What is Hotelling’s theory?
Hotelling’s theory, or Hotelling’s rule, postulates that owners of nonrenewable resources will only produce a supply of their commodity if it can bring in more than the financial instruments available, especially the US Treasury or others. similar interest-bearing securities. This theory assumes that markets are efficient and that owners of nonrenewable resources are profit-driven. Hotelling’s theory is used by economists to try to predict the price of oil and other non-renewable resources, based on prevailing interest rates. The Hotelling ruler was named after the American statistician Harold Hotelling.
Key points to remember
- Hotelling’s theory defines the price at which the owner or a non-renewable resource will extract and sell it, rather than leaving it and waiting.
- It bases the price on US treasury bills or a similar interest-bearing security.
- The ruler was designed by the American statistician Harold Hotelling.
Understanding Hotelling theory
Hotelling’s theory addresses a fundamental decision for the owner of a non-renewable resource: keep the resource in the ground and hope for a better price next year, or extract and sell it and invest the product in interest-bearing security . Consider an owner of iron ore deposits. If this miner expects a 10% appreciation of iron ore over the next 12 months, and the effective real interest rate (nominal rate minus inflation) at which he can invest is only 5% per year, he will choose not to extract the iron ore. The costs of extraction are ignored in his theory. If the figures were reversed, with an expectation of price appreciation of 5% and an interest rate of 10%, the owner would exploit the iron ore, sell it and invest the proceeds of the sale with a yield of 10% . The minor will be indifferent to 5% and 5%.
Theory and practise
In theory, therefore, the rates of increase in the prices of nonrenewable resources such as petroleum, copper, coal, iron ore, zinc, nickel, etc. are expected to keep pace with increases in real interest rates. In practice, the Federal Reserve Bank of Minneapolis concluded in a 2020 study that Hotelling’s theory failed. The price appreciation rates of all the commodities examined by the authors have been, some far below, below the average annual rate for US Treasury securities. The authors suspected that extraction costs explained the difference.
Who was Harold Hotelling?
Harold Hotelling (1895 – 1973) was an American statistician and economist affiliated with Stanford University and Columbia University at the beginning and mid-career, then at UNC-Chapel Hill until his retirement. Aside from the eponymous theory of non-renewable resource prices, it is known for the distribution of Hotelling’s square, Hotelling’s law and Hotelling’s lemma.