journal of environmental economics and management 35, 164189 (1998)

article no. EE981027

Optimal Exploration for and Exploitation of
Heterogeneous Mineral Deposits
Robert D. Cairns
1
Department of Economics, McGill University, 855 Sherbrooke St. W.,
Montreal, Canada H3A 2T7
and
Nguyen Van Quyen
1
Department of Economics, Faculty of Social Sciences, University of Ottawa,
Ottawa, Canada K1N 6N5
Received November 1993; revised February 1998
We model exploration for and production froma multiple-deposit, nonrenewable resource.
Exploration is viewed as a Bayesian process involving learning about undiscovered reserves,
and is undertaken both to improve the quality of and to replenish known reserves. Known
reserves are not physically dened, but depend on the realizations of discrete episodes of
exploration elsewhere and on decisions at each instant about the margin between ore to be
mined and low-grade material to be rejected. The appropriate measure of resource scarcity,
thesustainablelevel of thecontribution of theresource, and thetreatment of depletion in the
national accounts are considered. 1998 Academic Press
Key Words: exploration; extraction; learning; microfoundations; scarcity.
1. INTRODUCTION
Optimal mineral exploration is a multifaceted problem, and economists have
taken a number of perspectives on it. For want of space, we cannot do justice
to a copious literature; Cairns [5] provides a detailed review. Among the informa-
tivecontributionsarethoseof Peterson [17], Pindyck [18, 19], Devarajan and Fisher
[7], Arrowand Chang[2], Swierzbinski and Mendelsohn [24], and Quyen [20, 21].
Optimal management of mineral wealth typicallyrequirestrade-offsamongthree
typesof decision, namely, (1) whento explorefor newdeposits, (2) whento develop
previously known but inactive deposits, and (3) the margins of exploitation. To
model these trade-offs, we stress that deposits are distinct. Mine managers and an
exploration unit are perceived as havingdistinct decision problems.
In Section 2, we characterize the equilibriumextraction prole when there is no
exploration. We nd that some deposits will not be brought onstreamimmediately,
1
We thank J on Conrad, Pierre Lasserre, YangZhao and three referees for helpful comments.
164
0095-0696/98 $25.00
Copyright 1998 by Academic Press
All rights of reproduction in any formreserved.
mineral exploration and exploitation 165
but will be held on the shelf for more propitious conditions (in the model, a
higher price). Trocki [26] argues that this has been an important feature of iron
and copper supply in this century. Also, we nd that mines of varying quality will
beexploited simultaneously, clearlyafeatureof reality, and werevisenotionsabout
the optimal order of exhaustion of existingdeposits.
Section 3introduces exploration as a learningprocess. We provide three particu-
lar examples before solving the general problemof exploration and extraction. We
discusshowthequalityof existingdepositsaffectstheoptimal exploration program,
and how the exploitation model of Section 2 is nested within the problemof op-
timal exploration and extraction. Success and failure in exploration feed back into
the miningproblemthrough the choice of cut-off grades.
Our resultshelpto cast further light onsomeof themainissuesof nonrenewable-
resource economics, includingthe role of the r-percent rule, the denition of mea-
sures of scarcity and of depletion, and the role of human action through resource
management. In Section 4 we interpret the conditions derived in Sections 2 and 3
for (i) the choice of cut-off grade and quantity mined at a given time and (ii) the
timing of exploration. We nd that price is the appropriate measure of resource
scarcity, and we eliminate other proposed measures. An expression identied as
Hotellings [12] rule for the rate of growth of aggregate rent is presented. But ag-
gregate rent cannot be interpreted in terms of aggregate magnitudes. Moreover,
there is no single shadow price which obeys Hotellings rule. Rather, there are r-
percent rules explicit to each producing deposit, and to the unexplored reserves
(which collectively forma nonrenewable resource) as well. An implication is that
existingempirical work on Hotellings rule may be misspecied.
Additions to known reserves are often considered to be an appreciation of nat-
ural capital, for the national accounts and other purposes. But the appreciation of
known reserves comes at the expense of depleting unexplored resources. We nd
that an unbiased estimate of the gain in welfare is the cost of exploration itself.
However, actual realizations of exploration programs will, with probability 1, lead
to changesinprice, cut-off grades, theexpectedvalueof theprogram, andall future
anticipations, and necessitate revaluations as unexpected capital gains and losses.
The ability to vary cut-off grades gives the decision maker an additional control in
optimizingresource use.
A detailed interpretation of the results of the model is presented in Section 4.
2. EXTRACTION
The most suggestive approach to our problem entails rst discussing the sub-
problem of exploiting mineral deposits after the region is fully explored. Then
we discuss exploration. However, as the solution to the subproblem turns out to
characterize optimal extraction between episodes of exploration, the approach has
two benets: (1) Our model can also be discussed in the context of the litera-
ture on exploiting known deposits. (2) We illustrate how the extraction problem
is nested within the exploration problem, which is itself a nonrenewable-resource
problem.
Our argument, though stylized, is intricate. Manyvariables are introduced in this
and the next section. For the readers convenience, these variables are summarized
in a table in Appendix II.
166 cairns and quyen
2.1. Mineral Deposits
Weassumethat all mineral depositshaveidentical geometrical dimensions. Their
qualities, however, may be different. Following Cairns [4] and Krautkraemer [13],
we assume that a deposit takes the formof a vertical cylinder of xed length and
radius, both normalized to 1. The base of the cylinder is at depth 1, so that the
orebody has no overburden. The grade-distribution function of a deposit of quality
:, as a function of the distance from the axis, is given by :g(), 0 1.
The function g() is assumed to be known and to be common to all deposits; it is
strictlydecreasingand continuouslydifferentiable, with g(0) 1and g(1) = 0. The
grade-distribution functions imply that deposits may differ through a multiplicative
factor representingtheir qualities. Thequality, : (0, 1), of a deposit is not known
before the deposit is found, but is revealed upon discovery.
A deposit is exploited by excavating downward. At each instant i a disc of ore
of thickness l
i
and radius
i
(and hence with cut-off grade :g(
i
)) is mined and
processed. The volume of this disc is :
i
=
2
i
l
i
, and its metal content is :n(
i
)l
i
,
where n(
i
) =
_

i
0
2 g( ) J .
We assume that, once excavation has proceeded beyond any given depth, it is
not possible to return to mine the remaining mineral at that depth. This may
appear to be a strong assumption; occasionally, mining rms can return to re-
work mines which have already been exploited. Technological change usually
occurs, however, to enable this change (cf. Boldt [3], p. 137ff.). We offer the fol-
lowing explanation for our simplication. First, it is assumed in this article that
there is no technological progress. Second, when royalty rates in British Columbia
were raised substantially in the 1970s, base-metal mining rms responded with
complaints that huge quantities of close-to-marginal ore would be lost forever
because it would later be uneconomic to return to extract ore rendered sub-
marginal bythe policy. This argument suggests that, most plausibly, the assumption
may be viewed as the limiting case of a very high cost associated with return-
ing to exploit part of a mine which has already been worked. It is consistent
with our assumption, made in the following text, of a nite choke price and
also with the practice of backlling previously worked parts of an underground
mine.
The total cost of miningand processinga disc of ore of volume : at depth L will
be denoted by c(:, L). Because :g(0) - 1 and c(:, L) includes processing costs,
c(:, 0) > 0. We shall call c(:, L) the extraction-cost function. Let D
i
be the differ-
ential operator withrespect to theithargument of thefunctioninvolved. Weassume
that c(:, L) has the following properties. (1) For all : 0 and for all L |0, 1|,
c(:, L) iswell denedandcontinuouslydifferentiable. (2) For anygivenL, thefunc-
tion c(:, L) isconvexand strictlyincreasingin :, and satisesc(0, L) = 0(costsare
nil if extraction is not occurring) and D
1
c(0, L) > 0. (3) For any : 0, D
1
c(:, L),
and for : > 0, D
2
c(:, L) are strictly increasingin L.
Sometimes, to derive sharper results, we shall assume the followingspecial form
of the extraction-cost function,
c(:, L) = :b(L), b(0) > 0. (1)
In this specication, we interpret b(L) as the cost of mining and processing a unit
volume of ore at depth L.
mineral exploration and exploitation 167
2.2. Exploitation of Several Proven Reserves
Let (q) be the inverse demand function for the metal in question. We assume
that (q) is continuouslydifferentiable and strictlydecreasinguntil it reaches zero.
Furthermore, the choke price (0) is positive and nite. Let u(q) =
_
q
0
(,) J,
denote the social welfare derived fromconsuming the quantity of metal q. Future
social welfare is discounted at rate r > 0.
Suppose that at any time s 0 there are n proven reserves (deposits) having
qualities :
1
, . . . , :
n
, and that these reserves have already been exploited to depths
L
1s
, . . . , L
ns
, respectively. A planner aims to exploit these deposits from the ini-
tial condition(L
s
, s, x) = (L
1s
, . . . , L
ns
, s, :
1
, . . . , :
n
) to maximizediscountedsocial
welfare. (Note that we use bold type to represent a vector.) Let L
ii
be the mining
depth at time i in the ith reserve.
The problemto be solved can be formally stated as follows. Given (L
s
, s, x), at
each timei s and for each i determineadisc of ore(l
ii
,
ii
) to beextracted from
the ith deposit so as to maximize the net present value of future welfare, i.e., to
max
_

