The incentive effect in share contracts: The case of finite resources

Using share contracts is a universal response to exchange under uncertainty. However, the benefits of share payments are tempered by their negative moral hazard incentive effects. By incorporating geological considerations into the producer's wealth-maximizing decision problem, this paper demonstrates these incentive effects in the case of nonrenewable resources. This paper also develops an expression for estimating the size of the incentive effects in the case of petroleum production. This expression shows that underproduction is a function of the royalty rate used and certain reservoir characteristics that can be easily estimated from publicly available data. Using such data, this paper demonstrates that such production loss can be a significant portion of cumulative production. (JEL Q20).