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    NATURAL RESOURCE MODELING Volume 12, Number 4, Winter 1999 THE COSTATE VARIABLE IN NATURAL RESOURCE OPTIMAL CONTROL PROBLEMS KENNETH 8. LYON Economics Department Utah State University Logan, UT 84322-3530 E-mail: KLYON0B202.usu.edu ABSTRACT. In this paper we discuss the role of the costate variable (shadow value) for the resource stock in both nonrenewable and renewable resource problems. We separate the information in this variable into a scarcity and a cost effect. The scarcity effect is the portion of the shadow value that is due just to the scarcity of the resource relative to its demand, while the cost effect is a measure of the impact of the marginal unit upon future extraction costs. It is shown that in the nonrenewable resource, mining, problem both can exist simultaneously, but in the renewable resource, fisheries, model the two effects are mutually exclusive. In our analysis of the fisheries model we develop an expression for the time path of the marginal unit of fish stock. We do this using the theorem of Continuous Dependence on Initial Conditions. ‘This result is then used to generate the conclusion that 9! («) is the biological own rate of interest, where g(z) is the growth function for the resource stock, x. In this paper we discuss the role of the costate variable for the re- source stock in both nonrenewable and renewable resource problems. We also discuss information about this variable. The costate or auxil- iary variable of optimal control problems and Lagrange multipliers of nonlinear programming problems have similar characteristics. Both of these optimization problems can be viewed as applications of a Gener- alized Kuhn-Tucker Theorem for vector spaces (see Luenberger (1969, pp. 239-257]); hence, both the costate variable of optimal control the- ory and the Lagrange multipliers of nonlinear programming are Gen- eralized Lagrange multipliers. They are elements of the dual (vector) space of the constraint (vector) space, and they are implicit prices, shadow prices, or shadow values. Applying the envelope theorem to the nonlinear programming problem reveals that the Lagrange multi- plier is the rate of change of the solution value of the objective function Copyright ©1999 Rocky Mountain Mathematics Consortium 413 414 K.S. LYON with respect to the constraint value; hence, it is the value of relaxing the constraint by one unit. Applying the generalized envelope theo- rem to the optimal control problem identifies the costate variable as the rate of change of the optimal value of the objective functional with respect to the constraint value; hence, it is the value of relaxing the constraint by one unit. They are implicit or shadow values in that the Generalized Kuhn-Tucker theorem implies the existence of them at the optimum. For an alternative development. of these conclusions concerning the costate variable, see Clark (1990, pp. 102-107]. We first discuss the costate variable, or shadow value of the resource stock, in the nonrenewable resource or mining problem, and separate the information in this variable into a scarcity and a cost effect. The scarcity effect is the portion of the shadow value that is due just to the scarcity of the resource relative to its demand, while the cost effect is a measure of the impact of the marginal unit upon future extraction costs. Then we do the same things for the renewable resource or fishery problem. Although the association of these two concepts for the mining and fisheries problem is not exact, it is done to show the similarities and differences. Below we first discuss the nonrenewable resource model and then the renewable resource model. We will state the models and identify the symbols and concepts and discuss them. The Nonrenewable Resource Model. The objective of the optimization model is to maximize the present value of the resource stock, which is known with certainty, as are all items in the model. ‘The real interest rate, r, is constant to simplify the exposition. To achieve the objective, we maximize the present value of the net surplus stream, s(t), from the extractions, u(t). We let x(t) give the time path of the resource stock, which has an initial value of x(0) = zo. ‘The extraction cost function is written c(u(t),2(2)), with the following characteristics. Marginal extraction costs are positive and increase with the rate of extraction, c,(u,z) > 0, cuu(u,z) > 0, where the subscripts indicate partial derivatives. These are standard relationships for production costs, and they follow directly from production with a concave production function, which would be implied by the existence of price-taker (competitive) firms. In addition, we posit that not all units of the resource stock are equally easy to extract. Some units THE COSTATE VARIABLE 415 may be deeper in the ground than others. Thus, extraction costs are assumed to increase as the resource stock decreases, cz(u,v) <0. The demand function in inverse form is written as D(u(t)) with the usual negative slope, D'(u)) <0. Net surplus can be written u(t) s(u(t)) = [ D(v) dv — e(u(t), x(t). The problem is to maximize ‘T (1) we | e-"s(u(t)) dt subject to () de/dt=—u(é), 2(0) = a0, given @) u(t) 20, x(t) >0. The current value necessary conditions, for an internal solution, where optimal values are indicated with an asterisk, are: (4a) D(u’(t)) — eu(u*(t), 2*() — w*(t) =0 (4b) “ = rw*(t) + ex(u*(t),2°(4)) (4c) w'(T)a"(T") = 0 (4d) f D(wv) du — c(u* (T*),2*(T*)) — w*(T*)u*(T*) = 0 (4e) = =-u'(t), (0) =e, given. The theorem applied to generate these necessary conditions is given in Long and Vousden [1977, pp. 12-15] and Takayama [1985, p. 655]. The optimal current value costate variable, w*(t), gives the time path of the shadow value of the resource stock. The primary role of the shadow value is to ration the use of the resource between time periods. It does this by insuring that at the margin the resource has the same discounted value in each time period. In addition, as can be seen in equation (4c), at the optimal stopping time, 7”, either the resource stock is exhausted or the terminal shadow value is zero. At the terminal time, as we will 416 K.S. LYON show below, the shadow value is due solely to a scarcity effect; therefore, if the resource stock is not exhausted, it is not scarce and its scarcity value is zero, as expected. The resource stock will not be exhausted if extraction costs rise to a sufficiently high level relative to demand. The optimal stopping