s
e
ri
_
u
_
n
_
i=1
:
i
n(
ii
)l
ii
_

n
_
i=1
c(:
ii
, L
ii
)
_
Ji = +
n
(L
s
, s, x), (2)
subject to JL
ii
,Ji = l
ii
; l
ii
0; 0
ii
1; 0 L
is
L
ii
1. We shall assume
that (2) has a piecewise- and a right-continuous solution, i . (

l
ii
,
ii
)[
n
i=1
. For
each i, let

L
ii
denote the depth at time i in the ith reserve under the solution, and
let :
ii
=
2
ii

l
ii
; q
ii
= :
i
n(
ii
)

l
ii
; and q
i
=

n
i=1
q
ii
.
For each i, let T
i
be dened as follows. If the ith reserve is exploited indenitely,
set T
i
= . Otherwise, let T
i
be the exact time mining is terminated at the ith re-
serve. Weshall call T = max{T
1
, . . . , T
n
} thetimetheexploitation of then reserves
is terminated.
To solve (2), we rst dene the (present-value) Hamiltonian,
H(L, h, , , i) = e
ri
_
u
_
n
_
i=1
:
i
n(
i
)l
i
_

n
_
i=1
c(:
i
, L
i
)
_

n
_
i=1

i
l
i
.
Next, let

ii
= D
i
+
n
(L
i
, i, x), i = 1, . . . , n
betheshadowpriceof miningdepth in theith reservealongtheoptimal trajectory.
Because extraction costs increase with depth, and because of the assumption that
onceexcavationhasproceededbeyondagivendepthit isnot possibleto returnlater
to that depth to mine the remaining mineral, we must have D
i
+
n
0: the shadow
price of depth is nonpositive. Furthermore,
ii
evolves through time according to
the followingadjoint equation:
J
ii
Ji
= D
i
H
_

L
i
,

h
i
,
i
,
i
, i
_
= e
ri
D
2
c
_
:
ii
,

L
ii
_
. (3)
Weremark that (3) isther-percent ruleat adeposit, modied for theeffect on cost
of increasing depth. Although it will prove more direct to present our analysis in
present-value form, the rule is often written in terms of the current shadowvalue,

ii
=
ii
e
ri
. We can easily rewrite (3) as
J
ii
Ji
r
ii
= D
2
c
_
:
ii
,

L
ii
_
, (4)
to capture the intuition of the r-percent rule.
168 cairns and quyen
Because c(0, L) = 0 for all L, we have J
ii
,Ji = 0 when :
ii
= 0. Also, because
D
2
c(:, L) isstrictlyincreasinginL for anygiven: > 0, wemust havethat J
ii
,Ji >
0when :
ii
> 0. In short, the shadowprice of miningdepth in anydeposit is strictly
increasing when it is in production and remains constant when it is not. Because

ii
0, it is clear that if
ii
reaches 0at some time , then all miningfromthe ith
deposit will cease at .
At any time i when the ith reserve is in production, we must have both that

l
ii
> 0 and that
ii
> 0. Invoking the maximumprinciple, we obtain the following
rst-order conditions,
:
i
n
_

ii
_

_
q
i
_

2
ii
D
1
c
_
:
ii
,

L
ii
_

ii
e
ri
= 0, (5)
:
i
g
_

ii
_

_
q
i
_
D
1
c
_
:
ii
,

L
ii
_
= 0. (6)
If the ith deposit is not in production at time i, then either

l
ii
= 0 or
ii
= 0. If

ii
- 0, then the Hamiltonian is maximized only with

l
ii
= 0. If
ii
= 0, then as
argued before, miningat this reserve will never be undertaken after time i. Hence,
in this case,

l
ii
= 0 is also an optimal control. Therefore, when the ith proven
reserve is not exploited,

l
ii
= 0. Now, when

l
ii
= 0,
ii
is indeterminate and can
take on any value between 0 and 1. To remove the indeterminacy, recall condition
(6) and consider the following function:
ii
. :
i
g(
ii
)( q
i
) D
1
c(0,

L
ii
). It is
strictly decreasing and is equal to D
1
c(0,

L
ii
) - 0 at
ii
= 1. If :
i
g(0)( q
i
)
D
1
c(0,

L
ii
) > 0, then this function vanishes at a unique value of
ii
. In this case,
choose
ii
such that :
i
g(
ii
)( q
i
) D
1
c(0,

L
ii
) = 0. If :
i
g(0)( q
i
) D
1
c(0,

L
ii
)
0, then choose
ii
= 0.
Now, for each i = 1, . . . , n, we have

l
ii
_
:
i
n
_

ii
_

_
q
i
_

2
ii
D
1
c
_
:
ii
,

L
ii
_
e
ri

ii
_
= 0.
Summingthis expression over i = 1, . . . , n, we obtain
q
i

_
q
i
_

n
_
i=1
:
ii
D
1
c
_
:
ii
,

L
ii
_
e
ri
n
_
i=1

ii

l
ii
= 0. (7)
Furthermore, the followingresult comes fromthe HamiltonJ acobiBellman equa-
tion,
e
ri
_
u
_
q
i
_

n
_
i=1
c
_
:
ii
,

L
ii
_
_

n
_
i=1

ii

l
ii
= D
n1
+
n
_

L
i
, i, x
_
= re
ri
+
n
_

L
i
, 0, x
_
. (8)
In (8), the differentiation of +
n
in the middle expression is with respect to i,
the (n 1)th argument. The second equality comes from the obvious result that
+
n
(

L
i
, i, x) = e
ri
+
n
(

L
i
, 0, x). Equation (8) expressesthefamousresult (seeWeitz-
man [27]) that, alongthe optimal path, the Hamiltonian is equal to the interest on
the value of the objective function.
Using(7), we can rewrite (8) as
_
u
_
q
i
_
q
i

_
q
i
__

n
_
i=1
_
:
ii
D
1
c
_
:
ii
,

L
ii
_
c
_
:
ii
,

L
ii
__
= r+
n
_

L
i
, 0, x
_
. (9)
mineral exploration and exploitation 169
Some observations on (9) are in order. First, note that u( q
i
) q
i
( q
i
) 0, with
equalityif and onlyif q
i
= 0. Second, notethat for each i wehave :
ii
D
1
c( :
ii
,

L
ii
)
c( :
ii,

L
ii
) 0 because c(:, L) is convex and strictly increasing in : and c(0, L) =
0. Hence, on the left-hand side of (9), each expression inside a pair of square
brackets is nonnegative. Third, the right-hand side of (9) is strictly decreasingover
the interval |s, T|, and +
n
(

L
T
, 0, x) = 0. Therefore, q
T
= 0; i.e., the price ( q
i
)
rises to the choke price (0) at the time all extraction is terminated.
Although the price must ultimately rise to the choke price, in a simpler model
Levhari and Liviatan [14] argued that the price path may not be monotonic. The
intuition is that, while the right-hand side of (9) is decliningthrough time, the term
involving the summation sign might fall sufciently fast to make u( q
i
) q
i
( q
i
)
risetemporarily. Nevertheless, if theextraction-cost function assumes theformrep-
resented in Eq. (1), then :D
1
c(:, L) = c(:, L) for all : 0 and for all L |0, 1|,
and (9) reduces to
u
_
q
i
_
q
i

_
q
i
_
= r+
n
_

L
i
, 0, x
_
. (10)
In this case, it follows directly from (10) that q
i
is strictly decreasing to 0 as i
increases froms to T.
We summarize the results just derived in the followingproposition.
Proposition 1. The price of metal rises to the choke price when excavation ac-
tivities are winding down; i.e., ( q
i
) (0) when i T. Price need not be mono-
tonically increasing. But the rise to (0) is monotonic if the extraction-cost function
assumes the special functional form given by (1).
Proposition 1makesclear that Swierzbinski and Mendelsohn [24] and othersnd
that priceisstrictlyincreasingbecausetheyassumeconstant unit costsasin Eq. (1).
Now suppose that the ith deposit is in production at time i. If one maintains
the thickness of the disc of ore excavated at

l
ii
, but increases the cut-off radius
slightly, from
ii
to
ii
J
ii
, then the increase in the amount of mineral pro-
duced is Jq
ii
= :
i
2
ii
g(
ii
)

l
ii
J
ii
, and the increase in extraction cost is Jc
ii
=
2
ii

l
ii
D
1
c(
2
ii

l
ii
,

L
ii
)J
ii
. Thus, at the optimal cut-off radius,
ii
, the marginal
cost of metal is
Jc
ii
,Jq
ii
=
D
1
c( :
ii
,

L
ii
)
:
i
g(
ii
)
= ( q
i
). (11)
The second equality is due to condition (6). On the other hand, if one maintains
the radius of the disc of ore at
ii
but increases its thickness slightly from

l
ii
to

l
ii
Jl
ii
, then the increase in its metal content is Jq
ii
= :
i
n(
ii
) Jl
ii
, and the
increase in discounted extraction cost is e
ri
Jc
ii
= e
ri

2
ii
D
1
c(
2
ii

l
ii
,

L
ii
) Jl
ii
.
Furthermore, the variation in the user cost of miningdepth is
ii
Jl
ii
. Therefore,
the full discounted marginal cost incurred in mining one more unit by increasing
the thickness of the disc of ore excavated is
e
ri
Jc
ii
Jq
ii
=
e
ri

