Render Onto Hotelling or to Knight: Equilibrium Exhaustible Resource Price Dynamics with Ambiguity Aversion

Abstract

Most of resource extraction and pricing models assume that risks are known with certain. However, empirical studies show that implausible high degree of risk diversification is needed to rationalize a Hotelling/Capital-Asset-Pricing model of exhaustible resource. Many choice situations feature Knight uncertainty (i.e., ambiguity or uncertainty about risk) rather than the pure risk. We present an exhaustible resource pricing model with recursive multi-priors utility in continuous-time that demonstrates the effect of ambiguity aversion on resource extraction and pricing. To investigate the pricing problem under various market structures, we discuss not only a competitive market with homogeneous producers, but also a competitive market with heterogeneous producers. Results show that other than the famous Hotelling rule the ambiguity aversion also contributes to the exhaustible resource pricing. This explains the relative high excess return that has been empirically observed in the Hotelling/Capital-Asset-Pricing model of exhaustible resource. In other words, render unto Hotelling that which belongs to Hotelling and render unto Knight, that which belongs to Him.