will be low, even if this rate could only be sustained for a few years before the total physical supply was exhausted. Ehrlich made the fundamental mistake of ignoring the rate of production. But the environmental debate of that decade did raise what has become a pressing issue in ecological economics of getting the absolute scarcity of natural resources reflected in the price.

What we know more clearly now is that the rate of extraction of most minerals and fossil fuels follows a Hubbert curve, where the rate climbs before at some point peaking, the beginning a long decline. While many suggest that the peak generally occurs when 50% of the absolute physical quantity of the resource has been extracted, this peak in the rate of supply still does not mean there will be a peak, or explosion in the price at this point.

First, consider what happens when there is a small increase in the price of copper. This makes the use of copper in production less attractive than alternatives such as fibre optics. So demand will drop as well, stopping the price from spiking. The prices cannot get too ‘out of whack’ before other adjustments take place.

Consider then if Ehrlich had wagered on the price of oil, and that the bet began in 2000, with the cut off date 2010. A year ago one would have been inclined to think that Ehrlich was a genius for predicting the price spike. But in the last few months, Simon would have got the upper hand, and Ehrlich would be on the back foot making excuses about the so called ‘credit crunch’. But what really happened?

First, the oil price spike was the result of a decrease in the rate of supply of oil compared with the rate of supply of other natural resources. But more than that, it was the expectation of a continued increase in demand in the face of decreasing supply. If you take a look at the metals, their price also spiked on the expectation of future demand and low future supply.

But the catch was what happens when the economy adjusts. These ‘out of whack’ prices cannot be sustained. They flow on to the real economy. In this case, the high cost of oil and metals made it difficult to increase production as there were few susbsitutes, so economic output slowed. Suddenly, the expectation of high future demand was replaced with the expectation of recession, and prices or natural resources (oil and metals) fell accordingly.

That’s the thing with supply constraints and physical resource limits. The general rule of thumb is that relative prices between goods are caused by available technologies. When one input is constrained, it doesn’t change the relative prices so much in the long-run, rather it changes the output level - especially if there are very few or no substitute resources.

This net result of an output reduction is due the infinite complexity of the modern economy. Estimating the embodied resources in goods has been a pursuit of the past decade, but recently it is coming to light that due to this infinite complexity, all goods have equal embodiments of all resources. A dollars worth of petrol requires an equal amount of oil to produce as a dollars worth of a massage. Thus a constraint of a single natural resource flows through to have an impact on the price of every good in the economy.

So when I previously wrote that supply side restrictions are the only way to go for improving environmental quality, it implies that economic output will be reduced. If Ehrlich knew then what ecological economists now know, he would have had a much different wager. In fact he did propose a second wager. He wanted to bet that the quality of the environment would deteriorate over the 1990s by referring to 15 different environmental quality measures. Simon declined because he believed that measuring such things did not reflect well-being. Although he did lose a wager about the price of timber in Canada, but blamed new government policies.

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