2
ii
D
1
c( :
ii
,

L
ii
)
ii
:
i
n(
ii
)
= e
ri
( q
i
). (12)
In (12), the second equality is due to condition (5).
Therefore, there are two margins of exploitation, an intensive margin character-
ized by (6) and an extensive margin characterized by (5). At the extensive margin,
170 cairns and quyen
two kinds of cost are involved, extraction cost and user cost of mining depth. The
latter captures the depletion of the reserve. As noted previously, condition (3) is a
modied r-percent rule for miningdepth, applyingspecically at reserve i. To gain
more insight into that rule, we rewrite (12) as follows,
e
ri
_

_
q
i
_

2
ii
D
1
c( :
ii
,

L
ii
)
:
i
n(
ii
)
_
=

ii
:
i
n(
ii
)
. (13)
In (13), the left-hand side represents the discounted net benet contributed by a
unit of metal at theextensivemargin. Theright-hand side, in general, differsamong
the n reserves because of their differences in quality and depth. Indeed, the gaps
between price and the marginal costs of producing metal at the extensive margins
arenot ingeneral equalizedacrossthedepositsthat areinproductionat anyinstant:
we can rewrite (13) using(11) to showthat

ii
e
ri
:
i
n(
ii
)
= ( q
i
)

2
ii
D
1
c( :
ii
,

L
ii
)
:
i
n(
ii
)
=
_
q
i
_
_
1

2
ii
g(
ii
)
n(
ii
)
_
, (14)
which depends on the cut-off grade
ii
and hence the quality :
i
and the depth

L
ii
.
We have just proved the following.
Proposition 2. (i) At any instant, the costs of producing metal at the intensive
margins are identical for all deposits being exploited. (ii) Costs at the extensive margins
vary across producing deposits. A modied r-percent rule holds at the extensive margin,
but is particular to each deposit. (iii) Full marginal cost at each margin is equal to the
price of metal.
At any instant that the ith deposit is beingexploited, (6) holds, and so

_
q
i
_
=
D
1
c( :
ii
,

L
ii
)
:
i
g(
ii
)
>
D
1
c(0,

L
ii
)
:
i
g(0)

D
1
c(0, L
is
)
:
i
g(0)
. (15)
In (15), the strict inequality follows fromthe assumptions that c(:, L) is convex in
: and that g() is strictly decreasing in , and the second inequality follows from
the assumption that D
1
c(:, L) is strictly increasingin L. Hence, for any i (s, T),
(0) >
_
q
i
_
>
D
1
c(0, L
is
)
:
i
g(0)
, (16)
if the ith proven reserve is exploited at time i. We can now prove the following
proposition. (Proofs can be found in Appendix I.)
Proposition 3. Consider a reserve, i, with initial mining depth satisfying L
is
- 1.
This reserve will be brought into production if and only if :
i
> D
1
c(0, L
is
),|(0)g(0)|.
For the remainder of this section, we assume that, given the choke price (0),
all n reserves are of at least the minimal quality that they will be brought into
production some time after s, i.e., that
:
i
>
D
1
c(0, L
is
)
(0)g(0)
for all i. (17)
mineral exploration and exploitation 171
Wenowexploit Proposition3to demonstratehowthequalityandtheinitial depth
of a deposit affect its pattern of exploitation relative to the other proven reserves.
First, let :
.
and :
;
be dened as follows,
:
.
=
D
1
c(0, 0)
(0)g(0)
;
:
;
=
D
1
c(0, 1)
(0)g(0)
.
(18)
These are the minimal qualities for protable exploitation of a reserve at depths 0
and 1, respectively. It isclear that 0- :
.
- :
;
. Furthermore, for anyproven reserve
of quality: withinitial miningdepthequal to zero, thefollowingresultsfollowfrom
Proposition 3.
Corollary 1. Let :
.
and :
;
be dened by (18). Consider a deposit of quality :
and zero initial mining depth. (i) If : :
.
, then this deposit will never be exploited.
(ii) If : > :
;
, then the reserve will be mined all the way to depth 1. (iii) If :
.
- : :
;
,
then it will be mined down to the depth L dened implicitly by D
1
c(0, L),|:g(0)| =
(0). This cut-off mining depth is a strictly increasing function of : in (:
.
, :
;
|.
Intuitively, we expect that reserves with lower extraction costs should be brought
into production before those with higher extraction costs. It is well known that
when each proven reserve is of uniformquality and marginal extraction costs are
constant within each reserve, then a reserve with lower marginal extraction cost
should be exploited and exhausted before a reserve with higher marginal extraction
cost isbrought into production. Inour model, thereisno singlemeasureof marginal
extraction cost for any deposit. Cost at the intensive margin depends only on the
quality and the current mining depth. Cost at the extensive margin depends on
those same variables as well as the qualities and current miningdepths of the other
reserves. We provide the following partial answer to the question concerning the
order in which production in each reserve is started and ended.
Proposition 4. (i) Consider any two proven reserves, i and ], with qualities sat-
isfying :
.
- :
i
- :
]
and initial depths satisfying (17). If :
i
- :
;
then it is optimal to
mine the ]th reserve to a greater depth than the ith reserve. If :
]
- :
;
, both reserves
are exploited simultaneously, at least near the time T when all mining is terminated. If
:
]
> :
;
, then T
]
- T
i
.
(ii) Suppose that the extraction-cost function c(:, L) assumes the form given by
(1). If the quality of a reserve is sufciently high and its initial depth is shallow, then
it will be exploited immediately. Production from the other reserves may take place
only after the metal price has risen sufciently. On the other hand, a reserve having a
combination of low quality and high initial depth will be shelved temporarily.
Therefore, somemineralization(of lower qualitythan:
.
) isnever exploitedat all.
It maybethat somereserves(of lowqualitybut higher than:
.
) areheldontheshelf.
Other reservesareexploitedsimultaneously. Depositsof highquality(exceeding:
;
)
are exhausted (in the sense that L
T
= 1) in order of quality. But all deposits with
qualitybetween :
.
and :
;
aremined up to timeT and then closed with their depths
not havingreached L = 1.
172 cairns and quyen
3. EXPLORATION
Using geological knowledge of a given region, we partition it into N cells in the
belief that in each cell there is a single potential mineral deposit.
3.1. The Exploration Process
The metal content of a mineral deposit of quality : is 2:
_
1
0
g() J, which
is clearly proportional to :. Hence, we can identify the content of deposit i with
its (random) quality, :
i
. We assume that exploration at any cell can be carried
out instantaneously and yields perfect information about the value of :
i
. Also, the
potentials of the N cells are identical in the following sense. First, it costs the
sameamount, K > 0, to exploreeach cell. Second, :
1
, . . . , :
N
areindependent and
identicallydistributed randomvariables. Becauseall thepotentials areidentical, we
can assume that the cells are explored sequentially.
Consider a representative cell. We postulate a strictly increasing function
1
:
: . , with lim
:0

1
(:) = 0 and lim
:1

1
(:) = . The random variable
, which is an index of the quality, :, of the deposit in the cell, is taken to be
exponentially distributed with parameter ;
2
its density function is then given by
] ([) = e

, > 0.
To model learning in the exploration process, we apply Bayesian statistical de-
cision theory by postulating a prior density for , then revising it repeatedly via
Bayess formula, using the most recent data on discoveries as the exploration pro-
gram unfolds. We assume that initially has a gamma density with parameters
> 0 and > 0, and we write the conditional (on and ) density of as
g

() =

e
,

1
!()
, > 0,
where !() =
_

0
u
1
e
u
Ju for > 0, and !() = ( 1)!( 1) for > 1.
Thechoiceof agammadensityfor is madeto keep theexposition manageable.
In the statistical literature, the gamma density is known as a conjugate prior of the
exponential process. Usingaconjugateprior allowsoneto beginwithacertainform
of the prior and to end up with a posterior of the same functional form, after the
parameters have been updated by the sample information. Indeed, let
]

() =
_

0
] ([)g

() J,
2
The function
1
takes the actual distribution of : (0, 1) onto the range of so that we can
applystatistical decision theoryto . Weassumethat thedistribution of involves asingleparameter. It
would have been possible to use a less restrictive distribution, with more unknown parameters, such as
thelognormal which hastwo. However, theconjugatedistribution would haveamuch morecomplicated
form. (See Raiffa and Schlaifer [22], p. 55.) Manipulations would be more difcult, but would not yield
greater economic insight.
mineral exploration and exploitation 173
be the marginal density of , given the parameters and that characterize the
prior density of . The conditional density of , given , is
g

()] ([)
]

()
=

e
,

1
e

!()]

()
= g
1,
()
,
]

()
_


_
1
;
(19)
i.e., it is proportional to the gamma density with parameters
1
= 1 and
1
=
. Integrating(19) with respect to from0 to , we obtain
,
]

()
_


_
1
. (20)
Using(20) in (19), weseethat g

1
() is theposterior densityof , given . It also
follows from(20) that the marginal density of , given the parameters and of
the prior gamma density of , is
]

() =

_


_
1
= 1. (21)
Hence, can be characterized by the marginal probability mass function, ]

