EXHAUSTIBLE RESOURCES,LEARNING, AND THE THEORY OF THE SECOND BEST

We formulate and characterize the solutions to optimal control models of social welfare maximization in a resource industry composed of two parts — conventional, with unit cost that increases with cumulative production, and backstop, whose unit cost decreases with cumulative production, due to learning. Since marginal cost pricing leads to losses in backstop operations, we consider three “second best” constraints that ensure non-negative profits. These constraints introduce distortions away from marginal cost pricing. Two constraints cause a discontinuous upward jump in price at the time of transition from conventional to backstop, and a supply side distortion-violation of cost minimization to meet demand.