Hotelling's Rule: When to Extract a Finite Resource

The classic theory of how the owner of an exhaustible resource like oil decides when to extract it, and what it predicts about prices.

Oil, coal, copper and many minerals are exhaustible resources: there is a finite amount in the ground. Once extracted, they cannot be replaced. How should an owner decide whether to extract now or later? In 1931, the economist Harold Hotelling offered an influential answer.

Oil in the ground as an investment

Hotelling’s insight was to think of a resource in the ground as an asset, like money in a bank. The owner has two choices:

Extract and sell now, then invest the money and earn interest.
Leave it in the ground and sell later, hoping its value rises.

If the resource’s net value, its price minus extraction cost, is expected to rise faster than the interest rate, it pays to wait. If it rises more slowly, it pays to extract now and invest the proceeds.

Hotelling’s rule

In a competitive market, owners’ decisions push toward a balance where the net value of the resource rises at the rate of interest. This is Hotelling’s rule. The net value is sometimes called the scarcity rent: the extra value a resource has because it is finite.

The theory predicts that, as a resource is used up, its price should tend to rise over time, encouraging conservation and the development of substitutes.

The oil owner's choice

An oil owner can sell a barrel today for a net profit of 50 dollars and invest the money at 5 percent a year, giving 52.50 dollars next year. If she expects the net profit on that barrel to be 55 dollars next year, she should wait. If she expects 51 dollars, she should sell now. Across many owners, these decisions shape how fast oil is extracted.

Does it work in reality?

Real resource prices have often not followed Hotelling’s predicted path. Many mineral prices fell over long periods in real terms. Reasons include:

New discoveries that expanded known reserves.
Technological progress, such as fracking, that lowered extraction costs.
Substitutes and changing demand.
Market power, as with OPEC.

Still, the rule remains a key starting point for thinking about exhaustible resources and why the timing of extraction matters.

Thinking finite resources must quickly become scarcer and pricier

Many people predicted resources would run out and prices would soar. In practice, new discoveries, technology and substitution have often kept prices in check for long periods. Scarcity depends on economics and technology, not just geology.

Key takeaways

Harold Hotelling treated resources in the ground as assets in 1931.
Owners compare the expected rise in a resource's net value with the interest rate.
Hotelling's rule says the net value, or scarcity rent, rises at the rate of interest.
Real prices often deviate because of discoveries, technology, substitutes and market power.