(),
in (21). Note that this marginal probability mass function is indexed by the double
subscript, , that characterizes the prior density of .
3.2. Exploration and Learning
Nowsuppose that cell 1is explored and a deposit with qualityindex
1
is discov-
ered. ThereremainN 1unexploredcells. Theuncertainqualityof arepresentative
unexplored cell is nowbelieved to be exponential with parameter , which in turn
has a gamma density with updated parameters
1
= 1 and
1
=
1
. Alter-
natively, the uncertain quality of a representative potential mineral deposit can be
characterized usingthe marginal probability mass function, ]

1
(), whose explicit
formis given by (21). This revision process is repeated each time a cell is explored
and comes to an end either when all the cells have been explored or when it is
decided that exploration will be discontinued. If we interpret as the cumulative
mineral discovery in some former exploration region after cells have been ex-
plored, then at any point in time the cumulative discovery and the number of cells
already explored embody all the learningfromthe exploration process. Indeed, ac-
cordingto thisinterpretation, immediatelyafter thenewcell hasbeen explored, the
newcumulative discovery is
1
and the number of cells explored is
1
.
The distribution function associated with the density function ]

() is
I

() =
_

0
]

(,) J, = 1
_


_

. (22)
For any given > 0, and for any > 0, the function . I

() is strictly
increasing, and I

() 1as . Moreover, for any given > 0, and for any

> 0, the function . I

() is strictly decreasing, and I

() 1 as 0.
We summarize the results obtained in the followingtheorem.
174 cairns and quyen
Theorem 1. The family of distribution functions (I

) is stochastically decreasing
in and is stochastically increasing in . More precisely, for each given > 0,
(i) . I

() is strictly increasing for each given and I

() 1 as
;
(ii) . I

() is strictly decreasing for each given and I

() 1 as
0.
Theorem 1 plays a fundamental role in our analysis. Its economic content can
be explained as follows. Part (i) asserts that for any given , I

() increases as
increases; i.e., as increases, the chance that the index of the uncertain quality of
a potential mineral deposit exceeds decreases. Ceteris paribus, the higher is past
exploratory effort (for a given level of discovery), the lower the expected quality of
the remainingpotential deposits. In the extreme case that is large, I

() will be
close to 1 for any given ; i.e., the quality of a potential mineral deposit will tend
to be very low. Part (ii) asserts that for any given level of exploratory activity, ,
the higher is , the cumulated discoveryin the past, the richer will be the expected
quality of the remaining potential deposits. Furthermore, because I

() 1 as
0, the qualities of the remaining potential deposits will likely be poor if the
given cumulative discovery has been low.
3
To see how Theorem 1 is applied, suppose that we explore cell 1 and we nd
a deposit with index of quality
1
. At this point, we update the initial distribution
function, I

(), to I

1
(), where
1
= 1and
1
=
1
; I

1
nowcaptures
the quality index of the N 1 remaining unexplored cells. Whether I

1
is more
favorable than I

depends on the value of

1
. If
1
0 (the exploration of cell 1
resultsinafailure), thenI

1
isunambiguouslylessfavorablethanI

byTheorem
1(ii). On the other hand, if
1
is large, then by Theorem1(i), the discovery effect
can more than offset the negative effect resulting fromthe increase in the number
of cells explored, and render I

1
more favorable than I

.
Before we attack the general case of exploration with extraction, let us consider
three special, illustrative situations.
3.3. One Unexplored Cell, No Proven Reserve
Suppose that we begin at time zero with no proven reserve, but there is the
opportunityof exploringfor asinglepotential reserve. Let betheindexof quality
of the deposit. Once the deposit has been explored its qualityis revealed to be : =
(). ByCorollary1, this newlydiscovered reserve will be exploited onlyif : > :
.
.
The exploitation of such a reserve yields a discounted net welfare of +
1
(0, 0, :),
where +
1
(0, 0, :) = 0 if : :
.
. Before this deposit is explored, its expected value,
in terms of discounted social welfare net of extraction (but not exploration) costs,
3
At anytime, theinformationabout remainingunexploredcellsisassumedto beidentical; i.e., thereis
nogeological knowledgethat allowsdistinguishingamongcells. Particularlywithinanoil play, exploration
may systematically turn up larger reserves rst. See Cairns [5] for a discussion of the literature on
this problem. In a disaggregated model, modeling this feature would require modeling another type of
learning, movingbeyond the ad hoc assumption hitherto made in the literature, that quality declines or
cost increases with cumulative exploration in some known, unchanging and exogenously given way. We
leave the modelingof this type of learningto future research.
mineral exploration and exploitation 175
is given by
!
1

=
_

0
+
1
|0, 0, ()|]

() J. (23)
In this notation, !
n

is the discounted value of n unexplored cells when there is no

proven reserve. We have the followingresult.
Proposition 5. For any given , !
1

is strictly decreasing in and for any , !

1

is strictly increasing in . That is, ceteris paribus, the higher is the past cumulative
discovery, the higher is the value of the potential mineral deposit. Also, ceteris paribus,
the higher is the number of cells explored in the past, the lower is the value of the
potential deposit.
The decision whether or not to explore for the potential reserve depends on its
expected value relative to exploration costs. We have the followingobvious result.
Corollary 2. If !
1

> K, then one should search for the mineral deposit. Other-
wise, no exploratory activity should be undertaken.
3.4. One Unexplored Cell, One Proven Reserve
Suppose that we begin at time s 0 with a proven reserve of quality :
1
= (
1
)
and that this reserve has already been exploited to depth L
is
|0, 1). Suppose also
that there is a single unexplored cell. The indexof quality of the contained deposit
is
2
.
The problem we face can be stated formally as follows. Given L
is
, choose an
exploration date, , and an extraction program, (l
1i
,
1i
), s i - at the proven
reserve, to
max
_

_
_

s
e
ri
_
u
_
:
1
n(
1i
)l
1i
_
c
_

2
1i
l
1i
, L
1i
__
Ji
e
r
K
_

0
+
2
|L
1
, 0, , :
1
, ()|]

() J
_

_
= 4
1, 1

(L
1s
, s, :
1
), (24)
subject to JL
1i
,Ji = l
1i
; l
1i
0; 0
1i
1; 0 L
1s
L
1i
1, for all i |s, ).
4
In (24), the rst integral represents the net discounted social welfare derived
fromexploitingtheprovenreserveprior to exploring. Thesecondterm, e
r
K, isthe
discountedexplorationcost incurredat time. Immediatelyafter time, two proven
reservesareavailablefor exploitation, theoriginal reserve, whichhasbeenminedto
depthL
1
, andthenewlydiscoveredreserve, whichisof revealedquality:
2
= (
2
)
and has current miningdepth L
2
= 0. The discounted social welfare derived from
exploitingthesetwo provenreservesfromtheinitial condition(L
1
, L
2
, , :
1
, :
2
) is
+
2
(L
1
, L
2
, , :
1
, :
2
). Thesecondintegral isthusthepresent valueof theexpected
social welfare after time .
In the optimal-value function 4 dened in (24), the rst superscript refers to the
number of proven reserves currently available, and the second superscript refers
to the number of unexplored cells. The uncertainty concerning the quality of the
potential reserve is represented by the double subscript, . In general, if there
4
Weitzman [28] provides a quite intuitive perspective on the types of condition governingthe optimal
times of exploitation, exploration, etc.
176 cairns and quyen
are n proven reserves and n
/
potential reserves, then the appropriate notation is
4
n, n
/

(L
s
, s, x), with L
s
and x denoting vectors of the initial depths and qualities of
the n proven reserves.
Let be the optimal exploration date and let (

l
1i
,
1i
), s i - , be the optimal
programfor exploiting the proven reserve prior to . Also, for each i |s, ), let

L
1i
be the miningdepth at time i in the proven reserve under that program.
First, we must establish the followingresult.
Lemma 1. If K - !
1

, where !
1

is dened by (23), then it is optimal to explore

for the potential reserve at some time i s. If K !
1

, then one should never explore

but should concentrate on producing from the proven reserve.
For theremainder of thissection, weassumethat !
1

> K: it isoptimal to explore

for the potential reserve. We also assume that the extraction-cost function c(:, L)
has the formrepresented in (1).
If the potential reserve is explored immediately, then = s, and

L
1
= L
1s
.
If the proven reserve is exploited for some time before exploration, then > s
and

L
1
> L
1s
. For each i |s, ), let
ii
= D
1
4
1, 1

L
ii
, i, :
1
) be the shadowprice
of mining depth at time i in the proven reserve. As before,
1i
0 and obeys the
followingadjoint equation,
J
1i
Ji
= D
1
H
_

