Strategic Resource Extraction: When Easy Doesn't Do It

We show that, for strategic reasons, an oligopolist in anatural resource industry might employ a backstop technology to develop costly reserves even if it does not plan to exhaust all less expensive deposits. The reason is that an oligopolist with increasing marginal costs of cheap reserves essentially faces a reverse learning curve where increasing current output will increase future marginal costs. If competitors are expected to respond aggressively to these increased marginal costs (as could happen, for example, in a Nash quantity game) then a high current output will mean lower future profitability for the decision making firm. This drop in future profitability due to changes in competitors strategies is a strategic cost of increased current output, and causes firms to limit first period production to the point where marginal revenue equals marginal production cost (the change in present value of total costs from raising current output by one unit and holding all future output levels constant) plus strategic cost. Because the backstop technology may involve no strategic costs (its use today not affecting the firms marginal costs in the future) such a technology will be employed up to the point where marginal revenue equals marginal cost. Therefore, in equilibrium, while the private cost of both production methods must equal marginal revenue, strategic factors may lead to the use of the backstop technology over some cheaper reserves with lower social costs of extraction but higher strategic costs.