Optimal resource extraction under stochastic terms of trade

Abstract

This paper examines the optimal extraction of an exhaustible resource owned by a small open economy, when the terms of trade faced by this country follow an exogenous given time path that is subject to stochastic fluctuations. First, we will see that if the functions involved in the first-order conditions are non-linear, the optimal extraction path is changed due to uncertainty. A ‘certainty-equivalence’ solution would not bring out this result. Second, the ability of this country to withhold production in times when it's not profitable to deplete the resource (due to stochastic fluctuations of the terms of trade), provides an incentive to slow down the rate of production under uncertainty.