L
1i
,

l
1i
,
1i
,
1i
, i
_
= e
ri
D
2
c
_
:
1i
,

L
1i
_
, (25)
where :
1i
=
2
1i

l
1i
and H is the Hamiltonian dened by
H(L
1
, l
1
,
1
,
1
, i) = e
ri
_
u
_
:
1
n(
1
)l
1
_
c(:
1
, L
1
)
1
l
1
_
.
Invoking the maximumprinciple, we can assert that for any i |s, ),

l
1i
and
1i
satisfy the followingrst-order conditions,
:
1
n
_

1i
_

_
q
_

2
1i
D
1
c
_
:
1i
,

L
1i
_
e
ri

1i
= 0; (26)
:
1
g
_

1i
_

_
q
_
D
1
c
_
:
1i
,

L
1i
_
= 0, (27)
where q
i
= q
1i
= :
1
n(
1i
)

l
1i
is metal output at time i. In the current context of
one proven reserve and one potential reserve, (26) and (27) are the counterparts
of (5) and (6) previously derived, while (25) is the counterpart of (3). The analysis
of (26), (27), and (25) can, then, be conducted as in Section 2. This observation
indicates that theextraction problem, thetypical problemstudied in nonrenewable-
resourceeconomics, isnestedwithintheexplorationproblem. Also, becausethereis
alimited number of cells, theexploration problemitself isanonrenewable-resource
problem. In particular, the followingversion of (10) holds for any i |s, ),
n
_
q
i
_
u
_
q
i
_
q
i

_
q
i
_
= r4
1, 1

L
1i
, 0, :
1
_
. (28)
Because4
1, 1

L
1i
, 0, :
1
) !
1

K and becausen(q) is strictlyincreasingin q 0,

it follows directly from(28) that
q
i
n
1
|r(!
1

K)| > 0, s i - . (29)

It then follows from(27) and (29) that
D
1
c(0,

L
1i
)
:
1
g(0)
-
D
1
c( :
1i
,

L
1i
)
:
1
g(
1i
)
= ( q
i
) ().
The followingproposition is nowevident.
mineral exploration and exploitation 177
Proposition 6. If D
1
c(0,

L
1i
),|:
1
g(0)| (), where > 0 is dened in (29),
then exploration takes place immediately. That is, if a combination of mining depth and
quality makes the initial marginal cost of production at the intensive marginwhen this
margin is close to the axis of the proven reservesufciently high, then it is optimal to
search for the potential reserve immediately.
Proposition 6 provides a loose bound on (:
1
, L
1
) for there to be immediate ex-
ploration ( = s); theremaybevalues of (:
1
, L
1
) for which D
1
c(0,

L
1i
),|:
1
g(0)| -
() and yet exploration occurs immediately. Wecan also determinealoosebound
(which depends on :
1
, L
1s
, K, , and ) for thereto bea wait until theunexplored
cell is explored ( > s), as follows.
Corollary 3. It is not optimal to search immediately for the potential reserve if
the quality of the proven reserve is high and its current mining depth is shallow.
Nowas i tends to fromthe left, let q

= lim
i
q
i
. Then by (28),
n
_
q

_
= r4
1, 1

L
1
, 0, :
1
_
= r
_
_

0
+
2
_

L
1
, 0, 0, :
1
, ()
_
]

() J K
_
. (30)
Immediately after exploration has taken place, there are two proven reserves to
exploit and, given a newly discovered reserve of quality :
2
, the social welfare dis-
counted to time is updated to +
2
(

L
1
, 0, 0, :
1
, :
2
). The solution to this problem
was discussed in Section 2, and a version of (10) holds. Let q

= lim
i
q
i
. Then
n
_
q

_
= r+
2
_

L
1
, 0, 0, :
1
, :
2
_
. (31)
It isevident fromthesecond equalityin (30) that 4
1, 1

L
1
, 0, :
1
) - +
2
(

L
1
, 0, 0,
:
1
, :
2
) K,r for at least onevalueof :
2
. Indeed, 4
1, 1

(L
1s
, s, :
1
) iscontinuousat .
(See the denition of 4
1, 1

in (24).) Furthermore, +
2
(

L
1
, 0, 0, :
1
, :
2
) is increasing
and continuous in :
2
. Thus, by (30) there is an :
0
2
> 0 such that
+
2
_

L
1
, 0, 0, :
1
, :
2
_
_

_
- 4
1, 1

L
1
, 0, :
1
_

K
r
if :
2
- :
0
2
;
= 4
1, 1

L
1
, 0, :
1
_

K
r
if :
2
= :
0
2
;
4
1, 1

L
1
, 0, :
1
_

K
r
if :
2
> :
0
2
.
(32)
By (30) and (31), we assert that :
0
2
is that value of :
2
which equates the expected
(before ) and the updated (after ) values of the objective function, so that
4
1, 1

L
1
, 0, :
1
_
=
_

0
+
2
_

L
1
, 0, 0, :
1
, ()
_
]

() J K
= +
2
_

L
1
, 0, 0, :
1
, :
0
2
_
K,
and, when :
2
= :
0
2
,
n
_
q

_
= n
_
q

_
. (33)
It follows from(33) that if :
2
> :
0
2
then q

> q

and if :
2
- :
0
2
then q

- q

.
We have just demonstrated the followingproposition.
178 cairns and quyen
Proposition 7. Suppose that > s; i.e., exploration is not carried out immediately.
Then the expected value of the objective function, as updated, is continuous at the
optimal exploration date. Still, with probability 1, the metal price experiences a jump
at the exploration date. More precisely, if the quality of the newly discovered reserve
exceeds the critical value :
0
2
dened in (32), then the price takes a downward jump
at time , and the larger the difference :
2
:
0
2
, the larger the jump. If :
2
- :
0
2
, then
the price takes an upward jump and the size of the jump increases with the difference
:
0
2
:
2
.
ApplyingProposition 4(ii), we obtain the followingresult.
Corollary 4. (i) If the quality of the potential reserve is sufciently high, then this
reserve will be brought into production immediately after its discovery. More precisely, if

_
n
1
_
r+
2
_

L
1
, 0, 0, :
1
, :
2
___
-
D
1
c(0,

L
1
)
:
1
g(0)
,
then production from the original proven reserve should be suspended and all produc-
tion should be concentrated at the newly discovered reserve.
(ii) If :
2
is low but still greater than the cut-off quality (:
.
), then the newly
discovered reserve will be shelved temporarily. It will be brought into production after
the price of metal has risen sufciently. This will occur if

_
n
1
_
r+
2
_

L
1
, 0, 0, :
1
, :
2
___
-
D
1
c(0, 0)
:
2
g(0)
- (0).
3.5. Two Unexplored Cells, No Proven Reserve
Suppose that we begin at time zero with no proven reserve, but have an explo-
ration region of two cells. Cell 1isexplored rst and amineral deposit of quality:
1
is discovered. Immediately after the discovery of this reserve, we have one proven
reserve, and one potential reserve in cell 2. Before any exploration is carried out,
the density function of
i
, i = 1, 2, is ]

(
i
), as represented in (21). After cell 1
has been explored,
1
is known and
2
is then believed to have the densityfunction
]

1
(
2
), where
1
= 1 and
1
=
1
. Given :
1
, the expected discounted
utility is 4
1, 1

1
(0, 0, :
1
), as discussed in the previous subsection. Let
!
2

=
_

0
4
1, 1
1,
1
(0, 0, (
1
))]

(
1
) J
1
.
As dened, !
2

gives theexpected discounted utilitygross of thecost of exploring

cell 1under the decision to explore cell 1 immediately. The following result is
evident.
Proposition 8. If !
2

> K, then exploration of cell 1 should be undertaken im-

mediately. Otherwise, the exploration region should be abandoned.
Nowobserve that the function
1
. !
1
1,
1
is strictly increasing by Proposi-
tion 5. To avoid the degenerate case that the second cell will not be explored no
matter how large :
1
is, we assume that lim

!
1
1,
> K, and we dene
.
1
implicitly by
!
1,
.
1
= K. (34)
mineral exploration and exploitation 179
Then,
.
1
is the critical indexof quality such that if the rst cell is explored and the
indexof quality
1
of thediscovered reserveis found to beno greater than
.
1
, then
cell 2 will be abandoned. It is clear that, ceteris paribus,
.
1
is decreasing in . In
particular, if !
1
1,
> K, then
.
1
= 0; i.e., if , the past cumulative discovery, is
not too lowand if the qualityof the reserve found in cell 1falls short of the critical
value :
.
mentioned in Corollary 1, then cell 2 will be explored immediately after
cell 1.
Next, notethat theargument used to proveCorollary3can berepeated verbatim
to assert that if :
1
is high enough, then exploration will be temporarily suspended
after cell 1 has been explored. Metal production will come exclusively from the
reserve discovered in cell 1, and cell 2 will be explored only after mining in this
reserve has reached a certain depth. Keepingthese facts in mind, let us dene

;
1
= min
_
,

,
.
1
and if
1
,, then cell 2 will not be
searched immediately after cell 1 has been explored.
_
. (35)
The followingproposition is nowevident.
Proposition 9. Let
.
1
and
;
1
be dened by (34) and (35). Suppose that cell 1 is
explored and a reserve having index of quality
1
is discovered.
(i) If
1
-
.
1
, then cell 2 will be abandoned.
(ii) If
1

;
1
, then exploration will be temporarily suspended. The proven re-
serve in cell 1 will be exploited for some time before exploration of cell 2 is carried
out.
(iii) If
.
1

1
-
;
1
, then cell 2 will be explored immediately after cell 1, and in
a right neighborhood of time s, we have two reserves to exploit.
Nownote that 4
1, 1
1,
1
(:
1
)
(0, 0, :
1
) is increasing in :
1
. There are two reasons
for this result. First, a higher value of :
1
means a higher qualityfor the reserve just
found in cell 1. Second, the distribution function that characterizes the uncertain
quality of the potential reserve in cell 2 is I
1,
1
(
2
), which is stochastically
increasing in
1
by Theorem1, and hence in :
1
. By the same proposition, I

(
1
)
is stochastically increasing in . The following two-cell version of Proposition 5 is
evident.
Proposition 10. For any given , !
2

is decreasing in and for any given , !