time, T*, will be reached when the net surplus (net benefit) of the last time period is zero. This is seen in equation (4d) with w*(T*) =0. The differential equation (4b) with terminal value of w*(T"), has the solution (see Appendix A for the proof). These ideas were introduced by Lebvari and Liviatan [1977]. ‘T" (warm Marerry— [eM Meglut(s),2°(6)) ds ; This is the shadow value of the resource stock at time ¢ and has the role in equation (4a) of rationing the resource stock over time. It is the current value rate of change in the solution value of equation (1) per unit change in the resource stock at time ¢. For time zero this can be stated as OW*/Axo = w*(0). In equation (5), ent" ty (74) is the Scarcity Bffect, and - -[ ee, (u*(s), a*(s)) ds t is the Cost Effect. We have the following three observations: (1) As already discussed, if the resource stock is not exhausted, there will be no scarcity effect, or a scarcity effect can occur only if the resource stock is exhausted. (2) The cost effect approaches zero as approaches T* (CE ++ 0 ast++T*). (3) The cost effect: is zero if c, = 0 for all x, c; = 0. The scarcity effect at time ¢ is simply the terminal scarcity value discounted to the current time ¢, and the cost effect is the present value of the cost: saving associated with the marginal unit of the resource stock. Suppose we were to inject an epsilon unit of resource into the resource stock at time ¢. This will affect the marginal unit all along the optimal path, starting at time t. In doing so, it affects the extraction costs all along the path from time t on. The scarcity THE COSTATE VARIABLE Al7 effect: is the present value of these cost savings, as of time t. For the case where the resource stock is exhausted and cz < 0, the shadow value will contain the present value of the cost savings associated with the marginal unit and the present value of the scarcity effect of that unit. If the resource stock is not exhausted but optimal extractions take place over a positive time period, then the shadow value is due solely to the cost savings. On the other extreme, if c, = 0, then the shadow value is due strictly to scarcity. For the case where c, < 0 and the extractions are halted before the resource stock is exhausted, the costs simply become too high to warrant further extractions. In this case it is not the scarcity that rations the extractions of the resource, instead it is the extraction costs. We now discuss the shadow value in the renewable resource model. The Renewable Resource Model. As in the previous model the objective is to maximize the present value of the resource stock, which is known with certainty, as are all items in the model. The real interest rate, r, which is the market rate of interest minus the rate of inflation, is constant to simplify the exposition. To achieve the objective we maximize the present value of the net surplus stream, s(t), from the harvests, h(t). We let a(t) give the time path of the resource stock, which has an initial value of x(0) = a. The harvest cost function is written c(h(2), c(t), with the following characteristics. Marginal harvest costs are positive and increase with the rate of harvest, cp(h,z) > 0, cha(h,£) > 0. In addition, harvest costs decrease as the resource stock increases, cz(h,x) < 0, which is the usual relationship. The demand function in inverse form is written as D(h(t)) with the usual negative slope, D’(h) < 0. Net surplus can be written A(t) s(a(t)) -[ D(v) dv — c(h(t), 2(2)). The objective functional is the present value of net: surplus T 6) we [ ets(h(t)) dt +e"? S(x(T)), 418 K.S. LYON which is to be maximized subject to (2) dex/dt = 9(x(t))— h(t) zo =20, given (8) A(t), c(t) 20 on [0,7], T, given, where g(x) is the growth or reproduction function for fish, S is the terminal value function, and T is the end of the current time horizon. The graph of the growth function, g(x), is assumed to have an inverted “U” shape such as that related to the logistic curve and is assumed to be differentiable. Subtracting from this growth the harvest, h, yields the net growth, dx/dt. The terminal value function, S, can be thought of as a bequest function for the fish stock that is left to the next generation. The end of the current time horizon, T, is assumed to be sufficiently distant that the system will have evolved to the stationary state, the state where da/dt = 0. ‘The current value necessary conditions, for an internal solution, where optimal values are indicated with an asterisk, are: (Pa) D(K(O) ~ ex", 2") — 9" =9 (>) Fate gery) Heel. 2"(0) (94) PD) =S'e"(T) dz’ (94) g(z*(t))—h*(t), 2*(0)=2, given. dt The optimal current value costate variable, p* (t), gives the time path of the shadow value of the fish stock. It is the current value rate of change in the solution value of equation (6) per unit change in the resource stock at; time ¢. For time zero, this can be stated as IW*/8z9 = y*(0). The role of this shadow value, as seen in equation (9a), is to allocate the fish stock between harvests and investment in future fish stock. In addition, we will show below that yp" (t) is the present value of the return stream of the marginal unit of fish stock. This unit is either harvested and consumed or it is not harvested, retained in the fish stock; hence, for this latter alternative it will have a return stream associated with it. To gain information about y*(t) we examine equation (9b). This differential equation with terminal value of y*(T) = S"(x*(T)) has the THE COSTATE VARIABLE 419 solution (see Appendix B) p(t) = elt 4 fF 9") ds] (7) a - [ve [-re-9+ fF "oD 44] 6 (#(5), w*(s)) ds. F In this, Tet el -O+ JP oe (00) 48] 5+ 7) is the Scarcity Effect given that c, = 0 and -[ ebro fe g'(w" (u)) au) -a(h* (8), 2°(s)) ds t is the Cost Effect given that T is large. In the fishery model, the scarcity effect exists, if and only if, cx(h, 0 for all x (cp =0). In addition, the cost effect exists, if and only if c,(h,x) # 0 for at least some relevant values of 2; thus, these are mutually exclusive effects. This is very different from the mining model where the shadow value can be split between the two effects. In explaining this difference, the important distinction between the fishery and mining models is the optimal stopping time in the mining problem. In the fishery problem “T can be selected arbitrarily, so we can select, “I” large enough that the term labeled scarcity effect is nil, pushing everything into the cost effect. We note that g/(x*(t))

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