Question

Suppose a depletable natural resource has a renewable substitute. The depletable resource can be extracted from the ground at an increasing marginal cost while the renewable substitute can be extracted at a constant marginal cost. The marginal willingness to pay exceeds the marginal cost for the initial quantities, so it is worth extracting at least some of the depletable resource. The resources are extracted and allocated in a dynamically efficient manner. However, the government soon steps in and sets a price cieling on the depletable resource that is below the marginal extraction cost of the renewable resource.

1. How does the price ceiling on the depletable resource affect the timing of the switch to the renewable substitute relative to the switch point in the absence of a price ceiling? Explain.
2. With the price ceiling in place, is the transition from the depletable resource to the renewable substitute smooth or abrupt? Explain.
3. How does the price ceiling affect the allocation of the depletable resource between consumers in earlier and later periods?

Answer 1

- A price ceiling is a legislature or government forced price control on how high a price is charged for an item, product, or service. Governments use price ceilings to shield customers from conditions that could make goods really costly.

- In this case we have been informed that the government soon steps in and sets a price cieling on the depletable resource that is below the marginal extraction cost of the renewable resource

- With this it is no more profitable for the producers to sale the natural resources and with the

price ceiling on the depletable resource in place the timing of the switch to the renewable substitute relative to the switch point in the absence of a price ceiling will be faster. Now the switch will have at fast track pace.

- With the price ceiling in place, the transition from the depletable resource to the renewable substitute will be abrupt. Because it is not sustainable to operate at the price ceiling and many producers will be making heavy losses so the move to renewable will be fast and abrupt.

- With the price ceiling in place the supply will reduce and the allocation of the depletable resource between consumers in the later periods will reduce as compared to the earlier period.