2

is increasing in . That is, ceteris paribus, the higher is the past cumulative discovery,
the higher is the potential of the two-cell region. Also, ceteris paribus, the higher is the
number of cells explored in the past, the lower is the potential of the two-cell exploration
region.
Proposition 10 deals with the inuence of past exploration outcomes (from a
reference region, say) on the potential of a two-cell region. We nowconsider how
the net potential of an exploration region varies in terms of the number of cells
it contains. Suppose, then, that we begin at time zero with no proven reserve, but
havetheopportunityof exploringfor mineral reservesin an N-cell region. Then we
have the following.
Proposition 11. Suppose that we begin at time zero with an N-cell exploration
region but we have no proven reserve. For N = 1, the expected value in terms of
discounted welfare, net of exploration, and extraction costs, is !
1

K. For N = 2,
180 cairns and quyen
the corresponding value is !
2

K !
1

K. Furthermore, if we consider the value

of the rst cell as given by !
1

K, then the incremental contribution yielded by the

second cell is less than the (incremental) contribution of the rst cell.
3.6. The General Case
When there are n proven reserves and n
/
unexplored cells at time s, the value
function is
4
n, n
/

(L
s
, s, x) = max
_

_
_

s
_
u(q
i
)
n
_
i=1
c(:
ii
, L
ii
)
_
e
ri
Ji e
r
K

_

0
4
n1, n
/
1
1,
_
L
/

, , x
/
_
]

() J
_

_
, (36)
where L
/

= (L

, 0) and x
/
= (x, ()). The following theoremextends the analysis
to this general case.
Theorem 2. (i) The optimal value function 4
n, n
/

, dened in (36), is decreasing

in for given , and increasing in for given .
(ii) There are values,
.
n1
0 and
;
n1
>
.
n1
, for which the following
hold. (a) Exploration will not be undertaken again if the realized value of
.
n1
.
(b) Exploration will be undertaken immediately if
.
n1
-
;
n1
. (c) Exploration
will be suspended temporarily if >
;
n1
.
(iii) The expected value of the objective function is continuous at an optimal
exploration date. But, with probability one, there is a jump in price upon the realization
of exploration. There is a quality for the (n 1)th cell, :
0
n1
(= (
0
n1
) for some
value
0
n1
), which is realized with probability 0, and for which the jump is negative if
:
n1
> :
0
n1
and for which the jump is positive if :
n1
- :
0
n1
. Furthermore, the size
of the jump is increasing in the divergence of :
n1
from :
0
n1
.
(iv) The incremental value of an additional unexplored cell is positive but, ceteris
paribus, is decreasing in the number of unexplored cells.
4. ECONOMIC IMPLICATIONS
Use of the exponential process and its conjugate, the gamma process, to model
learning yields an economically intuitive result, namely Theorem1. Ceteris paribus,
a larger past cumulative discovery implies richer potential reserves while a greater
number of cells already explored makes one more pessimistic about the qualities
of the remaining potential reserves. We were able to model the multiple goals of
replenishment of reserves, discovery of better quality reserves, and reduction of
uncertainty, and the trade-offs amongthemin an optimal program.
In reality, we do expect that some discoveries havingonlylow-qualitymineraliza-
tion may never be mined. Medium-quality deposits are held on the shelf. Further-
more, deposits of widely differingquality are mined simultaneously.
Themodel has implications for someof theimportant questions of resourceeco-
nomics. Tietenberg[25], Chap. 13, lists four possiblemeasures of scarcityin perfect
market: price, marginal discovery cost, marginal (extraction) cost, and user cost.
Our examination eliminated thelast three. Marginal discoverycost isnot dened in
mineral exploration and exploitation 181
a model of discrete discoveries. Rather, expected incremental discoverycost is equal
to unity, in thefollowingsense: exploration occurs when theoptimal programvalue
has fallen to the point that, when K is expended, benets havingexpected value of
K will be obtained. User cost varies at producing deposits: there is no global price
bywhich reserves in situ can beaggregated. Cost at theintensivemargin is equal to
thepriceof thenal product. Pindyck [19], Devarajan and Fisher [7], and Adelman
[1] compared the resource rent per unit of reserves to the marginal discovery cost
of additional reserves. In our model there is no single measure of reserves, nor of
rent per unit of reserves.
The price of the nal product aggregates present and anticipated future values
of all relevant economic variables; it, not the shadow price of reserves in situ, is
the best indicator of scarcity. Using (4), (5), and (6) and recalling that
ii
=
ii
e
ri
is the current rent at deposit i, we can express a modied r-percent rule (between
episodes of exploration) as follows,
1

ii
J
ii
Ji
= r
_
D
2
c( :
ii
,

L
ii
)
D
1
c( :
ii
,

L
ii
)
__
g(
ii
)
n(
ii
)
2
ii
g(
ii
)
_
. (37)
This rule applies at individual producing deposits. The current rent at deposit i is

ii
l
ii
. The total current rent for the sector, then, is F
i
=

n
i=1

ii
l
ii
. In this
case, some manipulation usingthe same conditions yields
1
F
i
JF
i
Ji
= r
_
1

n
i=1

ii
l
ii
_

n
_
i=1

ii
l
ii
_
D
2
c( :
ii
,

L
ii
)
D
1
c( :
ii
,

L
ii
)
_
g(
ii
)
n(
ii
)
2
ii
g(
ii
)
_

l
ii
l
ii
_
. (38)
We identify(38) as Hotellings rule, a modied r-percent rule which holds for the
entiresector. Themodicationinvolvesacomplicatedconvexsum, withendogenous
weights, of the deposit-specic terms (and rules) represented in (37). There is no
rule for the rate of growth of aggregate rent in terms of aggregate magnitudes.
Rent is usually proposed as the national-accounts measure of depletion. The
economic denition of depletion is the reduction in the value of the optimal
program due to current exploitation. Indeed, between episodes of exploration,
D
i
4
nn
/

(L
i
, 0, x) =
ii
is the reduction in the expected current value at time i from
exploiting a unit length of deposit i. Therefore, in this model, (current) aggregate
depletion is given by F
i
.
In connection with themeasurement of depletion for thenational accounts, some
authors distinguish the roles of average as opposed to marginal resource rents, and
henceof total resourcerent as opposed to Hotelling rent. Equations (5), (6), and
(9) give a perspective on the attribution of rents. By (5), and (6),

_
q
i
_
:
i
_
n
_

ii
_

2
ii
g
_

ii
__

l
ii
=
ii

l
ii
.
The right-hand side is the rent at deposit i. The left-hand side is the current value
of metal mined less the value of metal at the marginal grade. Hotellings stance
on the issue of rent (as perhaps an oversimplication that, in a dynamic model,
aggregate rent is a determinant of price) is evident in Eq. (7). But the physical
levelsof cut-off gradesareendogenousto theprogram. If theplanner decentralizes
decisions to individual mine managers through quoting present and future prices,
182 cairns and quyen
then each manager could take Ricardos position to argue that price causes rent.
All Ricardian rents(differential rentsrelatingto thesurplusabovethecut-off grade,
to quality :, and to depth L) are incorporated into the rents which sum to the
Hotellingrent.
By the generalization of (9), however,
r4
n, n
/

= u
_
q
i
_

_
c
_
:
ii
,

L
ii
_
F
i
= n
_
q
i
_

__
:
ii
D
1
c
_
:
ii
,

L
ii
_
c
_
:
ii
,

L
ii
__
.
Consumers surplus plus what Cairns [6] refers to as rent due to technological cost
conditions (reecting decreasing returns to scale) is equal to interest on the value
of the objective. These rents can be consumed without affecting Hicksian income.
Total surplus is equal to the sum of these surpluses and resource rent. This is
consistent with the identication of resource rent as the measure of depletion in
this model.
Adelman [1] observes that depletion is not easily dened if, for whatever rea-
son (such asmonopolistic behavior), an optimal programisnot beingfollowed. The
formal equivalence of the problems for a social planner and a monopolist allows
immediate reection on the actions of a monopolist. A monopolist would tend to
discourage consumption by charging a higher price than optimal early in the pro-
gram, therebyappearingto have interests aligned with conservationists. Some have
called this effect Solows paradox, as Solow[23] noted it in reference to Hotelling
[12]. But a monopolist will have a nonoptimal pattern of exploration and level of
recovery of the resource. Hotelling himself cautioned conservationists against fa-
voringmonopoly for its slower rate of exploitation.
In challengingeconomists approach goingback to Hotellings [12], Adelman [1]
reasonsthat, at themargin, explorationcost, user cost, andpricenet of development
cost areequated. Our model formalizeshisintuition. By(36), at anexplorationdate
, exploration cost is equal to the expected jump in the value of the objective,
K =
_

0
4
n1, n
/
1
1,
_
L
/
s
, 0, x
/
_
]

() J 4
n, n
/

_
L
s
, 0, x
_
.
Bythedenition of F
i
andthegeneralization of (26), user cost istherateof change
of the objective due to depletion of the mines,
F
i
=
_

ii
l
ii
=
_
D
i
4
n, n
/

_
L
i
, 0, x
i
_
l
ii
.
Price obeys the relation
q
i
(q
i
)
_
:
ii
D
1
c
_
:
ii
,

L
ii
_
=
_
D
i
4
n, n
/

(L
i
, 0, x
i
)l
ii
.
Adelman calls existing oil deposits an inventory, to which additions through explo-
ration are continually being made. It is possible to viewboth known deposits held
on the shelf for future production and unexplored cells as types of inventory.
Theseinventoriesaredrawn down through time. Someauthors, such asHartwick
[11], argued that depletion of the type previously mentioned should be a negative
entryin the national accounts, but that additions to reserves should be treated as a
positive entry. Suppose we abstract for the moment fromthe effect of exploration
on knowledge and on changes to values of known reserves (which should also be
treated consistently). Then theoptimal-valuefunction in (36) stressesthat theaddi-
tion to reserves comes at the expense of a reduction in the inventoryof unexplored
cells. These cells are also natural assets, and the exploration of a cell (depletion of
mineral exploration and exploitation 183
an unexplored cell) should be treated as a negative entry in the national accounts,
to an extent offsetting the increase in reserves. As argued by Weitzman [27], the
goal of national income accounting would be, then, to account for changes in the
optimal-value function. Because there is no expected net gain to the program(in-
cluding information), the net contribution is random with mean zero. Thus, the
exploration cost K provides an unbiased estimator of the expected value of direct
contributions of discoveries plus their informational value. In an expected-value
sense, then, treating exploration as an investment captures the full effect of addi-
tions to reserves.
In a stochastic environment, there will be, with probability one, a jump in the
value function at each episode of exploration. The interest on the optimal-value
function at time i has been called by (among others) Weitzman [27] and Hartwick
[10], the equivalent sustained level of the resources contribution to national prod-
uct. With probabilityone, this level will change with exploration so that societywill
continually lurch away fromwhat Weitzman calls the anticipated result.
The way that new knowledge is incorporated into the optimal trajectory helps
to resolve a controversy in the literature. According to Norgaard [16], theoretical
models involvingHotellings rule are valid onlyif resource exploiters are informed;
if they are not, their calculations of rents will be faulty. Rather, the perceived rent
and level of scarcityof resources reect existingknowledgeand theanticipations of
future knowledge. Expected values of unexplored cells are integrated directly into
the measures of scarcity, ( q
i
), of the equivalent sustained contribution to national
welfare, r4
nn
/

, and of depletion, F
i
. Resourcemanagers utilizetheir information to
direct their efforts, therebydeterminingpaths of cost and price. But realizations of
events affect their valuations and change the direction of their efforts. Prospective
modelsmaybevalid in incorporatingwhat isknown about resourcescarcitybut still
may not readily explain economic history (ibid.: 24).
Evenabstractingfromexploration, Hotellingsrulewouldnot bereadilydiscerned
inanaggregateempirical model, however. Thereisno stock effect bywhichcostscan
be expressed as a function of remaining aggregate reserves. Halvorsen and Smith
[9] were unable to conrmpredictions of the theory of nonrenewable resources
using an econometric model with highly aggregated data. Compare also Livernois
and Uhler [15].
Bythesametoken, Levhari and Liviatans [14] depletion effect, bywhich costs are
held to be a function of cumulative extraction, must be interpreted in a subtle way.
In our model, what is depleted is a quantity, L
ii
, at each producing deposit, i, de-
termined alongan optimal path that accountsfor qualitiesand depletion elsewhere.
Although deningL
ii
in the present model is a convenient simplication for math-
ematical purposes, onewould nd it difcult to denean appropriatephysical state
variable at a real deposit. Even in the model, what we called depth for purposes of
illustration is not cumulative production of ore or metal. These are economically,
not physically, dened. In addition, cut-off grades, reserves, and expected rents are
revised upward or downward in response to exploration elsewhere. The model sug-
gests, then, that empirical work on depletion and Hotellings rule using physical
measures may have been done usinginappropriate data.
The ability to vary the cut-off grade gives the planner an additional control. If
discoveriesarenot favorable, theconsequent higher priceimpliesareductionof the
cut-off grade and a higher ultimate level of recovery from known mineralization.
Favorable discoveries allowfor increased current production at lower cost. Choices
184 cairns and quyen
of cut-off gradesand mineclosingsor openingsthehuman contributionmitigate
to an extent the effects of the physical attributes of deposits.
APPENDIX I: PROOFS
Proof of Proposition 3. If the ith reserve is exploited at some time i, then (16)
must hold and we have D
1
c(0, L
is
),|:
i
g(0)| - (0). Conversely, suppose that
D
1
c(0, L
is
),|:
i
g(0)| - (0); we want to prove that the ith reserve will be brought
into production at sometimei. Because( q
i
) (0) asi T, wecan ndatime
(s, T) such that ( q
i
) > D
1
c(0, L
is
),|:
i
g(0)|. Now, if we excavate a disc of ore
of thicknessl > 0andradius fromtheithreserveat time, thentheundiscounted
net social welfare at is u(

],=i
q
]
:
i
n()l)

],=i
c( :
]
,

L
]
) c(
2
l, L
is
).
The derivative of this expression with respect to is
2g():
i
l
_

_
_
],=i
q
]
:
i
n()l
_

D
1
c(
2
l, L
is
)
:
i
g()
_
. (39)
When 0, the expression inside the square brackets in (39) tends to the limit
( q
i
) D
1
c(0, L
is
),|:
i
g(0)| > 0. Hence, (39) is positive when is small; i.e., net
social welfare can be increased by exploitingthe ith reserve some time after .
Proof of Proposition 4. (i) Consider two reserves, i and ], whose qualities satisfy
:
i
- :
]
. There are several possibilities.
(a) If :
i
- :
;
- :
]
, then by Corollary 1(iii), the optimal cut-off depth in
the ith reserve,

L
iT
i
, satises D
1
c(0,

L
iT
i
),|:
i
g(0)| = (0). Because T
i
is the exact
time that all excavation in the ith reserve is terminated, by (5) we must have

_
q
T
i
_
=
D
1
c( :
iT
i
,

L
iT
i
)
:
i
g(
iT
i
)

D
1
c(0,

L
iT
i
)
:
i
g(0)
= (0).
Therefore, ( q
T
i
) = (0). Also, because q
i
> 0for all i - T, we can then conclude
that T
i
= T. Because :
i
- :
]
, we can invoke Corollary 1 to assert that

L
]T
]
>

L
iT
i
.
(b) If :
i
> :
;
, then by Corollary 1,

L
iT
i
=

L
]T
]
= 1.
(c) If :
i
- :
]
- :
;
, then the argument used for the ith reserve in the
discussion of (a) can be applied to the ]th reserve. In particular, T
i
= T = T
]
.
Now, suppose that there are at least two deposits, i and ], with :
i
:
;
- :
]
.
From(a), T
i
= T. Thus, we need to prove that T
]
- T. Dene l
1
= D
1
c(0, 1) =
:
;
g(0)(0). Then :
]
g(
]T
)(0) = l
1
. Therefore, g(
]T
) - g(0), and hence, by
(4) and (5),
]T
= (0):
]
|n(
]T
)
2
]T
g(
]T
)|e
rT
- 0, so that
]T
]
- 0 and

]T
]
> 0, as T
]
T. Suppose that l
]T
]
> 0. Then :
]T
]
> 0 and hence, by (4),
( q
T
]
JT
):
]
n(
]T
]
)
2
]T
]
D
1
c(:
]T
]
, 1) > 0. Clearly, it would be protable to set
aside Jl -- l
]T
]
until T
]
Ji, for then (lettingJ: =
2
]T
]
Jl),

_
q
T
]
JT
_
:
]
n(
]T
]
) Jl
2
]T
]
D
1
c(J:, 1) Jl >
]T
]
e
r(T
]
JT)
Jl,
by the strict convexity of c in :. Clearly, l
]T
]
> 0 is not optimal, and so :
]T
]
= 0.
Now, by (4) and then the denition of n and (5), at any time, i, for any deposit,
e
ri
( r) = :n: n2 l
1
= :n. (40)
mineral exploration and exploitation 185
Also, by (3) and the fact that :
]T
]
= 0, we can dene l
2
= D
2
c(0, 1) =
]T
]
e
rT
]
.
Suppose that T
]
= T. For ease of exposition we drop subscripts, on the under-
standing that, unless noted, variables refer to deposit ] at time T. Then, by (5),
:g = l
1
. We solve (40) to obtain :n( r) = l
2

2
l
1
r. Then,
l
1

_
1
g
_
= : =

2
l
1
r l
2
n( r)
-
l
1

2
n
_
.
This contradicts the fact that n
2
g. Therefore, T
]
- T. A similar proof shows
that, if :
l
> :
]
> :
;
then T
]
> T
l
, by substitutingD
1
c(0, 1),|(q
T
l
):
]
| for l
1
.
(ii) Let us now assume that the extraction-cost function has the formgiven
by(1). Then Eq. (9) holds at each point in time before T, and, in particular, at the
initial time, s, we have
n
_
q
s
_
= u
_
q
s
_
q
s

_
q
s
_
= r+
n
(L
s
, s, x). (41)
Now observe that +
n
increases if L
is
decreases or if :
i
increases. Also observe
that as L
is
0 and :
i
1, the mineral in any disc of ore (l, ), l > 0, > 0,
extracted from this deposit becomes very rich, and its extraction cost remains at
c(
2
l, L) at any given depth, L. Suppose that the richness of the other ore-
bodies is such that n( q
s
) - r+
n
(L
,i, s
, 0, s, x
,i
, :
;
), where, for any vector, u =
(u
1
, . . . , u
n
), u
,i
= (u
1
, . . . , u
i1
, u
i1
, . . . , u
n
). By (41), if D
1
c(0, L
is
),|:
i
g(0)| -
|n
1
(r+
n
(L
,i, s
, 0, s, x
,i
, :
;
))|, then theith reservewill bebrought into production
immediately. If D
1
c(0, L
is
),|:
i
g(0)| > |n
1
(r+
n
(L
,i, s
, 1, s, x
,i
, :
.
))|, then the ith
reserve will not be brought into production immediately.
Proof of Proposition 5. By Theorem1, the family of distribution functions asso-
ciated with ]

(), namely, (I

), is stochastically decreasing in and increasing

in . Hence, by Theorem 2.1 of Fishburn and Vickson [8], . !
1

is strictly
decreasingand . !
1

is strictly increasing.
Proof of Lemma 1. Suppose that at some time i s, when the proven re-
serve was mined to depth L
1i
, one decides to explore the second cell, and one
nds a reserve of quality :
2
. Then the discounted social welfare from i onward
is +
2
(L
1i
, 0, i, :
1
, :
2
). Because of the concavity of the welfare function, u(q), we
must have
+
2
(L
1i
, 0, i, :
1
, :
2
) +
1
(L
1i
, i, :
1
) +
1
(0, i, :
2
).
SubtractingKe
ri
fromboth sides and recallingthe result following(7), we obtain
+
2
(L
1i
, 0, i, :
1
, :
2
) Ke
ri
+
1
(L
1i
, i, :
1
) e
ri
|+
1
(0, 0, :
2
) K|. (42)
Takingthe expected value of (42) with respect to the distribution of
2
, we obtain
_

0
+
2
_
L
1i
, 0, i, :
1
, (
2
)
_
]

(
2
) J
2
Ke
ri
+
1
(L
1i
, i, :
1
) e
ri
_
!
1

K
_
. (43)
The left-hand side of (43) is the expected discounted social welfare, net of explo-
ration cost, fromi onward if one decides to explore the potential reserve at time
i. This expected discounted social welfare will be no greater than +
1
(L
1i
, i, :
1
) if
!
1

K. Thus, when !
1

K, one should never explore the cell.

186 cairns and quyen
Next consider the case !
1

> K, and suppose that one decides never to explore

the cell. The optimal discounted welfare is +
1
(L
1i
, i, :
1
). Since metal output will
be near zero if i is in a left neighborhood of T
1
, social welfare discounted to i
will be strictly less than !
1

K. At i, if one abandons the proven reserve and if

one explores the remaining cell, then the expected net discounted social welfare
is !
1

K. The decision never to explore for the potential reserve is clearly not
optimal.
Proof of Corollary 3. Assuming that the rst cell is in production at s, (26)
gives ( q
s
) = D
1
c(:
1s
, L
1s
),|:
1
g(
1s
)|. Let q
1s
be the quantity produced at s if
there is only a reserve of quality :
1
at depth L
1s
and no unexplored cell. Then
q
1s
q
/
1s
= n
1
|r+
1
(L
1s
, 0, :
1
)|, and ( q
1s
) ( q
/
1s
). Let :
2
betheexpected value
of :
2
under ]

(); i.e., :
2
=
_

0
()]

()J. If :
2
- D
1
c(0, 0),|g(0)( q
1s
)|
D
1
c(0, 0),|g(0)( q
/
1s
)|, then it is expected that a newly discovered deposit will not
contribute to production at s. Therefore, K will not be incurred until some time
> s.
Proof of Proposition 11. Suppose that !
1

> K. If N = 1, then the expected

value net of exploration cost is !
1

K. If N = 2 and only one cell is explored,

then the net expected discounted social welfare is !
1

K. However, depending
on the quality of the reserve found in this cell, one might nd it advantageous to
explore the second cell as well. Hence, the expected net discounted value of a two-
cell region, !
2

K, is strictly greater than !

1

K. Furthermore, we can show

that !
2

K - 2(!
1

K). Let :
1
be the quality of the reserve discovered in cell
1. Depending on the value of :
1
, it might or might not be optimal to explore cell
2. If it is decided that cell 2 should be abandoned, then the discounted welfare is
+
1
(0, 0, :
1
) K. On theother hand, if it isoptimal to explorecell 2at somefuture
time , then the contribution to discounted welfare derived fromthe deposit found
is bounded above by
e
r
_
+
1
(0, 0, :
2
) K
_
. (44)
In (44), :
2
is the quality of the deposit discovered in cell 2. Because the welfare
function u(q) is strictlyconcave and because the second reserve might be exploited
simultaneously with the rst reserve during some time interval, the contribution to
social welfare by the second reserve is never greater than the discounted welfare it
yields when it is the only one exploited.
Nowrecall that, given , the uncertain qualities of the potential reserves in the
two cellsareindependent exponential randomvariableswith parameter , andtheir
joint densityfunction is ] (
1
[)] (
2
[). Hence, given and :
1
, the contribution to
discounted welfare of the second is either nil or bounded above by the expected
value of (44), taken with respect to the probability mass function ] (
2
[), or
e
r
_
_

0
+
1
(0, 0, (
2
))] (
2
[) J
2
K
_
. (45)
The expected value of (45) with respect to the prior density of is
e
r
_
_

0
_
_

0
+
1
(0, 0, (
2
))] (
2
[) J
2
_
g

() JK
_
=e
r
(!
1

K). (46)
Therefore, the expected contribution to welfare from the second cell is bounded
above by the right-hand side of (46).
mineral exploration and exploitation 187
Proof of Theorem 2. (i) For n
/
given n, a simple induction argument serves.
For n given n
/
, use induction backward fromn n
/
proven cells (or n l proven
cells if exploration is abandoned after the lth attempt), notingthat
4
nn
/
1, 1

(L
s
, s, x
s
) = max
_

_
_

n
/
s
_
u
_
q
i
_

nn
/
1
_
i=1
c
_
:
ii
,

L
ii
_
_
Ji e
r
n
/
K

_

0
+
nn
/
1
_
L
s
, 0,
1
, x
s
, ()
_
]

() J
_

_
,
and an analogous formula holds if l - n
/
.
(ii) We dene
.
n1
implicitly by !
n
/
1
1,
.
n1
= K if there is a for which
!
n
/
1
1,
- K, and 0otherwise. Clearly, if ( q
/

)g(0) :
n1
D
1
c(0, 0), then wehave
a loose upper bound for
;
n1
, namely,
1
( :
n1
). The argument basically follows
that of Proposition 9.
(iii) Since, andhence:, iscontinuouslydistributed, theprobabilityof realiz-
inganyparticular valueiszero. Therest of theargument followsthat of Proposition
7 almost verbatim.
(iv) Fixn andtheboundaryconditionsat times. Let
n
/
1
bethetimeat which
the(n
/
1)th cell isexplored. Asargued in theproof of Proposition 11, bythestrict
concavity of u(q), at time s, 4
n, n
/
1

is bounded above by 4
n, n
/

e
r
n
/
1
|!
1

K|.
But,
n
/
1

n
/ . Hence, the bounds become progressively tighter as the number
of cells increases. Indeed, 4
n, n
/
1

4
n, n
/

4
n, n
/

4
n, n
/
1

; otherwise, noting the

strict concavity of u(q), expected social welfare under 4
n, n
/

could be increased by
rearranging anticipated production fromthe (n n
/
)th cell to coincide with what
would be anticipated from the (n n
/
1)th cell under 4
n, n
/
1

, contrary to the
optimality of 4
n, n
/

.
APPENDIX II: TABLE OF VARIABLES
i time
: quality of a deposit
distance of miningfromaxis; 0 1
g() grade at distance
n() metal content out to
l thickness of disc of ore mined
: volume of ore mined,
2
l
L depth of miningfromsurface; 0 L 1
c(:, L) miningand processingcost
D
i
differential operator wrt ith argument of function
b(L) unit cost at depth L in proportional cost function
q
i
quantity mined at deposit i, :
i
n(
i
)l
i
q total quantity mined in sector,

q
i
(q) inverse-demand function
u(q) utility function
r discount rate
+
n
objective function when there are n deposits
T
i
time at which deposit i is closed forever
188 cairns and quyen
T time at which miningceases, max
i
T
i
H(L, l, , , i) Hamiltonian

i
discounted shadowprice of miningdepth at deposit i

i
current shadowprice of miningdepth at deposit i
:
.
quality belowwhich mineralization is never mined
:
;
quality above which mine is exploited to depth L = 1
K cost of exploringa cell
randomvariable representingan index of deposit quality
function relating and :: : = ()
parameter of exponential distribution of quality
, parameters of gamma distribution used in updating
!
n

discounted value of n unexplored cells when there is no

proven reserve
n(q) consumers surplus, u(q) q(q)
4
i]

objective function; i proven reserves, ] unexplored cells

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